Bair and Reserves for All

I think the Fed's new Overnight Reverse Repurchase Facility is great. Sheila Bair, in the Wall Street Journal, thinks it's awful.

I think it will enhance the stability of the financial system. She thinks it will lead to instability. Well, at least we agree on the important issue.


What is it? Banks can have accounts at the Fed, called "reserves," and these accounts pay interest. In essence, the new program allows other financial institutions, that aren't legally "banks," to also have interest-paying accounts at the Fed. The program involves repurchase agreements, which is a bit silly -- who needs collateral from the Fed? -- but really think of it just as interest-paying bank accounts at the Fed.

I like the Fed's big balance sheet and interest-paying reserves, and I like opening up interest-paying reserves to everyone. I regard this as the first step to putting run-prone short-term financing out of business, by giving depositors a safe alternative. The Federal Government drove run-prone private banknotes out of business in the 19th century. Interest-paying reserves and Treasury floaters can drive run-prone interest-paying money out of business in the 21st. (This is the theme of "Toward a run-free financial system")  Interest-paying money is not inflationary.

Bair does not like it. She is a voice worth hearing.

The mere existence of this facility could exacerbate liquidity runs during times of market stress. ... Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers. 

...Banks could confront a sudden outflow of deposits, particularly those which are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer.

Ok, a crisis is defined exactly as a time in which investors want to take money out of private short-term debt and hold money -- now reserves. The Fed facility allows them to do that. But, without the Fed facility they can do it the old fashioned way -- put it in banks (preferably, for the investor, too big to fail banks), and the banks then use the money to buy reserves.

In fact, in the crisis, banks had a sudden inflow of deposits for exactly this reason, and contrary to Ms. Bair's prediction. The Fed's new program just takes the bankruptcy-prone intermediary out of that operation. And desirably so in my view.

And she forgets that in the end even reserves are backed by Treasuries. Reserves are Fed liabilities. The corresponding assets are ... Treasuries. (Well, and MBS, but let's not get too complicated here.) If money on net flows in to the Fed, either as reserves or through this new program, the Fed must go off and buy Treasuries. If the Fed does not, the quantity of reserves must decline dollar for dollar with expansion of this new program.

She mentions deposit insurance which is interesting. There is a limit to this business of putting money in to banks who put it in to reserves, giving perfectly safe interest-paying money, and that is deposit insurance. Overnight repo developed in may ways to provide a safer version of "deposits" in quantities larger than deposit insurance allows. And lending to the Fed directly allows for money to flow in to Treasuries without (unneeded in this case) deposit insurance limits too.

But so would holding a money market fund entirely invested in short term Treasuries. Large institutions can also just buy Treasuries directly. Which is exactly what they did in the crisis, driving up prices and down rates -- exactly the opposite of Ms. Bair's prediction.

A flight to quality is a flight to Treasury debt, directly, intermediated by the Fed, or intermediated by the Fed and then by banks.

Treasuries -> Fed -> Banks -> Deposits -> Investor

Treasuries -> Fed -> Investor

Treasuries -> Investor

It's just a question of how many intermediaries are in the way.

Now, Ms. Bair has a more interesting point. By providing an elastic supply of Treasury debt, including cash, intermediated or not, the Government facilitates the "flight to quality." She is advocating that the government stop doing it -- deliberately introduce financial frictions so that investors must hold the private short-term debt that they no longer want.

In that, she is advocating  a radical new approach to financial crises. Since about the mid 1800s in the UK and since the founding of the Federal Reserve in the US, our approach to financial crises has been to drown the system in money.  Bagehot's "lend freely" means exactly what Ms. Bair is decrying, allow investors to hold a vastly expanded amount of government liabilities -- money, reserves or treasuries -- and the government (mostly Fed, but Treasury too) in turn buys their assets or supplies the short term lending they no longer want to do.

Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender. 

Yes! Exactly as Bagehot, Friedman, and Bernanke said to do!

If you force people to hold something they don't want, then prices, not quantities adjust. As in the crisis, government interest rates hit zero (prices shot up as far as they could) and private rates shoot up (prices collapsed).  A massive demand for money (government short term debt), if not accommodated, leads to deflation. Like in the Great Depression.

Let prices adjust you may say, and perhaps everyone from Milton Friedman to Ben Bernanke who says otherwise is wrong to flood the market with government debt and try to stabilize prices and interest rates. I'm not arguing yes or no here, but recognize the plan for its far-reaching audacity.

