Macro-Finance

A new essay "Macro-Finance," based on a talk I gave at the University of Melbourne this Spring. I survey many current frameworks including habits, long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes, and debt or institutional finance. I show how all these approaches produce quite similar results and mechanisms: the market's ability to bear risk varies over time, with business cycles. I speculate with some simple models that time-varying risk premiums can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, rather than Keynesian flow constraints or new-Keynesian intertemporal substitution.

Syverson on the productivity slowdown

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

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

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

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

Chad:

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

An interesting read throughout. 

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

Lottery Winners Don't Get Healthier

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

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

The lives of a CEO, a lab supervisor, a janitor, and an unemployed mother illustrate how class shapes opportunities for good health. Those on the top have the most access to power, resources and opportunity – and thus the best health. Those on the bottom are faced with more stressors – unpaid bills, jobs that don’t pay enough, unsafe living conditions, exposure to environmental hazards, lack of control over work and schedule, worries over children – and the fewest resources available to help them cope. 

The net effect is a health-wealth gradient, in which every descending rung of the socioeconomic ladder corresponds to worse health.

If this were true, then increasing the wealth of a poor person would increase their health. That does not appear to be the case. In important new research David Cesarini, Erik Lindqvist, Robert Ostling and Bjorn Wallace look at the health of lottery winners in Sweden (75% of winnings within the range of approximately $20,000 to $800,000) and, importantly, on their children. Most effects on adults are reliably close to zero and in no case can wealth explain a large share of the wealth-health gradient:

In adults, we find no evidence that wealth impacts mortality or health care utilization.... Our estimates allow us to rule out effects on 10-year mortality one sixth as large as the crosssectional wealth-mortality gradient.

The authors also look at the health effects on the children of lottery winners. There is more uncertainty in the health estimates on children but most estimates cluster around zero and developmental effects on things like IQ can be rejected (“In all eight subsamples, we can rule out wealth effects on GPA smaller than 0.01 standard deviations”).

(My emphasis above)

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

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

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

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

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

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

Update:  Melissa Kearney writes,

"Bill Evans and Craig Garthwaite have an important study [AER] showing that expansions of EITC benefits led to improvements in self-reported health status among affected mothers. 

Their paper provides a nice counterpoint to the Swedish lottery study, one that is arguably more relevant to the policy question of whether more income would causally improve the health of low-income individuals in the U.S.

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

Lessons Learned I

I spent last week traveling and giving talks. I always learn a lot from this. One insight I got:  Real interest rates are really important in making sense of fiscal policy and inflation.

Harald Uhlig got me thinking again about fiscal policy and inflation, in his skeptical comments on the fiscal theory discussion, available here. At left, two of his graphs, asking pointedly one of the standard questions about the fiscal theory: Ok, then, what about Japan? (And Europe and the US, too, in similar situations. If you don't see the graphs or equations, come to the original.) This question came up several times and I had the benefit of several creative seminar participants views.

The fiscal theory says
 \[ \frac{B_{t-1}}{P_t} = E_t \sum_{j=0}^{\infty} \frac{1}{R_{t,t+j}} s_{t+j} \]
 where \(B\) is nominal debt, \(P\) is the price level, \(R_{t,t+j}\) is the discount rate or real return on government bonds between \( t\) and \(t+j\) and \(s\) are real primary (excluding interest payments) government surpluses. Nominal debt \(B_{t-1}\) is exploding. Surpluses \(s_{t+j}\) are nonexistent -- all our governments are running eternal deficits, and forecasts for long-term fiscal policy are equally dire, with aging populations, slow growth, and exploding social welfare promises. So, asks Harald, where is the huge inflation?

I've sputtered on this one before. Of course the equation holds in any model; it's an identity with \(R\) equal to the real return on government debt; fiscal theory is about the mechanism rather than the equation itself. Sure, markets seem to have faith that rather than a grand global sovereign default via inflation, bondholders seem to have faith that eventually governments will wake up and do the right thing about primary surpluses \(s\). And so forth. But that's not very convincing.

This all leaves out the remaining letter: \(R\). We live in a time of extraordinarily low real interest rates. Lower real rates raise the real value surpluses s. So in the fiscal theory, other things the same, lower real rates are a deflationary force.

