Cancel currency?

Ken Rogoff has  an interesting NBER Working paper "Costs and Benefits to Phasing Out Paper Currency."

Ken would like to get rid of paper currency in favor of all electronic transactions. I'm a big fan of low-cost electronic transactions using interest-paying electronic money. But I'm not ready to give up cash. 

Ken has two basic points: The zero bound, and tax evasion / illegal economy. 


Zero bound

Many economists would like the Federal Reserve to be able to set a negative interest rate target, as a way to further "stimulus." 

The conventional answer is that this is impossible because of currency. As long as you--and more importantly, banks -- can hold cash, which pays a zero interest rate, the Fed can't impose a negative interest rate on bonds.  In reality, holding cash is expensive, even for banks, so we can and do see slightly negative interest rates on occasion. But more than -0.5% or so would be hard to sustain. 

This has led to a number of creative proposals, which Ken summarizes

Willem Buiter.. has discussed ... devices for paying negative interest rates on currency...  stamp taxes... (currency would remain valid only if it were regularly stamped to reflect tax payment). ... Mankiw (2009) points out that the central bank could effectively tax currency by holding lotteries based on serial numbers, and making the “winners” worthless. 

Ken goes on to the ultimate version of this idea: get rid of cash all together and move entirely to electronic transactions.  

Let's leave aside the (dubious, in my view) claim that negative nominal interest rates are the vital cure for our ailing economies, and just focus on the question whether eliminating currency will allow it. 

So, quiz question for your economic classes: Suppose we have substantially negative interest rates -- -5% or -10%, say, and lasting a while. But there is no currency. How else can you ensure yourself a zero riskless nominal return? 

Here are the ones I can think of: 

• Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes. 
• Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets' coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off. 
• Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them. 
• Prepay bills. Send $10,000 to the gas company, electric company, phone company. 
• Prepay rent or mortgage payments. 
• Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn. 

Comments section: how many more can you think of?

Now in each case, you might say this can be changed. The IRS could refuse pre-payments for taxes, or charge a negative interest rate or a penalty for pre-payment. Businesses now charge penalties for late payment, so institutionally they could charge penalties for early payment.

But our legal and financial system deeply enshrines the right to pay early. Imagine the string of court cases in which consumers demand their right to pay rent, gas bills, etc.  vs. landlords who won't let them.

Politically, imagine the  outrage at an attempt by the Federal Government and Federal Reserve to enforce negative interest rates -- to "take away people's money'' -- at a magnitude that matters -- 5% say, not 5 bp --  and to eliminate people's right to hold cash to enforce that confiscation. You might as well propose to take away their guns, gold bars, and stocks of canned food.

So, bottom line, we cannot have strongly negative nominal rates without a legal revolution essentially negative-indexing the entire economy and payment system, and upending centuries of law giving you the right to pay bills at face value.

The zero bound is not just cash.

"Illegal" transactions, regulations, and tax evasion

Rogoff: 

Paper currency facilitates making transactions anonymous, helping conceal activities from the government in a way that might [!] help agents avoid laws, regulations and taxes. This is a big difference from most forms of electronic money that, in principle, can be traced by the government

Indeed. The central characteristic of currency is anonymity of its possession and of the transactions it facilitates. Though transactions aren't that closely monitored now, the computer revolution is making it more and more possible. And Ken is explicitly proposing even more: that the IRS and regulatory agencies will actively use their ability to monitor electronic transactions to enforce "laws, regulations and taxes."

Though anonymity facilitates evasion of "good" taxes and necessary regulations, the ability to transact anonymously is an important safety valve that protects our economy and many others around the world from a welter of "bad" taxes, laws, and overly intrusive regulations.  How much of each we have now, and how desirable strict enforcement is depends on where you sit. I imagine opinions differ at Harvard vs. Cato or Mercatus.

Regulations may be more important than taxes. Big companies and wealthy people who pay most of the taxes in the US don't have to cheat; they just hire good lawyers and lobbyists. Monitoring transactions is an excellent way to enforce compliance with all sorts of regulations. And we plausibly have more bad regulations than (even) bad taxes.

In the U.S., eliminating cash would heavily impact the poor. The U.S. has 11 million undocumented immigrants, most working and transacting in cash. It is likely that many readers of this post have violated the extensive Federal and State labor laws or immigration laws, in their hiring of household help, and able to do so by transacting in cash. Sub-minimum wage jobs would disappear without currency, as would many jobs available to ex-convicts and others facing legal restrictions on their employment. What little entrepreneurship and activity exists in many poor parts of inner cities survives on cash, by being able to evade not just taxes but onerous local regulations, occupational licensing restrictions, zoning restrictions, labor laws, and so forth. Are you buying lights windows or toilets that violate zoning energy or water laws? Not any more, you're not.

A lot of "tax evasion" using currency consists of quite poor people evading the astronomical marginal tax rates implicit in social programs. People on social security disability, and medicaid, say, who would lose lots of benefits if they reported income, pick up a lot of spare money working for cash. Do we really want them to obey all the rules strictly -- not work at all? Should the watch TV all day long?

I wrote about the pernicious consequences of e-verify here. The world in which the Federal Government must pre-approve every employment strikes me as a nightmare. The world in which the Federal Government is monitoring every transaction between people to enforce who it thinks you can and can't hire is a worse nightmare.

In other parts of the world, small businesses and labor markets only function at all by avoiding laws, taxes, or regulations. Estimates for Europe put the "shadow economy" at least 20% of GDP, and a larger fraction of employment especially for young people. Values in the rest of the world are likely larger. It's not obvious that eliminating cash and cash transactions in Europe would raise tax revenue, rather than simply lowering actual GDP and employment by 20% or more.

There is about $1.3 trillion currency outstanding, more than $3,000 per US citizen. 3/4 of it is $100 bills. Most is held abroad. You get the picture of who holds dollars and why. US policy makers my think all our taxes, rules and regulations are benificent, but we don't think that of the rest of the world. Do we really want to get rid of this safety valve for Russia, Argentina, Venezuela, Cuba, the Middle East, and so forth?

If the U.S. were willing to allow anonymous electronic transactions, then we could get rid of cash. But we already have lost a great deal of the ability to transact anonymously, and the current technological and policy trend is entirely in the other direction.  One used to be able to take more than $10,000 out of banks at will; now such a withdrawal must be reported. Smaller cash transactions are voluntarily reported by banks under fear of "know your customer" and anti-terrorism regulation. Remember the glorious ending of the Shawshank Redemption, where the hero takes huge piles of cash out of a bunch of banks and heads to the Mexican border? Forget it.  And it's already being used politically: Justice is using know-your-customer rules deny legal but unfavored industries such as marijuana dispensaries and payday lenders access to banking.

Treasury abolished bearer (anonymous) bonds in 1983, with the switch to electronic book-entry holdings. Anonymous Swiss bank accounts are a thing of the past. The SEC, IRS, and CFTC are none too happy about bitcoin.

Liberty

More deeply, a world in which the Federal Government can observe every single transaction made by every single person and corporation, and thereby reconstruct the size and composition of every person's wealth, strikes me as an Orwellian nightmare. Among the rights to privacy, the ability to make an anonymous transaction, already severely hampered, cannot disappear totally.

Imagine the repercussions for political liberty if the Federal Government has a record of every single transaction. If a candidate for political office once bought a racy magazine, that record is in government files. And one Lois Lerner or Edward Snowden away from a twitter feed. If a prominent political voice, or even an annoying economics blogger, had a purchase somewhere in his or her history they did not want made public, or that violated some nitwit law or regulation, they could quickly be silenced. Imagine what J. Edgar Hoover could have done to the civil rights and anti-war movements with the ability to see every transaction in the country.