The reverse repurchase facility also seems to be at cross-purposes with Congress's efforts to contain the government safety net. After many years of consideration, Congress in 2008 reluctantly gave the Fed authority to pay banks interest on the money they keep on deposit with it. The reverse repurchase facility essentially gives large nonbank financial institutions the routine ability to place money in the functional equivalent of an overnight deposit with the Fed and receive interest. 

Exactly! But this is not a "safety net." In the 1800s Congress also allowed non-banks to hold Federal Reserve Notes, the same thing but that does not pay interest, rather than hold notes issued by banks. The world did not end. We're just doing the same thing with interest-paying money.

Finally, the reverse repurchase facility seems to be at cross-purposes with the Fed's own efforts to address systemic risks emanating from money-market funds, which were subject to disruptive runs after Lehman Brothers collapsed in September 2008. Market pressure should be causing this unstable sector of the financial system to shrink, particularly in today's near-zero interest-rate environment. But by giving money funds a de facto insurance program, the Fed has thrown them a lifeline.

Here Ms. Bair is making another fundamental mistake in my view. Money market funds that hold government debt are completely safe and run-proof. What failed in 2008 were "prime" money market funds that held short term debt issued by risky banks and other financial institutions. Those institutions could not suddenly switch to holding interest-paying reserves, because they'd have to sell all their worthless paper first. The Fed (and SEC) should be loudly encouraging money market funds that hold Treasuries. Because those institutions are exactly the same thing as the Fed's new program!

Lucas and Sargent Revisited

The economics blogosphere has a big discussion going on over Bob Lucas and Tom Sargent's classic "After Keynesian Macroeconomics." You can start at Simon Wren-Lewis, Mark Thoma here and here and work back through the links.

A few thoughts here, as it bears on my WSJ oped from last week and my last post on EFG and how we do macro.

1. Views of Keynesian economics

Re-reading this paper, you will be struck about how much Lucas and Sargent praise Keynesian models, which you'd think it is their purpose to destroy.

They called the Keynesian revolution a "remarkable intellectual event." they continued

... some of its [Keynesian Revolution] most important features: the evolution of macroeconomics into a quantitative, scientific discipline, the development of explicit statistical descriptions of economic behavior, the increasing reliance of government officials on technical economic expertise, and the introduction of the use of mathematical control theory to manage an economy. 

Keynesian theory evolved from a disconnected, qualitative talk about economic activity into a system of equations that can be compared to data in a systematic way and which provides an operational guide in the necessarily quantitative task of formulating monetary and fiscal policy. 

neither the success of the Keynesisan Revolution nor its eventual failure can be understood at the purely verbal level at which Keynes himself wrote...

The Keynesian economics they are praising here is not Keynes' book -- one of those big muddy things that people are still writing "what did Keynes really mean" articles and books about nearly a century later -- but the subsequent quantification effort: Hick's creation of the ISLM model, its elaboration into computer models, estimation of those models, and the use of those models to make quantitative forecasts of the effects of policy interventions.

"Quantitative, scientific discipline," and "technical economic expertise" means we analyze policies by real models, not the opinions and judgments of famous economists turned public officials.

Yes, "mathematical control theory." Most readers will be too young to remember, but in the early 1970s academic journals were dynamic optimal control applied to simulations of large-scale Keynesian models.

Their goal was quite conservative: they wanted to preserve this great achievement:

The objectives of equilibrium business cycle theory are taken, without modification, from the goal which motivated the construction of the Keynesian macroeconometric models: to provide a scientifically based means of assessing, quantitatively, the likely effects of alternative economic policies. 

2. What was their basic criticism of Keynesian economics?

Lucas and Sargent make a two-pronged argument, one about theoretical coherence and the other about the grand econometric failure of Keynesian models.

As I see it, the main characteristic of "equilibrium" models Lucas and Sargent inaugurated is that they put people, time, and economics into macro.

Keynesian models model aggregates. Consumption depends on income. Investment depends on interest rates. Labor supply and demand depend on wages. Money demand depends on income and interest rates. "Consumption" and "investment" and so forth are the fundamental objects to be modeled.

"Equilibrium" models (using Lucas and Sargent's word) model people and technology. People make simultaneous decisions across multiple goods, constrained by budget constraints -- if you consume more and save more, you must work more, or hold less money.  Firms  make decisions across multiple goods constrained by technology.

Putting people and their simultaneous decisions back to the center of the model generates Lucas and Sargent's main econometric conclusion -- Sims' "incredible" identifying restrictions. When people simultaneously decide consumption, saving, labor supply, then the variables describing each must spill over in to the other. There is no reason for leaving (say) wages out of the consumption equation. But the only thing distinguishing one equation from another is which variables get left out.

