Frameworks for Central Banking in the Next Century

The special issue of the JEDC containing papers from the conference "Frameworks for Central Banking in the Next Century" is available until Jan 18 online for free. My "monetary policy with interest on reserves" is here.  Alas, Elsevier doesn't allow me to post a pdf and only allows free access until Jan 18, so if you want pdfs grab them now. 

The lineup is pretty impressive. Of those I have read, I highly recommend Sargent, Prescott, Ohanian, Ferguson and Plosser to blog readers. In particular, if you thought Friedman was always and everywhere MV=PY and 4%, read Sargent.

The lineup:


Michael D. Bordo, John B. Taylor, Introduction to frameworks for central banking in the next century.

Alex Nikolsko-Rzhevskyy, David H. Papell, Ruxandra Prodan, Deviations from rules-based policy and their effects.

Monika Piazzesi, Should the monetary policy rule be different in a financial crisis?

Richard H. Clarida, Monetary policy in open economies: Practical perspectives for pragmatic central bankers.

Maurice Obstfeld, On the use of open economy new Keynesian models to evaluate policy rules.

Lee E. Ohanian, The impact of monetary policy in the midst of big shocks.

Martin Schneider, Redistribution effects of inflation.

Andrew T. Levin, The design and communication of systematic monetary policy strategies.

Otmar Issing, Communication and transparency – The example of the ECB.

John H. Cochrane, Monetary policy with interest on reserves.

Edward C. Prescott, Interest on reserves, policy rules and quantitative easing.

Marvin Goodfriend, Lessons from a century of FED policy: Why monetary and credit policies need rules and boundaries.

Athanasios Orphanides, Are rules and boundaries sufficient to limit harmful central bank discretion? Lessons from Europe.

Michael D. Bordo, Rules for a lender of last resort: An historical perspective.

Jeffrey M. Lacker, Fed Credit Policy: What is a Lender of Last Resort?

Esther L. George, Supervisory frameworks and monetary policy.

George P. Shultz, The importance of rules-based monetary policy in practice.

Charles I. Plosser, Monetary rules: Theory and practice.

Thomas J. Sargent, The evolution of monetary policy rules.

John C. Williams, Policy rules in practice.

Barry Eichengreen, Methodology of economic history as an approach to assessing monetary policy.

Niall Ferguson, Central bank rules in historical perspective.

Allan H. Meltzer, Federal reserve independence.

Target the spread?

To send you off with some more Thanksgiving good cheer, here is another out of the box Neo-Fisherian idea.

Perhaps the Fed (or the Treasury) should target the spread between real and nominal interest rates.

Above, I plotted the real (TIPS) and nominal 5 year rates. By the usual relationship \[ i_t = r_t + E_t \left[ \pi_{t+1} \right] \] we typically interpret the difference between real (r) and nominal (i) rate as the expected inflation rate.

Now, the usual Neo-Fisherian idea says, peg the nominal rate (i), eventually the real rate (r) will settle down, and inflation will follow the nominal rate. It's contentious, among other reasons, because we're not quite sure how long it takes the real rate to settle down, and there is some fear that real rate movements induce a temporarily opposite move in inflation.

So why not target the spread? The Fed or Treasury could easily say that the yield difference between TIPS and Treasuries shall be 2%. (I prefer 0, but the level of the target is not the point.)  Bring us your Treasuries, say, and we will give you back 1.02 equivalent TIPS. Give us your TIPS, and we will give you back 0.98 Treasuries. (I'm simplifying, but you get the idea.) They could equivalently simply intervene in each market until market prices go where they want. Or offer nominal-for-indexed swaps at a fixed rate.

Now, I think, the Neo-Fisherian logic is even tighter. If the government targets the difference \( i_t - r_t  \), in a firmly committed way, \( E_t \left[ \pi_{t+1} \right] \) is going to have to adjust.  I plotted 5 years, because I'm attracted to the idea of nailing down 5 year inflation expectations, but the general idea works across the maturity spectrum.

They might have to buy and sell a lot, you say? Indeed.  $4 trillion is a lot already, and Japan is embarked on even larger QE.   This might have fiscal consequences, you say? Indeed. That is, actually a lot of the point. Neo-Fisherian ideas are wrapped up with fiscal theory of the price level, and the spread peg is pretty much a fiscal commitment. It's a way of committing that we're going to inflate away the nominal debt at 2%, no more, no less. It's almost a modern gold standard in that way.  TIPS are illiquid, you say? Indeed. The contract structure could be improved a lot. But most of all, they'll be a lot more liquid when the Fed starts trading them every day!

What about the level of interest rates? That's the best part of the idea. If you're a free-money-market type, you could advocate that the Fed no longer target the level of either rate. If you're of the view that raising the level of interest rates is an important policy for the Fed to stabilize the real economy and induce short-run inflation movements (dynamics here), then the Fed can also move the level of short rates around, and at the same time target the spread.

The Fed has long used the TIP-Treasury spread to measure inflation expectations. But the same equation suggests the Fed (and Treasury) can directly control those expectations.