Ken acknowledges this point:

A different type of argument against eliminating currency relates to civil liberties. In a world where society’s mores and customs evolve, it is important to tolerate experimentation at the fringes. This is potentially a very important argument, though the problem might be mitigated if controls are placed on the government’s use of information (as is done say with tax information), and the problem might also be ameliorated if small bills continue to circulate 

"Experimentation at the fringes" means anyone who bought booze in prohibition, or pot in the last 50 years, or sought public office. Campaign finance law is already a political cesspool. Imagine what it will look like when a rogue prosecutor can see every transaction. I'm not sure that's a fringe.

"Controls are placed." Absolutely we need controls, and we need them now even with currency. Let's add some subjects and active verbs here: Congress should pass clear stringent laws, with strong judicial oversight and equally strong penalties, on the limits of the government's collection and use of data on financial ownership and transactions.

Substitutes and a chilling ending:

Last but not least, if any country attempts to unilaterally reduce the use of its currency, there is a risk that another country’s currency would be used within domestic borders. Even if that risk is not great for a country like the United States, there is still the loss of revenue from foreign users of currency (many of whom may be engaged in underground or illegal activities within their own borders, even if not within US borders). Thus, any attempt to eliminate large-denomination currency would ideally be taken up in a treaty that included at the very least the major global currencies

Venezuela and Argentina get along on dollars. Don't be so sure the risk is not great for the US. Bitcoin, though very imperfect in a lot of dimensions, shows the strong demand for anonymous transactions and wealth holding. We could learn to use Euros pretty fast.

A global treaty banning currency and anonymous transactions...I can see the pitchforks now.

To be clear, this is a good essay, and Ken brings up all the important points. My disagreement here is just judgement on the importance of some considerations -- "good" tax and regulatory evasion, "good" anonymity, the importance of anonymity for political freedom -- relative to others -- seignorage (trivial in my view, important in Ken's) for example.

Ruble Trouble

On Russia, the fall of the Ruble.

This is an interesting event on which to test out our various frameworks for thinking about macroeconomics and monetary economics.

Theories

There are three basic perspectives on exchange rates.

1. Multiple equilibria. Lots of words are used here, "speculative attacks," "sudden stops," "hot money," "self-confirming equilibria" "self-fulfilling prophecies" "contagion" and so on. Basically, the exchange rate can go up or down on the whims of traders. There is often some news sparking or coordinating the bust.  Some of the mechanism is like bank runs, pointing to "illiquidity" rather than "insolvency" as the basic problem.

This has been a dominant paradigm since the early 1990s. I've been a bit suspicious both on the nebulousness of the economics (lots of buzzwords are always a bad sign), and since the analysis seems a bit reverse engineered to justify capital controls, currency controls, (i.e. expropriation of middle-class savers and poor currency-holders), IMF rescues, and lots of nannying by self-important institutions and their advisers who will monitor "imbalances," "control" who can buy or sell what, and so forth. But models are models and facts are facts.

2. Monetary. Exchange rates come from monetary events, and primarily the actions of central banks. For example, much of the analysis of the dollar strengthening relative to euro and yen attributes it to the idea that the US Fed has stopped QE and will soon raise rates, while the ECB and Japan seem about to start QE and keep rates low.

3. Fiscal theory. Exchange rates come fundamentally from expectations of future fiscal balance of governments; whether the governments will be able and willing to pay off their debts. If people see inflation or default coming, they bail out of the currency, which sends the price of the currency down. Inflation follows; immediately in the price of traded goods, more slowly in others.

Craig Burnside, Marty Eichenbaum and Sergio Rebelo's sequence of papers on currency crises, starting with  JPE "Prospecitve Deficits and the Asian Currency Crisis" (ungated drafts here) was big in my thinking on these issues. They showed how each crisis involved a big claim on future government deficits.  Prices fall, banks get in trouble, governments will bail out banks, so governments will be in trouble.  Inflation lowers real salaries of government workers. And so on.

The "future" part is important. Earlier work on crises noticed that current debts or deficits were seldom large, governments in crises often had surprisingly large foreign currency reserves, and there were no signs of sudden monetary loosening.  This earlier absence of a cause problem had led to much of the multiple-equilibrium literature. But money is like stock, and its value today depends on future "fundamentals."

Monetary and fiscal views are related. The question really is whether the central bank can stop an inflation and currency collapse by force of will, or whether it will have to cave in to fiscal pressures.

Most basically, a currency, like any asset, has a "fundamental" value, like a present value of dividends; it may have a "liquidity" value, like money; and it may have a "sunspot" or "multiple equilibrium value." The question is, which component is really at work in an event like this one -- or, realistically, how much of each? The money and fiscal views also much more clearly bring the currency into the picture.

So, as I read the stories of Russia's troubles, I'm thinking about which broad category of ideas best helps me to digest it. You can guess which one I think fits best. Yes, everyone likes to read the paper and see how it proves they were right all along. But at least being able to do that is the first step.


On a second level, of course, there is the question whether prices and wages are sticky, whether "demand" or "supply" accounts for fluctuations, whether devaluations are great things to "stimulate" economies, and so forth.

Facts

1. Oil prices have gone down by half. Russia is a big exporter, and the Russian government gets a lot of revenue from oil exports, 45% by one media account.

2. The Ruble is collapsing. The graph below (from Bloomberg.com) shows the fall's slow slide, the sharp slide in early December, the big collapse two weeks ago, a rebound following various moves (more below) and a new sharp decline as I write.

5. Sanctions are biting. Sanctions cut off Russian businesses and banks from foreign financial markets. The big problem is not so much financing new investment, but that they now cannot roll over debts. (Sanctions seem to mean you can't borrow new money, but you still have to repay the old money.)

Paul Gregory, who among other things writes a blog about Russia, had a presicent Forbes article last August:

Russia, with its thin capital markets, obtains half of its capital abroad. If cut off from European, American, and Japanese capital cold turkey, Russia might be able to replace some of its losses from non-sanctioning countries, like China, but only partially and at a high price. [Many stories now in the news about Russia-China financial links.] 

Refinancing is a particularly harsh problem for Russia with its absence of rule of law. Lenders will lend only for short maturities. According to Russia’s central bank (CBR),  24 percent of the foreign debt of Russian banks and companies, or $157 billion, comes due in 2014 alone. Sanctions take the option of refinancing off the table.  Rosneft, the national oil company, has $15.9 billion maturing this year and $16.2 billion the next, for example, and it is only one of many companies in this fix. 

Remarkably, even unsanctioned Russian companies are frozen out of Western credit markets.  

5. There is a very interesting and quite murky debt situation, especially in banks.  Russian banks and businesses have a lot of foreign currency debt they can't repay or roll over.

The government debt/GDP ratio isn't that bad, and past deficits are not the trouble. Russia ran big trade surpluses, meaning there are foreign assets somewhere. But those may have all ended up as Russian owned London apartments and Swiss banks and not available to Russian banks and businesses.

Chain of events

The mid-December collapse happened around the Roseft bank story (below).  As I read it,  if markets sniff that foreign reserves are going to get spent fast to bail out favored cronies, then capital flight is on.  Fiscal theory and multiple equilibria paint similar pictures here. In a fiscal interpretation, news can come about how much of state assets are going to be used to support currency and government debt, and how much is going to line pockets of insiders. 

In addition, it must be on everyone's mind when capital controls are coming. Naturally, you want to get your money out ahead of capital controls. The fact that so much of our policy establishment now approves of capital controls means that controls are more likely, which means that crises are more likely. If capital controls were considered an awful step, like expropriating property or invading other countries, then people would be less likely to try to jump in advance of capital controls. 

The central bank responded by sharply raising interest rates to 18%, and interbank rates rose to 25%. That didn't seem to have much effect.  Long term rates went up sharply, all on their own. Inflation is already rising, with an official forecast of 11.5% for next year. We'll see what actually happens. 

Russian 10 year bond yields. Source: Financial Times

At this point, I was about to hit "send" on this post. Burnside Eichenbaum and Rebelo redux.  But then the Ruble bounced back.