People make decisions thinking about the future. I think "static" vs. "intertemporal" are good words to use.  That observation goes back to Friedman: consumption depends on permanent income, including expected future income, not today's income. Decisions today are inevitably tied to expectations --rational or not -- about the future.

The lack of budget constraint (or the "missing equation" and "Walras' law" issues much studied in earlier Keynesian literature) strikes me as another big conceptual and methodological difference between Keynesian models and equilibrium models, which flows from putting people rather than aggregates at the center of analysis.

Notice when you read any textbook that the microeconomic "demand" suddenly becomes the macroeconomic "plan." Why is that? Because demand curves respect budget constraints even at off-equilibrium prices. "Plans" like consumption equals c bar plus alpha times income do not respect any stated budget constraint.  You're allowed to say you want to consume and save more than income allows.

Optimization, rational expectations, and flexible prices are the ballyhooed centerpieces of the first round of equilibrium models to follow Lucas and Sargent, such as Kydland and Prescott's famous "time to build" model and the subsequent "real business cycle" models (examples: Bob King and Sergio Rebelo, John Long and Charles Plosser). But I don't think these ingredients are central to the program. The "new-Keynesian" (or, better, DSGE) school put in sticky prices with all the other Lucas-Sargent ingredients, and thus under the "equilibrium" banner.  Mike Woodford's "Interest and prices" is aimed proudly at that program. Sticky wages, distortions, and so on are just as  often included.

Simon Wren-Lewis questions  whether Lucas and Sargent were really focusing on empirical failure or methodological critique. He suggested that accelerationist Phillips curves, though adapted after the failure and thus appearing a bit as epicycles, can account for the data. (Lucas and Sargent: "In economics as in other sciences,...there is always the hope that if a particular specific models fails one can find a more successful model based on roughly the same ideas.")

I think Simon is a bit too blasé about how easy this modification is. Not only did inflation accelerate far faster than Keyensian models of the 1960s predicted, inflation dropped like a stone in 1982, far faster than  Keynesians thought possible based on adaptive expectations views. (If someone can find the quote from Samuelson in the early 1980s predicting decades of depression to wring out inflation, please add to the comments.) Proud as some self-identified Keynesians are about how well they think their unwritten, unquantified "model" fits the current recession, deep unemployment with no movement in inflation fits no Phillips curve that was actually written before the crisis. Infinite wage stickiness is an ex-post invention too, and still just a verbal debating point.

But the paper is really clear that empirical failure matters deeply to Lucas and Sargent. They said that

A key element in all Keynesian models is a trade-off between inflation and real output: the higher is the inflation rate, the higher is output (or equivalently, the lower is the rate of unemployment). For example, the models of the late 1960s predicted a sustained U.S. unemployment rate as consistent with a 4 percent annual rate of inflation. Based on this prediction, many economists at that time urged a deliberate policy of inflation. [plus ça change...]... policy in this period should, according to all of these models, have produced the lowest average unemployment rates for any decade since the 1940s. In fact, as we know, they produced the highest unemployment rates since the 1930s. This was econometric failure on a grand scale. [My emphasis]

Here as elsewhere, they said "econometric," not economic. They meant it.

Everyone was perfectly aware of the lack of "microfoundations" of Keynesian models, and the 50 year fruitless search for such foundations. But so long as the models worked, that had no real impact on their use for the "scientific" and technical policy advice Lucas and Sargent so admired.

And rightly so. Chemistry, until the last few decades, lacked "microfoundations" in quantum mechanics, first because nobody knew quantum mechanics, and later because working out how chemicals react from first principles was too hard. That did not stop chemistry from being a perfectly viable science. Biology, until the last few decades, lacked "microfoundations" in chemistry.

But chemistry and biology worked pretty well. Lucas and Sargent pointed to, and needed to point to, a grand empirical failure.

And that failure had to be accompanied not just by "well, these are reasonable rules, but they're not microfounded." The failure had to be accompanied by showing how the Keyensian model was logically flawed. That failure had to be accompanied by a better theory, which showed why the Keynesian equations were inconsistent with basic economics. That better theory had already predicted Keynesian model's  failure -- Friedman 1968, Phelps, and Lucas' prediction that the Phillips curve would shift if exploited. That is a lot more than "methodological purity."

3. So what happened?

As I survey the landscape now, it is interesting how much of the macroeconomics Lucas and Sargent praised has vanished. Quantitative, scientific discipline? Explicit statistical descriptions of economic behavior? Reliance of government officials on technical economic expertise?  The use of mathematical control theory to manage an economy? All that has vanished.