And, I hate to mention it, if a government wants to raise inflation expectations, firmly targeting such a spread would be a way to do it.

Sequester, growth, and the deflation that did not bark.

Multiplier? What multiplier? 

Wall Street Journal, November 26 2014:

The economy expanded at its fastest pace in more than a decade during the spring and summer,... Gross domestic product...grew at a seasonally adjusted annual rate of 3.9% in the third quarter... combined growth rate in the second and third quarters at 4.25%, affirming the best six-month pace since the second half of 2003." 

The upward revision to overall growth, driven by [sic] stronger consumer and business spending and a smaller drag from inventory investment, surprised economists... 

Paul Krugman, February 22 2013, "Sequester of Fools"

The sequester, by contrast, will probably cost “only” around 700,000 jobs.

New York Times, Februrary 21 2013, "Why Taxes Have to Go Up"

Democrats and Republicans remain at odds on how to avoid a round of budget cuts so deep and arbitrary that to allow them now could push the economy back into recession. The cuts, known as a sequester, will kick in March 1 [my emphasis]

Paul Krugman, March 10, 2013: "Sequester Cuts Will Be Felt in Time"

..it will start to build, and it won't just be White House tours, it will be air traffic delays, ...as the effects kick in, it will remind people why we actually need a government that does its job.

(Actually,  manifest failures of government to do its job lately are pretty depressing. But not for lack of money.)

Meanwhile back in the worryzone

Deflationary Vortex?

Paul Krugman Sept 4 2014 "The Deflation Caucus"

Europe, which is doing worse than it did in the 1930s, is clearly in the grip of a deflationary vortex,

Really, "worse than the 1930s???" We're watching different versions of the History Channel.

Paul Krugman, undated,

... if the economy ... has excess capacity, and also ...i = 0 ...- it cannot get out. The output gap feeds expectations of deflation, and since the nominal interest rate cannot fall this implies a rising real interest rate, worsening the output gap. The economy, in short, falls into a deflationary spiral.

This prediction of a "deflation spiral" once we hit the zero bound with huge "output gaps" has to stand as a stark failure of Keynesian economics, on a par with its grand failure to predict inflation in the 1970s. Only, predicting a catastrophe that did not happen doesn't attract quite as much attention as failing to predict one that did.

If you're not getting the point, look at the graph. Let me remind you "deflation" means numbers less than zero, a lot less than zero. And "spiral" or "vortex" means getting steadily more negative, not asymptoting to zero. And if you patch a model ex-post and ad-hoc not to produce a spiral, then that model no longer predicts that inflation is a danger.

To be sure, I am being inconsistent today -- I have staunchly maintained that "models" must exist on paper or in computers, in objectively verifiable forms, with "predictions" that any operator can make, not in soothsayer's heads.  I have staunchly maintained that evaluating economic theories by pundit prognostication is completely meaningless.

But I also don't make it my business to vilify other people from misquoted opinions on current dangers. (Though I'm indeed pulling Paul's leg a bit, please notice the absence of "evil," "vile," "mendacious idiot," "corrupt," "stupid," "doesn't know economics," and so on from this post.)

So just this once I will give in to grumpy temptation.

Behavioral Political Economy

I was interested to read "Behavioral Political Economy: A Survey" by Jan Schnellenbach and Christian Schubert. (HT marginal revolution's irresistible links.)

Context: I have long been puzzled at the high correlation between behavioral economics and interventionism.

People do dumb things, in somewhat predictable ways. It follows that super-rational aliens or divine guidance could make better choices for people than they often make for themselves. But how does it follow that the bureaucracy of the United States Federal Government can coerce better choices for people than they can make for themselves?

For if psychology teaches us anything, it is that people in groups do even dumber things than people do as individuals -- groupthink, social pressure, politics, and so on -- and that people do even dumber things when they are insulated from competition than when their decisions are subject to ruthless competition.

So on logical grounds, I would have thought that behavioral economists would be libertarians. Where are the behavioral Stigler, Buchanan, Tullock, etc.?  The case for free markets never was that markets are perfect. It has always been that  government meddling is  worse. And behavioral economics -- the application of psychology to economics -- seems like a great tool for understanding why governments do so badly. It might also inform us how they might work better; why some branches of government and some governments work better than others.

This nice paper got my attention, since the paper says that's starting to happen.

...Assuming cognitive biases to be present in the market, but not in politics, behavioral economists often call for government to intervene in a “benevolent” way. Recently, however, political economists have started to apply behavioral economics insights to the study of political processes, thereby re-establishing a unified methodology. This paper surveys the current state of the emerging field of “Behavioral Political Economy”

I came away horribly disappointed. Not with the paper, but with the state of the literature that the authors ably summarize.


I notice a lot of theory rather than fact. Stigler and company were deeply empirical.  That theory seems focused almost entirely on individual perceptual and decision-making biases, rather than how people in groups produce bad decisions.