On 12/25 Russia's finance minster declared the crisis "over" (WSJ "Russia Says Ruble Is Stable, but Economic Troubles Remain"). In addition to the interest rate increase, designed to make Rubles more attractive, factors cited included

exporters converted their dollar holdings to rubles to meet local tax payments due by the end of the month. [JC: and soaking up some Rubles] 

The ruble’s recovery this week was steered by the government’s order that major state companies sell foreign currencies, which applies to big exporters including Gazprom and Rosneft. Within the next two months, the companies will need to cut their foreign-currency holdings to levels of early October, which will fulfill the market demand for dollars and euros needed to repay foreign debt.

These are "voluntary" capital controls of the offer-you-can't-refuse sort. But none of these moves address the fundamental problems, so some frictions or multiple equilibrium story does come to mind first. The articles also mention thin markets around holidays. It's easier to move prices in thin markets.

But then as of the end of the year, the Ruble is heading down again, which looks to me like fundamentals taking over.

On 12/26 "Ruble’s Recovery Runs Out of Steam'' says the Wall Street Journal. Interestingly, Russian Finance Minister Siluanov has become a fiscal theorist when it comes to steps to help the Ruble.

 Mr. Siluanov admitted that Russia will need to adapt its budgets to “new economic realities.” 

The minister said that Russia will need to reassess its military spending amid slowing economic growth and reduced access to global capital markets as falling oil prices have hit the domestic economy hard. 

...“The budget structure is extremely ineffective. It needs to be changed in the conditions when we have limited access to new sources of income,” Mr. Siluanov said.

The macroeconomic stories are interesting as well.  WSJ echoed the interest-rate-centric view of macroeconomic effects :

...the sharp interest-rate increase that the central bank imposed last week to stem the ruble’s slide, along with widening problems in the banking sector, has darkened the outlook for Russia’s economy dramatically.

Really? Of all the problems in Russia's economy too high interest rates and lack of "demand" are the most important?  Also, we will see whether 18% turns out to be a low or a high real interest rate.

Devaluation and inflation are  supposed to boost economies because prices and wages are sticky. There were great news stories about a crush to buy Ipads at the Apple store in Moscow, and Apple eventually closing it down because they couldn't keep up with currency changes. Ipads seem to be the new Krugerrands. So, there's a little bit of sticky price demand, I guess. Lasting maybe a day.

Some additional readings

Falling oil, rising cucumber prices: how much trouble is Russia in?

Recent calculations show that Russia needs oil to stick to around $105 a barrel for its budget to break-even. .

Russia’s external debt amounted to $731bn in June 2014. 74% of this is denominated in foreign currency, meaning that the depreciation of the rouble makes it more expensive to repay... $35bn of debts are due in December alone.

The largest component of debt is attributable to banks and other non-government sectors, which together owe more than $650bn to foreign lenders, 17% of which is short-term, and much of which (46%) is attributable to state-owned banks and enterprises.

Sanctions too are starting to bite. Companies directly under western sanctions account for about 60% of the total debt due by the end of 2015 (£).

While most of these companies are (for now) relatively cash rich, the fact that many are sanctioned from raising finance means that they cannot simply roll over debt by borrowing externally, and need to instead buy dollars in the market. There also appears to be growing evidence (£) of concerned western banks and financial institutions refusing to finance even those Russian companies that are not on the blacklist.

It is worth keeping in mind at this point that while not being state-run, private companies are often merely quasi-sovereign in Russia, and ownership structures are rather fluid and can change quite rapidly - the potential weight of debt on government finances goes beyond only state-run companies.

... banks alone have $192bn external debt (about 10% of GDP), up from $170bn in 2008, and from $18bn in 1998....The key point here is that Russia’s banks have few dollar assets to set against their dollar debts.

As an example of some of this debt issues, lies the Rosenft loan: Leonid Bershinsky (Dec 15)

Russia's state-owned oil company, Rosneft, raised 625 billion rubles ($10.8 billion at that day's exchange rate) with a bond issue that had a lower yield than Russian government bonds of similar maturity. The Central Bank quickly added the bonds to the list of securities it would accept as collateral from banks seeking liquidity. The deal was opaque,...

Central Bank technocrats have been worried that the government would force them to print rubles for the direct funding of industries, primarily the military industrial complex and the state companies run by Putin friends. The Central Bank's obvious complicity in the Rosneft deal means the pressure is on, and the Central Bank is caving.

Andrew Kramer at the New York Times (dec 16)

He [Putin] faces a particularly delicate dance with Russian companies, which are under significant financing strains. Russian corporations and banks are scheduled to repay $30 billion in foreign loans this month.

And next year, about $130 billion will be due. There is no obvious source for these hard currency payments other than the central bank, whose credibility is now being called into question.

Rosneft, for example, had been clamoring for months for a government bailout to refinance debt the company ran up while making acquisitions when oil prices were high. Because of sanctions, those loans cannot be rolled over with Western banks. Debt payments are coming due later this month.

... With the oil giant in a bind, the central bank ruled that it would accept Rosneft bonds held by commercial banks as collateral for loans.

Rosneft issued 625 billion rubles about $10.9 billion at the exchange rate at the time, in new bonds on Friday. The identities of the buyers were not publicly disclosed, but analysts say that large state banks bought the issue.

When these banks deposit the bonds with the central bank in exchange for loans, Rosneft will have been financed, in effect, with an emission of rubles from the central bank. The deal roiled the ruble on Monday, according to analysts.

The reason for Monday’s currency crash is “well known,” Boris Y. Nemtsov, a former deputy prime minister who is now in the political opposition, wrote on his Facebook page. “The central bank started the printing press to help the Sechin-Putin business, and gave Rosneft 625 billion newly printed rubles. The money immediately appeared on the currency market, and the rate collapsed.” Rosneft, in a statement, denied it had exchanged funds raised from the bonds for hard currency.

Holman Jenkins at Wall Street Journal

Which brings us to Rosneft . This week’s sharp plunge in the ruble was less linked to oil than to a mysterious “bond offering” by the state-controlled Russian oil giant, indirectly financed by Russia’s central bank. 

On Monday, Rosneft felt obliged to issue a one-paragraph statement denying that the ruble proceeds would be used to buy foreign currencies to meet Rosneft’s hefty foreign-debt repayments.

On Why the Ruble is Collapsing,

The value of the ruble dropped as much as 19 percent in the last 24 hours, the worst single-day drop for the ruble in 16 years. Now Russians are reportedly bum-rushing malls to swap cash for washing machines, TVs, or laptops—anything that seems as if it might hold value better than paper money, whose worth is evaporating in real time....

Russia's Central Bank has been trying to fight this trend, first by using its stockpile of foreign currencies to go out into the market and buy rubles, hoping to prop up the price. Then, early in the morning on Tuesday in Moscow, the Central Bank announced a gigantic interest rate increase. The idea is that if you offer people higher interest rates, they're more likely to keep their money in rubles.

Neither move has worked. 

Neil Irwin at New York Times

But interest rate increases aren’t free. Higher interest rates are sure to choke off any chance for growth in a Russian economy that is already reeling from falling oil prices.

Financial Times

The main reseller of Apple in Moscow, re:Store, saw sales two to three times higher than normal at one central branch, according to a salesman, reports Jack Farchy in Moscow.
Another store visited by the FT had sold out of iPhone 6's and iPad Airs entirely by Tuesday night (see first picture).

Marginal revolution commentary and links.

A nice graph from Bloomberg's Henry Meyer and Ilya Arkhipov capturing some of the events:

Inequality at WSJ -- the oped

This is a Wall Street Journal oped on inequality. With 30 days passed, I can post it here. It's a much edited version of my evolving "Why and How we Care About Inequality" essay.


What the ‘Inequality’ Warriors Really Want

Progressives decry inequality as the world’s most pressing economic problem. In its name, they urge much greater income and wealth taxation, especially of the reviled top 1% of earners, along with more government spending and controls—higher minimum wages, “living” wages, comparable worth directives, CEO pay caps, etc.