The effect is quite powerful. For a simple back of the envelope approach, we can apply the Gordon growth formula to steady states. Surpluses \(s\) grow at the rate \(g\) of the overall economy. So, in steady state terms,
 \[ \frac{B_{t-1}}{P_t s_t} = E_t \sum_{j=0}^{\infty} \frac{(1+g)^j}{(1+r)^j} \approx \frac{1}{ r - g} \]
\[ \frac{P_t s_t}{B_{t-1}}  \approx  r - g \; \; (1) \]
(and exact in continuous time). The left hand side is the steady state ratio of surpluses to debt. The right hand side is the difference between the real interest rate and the long-run growth rate.

So, with (say) a 2% growth rate g, and a 4% long-run interest rate r, surpluses need to be 2% of the real value of debt. But suppose interest rates decline to 3%. This change cuts in half the needed long-run surpluses! Or, holding surpluses constant, if long-run interest rates fall to 3%, the price level falls by half.

You can see the punchline coming. Long term real interest rates are really low right now. If anything, we're flirting with \(r \lt g\), the magic point at which governments can borrow all they want and never repay the debt.

With this insight, Harald should have been asking of the fiscal theory, where is the huge deflation? And the answer is, well, we're sort of there. The puzzle of the moment is declining inflation and even slight deflation despite all our central bankers' best efforts.

Pursuing this idea, there is a larger novel story here about growth, interest rates, and inflation.

Obviously, there is an opposite prediction for what happens when real interest rates rise. Higher real rates, unless accompanied by higher surpluses, will drive inflation upwards.

In conventional terms, looking at flows rather than present values, suppose a government that is $20 Trillion in debt faces interest rates that rise from 2% to 5%. Well, then it has to increase surpluses by $600 billion per year; and if it cannot do so inflation will result.

A similar story makes sense for the cyclical falls in inflation. What happened to our equation in 2008?  Surpluses fell -- deficits exploded -- and future surpluses fell even more. Debt rose sharply. Why did we see deflation? Well, real interest rates on government debt fell to unprecedentedly low levels. This really isn't even economics, it's just accounting. The equation holds, ex-post, as an identity!

To think a bit more about real rates, growth, and inflation, remember the standard relation that the real interest rate equals the subjective discount rate (how much people prefer current to future consumption) plus a constant times the per capita growth rate
\[ r = \delta + \gamma (g-n) \]
The constant \(\gamma\) is usually thought to be a bit above one.

With \(\gamma=1\) (log utility), then we have \(r-g = \delta-n\). The magic land of unbounded government debt can occur because government surpluses can grow at the population growth rate, while interest rates are determined by the individual growth rate. But population growth is tapering off, and must eventually cease, and bondholders prefer their money now. With \(\gamma \gt 1 \) ,
\[ r-g = \delta - n + (\gamma-1)(g-n) \; \; (2)\]
The new term is the per capita growth rate, which is positive, further distancing us from the land of magic.

More to the point, though, we now have before us the central determinant of long run real interest rates. Real interest rates are higher when economic growth is higher. And \(r-g\) rises when economic growth \(g\) rises.

So, going back to my equation (1), we actually had a puzzle before us. Higher real interest rates would mean lower values of the debt, and would thus be inflationary if not accompanied by austerity to pay more to bondholders. But higher real interest rates must come with higher economic growth, and higher economic growth would raise surpluses, helping the situation out. Which force wins? Well, equation (2) answers that question: With \(\gamma \gt 1\), the usual case (a 1% rise in consumption growth comes with a more than 1% rise in real interest rates), higher growth g comes with higher still interest rates r, and thus remains an inflationary force, again holding surpluses constant.

All in all then, we have the hint of a fiscal theory Phillips curve: Inflation should be procyclical. In good times, interest rates rise and the real value of government debt falls, producing more inflation. In bad times, interest rates fall and the real value of government debt rises, producing less inflation.

Central banks have been absent in all this. The natural next question is, does this provide another reinforcing channel by which central banks might raise inflation if they raise interest rates? I don't think so, but one needs more equations to really answer the question.

What matters here are very long-term real interest rates, the kind that discount expectations of surpluses -- yes, we need some surpluses! -- 20 to 30 years from now to establish bondholder's willingness to hold debt today.