On "theory," you can see where we're going with

We distinguish between a “weak” and a “strong” variant of BPE. The former merely alters specific auxiliary assumptions on either agents’ cognitive capacities or the content of their utility functions, by arguing, for example, that voters not only care about political outcomes, but also about their “citizen duty” when going to the polls, or that they care about other aspects that seem irrelevant from an orthodox instrumental standpoint, like a candidate’s looks... The “strong” variant of BPE goes beyond this and attempts to actually explain (rather than just postulate) motivational and other psychologically informed extensions to the standard model. For instance, it may try to examine the mental processes causing differences in agents’ susceptibility to certain biases

In particular, the first substantive section is

2. Voter preferences and voter behavior

which deals with the age old question, why do people bother to vote? Some of the answers

compliance with social norms..costs of moral behavior...utility gained by expressing one’s opinions...direct democracy appears to provide voters with procedural benefits by letting them participate in the decision-making process, independent of altering results in their favor...voters may overestimate the  probability of their personal vote being decisive...

This little quote suggests some of the character of the enterprise

...expressive utility is by now probably the most widely accepted element of BPE. Hamlin and Jennings (2011) define the “expressive” aspects of voting behavior as reflecting benefits from the act of voting that neither derive from its instrumental nor from its consumptive value, but from its symbolic or representational aspect: not from the act, but from its meaning”

The review covered not one salient fact, other the fact that people vote at all. They are all apparently highly complex ex-post stories. How would one even tell these theories apart?

I was expecting (hoping?) for things like, "XYZ study the FAA's perplexing inability to write rules allowing commercial use of drones, analyzing meeting schedules, showing that PDQ's theories of small group dynamics account for the pattern of indecision,'' or "ABC study data collection by Federal Agencies and how the agencies use control of the data to influence academics to write articles supportive of the agency's goals."  I was hoping even for some good stories of how bureuacratic decisions, lobbying results, bill writing, or anything political/economic can be understood by psychology -- or anything else. Alas, no.

After just one section, it's back to people are dumb, so omniscient bureaucrats should manipulate them (not the authors, to be clear, but the literature they are surveying)

3 Policy-makers ...

3.1 What should politicians do? ..

...attempts to derive policy implications from an explicitly “behavioral” model of how citizens respond to policies. Bolton and Ockenfels (2012) suggest an approach they call “behavioral economic engineering” that tries to integrate such ideas. Harstad and Selten (2015) also model citizens as responding to policies in a non-optimizing way: They are guided instead by “lower-dimensional” rules of thumb that are much easier to apply. The authors argue, quite convincingly [?], that policymakers should take these observations into account, as many important policy recommendations go awry when inadequately modeling citizens as homines oeconomici.

Yes, but we were supposed to be here to see what recommendations go awry when inadequately modeling bureacrats and politicians as homines oeconomici, not as deus-ex-machina, or pater familias.

Another little quote to alert you to the prose style you're going to have to master if you want to take up this topic.

Other approaches extend the process-oriented perspective. ...a theory of economic policy-making should take into account how politicians and citizens interpret political problems.... social communication constructs the beliefs in which concrete policy-measures are rooted.... A theory of economic policy would then need to be open to explanatory approaches from social psychology and sociology, which help to understand how common beliefs are formed and dispersed.

Again, and again, things we ought to listen to in order to construct new theories. Please could we try to study a single fact?

Finally I seemed to find what I was looking for

4. Bureaucrats, regulators, and lobbyists

And

While there is a very broad literature on how bureaucrats should efficiently regulate the actions of individuals suffering from choice imperfections, [!] so far there is very little research on the biases that regulators themselves may be subject to (see however Kuenhanss et al. 2015 and Tasic 2011 for a first survey). 

Aha! But the hoped-for research isn't there. For example,

 Guided by re-election concerns, they [politiicans] will choose to regulate those risks that are perceived to be particularly salient by the general public at a given point in time, which may direct regulatory resources away from other, objectively more pressing but less salient risks (Jolls et al. 1998)....

regulators face a trade-off between, on the one hand, maximizing social welfare, and, on the other hand, serving their career concerns by following the politicians’ demands. 

That is not terribly deep to put it mildly.

I was hoping for solutions, empirical evaluation guided by theory of what larger frameworks produce better outcomes. Alas what we get is

The authors suggest some institutional remedies that could alleviate the problems of bias in bureaucracies. An example is “de-biasing” by assigning a team within the bureaucracy to play the role of advocatus diaboli, and thereby make sure to get all arguments on the table. Another proposal is to incentivize bureaucrats by making parts of their rewards dependent on long-term outcomes

Madison and Hamilton on separation of powers this is not. (And a great example of my least favorite verb voice, the regulatory passive. "To incentivize." Who is going to do this "incentivizing" please?)

I had some hope finally for

5. Applying BPE: Two examples 

But no. The two examples are

5.1. Libertarian Paternalism..as popularized by Thaler & Sunstein (2008)

Back to Gruberism.

5.2. The Long-Term Effects of the Welfare State 

A suggestion that "social norms" can mollify the disincentives of the Welfare State.