Inequality may be a symptom of economic problems. But why is inequality itself an economic problem? If some get rich and others get richer, who cares? If we all become poor equally, is that not a problem? Why not fix policies and problems that make it harder to earn more?


Yes, the reported taxable income and wealth earned by the top 1% may have grown faster than for the rest. This could be good inequality—entrepreneurs start companies, develop new products and services, and get rich from a tiny fraction of the social benefit. Or it could be bad inequality—crony capitalists who get rich by exploiting favors from government. Most U.S. billionaires are entrepreneurs from modest backgrounds, operating in competitive new industries, suggesting the former.

But there are many other kinds and sources of inequality. The returns to skill have increased. People who can use or program computers, do math or run organizations have enjoyed relative wage increases. But why don’t others observe these returns, get skills and compete away the skill premium? A big reason: awful public schools dominated by teachers unions, which leave kids unprepared even to enter college. Limits on high-skill immigration also raise the skill premium.

Americans stuck in a cycle of terrible early-child experiences, substance abuse, broken families, unemployment and criminality represent a different source of inequality. Their problems have proven immune to floods of government money. And government programs and drug laws are arguably part of the problem.

These problems, and many like them, have nothing to do with a rise in top 1% incomes and wealth.

Recognizing, I think, this logic, inequality warriors go on to argue that inequality is a problem because it causes other social or economic ills. A recent Standard & Poor’s report sums up some of these assertions: “As income inequality increased before the [2008 financial] crisis, less affluent households took on more and more debt to keep up—or, in this case, catch up—with the Joneses. ” In a 2011 Vanity Fair article, Columbia University economist Joe Stiglitz wrote that inequality causes a “lifestyle effect . . . people outside the top 1 percent increasingly live beyond their means.’’ He called it “trickle-down behaviorism.”

I see. A fry cook in Fresno hears that more hedge-fund managers are flying in private jets. So he buys a pickup he can’t afford. They are saying that we must tax away wealth to encourage thrift in the lower classes.

Here’s another claim: Inequality is a problem because rich people save too much. So, by transferring money from rich to poor, we can increase overall consumption and escape “secular stagnation.”

I see. Now we need to forcibly transfer wealth to solve our deep problem of national thriftiness.

You can see in these examples that the arguments are made up to justify a pre-existing answer. If these were really the problems to be solved, each has much more natural solutions.

Is eliminating the rich, to eliminate envy of their lifestyle, really the best way to stimulate savings? Might not, say, fixing the large taxation of savings in means-tested social programs make some sense? If lifestyle envy really is the mechanism, would it not be more effective to ban “Keeping Up With the Kardashians”?

If we redistribute because lack of Keynesian “spending” causes “secular stagnation”—a big if—then we should transfer money from all the thrifty, even poor, to all the big spenders, especially the McMansion owners with new Teslas and maxed-out credit cards. Is that an offensive policy? Yes. Well, maybe this wasn’t about “spending” after all.

There is a lot of fashionable talk about “redistribution” that’s not really the agenda. Even sky-high income and wealth taxes would not raise much revenue for very long, and any revenue is likely to fund government programs, not checks to the needy. Most inequality warriors, including President Obama, forthrightly advocate taxation to level incomes in the name of “fairness,” even if those taxes raise little or no revenue.

When you get past this kind of balderdash, most inequality warriors get down to the real problem they see: money and politics. They think money is corrupting politics, and they want to take away the money to purify the politics. As Berkeley economist Emmanuel Saez wrote for his 2013 Arrow lecture at Stanford University: “top income shares matter” because the “surge in top incomes gives top earners more ability to influence [the] political process.”

A critique of rent-seeking and political cronyism is well taken, and echoes from the left to libertarians. But if abuse of government power is the problem, increasing government power is a most unlikely solution.

If we increase the top federal income-tax rate to 90%, will that not just dramatically increase the demand for lawyers, lobbyists, loopholes, connections, favors and special deals? Inequality warriors think not. Mr. Stiglitz, for example, writes that “wealth is a main determinant of power.” If the state grabs the wealth, even if fairly earned, then the state can benevolently exercise its power on behalf of the common person.

No. Cronyism results when power determines wealth. Government power inevitably invites the trade of regulatory favors for political support. We limit rent-seeking by limiting the government’s ability to hand out goodies.

So when all is said and done, the inequality warriors want the government to confiscate wealth and control incomes so that wealthy individuals cannot influence politics in directions they don’t like. Koch brothers, no. Public-employee unions, yes. This goal, at least, makes perfect logical sense. And it is truly scary.

Prosperity should be our goal. And the secrets of prosperity are simple and old-fashioned: property rights, rule of law, economic and political freedom. A limited government providing competent institutions. Confiscatory taxation and extensive government control of incomes are not on the list.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

Autopsy

Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas.  As usual, the whole thing will be here in a month.

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

Read more at WSJ...

Update: Hoover has an ungated version here;  Cato has an ungated version here.

Deflation links

Commenter Zack sent the following Paul Krugman links and quotes, which deserve promotion from the comments section.

"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster."
http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk/

"So we're really heading into Japanese-style deflation territory"
 http://krugman.blogs.nytimes.com/2009/07/02/smells-like-deflation/

 "So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend." http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/

 "But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
http://www.nytimes.com/2009/05/04/opinion/04krugman.html

"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
http://krugman.blogs.nytimes.com/2010/07/11/trending-toward-deflation/

"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."
http://www.nytimes.com/2009/02/06/opinion/06krugman.html?partner=permalink&exprod=permalink&_r=0

As we know, it didn't turn out that way. We have had positive inflation for 6 years.

Why does this matter? Normally, it doesn't and it shouldn't.

To repeat points made earlier, economics should be science, not witchraft. We do not say "the witch doctor said it would rain, and it did!," and follow him for a while. At a minimum, we measure a forecaster's ability by collecting all his or her forecasts, not just the good ones -- or the bad ones. More deeply, personal prognostication is a nearly useless test of economic models. Prognostication mixes judgement, opinion, forecasts of what politicians will do and what shocks will hit the economy, along with economic  models, in ways that tell you little about the models. If a climate scientist tells you he thinks it will rain this weekend and it's sunny instead, we do not say "well, climate science is bunk." You can only "test" a model once it is written down in a way that anyone operating the model can agree what its prediction is.  Finally, there are a lot of other shocks hitting the economy; a forecaster that was right 60% of the time would be a genius in this business, so one blown forecast is meaningless. If anyone else had written these, they could reasonable respond "it's still a danger, we only avoided it by the Fed's QE and huge deficits."

But I don't write endless posts excoriating "inflationistas" for the lack of their largely mischaracterized inflation forecasts, crowing about how I'm always right about everything,  damning others for failing to learn from evidence, and Bulverizing (look it up, here too, a great word) about their evil motives. So a few look-in-the-mirror-why-don't-you quotes are appropriate.  I've been too lazy to look up these quotes, so I thank Zack for doing it.

This also will matter Monday -- I have a piece coming out that mentions the failure of the widespread "deflationary spiral" forecast. These quotes offer a nice documentation.

By the way, yes, at the time I warned of the risk of inflation, and that didn't happen either. I was quite clear it was a risk not a forecast. California has a risk of earthquakes. And the failure to see one in six years does not prove geologists are all mendacious morons. There are precedents for the inflation risk. Reinhart and Rogoff pointed to quite a few cases in which after a "quiet period," banking crises are followed by sovereign debt crises or defaults.

As I see it, that risk remains, though it has declined a lot. The reason it declined is that our government, and the European governments, kept their eyes on long-term budget issues. Our Administration has from the beginning always promised long-term budget repair, despite Keynesian theory that says if you want to stimulate, you keep quiet about future taxes or spending reductions. No point in waking up the Ricardian genie. You might complain the Administration wasn't serious enough, but they were always saying there would be a long term plan, and bond markets evidently bought it. Many in Congress too have had their eyes on long-term budgets, and long-term fiscal solvency depends if anything more on Congress than on this Administration.