In no model I have played with can central banks affect real interest rates for that long. I think a quick look out the window convinces us that central banks cannot substantially raise interest rates in a slump, with supply of global savings so strong compared to demand for global investment. Long-term interest rates really must come from supply and demand, not monetary machination. Higher real interest rates require higher marginal products of capital, and thus higher economic growth, not louder promises, more speeches, or more energetic attempts to avoid the logic of a liquidity trap.

A very simple neo-Fisherian model

A sharp colleague recently pushed me to write down a really simple model that can clarify the intuition of how raising interest rates might raise, rather than lower, inflation. Here is an answer.

(This follows the last post on the question, which links to a paper. Warning: this post uses mathjax and has graphs. If you don't see them, come back to the original. I have to hit shift-reload twice to see math in Safari. )

I'll use the standard intertemporal-substitution relation, that higher real interest rates induce you to postpone consumption, \[ c_t = E_t c_{t+1} - \sigma(i_t - E_t \pi_{t+1}) \] I'll pair it here with the simplest possible Phillips curve, that inflation is higher when output is higher. \[ \pi_t = \kappa c_t \] I'll also assume that people know about the interest rate rise ahead of time, so \(\pi_{t+1}=E_t\pi_{t+1}\).

Now substitute \(\pi_t\) for \(c_t\), \[ \pi_t = \pi_{t+1} - \sigma \kappa(i_t - \pi_{t+1})\] So the solution is \[ E_t \pi_{t+1} = \frac{1}{1+\sigma\kappa} \pi_t + \frac{\sigma \kappa}{1+\sigma\kappa}i_t \]

Inflation is stable. You can solve this backwards to \[ \pi_{t} = \frac{\sigma \kappa}{1+\sigma\kappa} \sum_{j=0}^\infty \left( \frac{1}{1+\sigma\kappa}\right)^j i_{t-j} \]

Here is a plot of what happens when the Fed raises nominal interest rates, using \(\sigma=1, \kappa=1\):

When interest rates rise, inflation rises steadily.

Now, intuition. (In economics intuition describes equations. If you have intuition but can't quite come up with the equations, you have a hunch not a result.) During the time of high real interest rates -- when the nominal rate has risen, but inflation has not yet caught up -- consumption must grow faster.

People consume less ahead of the time of high real interest rates, so they have more savings, and earn more interest on those savings. Afterwards, they can consume more. Since more consumption pushes up prices, giving more inflation, inflation must also rise during the period of high consumption growth.

One way to look at this is that consumption and inflation was depressed before the rise, because people knew the rise was going to happen. In that sense, higher interest rates do lower consumption, but rational expectations reverses the arrow of time: higher future interest rates lower consumption and inflation today.

(The case of a surprise rise in interest rates is a bit more subtle. It's possible in that case that \(\pi_t\) and \(c_t\) jump down unexpectedly at time \(t\) when \(i_t\) jumps up. Analyzing that case, like all the other complications, takes a paper not a blog post. The point here was to show a simple model that illustrates the possibility of a neo-Fisherian result, not to argue that the result is general. My skeptical colleauge wanted to see how it's even possible.)

I really like that the Phillips curve here is so completely old fashioned. This is Phillips' Phillips curve, with a permanent inflation-output tradeoff. That fact shows squarely where the neo-Fisherian result comes from. The forward-looking intertemporal-substitution IS equation is the central ingredient.

Model 2:

You might object that with this static Phillips curve, there is a permanent inflation-output tradeoff. Maybe we're getting the permanent rise in inflation from the permanent rise in output? No, but let's see it. Here's the same model with an accelerationist Phillips curve, with slowly adaptive expectations. Change the Phillips curve to \[ c_{t} = \kappa(\pi_{t}-\pi_{t-1}^{e}) \] \[ \pi_{t}^{e} = \lambda\pi_{t-1}^{e}+(1-\lambda)\pi_{t} \] or, equivalently, \[ \pi_{t}^{e}=(1-\lambda)\sum_{j=0}^{\infty}\lambda^{j}\pi_{t-j}. \]

Substituting out consumption again, \[ (\pi_{t}-\pi_{t-1}^{e})=(\pi_{t+1}-\pi_{t}^{e})-\sigma\kappa(i_{t}-\pi_{t+1}) \] \[ (1+\sigma\kappa)\pi_{t+1}=\pi_{t}+\pi_{t}^{e}-\pi_{t-1}^{e}+\sigma\kappa i_{t} \] \[ \pi_{t+1}=\frac{1}{1+\sigma\kappa}\left( \pi_{t}+\pi_{t}^{e}-\pi_{t-1} ^{e}\right) +\frac{\sigma\kappa}{1+\sigma\kappa}i_{t}. \] Explicitly, \[ (1+\sigma\kappa)\pi_{t+1}=\pi_{t}+\gamma(1-\lambda)\left[ \sum_{j=0}^{\infty }\lambda^{j}\Delta\pi_{t-j}\right] +\sigma\kappa i_{t} \]

Simulating this model, with \(\lambda=0.9\).