The conclusion is ringing. Once again, bravo to  Schnellenbach and  Schubert:

We have also seen that what makes political behavior a particularly suitable candidate for applying insights from psychology is the fact that it exhibits incentive structures that differ markedly from those prevailing in the marketplace: Behind the veil of insignificance, people are essentially free to pursue any kind of non-standard goals. [Amen!]

But,

... BPE models still often display an asymmetry with regard to their basic assumptions, when, for example, “behavioral” voters are modeled as interacting with perfectly rational policy-makers or lobbyists. There is a danger here to introduce a new dichotomy in behavioral assumptions without much concern for the empirical evidence.

Indeed.

The opportunity for deeply empirical, behavioral public-choice economics, studying how individual and group psychology helps us to understand government failures. And hopefully, to craft instutitonal structures that will lead to better outcomes.

Why not? Perhaps, to indulge in a little behavioral ex-post story telling of my own, a behavioral Stigler would be hated equally by the public choice school, which uses rational-actor economics, and by behavioral economists, who seem, in this wide-ranging review, to remain overwhelmed by dumb-voters-in-need-of-our-enlightened-guidance dirigisme.

Writing compactly

A correspondent sends a suggested edit of a part of my writing tips for PhD students

With markup

Keep it short

Keep the paper as short as possible. Be concise. Every word must count. As you edit the paper ask yourself constantly, “can I make the same my point in less space?” and “Do Must I really have to say this?” Final papers should be no more than  under 40 pages, drafts should beshorter. (Do as I say, not as I do!) Shorter is better.

 

Clean: 

Keep it short

Be concise. Every word must count. As you edit, ask yourself, “can I make my point in less space?” and “must say this?” Final papers should be under 40 pages, drafts shorter.  Shorter is better.

Well, I did say "do as I say, don't do as I do!" 

Segregated Cash Accounts

An important little item from the just released minutes of the October Federal Open Market Committee meeting will be interesting to people who follow monetary policy and financial reform issues.

Finally, the manager reported on potential arrangements that would allow depository institutions to pledge funds held in a segregated account at the Federal Reserve as collateral in borrowing transactions with private creditors and would provide an additional supplementary tool during policy normalization; the manager noted possible next steps that the staff could potentially undertake to investigate the issues related to such arrangements.

A slide presentation by the New York Fed's Jamie McAndrews explains it.

The simple version, as I understand it, seems like great news. Basically, a company can deposit money at a bank, and the bank turns around and invests that money in interest-paying reserves at the Fed. Unlike regular deposits, which you lose if the bank goes under, (these deposits are much bigger than the insured limit) the depositor has a collateral claim to the reserves at the Fed.

This is then exactly 100% reserve, bankruptcy-remote, "narrow banking" deposits.  I argued for these in "toward a run-free financial system" as a substitute for all the run-prone shadow-banking that fell apart in the financial crisis. (No, this isn't going to siphon money away from bank lending, as the Fed buys Treasuries to issue reserves. The volume of bank lending stays the same.)


A second function of such deposits is that, like the new repo facility, it's going to help the Fed to raise rates. When the Fed wants to raise rates it will pay more interest on reserves. The question is, will banks pass that interest on to depositors? If they were competitive they would, but that's not so obvious. If large depostitors can access interest-bearing reserves through the repo program, or now through this narrow-banking program, it's likely to more quickly transmit the interest on reserves to the wider economy.


 

Dusty corners of the market

Thursday and Friday I attended the NBER Asset Pricing conference. As usual it was full of interesting papers and sharp discussion. Program here.

A bloggable insight: Itamar Drechsler, and Qingyi F. Drechsler "The Shorting Premium and Asset Pricing Anomalies." They carefully found the cost to short-sell stocks.

Here's their Table 5. F0 are all the easy to short stocks. F3 are the hardest to short stocks. They construct long-short anomaly portfolios in each group. "F 0 Mom" for example is the average monthly return of past winners minus that of past losers, among the easy to short stocks. Now compare the F0 row to the F3 row. The anomaly returns only work in the hard-to-short portfolios.

The second panel shows  Fama-French alphas, which are better measured. The sample is alas small. But the result is cool.

The implication is that a lot of anomalies exist only in hard to trade stocks. There is a lot more in the paper, of course.

Table 5: Anomaly Returns Conditional on Shorting Fees

We divide the short-fee deciles from Table 2 into four buckets. Deciles 1-8, the low-fee stocks, are placed into the F0 bucket. Deciles 9 and 10, the intermediate- and high-fee stocks, are divided into three equal-sized buckets, F1 to F3, based on shorting fee, with F3 containing the highest fee stocks. We then sort the stocks within each bucket into portfolios based on the anomaly characteristic and let the bucket's long-short anomaly return be given by the di erence between the returns of the extreme portfolios. Due to the larger number of stocks in the F0 bucket, we sort it into deciles based on the anomaly characteristic, while F1 to F3 are sorted into terciles. Panel A reports the monthly anomaly long-short returns for each anomaly and bucket. Panel B reports the corresponding FF4 alphas. Panel C reports the FF4 + CME alphas. The sample period is January 2004 to December 2013.