The sub-basements of central banks have big DSGE models, or combined models where you can turn Lucas and Sargent on and off. But I think it's fair to say nobody takes the results very seriously. Policy -- our stimulus, for example -- is based on back of the envelope multipliers and the authority and expertise, if you're charitable, or the unvarnished, verbal, opinions if you're not, of administration officials.

There are some large-scale empirical DSGE models left in academia too. But the vast bulk of policy analysis does not use them, as they did, say, the models of 1972. At conferences and in papers, academic work uses small scale toy models and a lot of words. Models do not seem to be cumulative. Each paper adds a little twist ignoring all the previous little twists.

A complete split occurred. "Equilibrium" models, in which I include new-Keynesian DSGE models, took over academia. The policy world stuck with simple ISLM logic -- not "models" in the quantitative scientific tradition Lucas and Sargent praised -- despite Lucas and Sargent's devastating criticism.   And, as I remarked in the earlier blog posts, the "purely verbal" or literary style of analysis is becoming more and more common now in academia as well as policy.

I'm not complaining about good vs. bad here. I write simpler and simpler models as I grow older, and spend more time thinking and writing about what those equations mean. It just is a fact about how we do things today and the "scientific," quantitative status of macroeconomics.

Lucas and Sargent's last sentence:

Unless the now evident limits of these models are also frankly acknowledged and radically different new directions taken, the real accomplishments of the Keynesian Revolution will be lost as surely as those we know to be illusory. 

Academic economics took the first half to hart. Policy economics froze in place. But Lucas and Sargent's "real accomplishments" were lost, or at least consciously abandoned, anyway.

PS: Lucas and Sargent have a delicious quote about Keynesian's loss of faith in their own model, as applicable now as then:

The current wave of protectionist sentiment directed at "saving jobs" would have been answered ten years ago with the Keynesian counterargument that fiscal policy can achieve the same end but more efficiently. Today, of course, no one would take this response seriously, so it is not offered. Indeed, economists who ten years ago championed Keynesian fiscal policy as an alternative to inefficient direct controls increasingly favor such controls as supplements to Keynesian policy. 

Summer Institute

I just got back from the NBER Summer Institute. The Economic Fluctuations and Growth meeting organized by Larry Christiano and Chad Jones sparks some thoughts on where macro is and where we're going. (I also attended the monetary economics and asset pricing meetings, which were excellent and thought provoking too, but one can only blog so much.)

Review:


There were two papers on macro theory. Fist, the conference started with Gauti Eggertsson and Neil Mehrotra's "A Model of Secular Stagnation," which I discussed, slides here.

I think it's an important paper. The standard simple New-Keynesian model has a lot of trouble to produce a steady slump with positive inflation.  So if you want "secular stagnation," you need a new model. I also have a lot of trouble with the "negative natural rate." It tends to be a deus-ex-machina, output is lower than I'd like so the natural rate must be negative.  It would be much more convincing if we could separately measure the natural rate, but that too needs a model. This paper provides a model whose steady states resemble old fashioned static Keynesian relations, not the dynamic new-Keynesian ones, and a model where one could think about separately measuring the negative natural rate.

"Important" doesn't mean "right" or "conclusive." This model rules out storage, has no money, and hobbles the rate of return on capital, all of which tend to put bounds of zero or above on long-term real interest rates. More thoughts on the slides, which I may write up at more length some day. (Olivier Blanchard discussed the same paper on Friday, bringing in data from around the world. If he posts his slides I'll update.)

Second, Paul Beaudry presented his paper with Dana Galizia, Franck Portier, titled "Reconciling Hayek's and Keynes' Views of Recessions," which Ivan Werning discussed. It was a rather complex model trying to capture overaccumulation and liquidation.

There were two empirical papers. Simon Gilchrist, presented his paper with Raphael Schoenle, Jae Sim, Egon Zakrajsek, "Inflation Dynamics During the Financial Crisis," discussed by  Mark Bils. Companies short of cash in the financial crisis raised prices; companies with a lot of cash lowered them. Clean dynamic model, clean data, a nice bit of the micro data analysis going on in macro these days.

Sarah Zubairy presented her paper with Valerie Ramey, "Government Spending Multipliers in Good Times and in Bad: Evidence from U.S. Historical Data," discussed by Yuriy Gorodnichenko. As Valerie has done before, they regress output on military spending shocks to estimate multipliers. Here the question is whether the effects are larger when there is higher unemployment or a low interest rate, with a bunch of small but important methodological improvements. The conclusion is no, and multipliers a bit below one throughout, but much methodological discussion on how one interprets the facts.