As you can see, we still have a completely positive response. Inflation ends up moving one for one with the rate change. Consumption booms and then slowly reverts to zero. The words are really about the same.

The positive consumption response does not survive with more realistic or better grounded Phillips curves. With the standard forward looking new Keynesian Phillips curve inflation looks about the same, but output goes down throughout the episode: you get stagflation.

The absolutely simplest model is, of course, just \[i_t = r + E_t \pi_{t+1}\]. Then if the Fed raises
the nominal interest rate, inflation must follow. But my challenge was to spell out the market forces
that push inflation up. I'm less able to tell the corresponding story in very simple terms.

The Habit Habit

The Habit Habit. This is an essay expanding slightly on a talk I gave at the University of Melbourne's excellent "Finance Down Under" conference. The slides

(Note: This post uses mathjax for equations and has embedded graphs. Some places that pick up the post don't show these elements. If you can't see them or links come back to the original. Two shift-refreshes seem to cure Safari showing "math processing error".)

Habit past: I start with a quick review of the habit model. I highlight some successes as well as areas where the model needs improvement, that I think would be productive to address.

Habit present: I survey of many current parallel approaches including long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes -- both behavioral and from ambiguity aversion -- and debt or institutional finance. I stress how all these approaches produce quite similar results and mechanisms. They all introduce a business-cycle state variable into the discount factor, so they all give rise to more risk aversion in bad times. The habit model, though less popular than some alternatives, is at least still a contender, and more parsimonious in many ways,

Habits future: I speculate with some simple models that time-varying risk premiums as captured by the habit model can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, as an alternative to  Keynesian flow constraints or new Keynesian intertemporal substitution. People stopped consuming and investing in 2008 because they were scared to death, not because they wanted less consumption today in return for more consumption tomorrow.

Throughout, the essay focuses on challenges for future research, in many cases that seem like low hanging fruit. PhD students seeking advice on thesis topics: I'll tell you to read this. It also may be useful to colleagues as a teaching note on macro-asset pricing models. (Note, the parallel sections of my coursera class "Asset Pricing" cover some of the same material.)

I'll tempt you with one little exercise taken from late in the essay.


A representative consumer with a fixed habit \(x\) lives in a permanent income economy, with endowment \(e_0\) at time 0 and random endowment \(e_1\) at time 1. With a discount factor \(\beta=R^f=1\), the problem is

\[ \max\frac{(c_{0}-x)^{1-\gamma}}{1-\gamma}+E\left[ \frac {(c_{1}-x)^{1-\gamma}}{1-\gamma}\right] \] \[ c_{1} = e_{0}-c_{0} +e_{1} \] \[ e_{1} =\left\{ e_{h},e_{l}\right\} \; pr(e_{l})=\pi. \] The solution results from the first order condition \[ \left( c_{0}-x\right) ^{-\gamma}=E\left[ (c_{1}-x)^{-\gamma}\right] \] i.e., \[ \left( c_{0}-x\right) ^{-\gamma}=\pi(e_{0}-c_{0}+e_{l}-x)^{-\gamma}% +(1-\pi)(e_{0}-c_{0}+e_{h}-x)^{-\gamma}% \] I solve this equation numerically for \(c_{0}\).

The first picture shows consumption \(c_0\) as a function of first period endowment \(e_0\) for \(e_{h}=2\), \(e_{l}=0.9\), \(x=1\), \(\gamma=2\) and \(\pi=1/100\).

The case that one state is a rare disaster is not special. In a general case, the consumer starts to focus more and more on the worst-possible state as risk aversion rises. Therefore, the model with any other distribution and the same worst-possible state looks much like this one.