(From Table 4 caption) The anomalies are: value-growth (B=M), momentum (mom), idiosyncratic volatility (ivol), composite equity issuance (cei), nancial distress (distress), max return (maxret), net share issuance (nsi), and gross pro tability (gprof). The sample is January 2004 to December 2013.

Inequality at WSJ

"What the Inequality Warriors Really Want" a Wall Street Journal oped on inequality. It's a much edited version of my evolving "Why and How we Care About Inequality" essay. Any writers will appreciate the pain that cutting so much caused.

As usual I can't post the whole thing for 30 days, but you might find the WSJ short version interesting, especially if you couldn't slog through the whole thing. Their comments might be fun too.

Guilds

The Syndics of the Drapers' Guild by Rembrandt, 1662.

I enjoyed Sheilagh Ogilvie's The Economics of Guilds in the latest Journal of Economic Perspectives. Bottom line:

..the behavior of guilds can best be understood as being aimed at securing rents for guild members; guilds then transferred a share of these rents to political elites in return for granting and enforcing the legal privileges that enabled guilds to engage in rent extraction. 

The paper nicely works through all the standard pro-guild and pro-regulation arguments. If you just replace "Guild" with "regulatory agency" it sounds pretty fresh.

Did guilds provide contract enforcement, security in weak states, property right protections not otherwise available? No.

Overall, the empirical findings suggest that impersonal exchange in medieval and early modern Europe was sustained not by particularized arrangements such as guild jurisdictions or interguild reprisals, but by generalized institutions: private business practices backed up by public-order municipal or state institutions, which were open to all traders, not just members of privileged guilds.

Did guilds improve quality, protecting the unwary consumer?

..guilds typically penalized their members’ quality violations too mildly to deter them (Homer 2002; Forbes 2002; Ogilvie 2005). Customers often described guild quality controls as inadequate, and wholesale merchants added their own quality inspections at point of purchase. As one German guild inspector declared in 1660, “the cloth-sealing takes place very badly, and when one says anything about it, one incurs great enmity” (as quoted in Ogilvie 2004a, p. 295). Guild inspectors lacked the incentive to develop the skills and deploy the effort necessary to detect low-quality work beyond superficial features (such as size), which were readily apparent to wholesale merchants and consumers anyway (Ogilvie 2005; Boldorf 2009)...

Guilds were certainly often active in regulating quality. But there is little empirical support for the idea that they were efficient institutions for solving information asymmetries between producers and consumers.

Uber stars vs. taxicab regulators, circa 1350.

Did guilds provide better training and certification?

While craft guilds often made apprenticeship and journeymanship compulsory— at least on paper—the extent of actual training sheds bleak light on the incentives of monopolistic professional associations with regard to human capital investment. Contemporaries often complained that guilds failed to penalize neglectful masters of apprentices, issued certificates to apprentices without examination, or granted mastership without training or examination to masters’ relatives and well-off youths who paid for “privileges” (La Force 1965; Kaplan 1981; Horn 2006).

Black-market “interlopers” who failed to obtain guild training—often, as in the case of women and Jews, because guilds excluded them—were vigorously opposed by guilds precisely because they had skills indistinguishable from those of guild members and were willingly hired by customers (Wiesner 2000; Ogilvie 2003, 2004b, 2007a; Hafter 2007; van den Heuvel 2007).

A good reminder that modern union's behavior - quick exclusion of minorities for example -- goes back a long way.

Technology? Did guilds, as professional organizations, help to spread information about new techniques?

How did guilds affect technological innovation? The most visible way in which guilds interacted with new techniques was when, as often happened, they opposed them. Many guild members thought there was a limited lump of labor to go around. Innovations that squeezed more output from existing inputs would flood markets  depress prices, and put guild masters out of work. As one fourteenth-century Catalan intellectual put it, “If a shoemaker comes along with new tools and makes 70 shoes in a day where others make 20 . . . that would be the ruin of 100 or 200 shoemakers.”

A lot of 20th century economists, commentators, politicians and "policy-makers" apparently believe the same thing.

Continuing,

Leiden distinguished itself from other cities by limiting or altogether banning textile guilds, yet its flourishing industries were at the forefront of technological innovation, introducing hundreds of new fabrics and a vast array of innovative methods and devices between 1580 and 1797 (Ogilvie 2007a; Davids 2008; Lis and Soly 2008). Within England, the mechanical innovations of the Industrial Revolution were introduced not in the guilded “borough” towns but in fast-growing centers such as Birmingham, Manchester, Leeds, Halifax, Sheffield, and Wolverhampton, which had no guilds (Clark and Slack 1976; Coleman 1977; Pollard 1997). 