There were two "Growth" papers. First, Roland Benabou presented "Forbidden Fruits: The Political Economy of Science, Religion and Growth" with Davide Ticchi and Andrea Vindigni. The basic idea is that religion blocks or adapts to new ideas, going back centuries. History, going back a thousand years, regressions of patents on religiosity, all building to a big model, with section titles like "Inequality, Religion and the Politics of Science."

Paul Romer "discussed" the paper, i.e. gave a long and thoughtful speech, covering religion, social norms, neuroeconoimcs (Southerners faced with a slight insult have big spikes in cortisol levels compared to Northerners), the shocking rate of incarceration in the US, words vs. equations in economics, and lots more.

Last but certainly not least, Ufuk Akcigit presented "Young, Restless and Creative: Openness to Disruption and Creative Innovations" with  Daron Acemoglu and Murat Alp Celik, discussed by Sam Kortum, The basic idea is that companies with young CEOs are more likely to make radical innovations rather than incremental ones. A complex model precedes regressions of patent citations on CEO age.

Thoughts:

Just how we do economics was a big theme running through all the discussion. Words vs. equations; models and empirical work; and what kinds of things we look at and what kind of work people are doing.

Most of the theory papers had some "motivating" facts. Most of the facts papers and more or less motivating theory. Not one paper wrote down a model, estimated or calibrated its parameters, and compared that model to data.  (Gilchrist came pretty close, but more the exception that proves the rule.) This isn't a complaint, really, it's just where we are. The kinds of things people want to investigate are just too hard to write down models rich enough to take to the data.

This point came up again and again. Sam gently chided Ufuk at al for presenting 24 pages of complex model all to "motivate" some regressions. He suggested that the model should be used to guide and constrain regressions, and to give a more structural interpretation to the parameters. Pat Kehoe, asking a question, complained that it's awfully hard to measure a fiscal multiplier with no guidance of which model for its possible operation. He pointed out that any model restricts how many variables together should respond to a fiscal expansion. For example the static Keynesian model says consumption should rise. The real business cycle model gives a multiplier through impoverishing people, which has joint predictions across consumption, labor, etc. Likewise I complained that in wars, the assumption that everything else is on average equal -- made when regressing output on fiscal shocks -- seems a bit stretched.

Similarly, both of the macro theory papers stopped well short of serious confrontation with data. We didn't see anything like the standard fully specified models of the Larry Christiano type, compared to, say, impulse-response functions.  The models are so stylized you can't begin to quantify them.  (I got off  cheap shot pointing out that secular stagnation required deflation in the model. Since we do not have deflation, case closed. It's a cheap shot because I think the model could be easily modified to have stagnation with low positive inflation.) This too is not really a criticism. I've been working with simpler and simpler models, as I find it hard to keep the intuition and quantitative parable aspect alive as models get more complex. You have to walk before you can run. But questions like, how could Ed Prescott and Ellen McGrattan go off and measure the natural rate, are not yet answered.

A similar issue came up in the paper I discussed for Asset Pricing, Aytek Malkhozov, Philippe Mueller, Andrea Vedolin, and Gyuri Venter "Mortgage Risk and the Yield Curve," slides here. It developed a really nice arbitrage-free model with supply effects. And then used the model only to "motivate" regressions of returns on a measure of duration. Though the regression coefficient is tied to structural model parameters, the authors never made that link at all. Well, the model was perhaps too simple to do that. And, everyone else seems to be writing papers the same way. It's not a criticism, here, but an observation on our emerging culture.

Math vs. literature is a similar theme to atheoretical regressions/models as parables vs. estimates and tests. In my 30 years as an economist, our field has become much more literary and less quantitative. In part that reflects a different emphasis. It's really hard to build towards maximum likelyhood tests of effects of religion on the adoption of new ideas. Paul Romer commented on this at length, with "models vs. words" on his slides. In his view, math is a useful language because it removes much of the value-laden elements of language and forces logic to be out in the open. He linked language to us vs. them, social norms, morality, and those pesky cortisol levels. (I'm doing my best to recall a speech, so forgive me Paul if I don't get it all right.) He pointed to my use of "paleo-Keynesian" to describe the static models from the 1960s, guessing nobody would remember anything else from my discussion. When I complained that Paul Krugman invented the term, he pointed out (correctly) that such borrowing just made its use more rhetorically effective. There go the cortisol levels. I'm not sure in the end though whether Paul was approving or bemoaning the shift back towards literature in economic analysis. Certainly his vision for the future of growth theory, centered on values, social norms, biology, and so forth, does not lend itself easily to quantification.