Watch the blue \(c_0\) line first. Starting from the right, when first-period endowment \(e_{0}\) is abundant, the consumer follows standard permanent income advice. The slope of the line connecting initial endowment \(e_{0}\) to consumption \(c_{0}\) is about 1/2, as the consumer splits his large endowment \(e_{0}\) between period 0 and the single additional period 1.

As endowment \(e_{0}\) declines, however, this behavior changes. For very low endowments \(e_{0}\approx 1\) relative to the nearly certain better future \(e_{h}=2\), the permanent income consumer would borrow to finance consumption in period 0. The habit consumer reduces consumption instead. As endowment \(e_{0}\) declines towards \(x=1\), the marginal propensity to consume becomes nearly one. The consumer reduces consumption one for one with income.

The next graph presents marginal utility times probability, \(u^{\prime}(c_{0})=(c_{0}-x)^{-\gamma}\), and \(\pi_{i}u^{\prime}(c_{i})=\pi _{i}(c_{i}-x)^{-\gamma},i=h,l\). By the first order condition, the former is equal to the sum of the latter two. \ But which state of the world is the more important consideration? When consumption is abundant in both periods on the right side of the graph, marginal utility \(u^{\prime}(c_{0})\) is almost entirely equated to marginal utility in the 99 times more likely good state \((1-\pi)u^{\prime}(c_{h})\). So, the consumer basically ignores the bad state and acts like a perfect foresight or permanent-income intertemporal-substitution consumer, considering consumption today vs. consumption in the good state.

In bad times, however, on the left side of the graph, if the consumer thinks about leaving very little for the future, or even borrowing, consumption in the unlikely bad state approaches the habit. Now the marginal utility of the bad state starts to skyrocket compared to that of the good state. The consumer must leave some positive amount saved so that the bad state does not turn disastrous -- even though he has a 99% chance of doubling his income in the next period (\(e_{h}=2\), \(e_{0}=1\)). Marginal utility at time 0, \(u^{\prime }(c_{0})\) now tracks \(\pi_{l}u^{\prime}(c_{l})\) almost perfectly.

In these graphs, then, we see behavior that motivates and is captured by many different kinds of models:

1. Consumption moves more with income in bad times.

This behavior is familiar from buffer-stock models, in which agents wish to smooth intertemporally, but can't borrow when wealth is low....

2. In bad times, consumers start to pay inordinate attention to rare bad states of nature.

This behavior is similar to time-varying rare disaster probability models, behavioral models, or to minimax ambiguity aversion models. At low values of consumption, the consumer's entire behavior \(c_{0}\) is driven by the tradeoff between consumption today \(c_{0}\) and consumption in a state \(c_{l}\) that has a 1/100 probability of occurrence, ignoring the state with 99/100 probability.

This little habit model also gives a natural account of endogenous time-varying attention to rare events.

The point is not to argue that habit models persuasively dominate the others. The point is just that there seems to be a range of behavior that theorists intuit, and that many models capture.

When consumption falls close to habit, risk aversion rises, stock prices fall, so by Q theory investment falls. We nearly have a multiplier-accelerator, due to rising risk aversion in bad times: Consumption falls with mpc approaching one, and investment falls as well. The paper gives some hints about how that might work in a real model.

The 13 Trillion Dollar Question

On Tuesday Nov 10 there will be a conference in Chicago on "The $13 Trillion Question: Managing the U.S. Government’s Debt" hosted by the Initiative on Global Markets at Chicago Booth, and the Hutchins Center on Fiscal and Monetary Policy at Brookings. (The Brookings announcement here.)

Robin Greenwood will present "The Optimal Maturity of Government Debt and Debt Management Conflicts between the U.S. Treasury and the Federal Reserve" arguing that the Fed and Treasury are working to cross-purposes -- the Fed buys what the Treasury sells -- and that the government  should go after low rates on long term bonds rather than the budget insurance of issuing long term bonds.

(The government faces the same decision a homeowner does: borrow at near-zero floating rates,  but maybe rates shoot up and so do your payments, or borrow long at 2% rates, and pay more if rates don't go up. Robin and Larry favor the former. I'm more risk averse. Maybe living in California has sensitized me  that just because you haven't seen an earthquake recently doesn't mean you shouldn't buy earthquake insurance. But it's a good argument to have qualitatively -- what's the risk, and what's the reward.)

I will present "A new structure for Federal Debt," arguing for an overhaul of which instruments the Treasury issues, to make them more useful for financial markets and financial stability as well as for government borrowing and risk management. (Earlier blog post about this paper here.)