Why did guilds die out?  Early in the paper, Ogilvie mentions competition from the unguilded countryside and abroad.  "Globalization" and competition do their work.  In the last section,

... current scholarship suggests a complex of factors that created a new equilibrium in which both the political authorities and the owners of industrial and commercial businesses gradually discovered they could do better for themselves by departing from the particularist path and beginning to use more generalized institutional mechanisms. These factors included stronger representative institutions (parliaments) that increasingly constrained how rulers could raise revenues and grant privileges to special interest-groups; a more highly diversified urban system in which towns did not act in concert, but rather competed and limited each other’s ability to secure privileges from the public authorities; a more variegated social structure including prosperous, articulate, and politically influential individuals who wanted to practice trade and industry and objected to its being monopolized by members of exclusive organizations; and governments that gradually made taxation more generalized and developed markets for public borrowing, reducing the attractiveness of short-term fiscal expedients such as selling privileges to special-interest groups (de Vries 1976; Lindberg 2008, 2010; Mokyr 2009; Ogilvie 2011; Gelderblom 2013; Ogilvie and Carus 2014).

A nice ending

The historical findings on guilds thus provide strong support for the view that institutions arise and survive for centuries not because they are efficient but because they serve the distributional interests of powerful groups. 

The trade of competition-stifling regulation for political support continues. The question is how many centuries will it take now, and what similar political and economic forces will undermine it.

Update:

In this (Nov 18) morning's Cato News Summary,

 According to a front-page analysis from Robert Pear of the New York Times (11/18, A1, Subscription Publication, 9.9M), titled “Health Law Turns Obama And Insurers Into Allies,” Obama “is depending more than ever on the insurance companies that five years ago he accused of padding profits and canceling coverage for the sick.” Pear says that since the passage of the Affordable Care Act, “the relationship between the Obama administration and insurers has evolved into a powerful, mutually beneficial partnership that has been a boon to the nation’s largest private health plans and led to a profitable surge in their Medicaid enrollment.” 

Who is afraid of a little deflation?

Who is afraid of a little deflation? Wall Street Journal Op-Ed.

Fears of "tipping" into deflation are overblown. I poke a little fun at sticky wages, Fed headroom, deflation-induced defaults and the long-predicted Keynesian deflationary spiral that never seems to happen, and the doom and gloom language from the ECB, IMF and other worriers who just happen to (of course) want to spend trillions to fix this latest "biggest economic problem."

One point that went by a little too quickly in the interest of space: Deflation can be a symptom of bad things. The issue is whether deflation is by itself a bad thing, and causes further damage.

Also, I should have been clearer on a big bottom line: we don't need huge "infrastructure" projects just to save us from deflation.  

They ask me not to post the whole thing for 30 days, so those of you without WSJ access will just have to google or wait breathlessly.

Update: Ed Leamer wrote a great similar piece for Economists' Voice a while back "Deflation Dread Disorder; 'The CPI is Falling!'"  In addition to a better title, he's got a cool Godzilla reference and picture.

Reason for big Government: The Firm

I enjoyed John Goodman's essay at Forbes.com, "Reason for big Government: The Firm"

California has a new law that requires all eggs sold in the state to come from chickens that are housed in roomier cages. Specifically, the hens “must be able to lie down, stand up and fully spread their wings.” 

So how many Californians have been arrested for eating the wrong kind of egg? Zero. Not even one? Not one. Actually, the law doesn’t take effect until January, but even then egg eaters will have nothing to fear. The reason: the law doesn’t apply to people who eat eggs. It only applies to people who sell eggs.

When you stop to think about it, that’s not unusual. Almost all government restrictions on our freedom are indirect. They are imposed on us by way of some business. In fact, laws that directly restrict the freedom of the individual are rare and almost always controversial.

John's main point: the regulatory state entangles businesses but largely leaves people (i.e. voters) alone. If it did, us peasants would rise up with pitchforks and put a stop to it. He has a bunch of examples:

Take OSHA regulations. If a construction firm employs carpenters who climb ladders, federal law regulates how safe the ladder must be. But is there any law that tells you how safe your own ladder must be if you decide to climb up on your own roof? Of course not. Although the federal government imposes safety standards on almost every work place, it imposes no safety standards on how those workers behave when they are not at work. They can sky dive, hang glide, scale vertical cliffs, scuba dive in caves – and take just about any other risk they desire.

I don't really buy the provocative bottom line counterfactual

Bottom line: if there were no firms, taxes would be much lower, there would be far fewer regulations and government would be a much less important institution in our lives. 

Perhaps he means "democratic" government as there have been plenty of modern tyrannies that restrict individuals. And many firms welcome, nay, demand, regulation as a way to stifle competition.
But that aside, the basic point that our government hyper-regulates firms, but dares not do such things to individual voters is good and interesting.

The Neo-Fisherian Question

On the "Neo-Fisherian" idea that maybe raising interest rates raises inflation, Nick Rowe asks an important question. What about the impression, most recently in a host of countries that seemed to raise rates "too early" and then backed off, that raising interest rates lowers inflation? (And thanks to commenter Edward for the pointer.)