The use of ancient quotations came up several times. I  complained a bit about Eggertsson and Mehrotra's long efforts to tie their work to quotes from verbal speculations of Keynes, Alvin Hansen, Paul Krugman and Larry Summers. Their rhetorical device is, "aha, these equations finally explain what some sage of 80 years ago or Important Person today really meant."  Ivan Werning really complained about this in Paul Beaudry's presentation. What does this complex piece of well worked out "21st century economics" have to do with long ago muddy debates between Keynes and Hayek? It stands on its own, or it doesn't. (In his view, it did, so why belittle it?)

Yes. Physics does not write papers about "the Newton-Aristotle debate." Our papers should stand on their own too. They are right or wrong if they are logically coherent and describe the data, not if they fulfill the vague speculations of some sage, dead or alive. It's especially unhelpful to try to make this connection, I think, because the models differ quite sharply from the speculations of the sage. Alvin Hansen certainly did not think that a Taylor interest rate rule with a phi parameter greater than one was a central culprit in "secular stagnation." I haven't checked against the speech, but I doubt he thought that inflation would completely cure the problem in the first place.

Sure, history of thought is important; tying ideas to their historical predecessors is important; recognizing the centuries of thinking on money and business cycles is important. But let's stand up for our own generation; we do not exist simply to finally put equations in the mouths of ancient economists.

But, tying it all up, perhaps I'm just being an old fogey. Adam Smith wrote mostly words. Marx like Keynes wrote big complicated books that people spent a century writing about "this is what they really meant." Maybe models are at best quantitative parables. Maybe economics is destined to return to this kind of literary philosophy, not quantified science.

Curious too what was missing. All the macro was decidedly Keynesian. General equilibrium with distortions, anything other than trend on "supply" was noticeable by its absence. So was the discussion. But maybe that's my fault for going to the NBER and not the Minnesota Macro meetings.

A last thought. Economic Fluctuations merged with Growth in the mid 1990s. At the time there was a great confluence of method as well as interest. Growth theorists were studying growth with Bellman equations, dynamic general equilibrium models of innovation and transmission of ideas, thinking about where productivity shocks came from. Macroeconomists were using Bellman equations, and studying dynamic general equilibrium models with stochastic technology, along with various frictions and other propagation mechanisms.

That confluence has now diverged. I enjoyed spending an hour or two thinking about how religion has blocked or adapted to ideas over the centuries, and Paul's view on social norms or neuroeconomics. But I don't really have any expertise to contribute to that debate. Questions like whether young CEOs head more innovative companies, or whether, like deans, what matters is the age of the faculty are a little closer to home, since I spend a lot of time consuming corporate finance. But the average sticky-price macro type does not. Likewise, when Daron Acemoglu, who seems to know everything about everything, has to preface his comments on macro papers with repeated disclaimers of lack of expertise, it's clear that the two fields really have gone their separate ways. Perhaps it's time to merge fluctuations with finance, where we seem to be talking about the same issues and using the same methods, and growth to merge with institutions and political or social economics.

Summer Institute Dining

I'm at the NBER summer institute. By quirk of fate I ended up spending a week here, with my son, so we ended up exploring a lot of local restaurants. There's no NBER wiki for "summer institute restaurants" so we'll start one here. There is now a rent a bike stand right in front of the Galleria which makes getting some places a lot easier.

So, here are our best finds. Use the comments to post yours. Perhaps Cambridge locals will have good suggestions or comments on these.


My tastes run to mid price, small, good food, don't need reservations, and within walking distance, rather than really fancy places and needing to cab to get there. I.e. when at the institute the sort of place that you can grab a few friends and go.

A+ : Helmand, First and Bent street about two blocks from the Sonesta. Afghanistan food, really yummy. The spinach dish stood out. It's a nice quiet spot too.

A+: Courthouse Seafood, 6th street and Cambridge. It's about a mile down Cambridge. Great fish, in a really simple local storefront. This is an order at the back, pick it up, and sit on benches kind of place, not even a restaurant. Clean though, and the staff are really friendly. Did I say great fish? This is what Legal Seafood was in the 1970s.

A+: Trattoria Di Monica, Prince Street, North end. About a mile and a half walk, but worth it. Very small, a bit loud, Italian place, a bit off the track of the huge touristy north end restaurants. You go here for pasta, excellent home-made pasta.

A+ : Tatte Bakery and Cafe', third street just past Binney. About half a mile from the Sonesta. Ditch the hotel, ditch the Starbucks, walk a few blocks and get your annual carbs for breakfast here. The egg dishes and muesli that the people next to us were eating looked great too. Opens at 7.
A-: Fuji at Kendall, 3d and Munroe, about 4 blocks from the Sonesta. Straightforward sushi place, with somewhat Americanized other dishes. Good plain sushi, nothing fancy. Clean modern new restaurant in the Kendall Square style. Very nice service.