There will be extensive discussion and broader issues, and (the big draw) a panel of Seth  Carpenter, Charles Evans, and Sara Sprung, moderated by David Wessel.

The conference is by invitation, but you can still sign up here until they run out of room, or email Jennifer (dot) Williams at chicagobooth (dot) edu. It will also be viewable by live webcast, link here, starting 1:30 central.

Update: Video of the event here.



Program

Session I - The Optimal Maturity of Government Debt and Debt Management Conflicts between the U.S. Treasury and the Federal Reserve

Speakers

Robin Greenwood, George Gund Professor of Finance and Banking, Harvard Business School
Samuel G. Hanson, Assistant Professor of Business Administration, Harvard Business School

Discussant

Guido Lorenzoni, Breen Family Professor, Northwestern University

Moderator

Austan Goolsbee, Robert P. Gwinn Professor of Economics, University of Chicago Booth School of Business

Session II - A New Structure for U.S. Federal Debt

Speaker

John H. Cochrane, Senior Fellow, Hoover Institution and Distinguished Senior Fellow, University of Chicago Booth School of Business

Discussant

James J. McAndrews, Executive Vice President, Federal Reserve Bank of New York

Moderator

Anil K Kashyap, Edward Eagle Brown Professor of Economics and Finance, University of Chicago Booth School of Business

Session III - Panel Discussion

Panelists

Seth B. Carpenter, Assistant Secretary for Financial Markets, Department of the Treasury
Charles Evans, President and Chief Executive Officer, Federal Reserve Bank of Chicago
Sara Sprung, Managing Director, Neuberger Berman

Moderator

David Wessel, Director, The Hutchins Center on Fiscal and Monetary Policy, Brookings Institution

Open-Mouth Operations

(Note: This post uses mathjax and has embedded pictures. When posts are reposted elsewhere these often get mangled. If it's not displaying well, come to the original at johnhcochrane.blogspot.com)

Our central banks have done nothing but talk for several years now. Interest rates are stuck at zero, and even QE has stopped in its tracks. Yet, people still ascribe big powers to these statements. Ms. Yellen sneezes, someone thinks they hear "December" and markets move.

Buried deep in the paper I posted earlier this week is a potential model of "open mouth" operations, that might of interest to blog readers.

Use the standard "new-Keynesian" model \[ x_{t} = E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1}) \] \[ \pi_{t} = \beta E_{t}\pi_{t+1}+\kappa x_{t} \] Add a Taylor rule, and suppose the Fed follows an inflation-target shock with no interest rate change \[ i_t = i^\ast_t + \phi_\pi ( \pi_t - \pi^\ast_t). \] \[ i^\ast_t = 0 \] \[ \pi^\ast_t = \delta_0 \lambda_1^{-t} \] Equivalently express the Taylor rule with a ``Wicksellian'' shock, \[ i_t = \hat{i}_t + \phi_\pi \pi_t \] \[ \hat{i}_t = - \delta_0 \phi_\pi \lambda_1^{-t}. \] In both cases, \[ \lambda_{1} =\frac{\left( 1+\beta+\kappa\sigma\right) +\sqrt{\left( 1+\beta+\kappa\sigma\right) ^{2}-4\beta}}{2} \gt 1 \] Yes, this is a special case. The persistence of the shocks is just equal to one of the roots of the model. Here \(\delta_0\) is just a parameter describing how big the monetary policy shock is.

Now, solve the model by any standard method for the unique locally bounded solution. The answer is \[ \pi_{t} = \delta_0 \lambda_1^{-t}, \] \[ \kappa x_{t} = \delta_0 (1-\beta \lambda_1^{-1}) \lambda_1^{-t} \] \[ i_t = 0 \]

Here is the equilibrium path of inflation and interest rates (flat red line at zero).

And here is the path of output.  In each case \(\delta_0\) in the graph gives the size of the monetary policy shock. It's also the size of the inflation jump at time zero induced by the monetary policy shock.

Watch this mom, no hands... Interest rates do not budge throughout the episode. The Fed announces a monetary policy shock, and inflation moves just enough so that the systematic part of monetary policy offsets the shock, and Fed doesn't end up actually doing anything! We get the traditional results of monetary policy -- lower inflation and lower output, for example -- based just on talk!