Partly in answer, and partly just in mulling it over, I think I can boil down the issue to this question:

If the central bank pegs the nominal rate at a fixed value, is the economy eventually stable, converging to the interest rate peg minus the real rate? Or is it unstable, careening off to hyperinflation or deflationary spiral?

Here are some possibilities to consider. At left is what we might call the pure neo-Fisherian view. Raise interest rates, and inflation will come.

I guess there is a super-pure view which would say that expected inflation rises right away. But that's not necessary. The plot in Monetary Policy with Interest on Reserves worked out a simple sticky price model. In that model, dynamics were pretty much as I have graphed to the left: real rates rise for the period of price stickiness, then inflation sets in.

Now,  here is a possibility that I think might satisfy  Neo-Fisherism, Nick, and a lot of people's intuition:

In response to the interest rate rise, indeed in the short run inflation declines. But if the central bank were to persist, and just leave the target alone, the economy really is stable, and eventually inflation would give up and return to the Fisher relation fold. (I was trying to get the model of "Interest on Reserves" to produce this result, but couldn't do it. Maybe fancier price stickiness, habits, adjustment costs...?)

This view would account for the Swedish and other experience.

We don't see the Fisher prediction because central banks never leave interest rates resolutely pegged. Instead, they pursue short-run pushing inflation around.


And there's nothing really wrong with that if they know what they're doing. If you have a system with this kind of short run dynamics, you can get inflation where you want it faster by pushing the short run dynamics around, rather than pegging interest rates and just waiting for the long run to arrive. Lower rates, which pushes inflation up in the short run, then follow inflation up, with a quick burst of high rates to stop inflation, then back to normal.

I think the revival of Neo-Fisherism occurs by watching our period of zero rates, in which central banks can't push rates down any more. If you held the last view,  raising rates and waiting for the long run seems like a possible strategy.

But these dynamics are not the standard view. The standard view is that the economy is inherently unstable. If the central bank were to raise rates and leave them there, the economy would spiral off to never ending deflation. Conversely, a too low interest rate peg would send the economy off to spiraling inflation.

Now, we don't see such spirals. But that is because central banks don't peg interest rates.

In the standard view, a central bank would soon see inflation spiraling down, would quickly lower interest rates to push it back up again. Upside down, this might be a stylized view of the 1970s and 1980s.

Alas, central banks pushing short-run dynamics around in my second neo-Fisherian view graph would lead to time series and impulse responses that look like this as well.

So in normal times it would be devilishly hard to tell long run stability from long run instability by looking at time series of inflation and interest rates. (Most impulse response functions do feature interest rates with interesting dynamics after a shock. So we can't really tell if the resulting inflation path is due to the initial shock or to the subsequent behavior of interest rates)

We can put the issue more generally as, if the central bank does nothing to interest rates, is the economy stable or unstable following a shock to inflation?

For the next set of graphs, I imagine a shock to inflation, illustrated as the little upward sloping arrow on the left. Usually, the Fed responds by raising interest rates. What if it doesn't?  A pure neo-Fisherian view would say inflation will come back on its own.

Again, we don't have to be that pure.

 The milder view allows there may be some short run dynamics; the lower real rates might lead to some persistence in inflation. But even if the Fed does nothing, eventually real interest rates have to settle down to their "natural" level, and inflation will come back. Mabye not as fast as it would if the Fed had aggressively tamed it, but eventually.

By contrast, the standard view says that inflation is unstable. If the Fed does not raise rates, inflation will eventually careen off following the shock.

We don't see that outcome in the data, because even if not right away (as the Taylor rule recommends), eventually central banks wise up, raise rates, and bring inflation back again.

Which brings us to the current moment.

The last 5 years have brought us a delicious opportunity for measurement. Once we hit the zero bound, interest rates can't move any more. So the whole problem of empirically verifying long run dynamics is a lot easier.

What happened when the Fed kept interest rates at zero for 5 years? Pretty much nothing! OK, you see inflation going up and down, but look at the left hand scale -- one percentage point. Given the colossal scale of other events in the economy, that's nothing. Japan has been at it even longer, with similar results.

We seem to have in front of us a pretty clear measurement that long run dynamics are stable.

"Nothing" is astounding. This dog that did not bark has demolished a lot of macroeconomic beliefs:

• MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation -- or at most we're arguing about percentage points -- it has to go out the window. 
• Keynesian deflationary spirals. Just as much as monetarists worried about hyperinflation, Keyensians' forecast of a deflationary spiral just didn't happen. 
• The Philips curve. Unemployment went to levels not seen since the great depression; the output gap went to 10 percent and ... inflation moved less than one percent. Adieu. (Actually, Phillips curve lovers turn this on its head, to proclaim that all we need is 1% more inflation to bring the economy roaring back, but you can see how tortured that one is.) 
• Fiscal stimulus... well, we'll take that up another day

So, I bring you the question, which is not so obvious as Nick makes it sound.

If the Fed completely and permanently pegs interest rates, is inflation in the long run stable or unstable?

In response to shocks (left arrows) and after a period of short-run dynamics (squiggly path), will inflation eventually return to the Fisher relation?