The Europeans have gone through several rounds of "austerity," despite Keynesian and especially Krugmanian excoriation. (True, they started with counterproductive high-marginal-tax austerity, but Europe seems quickly to have learned that less spending and structural reform are a better path.) They came darn close. If Italy and Spain had defaulted, we would likely be having a different conversation today.

Doing so, our and Europe's governments persuaded bond markets that the currency and debt are safe -- maybe even too safe - -and avoided, for now, the sovereign debt fate Reinhart and Rogoff warned about.  If I erred in overestimating the inflationary risk, I erred in underestimating the fiscal sobriety of all our governments, and I overestimated the extent to which they believed the Keynesian advice to ignore, default, devalue, or inflate away debt. That's why no earthquake in 6 years hasn't changed all that much my views on the "model," in this case of underlying causes of inflation.

On the "spiral" or "vortex." Perhaps there are a few true-blue Keynesians reading who can help me out. I understand the idea that deflation leads to high real rates leads to lower demand leads to lower output leads to more deflation. ("Understand" ≠ "Agree".) I don't see how the model ever predicts this to end. Is there some clear "and it bottoms out when x y z?" In my model, it bottoms out when you hit the top of the present value Laffer curve, and future taxes cannot hope to pay back the deflationary increase in the real value of the debt.  But I don't know where it ends in the standard old-Keynesian model. Positive eigenvalues are positive eigenvalues. Maybe some wealth effect of government bonds (Another way to put "my model")? But why doesn't that stop the spiral in the first place? Is it right to characterize the model's prediction as an endless spiral to zero? If not why not?

Update: Commenter JZ sends the following link, and it's only fair to include it.

" ... back when the crisis started, I did expect to see deflation, Japanese style, if it went on for an extended period. I was wrong ... "
http://krugman.blogs.nytimes.com/2013/03/05/why-dont-we-have-deflation

Real or risk-neutral wolf?

Today's Torsten Slok chart. In yesterday's chart, we saw that the market forward curve keeps forecasting a recovery that never comes. Here, we see the same pattern, over much longer time period, in the survey of professional forecasters. They're always forecasting that interest rates will rise.

I think there are deep lessons from this chart. And not the simple "economists are always wrong," or even "economic forecasts are biased." The chart offers a nice warning about how we interpret surveys.

Expectations matter a lot to modern macroeconomics. But you can't directly see expectations. So many researchers have turned to surveys to measure what people say they "expect." And they find all sorts of weird things. People "expect" stock returns to be implausibly high in booms, and low in busts. Professional forecasters "expect" interest rates always to go up.

The trouble here, I think, is that we have forgotten what "expect" means to the average person.


To the average person, "expect" means about what the upper 95% quantile means for a statistician. "Expect" is what happens if most things go right. "Risk" is all downside, the chance of something going wrong. The idea that "risk" means you  might earn a lot more money than you "expected" will leave some glazed eyes.

Statisticians developed the concept of "conditional mean." They adopted the colloquial tern "expect" to denote it. Economic survey researchers then use responses of "what do you expect?" to infer subjective conditional means.  But the average person never took a statistics class, and those that did haven't changed their use of colloquial language.

Understanding how real people use the word makes sense of a lot of surveys. I once delved in to venture capital and discovered that analysts were using 40% rate of return hurdles. This makes no sense, right? Except if you understand that "cash flow expectations" means "how much we'll make if everything goes right" -- about the 95% quantile, not the conditional mean -- then a 40% discount rate might be a reasonable rough and ready way to adjust for that.

Moreover, the average person doesn't distinguish well -- and if he or she does, the survey never asks -- whether "expect" refers to the true or the risk-neutral distribution.

The risk-neutral distribution -- probability multiplied by pain (marginal utility) -- is a wonderful concept. For many decisions, the risk-neutral probability is a good sufficient statistic: Pay attention to probable events or painful events. When someone wishes you a safe flight, they're not ignorant of the vanishing probability of a plane crash. They are multiplying low probability times the high marginal utility (pain) of the event. A rise in interest rates, to a long-term bond investor, is a painful event.

The market forecast in forward rates is exactly the risk-neutral  mean. And today's chart suggests that survey forecasters' response to "what do you expect" isn't straying far from the risk-neutral mean either. (Or, it's not straying that far from forward rates!)

In sum, next time you see a paper that uses surveys to measure "expectations," ask if the survey respondents knew the difference between "mean," "median" and "risk-neutral vs. true probability?" (Of course not.) Then you can ask why the author assumes one rather than the other.

More constructively, when using surveys, it's important to make use of the data in ways such that the precise meaning of the word doesn't matter. It  would also be interesting to develop some survey methodology that recognized the colloquial meanings of "expect" have little to do with the statistical concept.

1994?

Torsten Slok at Deutsche Bank sends the graph, along with some musings on the eternal question: When (if?) interest rates rise, will it look like 1994, or like 2004? Will rates rise quickly, leading to a bath in long-term bonds? Or will rates rise slowly and predictability?

The graph shows you actual short term rates (red) and forward curves. As this lovely graph points out, the forward curve has been predicting rises in rates for years now. And it's been wrong over and over again. Economists all over have been forecasting a robust recovery too, and that hasn't happened either.

(To non-finance people: The forward rate is the rate you can lock in today to borrow in the future. So the forward curve ought to reflect where the market expects interest rates to go. If people expect rates to rise more than the forward curve, they rush to lock in now, which drives up the forward curve. Also, the forward curve is a cutoff between making and losing on long-term bonds. If interest rates rise following the forward curve, then long bonds and short bonds give the same return. If rates rise slower, long-term bondholders make more money. If rates rise faster, long bonds make less than short or even lose money. So, should you buy long term bonds? Compare your interest rate forecast to the last dashed line and decide.)

Torsten:

The chart .. makes you humble when it comes to the timing of the first rate hike.

Indeed.

But once the Fed starts hiking, they will likely raise rates faster than the market currently is anticipating. Think about it: The Fed has basically decided that they will only start hiking rates once there are signs of inflation.. If the economy is overheating, then raising the fed funds rate to 0.5% is not going to slow the economy down....To cool the economy down, the fed funds rate needs to be above the neutral fed funds rate, which we estimate to be 3.5%...to get inflation under control, the Fed will likely have to raise rates well above the neutral level, potentially above 5%...

So his scenario is, interest rates low and more good times for long term bonds until (if) inflation substantially exceeds 2%, then a big rout, as small rises will not do much quickly to dampen inflation. More like 1994.

An interesting view into the brains of bond traders:

The reaction I often get in client meetings when we discuss these issues is along the lines of: “Yes, I understand what you are saying but I have been positioned for higher rates for several years and it hasn’t happened. As a result I have underperformed my benchmark. Instead, I will now wait until I actually see the Fed raising rates”. The main problem from a trading perspective is that we don’t know when this will happen... In the meantime, rates will remain low, not because investors don’t believe in the recovery continuing but because investors cannot afford to be positioned for higher rates for several years.

There is so much here... "Positioned for higher rates" means "sell my long term bonds and hold short term bonds."

"Underperforming" is true. Anyone who "positioned themselves for higher rates" has watched as those willing to hold the risk of longer term bonds got higher yields, and higher prices as well. As anyone who "positioned themself for the end of the internet boom" did in 1997, or who "positioned themselves for the end of the credit boom" in 2005.

But think of the madness of "underperforming my benchmark" in bond markets. It means that long-term bond investors are hiring active managers, then rewarding the managers based on one-year returns relative to a long-term bond index, which the manager wins or loses by simply going a bit longer or shorter than the index. It would be silly enough for stocks -- rewarding managers for taking a bit more or less beta -- but it's double silly for bonds, because when bond prices go down, yields go up, and you always end up back where you started. Rewarding active bond managers for one-year duration bets is just... the standard way this nutty business works apparently.