Of course when in Cambridge you go for ice cream after dinner. The places have all changed since I was a grad student.

A+:   Toscanini's Main street and Mass. Ave. A bit more than 1 mile from the Sonesta. Nice walk back through MIT

A-:  Christina's in Kendall Square. A longish walk, and not as good as Toscanini's, but worth the variety.

When bored, try the Kayak rental just up the river from the Sonesta. Oh, and the conference is darn good too.

A Legislated Taylor Rule?

John Taylor announces in his blog post, "New Legislation Requires Fed to Adopt Policy Rule'' that today (June 8)

.. the ‘‘Federal Reserve Accountability and Transparency Act of 2014” was introduced into Congress. It requires that the Fed adopt a rules-based policy. Basically, the Fed would have to report to Congress and explain any deviation from a "Reference policy rule,"

The term ‘Reference Policy Rule’ means a calculation of the nominal Federal funds rate as equal to the sum of the following: (A) The rate of inflation over the previous four quarters. (B) One-half of the percentage deviation of the real GDP from an estimate of potential GDP. (C) One-half of the difference between the rate of inflation over the previous four quarters and two. (D) Two.

Wow. John will testify at a hearing at the House Financial Service Committee on Thursday, along with Mark Calabria, Hester Peirce and Simon Johnson. This should be very interesting.

Questions for discussion:


1. What is most interesting about a rule is what it leaves out. Notably absent here is "macroprudential" policy, "financial stability" goals, i.e. raising rates to prick perceived asset price "bubbles" and so forth. Janet Yellen's remarkable recent speech foreswore a lot of that.

Of course, the Fed could always add it as a "temporary" need to deviate from the rule. Still, many people might think that should be part of the rule not part of the exception. It also leaves out housing, exchange rates, and all the other things that central banks like to pay attention to.

A rule really is a list of things that the Fed shall not react to without explanation.

2. I will be interested to hear the debate between inflation targeters and rules advocates. Inflation targeting is a similar legislative approach, but it basically says "here is the goal. It is a very limited goal. Don't pay attention to anything else, and we won't blame you for anything else. Do whatever you want to get there." A rule prescribes the actions the Fed should take, with only limited statement about what the goal should be.

Inflation targeting is like "go to Minneapolis, not St. Louis, and don't get distracted by shopping along the way. The rest is up to you, wake me up when we're there." A rule is like "Stay on I-94. When the white line gets too close to the right wheels, turn a bit to the left; when the dashed line gets too close to the left wheels, turn a bit to the right. If you need to go to the bathroom, wake me up and tell me why we're getting off the freeway."

I am making too light of it, as these are serious issues. The point is to enhance the stability and predictability of monetary policy, to "anchor expectations," to help the Fed to precommit ex ante to actions it will be tempted to take ex-post, and to help the Treasury to precommit ex ante to provide the fiscal and legislattive support necessary to fight inflation or deflation -- an often overlooked issue -- and to precommit that Congress will not complain about the Fed if it follows the rule.

Rules vs. targets is a deep question that needs to consider political economy, expectations, game theory, and so forth.

3. Of course, if this goes anywhere we will have a big debate over what rule to enshrine in Federal legislation for a generation. Price level target or inflation rate target? Two? What about secular stagnation? Expected inflation or past inflation? Oh-Oh, here come the nominal GDP targeters. And the monetarists...

4. This only covers the short term Federal Funds rate, which may remain at zero for decades the way things are going. What about rules for asset purchases, macroprudential regulation, etc. etc.?

One idea for renewing prosperity

For its 125th anniversary issue, the WSJ asked "If you could propose one change in American policy, society or culture to revive prosperity and self-confidence, what would it be and why?" Oh, and you have 250 words.

My answer, along with some great other essays here at the WSJ as "Ideas for Renewing American Prosperity."

I asked my son what to do. He answered quickly, "wish for more wishes." That's pretty much what I did.

Macro debates

A Wall Street Journal Op-Ed, on supply vs, demand in understanding slow growth.

The underlying paper is The New Keynesian Liquidity Trap, for those wanting more substance to some of the claims about New Keynesian models.

They didn't want the graph, but I think it illustrates the point well.

Please follow the link for the oped itself.

Deflation Skeptics

Michele Boldrin, Giovanni Federico and  Giulio Zanella have an excellent essay on noisefromamerika, Should we worry about deflation? Maybe yes, maybe no. (If your Italian is rusty, Google translate does a fine job with it.) This matters of course, as deflation is the great European preoccupation at the moment.