Or, will inflation eventually diverge -- until the Fed gives up on the target?

Think of holding a broom upside down. That's the standard view of interest rates (on the broom handle) and inflation (the broom). Anytime the Fed sees inflation moving, it needs to quickly move interest rates even more to keep inflation from toppling over -- the Taylor rule. To raise inflation, the Fed needs first to lower interest rates, get the broom to start toppling in the inflation direction, then swiftly raise rates, finally raising them even more to re-stabilize the broom.

The neo-Fisherian view says the Fed is  holding the broom right side up, though perhaps in a gale. To move the bottom to the left, move the top to the left, and wait.  But alas, the broom sweeper has thought it was unstable all these years, so has been moving the handle around a lot.

Theories: Both monetarist and old Keynesian theories are of the unstable sort.

For Keynesian models, I like very much John Taylor 1999 Journal of Monetary Economics This paper (or at least my reading of it starting p. 601 here) shows that old-Keynesian models with fixed interest rate targets are unstable, with explosive eigenvalues. Adopting a Taylor rule with inflation coefficient greater than one makes the economy stable -- the Taylor rule says, move the broom handle more than the top of the upside-down broom is moving, and you'll keep it balanced.

For monetarism, read (re-read!) Milton Friedman's "Role of monetary policy" starting on p. 5 regarding interest rate pegs.

Adaptive expectations are, I think, the key features that make these models unstable. By contrast, new-Keynesian models, with rational forward-looking expectations produce stability with interest rate pegs. They produce too much stability, and thus multiple equilibria. (Stephanie Schmitt-Grohe' and Martin Uribe's papers on this topic are a good place to look.)  Fiscal theory removes the indeterminacy, so seems to give a determinate Neo-Fisherian answer. And it empahsizes, that what will happen both in the short and long run depends on fiscal policy.

At the cost of repeating myself (this means you, Nick!) the issue is the long run stability of inflation under an interest rate peg (and appropriate fiscal policy!), not short-run dynamics. And it's not so easy to tease out of the data, though certainly worth the challenge. A clever VAR, noting periods of forced pegging due to the zero bound, might help.

Across the Great Divide

Across the Great Divide: New Perspectives on the Financial Crisis is published. This is the book form of the joint Brookings-Hoover conference on the financial crisis, organized by Martin Baily and John Taylor.  The link allows you to download the whole thing as pdf for free, or buy the book.

There will be a webcast book event on Wed Nov 5, from the Hoover Institution's Washington D. C. offices, also available after the fact at that link.

My "Toward a Run-Free Financial System" is in it, in published form, also available on my webpage.

Larry Summers' Low Equilibrium Real Rates,  Financial Crisis, and Secular Stagnation is an interesting read in his evolving case for "secular stagnation," which I'm sure will get a lot of attention.

But lots of the other papers are really interesting as well.

Previous posts on this interesting conference here and on the Summers speech here.

The rest of the table of contents:

Introduction
By Martin Neil Baily and John B. Taylor


Chapter 1: How Efforts to Avoid Past Mistakes Created New Ones: Some Lessons from the Causes and Consequences of the Recent Financial Crisis
by Sheila C. Bair and Ricardo R. Delfin

Chapter 2: Low Equilibrium, Real Rates, Financial Crisis, and Secular Stagnation
By Lawrence H. Summers

Chapter 3: Causes of the Financial Crisis and the Slow Recovery: A Ten-Year Perspective
By John B. Taylor

Chapter 4: Rethinking Macro: Reassessing Micro-foundations
By Kevin M. Warsh

Chapter 5: The Federal Reserve Policy, Before, During, and After the Fall
By Alan S. Blinder

Chapter 6: The Federal Reserve's Role: Actions Before, During, and After the 2008 Panic in the Historical Context of the Great Contraction
By Michael D. Bordo

Chapter 7: Mistakes Made and Lesson (Being) Learned: Implications for the Fed's Mandate
By Peter R. Fisher

Chapter 8: A Slow Recovery with Low Inflation
By Allan H. Meltzer

Chapter 9: How Is the System Safer? What More Is Needed?
By Martin Neil Baily and Douglas J. Elliot

Chapter 10: Toward a Run-free Financial System
By John H. Cochrane

Chapter 11: Financial Market Infrastructure: Too Important to Fail
By Darrell Duffie

Chapter 12: "Too Big to Fail" from an Economic Perspective
By Steve Strongin

Chapter 13: Framing the TBTF Problem: The Path to a Solution
By Randall D. Guynn

Chapter 14: Designing a Better Bankruptcy Resolution
By Kenneth E. Scott

Chapter 15: Single Point of Entry and the Bankruptcy Alternative
By David A. Skeel Jr.

Chapter 16: We Need Chapter 14—And We Need Title II
Michael S. Helfer

Remarks on Key Issues Facing Financial Institutions
Paul Saltzman

Concluding Remarks
George P. Shultz

Summary of the Commentary
Simon Hilpert