But it echoes conversations I've had over the years. Me: "so, you really think two percent on long-term treasuries is a good deal? Inflation won't bust two percent for 20 years?" Trader: "Are you kidding? There is going to be a bloodbath. But I think it's still going up for a while before the rout." Not a recipe for long-run stability. And yet rates did not move, and trader was right, year after year.

The "main problem" from a trading perspective is that you can't sell after prices already went down!

Risk premiums

The alternative interpretation of Torsten's chart is risk premium. The market expects zero rates forever, and the upward sloping forward curve and great returns to long term bonds are just the premium for holding the risk of long-term bonds.

The deep trouble is, we really don't know that much about this premium. The models basically use regressions. And the longer we see an upward sloping forward curve and no movements in rates, the more "models" will say "it's a risk premium."

Monika Piazzesi and I did our best to get a handle on this risk premium business. The bottom line, there typically is a big risk premium early in recessions, but later in recessions the forward curve is more likely to signal rate rises that really are coming. Just how late is "late," and how sure you are about the diagnosis, is the big question separating academics from traders.

But you can't have a "risk premium" without risk. That interpretation just changes the probability of a 1994 event, not that it can't happen.

Who is afraid of a little deflation? Op-Ed

This was a Wall Street Journal Op-Ed from a month ago. Now I can post the whole thing in case you missed it then.

Who is Afraid of a Little Deflation?

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.


Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

There are good reasons to believe it can’t happen. Most of all, government solvency fears that don’t matter for 2% deflation kick in and stop a deflation spiral. If prices fall 20%, or 30%, bond-holders will see that governments cannot pay back debts. They try to get rid of their bonds before the coming default. They buy things or other currencies, nipping the deflation spiral in the bud.

There is an unsettling feature of the current inflation situation, however. Clearly, our central banks want higher inflation, and the current slow decline was unintended. So, just as clearly, central banks have a lot less understanding of and control over inflation and deflation than most people think.

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happened. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution and an adjunct scholar at the Cato Institute.

Loggerheads

Government Debt Management at the Zero Lower Bound is a very nice and interesting paper by Robin Greenwood, Sam Hanson, Josh Rudolph, and Larry Summers.

Figure 1. Comparing Quantitative Easing and Treasury Maturity Extension, 2007–2014 ...the cumulative change in 10-year equivalents (scaled as a percentage of GDP) associated with the respective balance sheet policies undertaken by the Federal Reserve and the Treasury. Positive values increase the interest rate risk placed in public hands (Treasury policies), while negative values decrease it (typically Fed QE, but also Treasury maturity shortening in 2008–2009).

First point, what the Fed taketh away, the Treasury giveth. (Hence the title of this post). The Fed bought lots of long-term debt, with the idea that this would raise the price, lower the interest rate on the long-term debt, and thus stimulate the economy.

At the same time, however, the Treasury was selling lots of long-term debt. Interest rates are very low, and debts are high, so it's a great time to lock in low-rate financing. Homeowners and businesses are doing the same thing.


Alas, the Treasury and Fed are part of one budget constraint, so you can't have it both ways. As it turns out, the Treasury sold even more than the Fed bought, so by their calculations, during the period of QE, the private sector absorbed more long-term government debt!

...despite successive rounds of QE, the stock of government debt with a maturity over 5 years that is held by the public (excluding the Fed’s holdings) has risen from 8 percent of GDP at the end of 2007 to 15 percent at the middle of 2014. Said differently, the volume of 10-year duration equivalent debt has doubled from 13 percent of GDP to 26 percent of GDP over the same interval. Pressure to absorb long-term government debt has actually increased rather than decreased over the last six years!

The closing section, and main point, I think, is a proposal for how  Fed and Treasury should divide responsibility to avoid such loggerheads.

QE

Obviously, if the public has been holding more, not less, long term debt overall, that calls in to question if or how QE "worked.''

If  QE works, does it work down some price-pressure, portfolio-balance, segmented-market, demand-for-maturity curves? Or does it work by signaling Fed intentions about interest rates, and not at all per se? The fact that Treasury also changes maturity structure in private hands can let us sort out the two stories

But if the direct supply effects of QE have been offset by the massive expansion in outstanding government debt and the Treasury’s decision to extend the debt maturity, then what explains the large market impact of QE announcements documented in so many studies, as well as the fact that estimates of term premia on long-term bonds have been steadily driven into negative territory and remain miniscule today, as shown in Figure 3? The most natural explanation is that the Fed’s announcements about its intended asset purchases also conveyed information about its future policies, including both the likely path of future short-term rates and the Fed’s willingness to undertake further asset purchases in response to evolving economic conditions...

... there are reasons to think that announcements of Fed asset purchases may have a greater impact on term premia than comparably sized Treasury supply announcements. Consistent with this, Rudolph (2014) provides event-study evidence suggesting that Fed announcements have about twice the impact as Treasury announcements of a similar size...

I might add that event studies around announcements of future purchases tell us what the market thinks the effect of those purchases will be. Rational expectations is not a solid guide to events outside of all historical experience.

I've long wondered, if the Fed wanted to move long term rates, why did it not just do it -- buy and sell as required to nail the long term bond rate to 2%, say? It turns out this has a precedent:

A few months after the U.S. entered World War II, and in the midst of a rapid increase in government spending, the Fed and the Treasury agreed to fix the entire yield curve of Treasury securities. Three-month bill yields were limited to 0.375% and bond yields were held at 2.5%. The Fed stood ready to buy or sell any amount of treasury securities necessary to maintain this positively sloped yield curve

Optimal maturity structure: Liquidity premium vs. insurance against rate rises 

They argue for a much shorter maturity structure overall, trading the liquidity and low interest rate benefits of issuing short term debt against the insurance against interest rate rises benefits of issuing longer debt.

the main messages we take from these counterfactual exercises are (1) that the additional budgetary volatility incurred by shifting the government debt into short-term securities is less than is commonly supposed, and (2) that doing this would have allowed the government to capture liquidity premia on an ongoing basis

Here's the simulation. They compare surplus/deficit and total debt under existing debt and what would have happened if the Treasury issued only 3 month bills.

Figure 8 Debt and Deficits under Counterfactual Debt Management Plans. The counterfactual exercise measures the path of deficits and debt supposing that the U.S. Treasury had financed itself using rolling 3-month Treasury bills starting in 1952. ....

You can see with 3 month bills that interest-induced changes in deficits come sooner. But there isn't a big difference. From this they conclude that the interest-rate-insurance that comes from long term debt isn't a big deal.

I've been worrying about the interest-costs that a rise in interest rates would imply for some time now,  and advocating longer maturity structures on that basis. (For example in an earlier blog post  here and a longer paper here and most recently in "monetary policy with interest on reserves" ). So what's the difference? I'd make a two little complaints

1. The  US maturity structure is quite short. Last time I put together the numbers, the US rolls over half our debt every two years. And historically, it's been much shorter. So shortening down to three months doesn't change things a lot. How would lengthening to perpetuities work here?
2. The danger is a large debt to GDP ratio and the risk of a rate rise. Now we have $18 trillion of debt, so interest rates rising to 4% means $760 billion more deficits.  The graphs show two important data points really. At the end of WWII we had big debt/DGP. And interest rates stayed low until the 1970s. At the end of the 1980s, we had a big rise in real rates. And a low debt/GDP ratio.  So, Russian roulette, the gun clicked twice, doesn't mean we're safe. This isn't about averages, it's about risk management. 

Still, it's a challenging calculation, and to answer it properly requires a simulation of possible interest rate paths and debt stocks. 

They opine on real vs. nominal debt, too, arguing for more nominal debt, and much else. The whole thing is a good read.

Level, Slope and Curve for Stocks

"The Level, Slope and Curve Factor Model for Stocks" is an interesting and important empirical finance paper by Charles Clarke at the  University of Connecticut.