If you're inclined to this sort of model, you might want to pursue this sort of solution as a model of our current "open-mouth" regime.

Historical Fiction

Steve Williamson has a very nice post "Historical Fiction", rebutting the claim, largely by Paul Krugman, that the late 1970s Keynesian macroeconomics with adaptive expectations was vindicated in describing the Reagan-Volker era disinflation.

The claims were startling, to say the least, as they sharply contradict received wisdom in just about every macro textbook: The Keynesian IS-LM model, whatever its other virtues or faults, failed to predict how quickly inflation would take off in the 1970, as the expectations-adjusted Phillips curve shifted up. It then failed to predict just how quickly inflation would be beaten in the 1980s. It predicted agonizing decades of unemployment. Instead, expectations adjusted down again, the inflation battle ended quickly. The intellectual battle ended with rational expectations and forward-looking models at the center of macroeconomics for 30 years.

Just who said what in memos or opeds 40 years ago is somewhat of a fodder for a big blog debate, which I won't cover here.

Steve posted a graph from an interesting 1980 James Tobin paper simulating what would happen. This is a nicer source than old memos or opeds from the early 1980s warning of impeding doom. Memos and opeds are opinions. Simulations capture models.

The graph:

Source: James Tobin, BPEA. 

I thought it would be more effective to contrast this graph with the actual data, rather than rely on your memories of what happened.

The black lines are the Tobin simulation. The blue lines are what actually happened. (I'm not good enough with photoshop to superimpose the graphs, so I read Tobin's data off his chart.)

The two curves parallel in 81 to 83, with reality moving much faster. But In 1984 it all falls apart. You can see the "Phillips curve shift" in the classic rational expectations story; the booming recovery that followed the 82 recession.

And you can see the crucial Keynesian prediction error: After the monetary tightening is over in 1986, no, we do not need years and years of grinding 10% unemployment.

So, conventional history is, it turns out, right after all. Adaptive-expectations ISLM models and their interpreters were predicting years and years of unemployment to quash inflation, and it didn't happen.


One can debate 1981 to 1983. Here reality followed the general pattern, moving down a Phillips curve. Perhaps that is the success.  But the move was much quicker than Tobin's simulation. One might crow that inflation was conquered much more quickly than Keynesians predicted. But perhaps the actual monetary contraction may have been larger than what Tobin assumed, and assuming a harsher contraction would have sent the economy down the same curve faster?

Tobin describes his simulation thus:

The story is as follows: beginning in 1980:1 the government takes monetary and fiscal measures that gradually reduce the quarterly rate of increase of nominal income, MV. It is reduced in ten years from 12 percent a year to the noninflationary rate of 2 percent a year, the assumed sustainable rate of growth of real GNP. The inertia of inflation is modeled by the average of inflation rates over the preceding eight quarters. The actual inflation rate each quarter is this average plus or minus a term that depends on the unemployment rate, U, relative to the NAIRU, assumed to be 6 percent. This term is (6/U(-1) - 1). It implies a Phillips curve slope of one-sixth a quarter, two-thirds a year at U = 6 and has the usual curvature.

So, I think the answer is no. A faster monetary contraction leaves the 8 quarter lag of inflation in place, so you'll get even bigger unemployment and not much contraction in inflation. If someone else wants to redo Tobin's simulation with the actual 81-83 inflation, that would be interesting. But it is a bit tangential to the central story, 1984. You can also see here in the highlighted passage (my emphasis) how adaptive expectations are crucial to the story.

Now, let's be fair to Tobin. Yes, as quoted by Steve, he came out in favor of "Incomes policies," which used to be a nice euphemism for wage and price controls, but have an even more Orwellian ring these days. But Tobin also wrote, just following this graph,

This is not a prediction! It is a cautionary tale. The simulation is a reference path, against which policymakers must weigh their hunches that the assumed policy, applied resolutely and irrevocably, would bring speedier and less costly results. There are several reasons that disinflation might occur more rapidly. When unemployment remains so high so long, bankruptcies and plant closings, prospective as well as actual, might lead to more precipitous collapse of wage and price patterns than have been experienced in the United States since 1932. Moreover, the very threat of a scenario like figure 6 may induce wage-price behavior that yields a happier outcome. A simulated scenario with rational rather than adaptive expectations of inflation would show speedier disinflation and smaller unemployment cost, to a degree that depends on the duration of contractual inertia, explicit or implicit.