They remind us that, although deflation was correlated with the Great Depression in the US and some other countries,

Source: noisefromamerika.org. "PIL" is GDP

that correlation is not universal. For example, in the late 19th century, deflation coincided with strong growth,

What's the difference?


Well, read the article, but in short the key to becoming an economist is recognizing that there are always two forces at work, something like "supply" and "demand." Demand-driven deflation is -- or is a sign of -- something bad. (Actually, the "bad" comes from prices being "sticky" which one might argue means not enough deflation!) Supply-driven deflation -- productivity growth making things cheaper -- is a sign of something good. Most analysis presumes it's always "demand," and that the cause runs from deflation to output, not the other way, and not some third cause. It's never so obvious. Is Europe's deflation bad or good? Neither they nor I take a stand, but it's enough to shout from the mountaintops "wait a minute, it's not so obvious."

They blow up the standard story that with deflation people wait around to spend later when their money is worth more.

They remind us of a few articles with similar findings, including David Beckworth on Aggregate Supply-Driven Deflation and  Andy Atkeson and Pat Kehoe in the AER, who confirm some cross-sectional relation between deflation and Great Depression,

Source: Atkeson and Kehoe, American Economic Review

but likewise point out the absence of any relationship in larger more comprehensive historical experience,

Source: Atkeson and Kehoe, American Economic Review.

Andy and Pat conclude,

The data suggest that deflation is not closely related to depression. A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation.

i.e, hyperinflation is usually accompanied by depression,  not a boom. 

"What about Japan?" I hear you ask?

Figure 4 essentially shows a 40-year decline in the output growth rate (Fig. 4A) and a 30- year decline in the inflation rate (Fig. 4B). We think standard theories, either neoclassical or new Keynesian, would have a hard time blaming Japan’s secular growth slowdown on its secular decline in inflation. [JC: What they're saying is that monetary policy is eventually neutral. Prices are not sticky for 30 years in any model.] 

But that slowdown would naturally arise in many growth models in which a country grew rapidly in the early postwar period because it had been below its steady state growth path; as it caught up to this path, its growth would naturally slow. Has Japan’s growth slowed too much? Not relative to countries like Italy and France. At 1.41, Japan’s growth in the 1990’s was dismal compared to the U.S. growth of 3.20, but not compared to the growth of Italy (1.61) or France (1.84)

Boldrin, Federico and  Zanella update and expand on the comparison

Two decades from the beginning of the "deflationary depression" in Japan, it's worth noting that Real GDP per capita in Japan in 2012 was about 18% higher than it was in 1990, while in Italy it was slightly lower. GDP per hour worked (productivity) in Japan is today roughly 35% larger than 20 years ago. In Italy it is 6% larger. The unemployment rate in Japan is nearly a third (1/3!) of the Italian rate, in the face of a 25% larger labor force participation rate. 

In other words: If Japan is in a twenty year recession caused by persistent deflation, we (Italians) have been in a twenty-year disaster that is much worse, and this notwithstanding that the Italian inflation rate, in the same time period, has been positive and among the largest in the euro area.

An intriguing question is left a bit open, what does cause these long periods of slow deflation? Boldrin, Federico and  Zanella endorse a demographic view, that aging societies have low inflation. I find it interesting but not quite obvious to "anyone who doesn't have salami slices on their eyes" (best expression of the month prize.)

Conclusions:

Neither theory nor data suggest that deflation may be the cause of a deep economic depression. Even in the one significant historical case in which deflation and depression went together, the 1930s, the causal relationship is  dubious, and the object of ongoing debate among researchers in economic history. On average, deflation is associated with economic growth, not a recession. From the point of view of economic theory, the argument that "when prices are expected to fall, you defer purchases and this creates a vicious circle of recession / deflation" is, with all due respect to Mike Woodford and all the theorizing about "forward guidance", unfounded both in logic and in predictions. Removing that theory, nothing, or practically nothing remains to motivate the great fear of deflation. 

The only reason by which today, in Europe in 2014, a serious and persistent deflation could be a negative factor is the risk of public debt, whose costs are not indexed to price changes. Countries, such as Italy, which are highly indebted and have issued a substantial amount of long-term debt, at fixed nominal rates,  would see the real burden of debt rise if the price level began to decline or stagnate for many years. This is a real risk, no doubt. But, on the one hand, does not have anything to do with the problems of growth and development, and, second, there is a solution...

where they describe a clever swap of non-indexed for indexed debt.

It's fascinating how many economists, pass on stories that just ain't so, selected anecdotes, and ignore that there is always the possibility of supply, not demand; of reverse or third causality, and so forth.