Charles uses the Fama-French (2008) variables to forecast stock returns, i. e.,  size, book to market, momentum, net issues, accruals, investment, and profitability. \[ Ret_{i,t+1} = \beta_0 + \beta_1 Size_{i,t} + \beta_2 BtM_{i,t} + \beta_3 Mom_{i,t} + \beta_4 zeroNS_{i,t} + \beta_5 NS_{i,t} + \beta_6 negACC_{i,t} + \] \[ + \beta_7 posACC_{i,t} + \beta_8 dAtA_{i,t} + \beta_9 posROE_{i,t} + \beta_{10} negROE_{i,t} + e_{i,t+1} \] He forms 25 portfolios based on the predicted average return from this regression, from high to low expected returns.  Then, he finds the principal components of these 25 portfolio returns.

Source: Charles Clarke

And the result is... hold your breath... Level, Slope and Curvature! The picture on the left plots the weights and loadings of the first three factors. The x axis are the 25 portfolios, ranked from the one with low average returns to 25 with high average return. The graph represents the weights -- how you combine each portfolio to form each factor in turn -- and also the loadings -- how much each portfolio return moves when the corresponding factor moves by one.

No surprise, the 3 factors explain almost all the variance of the 25 portfolios returns, and the three factors provide a factor pricing model with very low alphas; the APT works.

Now, why am I so excited about this paper?

There are now dozens -- above 300 in the literature (see  Green, Hand, and Zhang and Harvey, Liu and Zhou) -- of variables that supposedly forecast stock returns in the cross section. The first, hard, question is which of these really matter, in a multiple regression sense, and how much data mining is there in the whole business?

The next, harder, and less examined, question is, how do these patterns in mean returns correspond to covariances?  Each variable seems also to be a factor in the variance sense -- assets sorted by variables that forecast returns turn out to move together ex-post. But how many such factors do we really need? To explain the cross-section of average returns, do we need growth and profitability factors in the presence of value? Look at Fama and French and  Robert Novy-Marx wrestling with one factor vs. another.  Discount Rates wrestled with this question, suggesting that we need to model the covariance matrix as a function of characteristics, essentially running regressions of the product \( R_{i,t+1}R_{j,t+1} \) on the same right hand variables, somehow factor analyze that, somehow sort through the same multiple regression/fishing problem to see which characteristics are really important to second moments, and then see if the first moment function of characteristics is linearly proportional to covariance as a function of characteristics. Ugh.

Charles cuts through the latter huge multiple-regression chaos. His big idea is,  look at the only characteristic that matters, the expected return itself!  And he comes up with level, slope, and curvature, which is always the answer and thus beautiful. We just had to know which question to ask. The fishing problem in expected returns remains, but relating the expected returns to factors is much simpler.

More deeply, I think Charles is leading us down a second step of how we think about asset pricing models. First, we thought of expected return and betas of individual companies. But those are unstable over time, so on average all companies look about the same. Then, we thought of expected return and betas as functions of characteristics like size and book to market, ignoring the company name. That worked well with one or two characteristics, but it's falling apart with hundreds of characteristics. By using expected return itself as the only characteristic for second moments, Charles dramatically simplifies the task.

Lustig, Roussanov and Verdehlan  did something quite similar for the carry trade. Sorting countries by expected return, they found a stable structure, and level slope and curvature factors; they found the slope factor accounted for expected returns.  But that was still basically using only one signal, so I didn't see the big point. In Charles' paper, the level slope and curvature factors of the expected-return portfolios allow you to  avoid the whole highly multivariate modeling of the covariance matrix.

Bravo.

(Students: factor analysis is really easy. [Q,L] = eig(cov(rx)) in matlab, where rx is the T x N vector of returns. The columns of Q are then the weights and loadings of the principal components. Detailed explanation starting p. 551 here. )

Policy penance

The last few posts haven't worked out so well, that's for sure. After a too-grumpy reaction to Alan Blinder's review,  I wanted to say something nice and find common ground with the "what's wrong with macro" articles and even Krugman's posts. In doing so I was much too quick and superficial in characterizing what's going on at high levels of our policy institutions. The only result was that  I managed to annoy all my friends and colleagues at the Fed, IMF, and so on.

As penance, I'll try a blog post that more accurately characterizes the interaction of research and policy, "Keynesian" and modern economics, and so on, as I see it.

If we look one step below the political level, for example at the FOMC minutes and what research staff are up to at institutions like Fed and IMF, you see a very sophisticated interaction between the ideas of modern economic research and policy. The FOMC minutes and speeches by board members (all easy to find on the Fed's website) are a great source. The FOMC seems, to an outsider,  like the world's highest-level debating club on modern macroeconomics.

On many of the dividing lines between traditional Keynesian and modern economics, the policy discussion is decidedly modern.

Traditional Keynesian economics is above all, static. Consumption depends on income, today; investment depends on interest rates and animal spirits, today, and so on. This is in part its great success. At the time, people didn't have the tools to do dynamic intertemporal economics.

Now we do. Modern macroeconomics is, above all, intertemporal. People make consumption and investment decisions, thinking about today and the future. This intertemporal revolution started with the permanent income model, that consumption depends on expected future income, and continues to this day.

(Let me quickly stop a discussion that will spin out of control into quotations from Keynes and what he might have "really meant." What matters is what was in Keynesian models, used in policy for generations, and that's ISLM. Perhaps a deeper reading of Keynes -- or Marx, or Smith, or the Talmud -- might reveal some intertemporal poetry. But it really had little effect on how models are used or policy was done. So here "Keynesian" means ISLM-ASAD.)

Now, if you read FOMC minutes, Fed speeches, or talk to people at the Fed about policy, you will see that this intertemporal, expectation-focused approach resulting from the revolutions of the 1970s permiates the policy-making process. For example, "forward guidance" is the rage. It only takes one beer for the conversation to quickly acknowledge that QE likely worked as much by signaling low interest rates for a long time than it did by exploiting some sort of permanent price-pressure in Treasury markets.

More deeply, the Fed policy discussion recognizes that "expectations" are not the same things as "speeches by public officials." People have heard lots of promises before. Policy faces a deep "time consistency" and "commitment vs. discretion" problem, again part of the late 1970s revolution in macroeconomics. People don't believe promises made now, because they know the Fed may change its mind later.

This realization led modern macroeconomics to focus on policy rules, rather than policy actions, which we can chalk up as a second major break between traditional Keynesian analysis and modern macroeconomics. Rules can be written down, legal or constitutional constraints, or simply traditions long observed.  The best way to "manage expectations" is not to "manipulate" them with speeches, but instead to follow well-established rules -- even when you'd rather not.  Friedman's 4% rule from the 1960s had some of this flavor. Taylor's interest rate rule from the 1990s has it explicitly, and inflation target rules even more strongly.

Over the last 20 years, and especially under chairman Ben Bernanke, you could see the importance of transparent, predictable, rule-based thinking take hold. The early Fed was deliberately secretive and deliberately obscure. There was a time when they wouldn't even tell markets what the Federal Funds target was!  Since then, explanation of what the Fed is doing, why the Fed is doing it, what the Fed is likely to do in the future, and finally how the Fed will react to events in the future -- a "state-contingent" rule -- has become more and more important in Fed discussions.

This attitude took a little step back recently; the Fed tried to communicate that interest rates would rise when unemployment fell below 6.5%.  (Clarification below.) That promptly happened, unexpectedly, forcing the Fed to backtrack and say no, wait, we really want to look at broader labor market indicators.

Well, it's hard to follow rules ex-post. That's the whole point of rules! Adopting rules needs major changes in what we expect of policy too. If Janet Yellen had raised rates as "promised," then went to Congress to say "we proclaimed a rule, so we had to stick to it even though we and you both thought the economy way too weak to raise rates," you can imagine the howls.

I'm not here to criticize, or to opine on just how firm Fed rules should be. The point is that the Fed is conducting this debate at the highest levels, fully informed by modern academic research on the subject.

The discussion surrounding fiscal stimulus in 2008-2009 strikes me as having been a good deal less sophisticated and much more "old-Keynesian," involving static "multipliers," straight from a 1970s textbook. But that may be a poor example as it was done in a huge hurry, inside the Administration, and away from the kind of carefully constructed policy process that the Fed and other agencies maintain.

Fed speeches, even from chairs Bernanke and Yellen, are peppered with citations to academic work and staff work. More evidence of a tight connection between modern research and top level policy discussions.

In fact, one can quite plausibly complain that the Fed, IMF, and similar institutions are too close to academic research, or perhaps that academic research is too motivated by finding reasons for the latest policy idea. In no other area that I can think of, where important policy is made and there is a corresponding body of academic research, do people seriously propose to guide policy based on the latest, usually unpublished, and usually novel, research. We wait a while for ideas to settle.

As an instance, I've been a bit critical of the apparent distance between policy and research, and I've also been quite critical of the current generation of new-Keynesian models.  Well, John, make up your mind! On the latter view, I should certainly not advocate that the Fed tomorrow implement policy based on the latest large-scale estimated new-Keynesian model. But on the former, I have to admit that sort of thing has been standard academic research for 20 years now. Most bloggers mean "the Fed should pay more attention to my research," but I won't -- yes, research has to settle before being used for policy.

The hard fact is that economic models are quantitative parables, not explicit and complete descriptions of reality. The step of understanding the model's "intuition," "basic message," and so forth is devilishly hard. That's why we have such deep verbal discussions about economic models, where we imagine physicists just test them and are done.  (They don't, but that's another story.)

An example. In 2012, Mike Woodford gave a subsequently famous paper at the Jackson Hole conference, arguing that in new-Keynesian models, "forward guidance" that interest rates will be kept low for longer than usual can create stimulus at the zero bound. This paper generated lots of controversy, not least from me. Do people believe such promises? Yes, we can write a model in which the Fed announces a new new rule, and everyone believes it. But does the world work that way? More deeply, is the underlying model right? For example (of many) is my complaint that it assumes the Fed threatens to blow up the economy a big problem, or just an easily-fixed technical simplification?

Be it as it may, this was first-rate academic research, by a first-rate academic, and it evidently profoundly influenced the policy debate.

A similar story occurs daily on how the Fed should think about "secular stagnation," "macroprudential policy," "pricking asset price bubbles," long term labor force participation, inequality, and so on and so on.   As a concrete example, Jeremy Stein when on the board gave an excellent series of thoughtful speeches on the relation between monetary policy and financial stability. Here is a good one, bristling with citations to academic research.

The trouble with all this is not a lack of contact between Fed and academic research. The trouble is, if anything too much! The basic "trouble with macroeconomics," circa 2014, is about the same as the "trouble with physics," circa 1790. We know a lot. But there is so much we don't know.

All of this work, really, is about "frictions" in the economy. "sticky prices," "sticky wages," whatever they really mean, "financial frictions," leverage constraints, collateral constraints, temporarily segmented markets, "liquidity," as much in the eye of the beholder as smut, and so on and so forth. The "trouble" with macroeconomics is that we're really only beginning to figure out what all this really means and how it works.

To the similar complaint that there is "too much math" in economics: no, there is too little! We don't have the tools to model, understand, and control all these hazy ideas that seem to matter when we look at the world.

I think there are some unfortunate heirs of the old-Keynesian tradition still at work in policy-making, however.  It is natural that they are there, but I think it will be good when they vanish.

First, since models are quantitative parables, and it takes a long time to digest what they really mean for a given situation, it is natural that the top level of policy makers to continue to digest new work in an old model. "Oh yes, I see, this model really means 'aggregate demand' is low and stimulus will raise it.  Now I get it." That's a perfectly normal reaction.

Second, and deeper, the Keynesian policy tradition left a strong desire for activist, discretionary, "what do we do today?" sorts of answers.

I long ago sat at a hilarious academic advisory meeting at a Federal Reserve, at which the bank president asked, bottom line, whether we thought the Fed should raise, cut, or leave alone the funds rate. Academic after academic gave beautiful speeches about the right policy rule. (Me, an ode to price level targets rather than inflation rate targets.) The poor exasperated president said, "that's all very nice, but what should we do now?"

This call for action, for activist discretionary response, is at the core of Keynesian economics. It's very very hard to talk about rules and institutions rather than actions. And the core answer of modern intertemporal economics is to unask the question.  But people expecting a daily discretionary decision just don't want to hear about the rule.  In this regard, the policy mindset still is decidedly old-Keynesian.

As a counterexample, consider asking the question "what should monetary policy do about unemployment" in the 1800s. There was no Fed. "Monetary policy" consisted of the gold standard, implemented by the Treasury.  The answer would be, "the price of gold is $20 per ounce. What's your question?" I'm not (!) saying that's the right policy, but it is a pure example of a rule rather than activist discretion.  A serious discussion about a rules-based Fed would start by canceling the regular FOMC meetings and the economic review. That just presupposes that the whole process is to come to a discretionary decision.

Third, economic policy discussion seems to ignore the tremendous lack of knowledge we have over basic cause and effect mechanisms, even the signs and causal channels of effects let alone magnitudes. Policy discussions jump to exploiting the latest friction before the ink is dry.

But by and large policy decisions don't, and are quite conservative about implementing new ideas. Expectations, rules, discretion and commitment, are from the late 1970s!

When things are ambiguous, you stick with what you've got. Keneysian orthodoxy ruled for a long time. Even if it's shown to be wrong, replacement models are so different, still so untested and unrefined, continuing to use basic Keynesian intuition is a natural response to ambiguity.

Fourth, I will complain a bit about how much academic research produces answers to support desired policy rather than the other way around. Stimulus came on the political landscape, and a hundred papers are written about how stimulus might work. The one thing I will gently chide some people (not all!) at the Fed for is how often staff reports come up with the number that the chair wants to hear. This is particularly true when introducing "frictions" to models. Yes, this or that friction might justify a policy. But if you really think sticky wages are the problem, why write articles justifying central bank intervention, and not one on how wages might be profitably unstuck?

But these minor complaints aside, as I look at the layer of policy process just below the headline political appointees, and just above the silly stuff in the opinion pages of the New York Times, really the interplay of academic ideas and policy is about as healthy as I could make it. (Obeying the rule that one has to be evenhanded about all research, not just my research!) A residual, fading, back of the envelope Keynesianism is pretty natural.  And the good ideas of modern, intertemporal, people-based, budget-constraint-disciplined, economics are being digested and slowly implemented.

Next, this whole new Keynesian vs. old-Keynesian thing.

Update: A correspondent points out that the actual FOMC statement is more nuanced,

[The committee] currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. 

But the perception of a rule and backtracking was real.

Update 2: I see from blogger's trackbacks that Paul Krugman covered this post. I'll keep to the usual don't-respond-to-Krugman policy, with one exception. Krugman writes:

Well, at least Cochrane now concedes that Woodford isn’t stupid. Progress!

I have never, ever, anywhere, in writing, in words, in thought, in insinuation, or veiled reference, said that Mike Woodford is "stupid.." I have never said or written that anyone is "stupid," "mendacious", "mendacious idiot," "evil," "corrupt," "hack," or any other ad-hominen attack or insult.  Google all you want, you will not find any such quote. Yes, I mercilessly skewer bad ideas, but never people. To me that is the most bedrock ethical principle of intellectual honesty.

Mike Woodford in particular has been a friend and a colleague for many years. I have learned a lot from him, I have benefited enormously from his comments on my work, and I've read his in detail.  I taught PhD classes from his book.

The charge that I don't know or haven't read or recently discovered Woordford is laughable. I spent about 5 years of my research life writing "Determinacy and Identification" which is nothing but a careful dissection of new-Keynesian economics as distilled in Mike's book. I may be wrong, but not out of ignorance.

Mike, if you're listening, I can't control the vitriol that the New York Times sees fit to print, so all I can do is post a correction to my humble blog -- Krugman is making this up out of thin air.

Update 3: Due to an avalanche of hateful comments from Krugman's choir, I've turned off comments on this post.