My emphasis. Now, having seen only one big Phillips curve failure in the 1970s, it might be reasonable for policy-oriented people not to jettison their entire theoretical framework in one blow. And this Tobin piece, using adaptive expectations, does incorporate some of the lessons of the 1970s. In the 1960s, Keynesians used a fixed Phillips curve. Friedman famously pointed out that it would not stay fixed -- but even Friedman (1968) had adaptive expectations in mind. For policy purposes it might make sense to integrate over models and adapt slowly, an attitude I just recommended in present circumstances.

You can see Tobin clearly seeing the possibilities, and clearly seeing the conclusions that we would come to after seeing the "happier outcome." That he had not come to these conclusions before the fact is understandable.

That contemporary commentators should forget or obfuscate this history, in an effort to resuscitate a comfortable, politically convenient, but failed economics of their youth, is less forgivable.

I don't want to fully endorse the classic resolution of 1984. Lots of other things changed, in particular deregulation and a big tax reform in the air. There was a lot of new technology. Financial deregulation was kicking in. We may find someday that such "supply side" changes were behind the 1980s boom. And we may jettison or radically reunderstand the Phillips curve, even with the free expectations parameter to play around with. It certainly has fallen apart lately (here, here and many more). But ISLM / adaptive expectations as an eternal truth just doesn't hold up. It really did fail in the 70s, and again in the 80s.

PS: The chart using actual inflation FYI

Whither inflation?

(Note: This post uses mathjax to display equations and has several graphs. I've noticed that the blog gets picked up here and there and mangled along the way. If you can't read it or see the graphs, come back to the original .)

The news reports from Jackson Hole are very interesting. Fed officials are grappling with a tough question: what will happen to inflation? Why is there so little inflation now? How will a rate rise affect inflation? How can we trust models of the latter that are so wrong on the former?

Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. (It's often called "new-Keynesian" but I'm trying to avoid that word since its operation and predictions turn out to be diametrically opposed to anything "Keyneisan," as we'll see.)

Here is the model's answer:

Response of inflation (red) and output (black) to a permanent rise in interest rates (blue). 

The blue line supposes a step function rise in nominal interest rates. The red line plots the response of inflation and the black line plots output.  The solid lines plot the answer to the standard question, what if the Fed suddenly and unexpectedly raises rates? But the Fed is not suddenly and unexpectedly doing anything, so the dashed lines plot answers to the much more relevant question: what if the Fed tells us long in advance that the rate rise is coming?

According to this standard model, the answer is clear: Inflation rises throughout the episode, smoothly joining the higher nominal interest rate. Output declines.

The model: \begin{equation} x_{t} =E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1}) \label{one} \end{equation} \begin{equation} \pi_{t} =\beta E_{t}\pi_{t+1}+\kappa x_{t} \label{two} \end{equation} where \(x\) denotes the output gap, \(i\) is the nominal interest rate, and \(\pi\) is inflation. The solution  is \begin{equation} \pi_{t+1}=\frac{\kappa\sigma}{\lambda_{1}-\lambda_{2}}E_{t+1}\left[ i_{t}+\sum _{j=1}^{\infty}\lambda_{1}^{-j}i_{t-j}+\sum_{j=1}^{\infty}\lambda_{2} ^{j}E_{t+1}i_{t+j}\right] \label{three} \end{equation} \begin{equation*} x_{t+1}=\frac{\sigma}{\lambda_{1}-\lambda_{2}}E_{t+1}\left[ (1-\beta\lambda_1^{-1}) \sum _{j=0}^{\infty}\lambda_{1}^{-j}i_{t-j}+(1-\beta \lambda_2^{-1}) \sum_{j=1}^{\infty}\lambda_{2}^{j}E_{t+1}i_{t+j}\right] \end{equation*} where \[ \lambda_{1} =\frac{1}{2} \left( 1+\beta+\kappa\sigma +\sqrt{\left( 1+\beta+\kappa\sigma\right)^{2}-4\beta}\right) > 1 \] \[ \lambda_{2} =\frac{1}{2}\left( 1+\beta+\kappa\sigma -\sqrt{\left( 1+\beta+\kappa\sigma\right)^{2}-4\beta}\right) < 1. \] I use \(\beta = 0.97, \ \kappa = 0.2, \ \sigma = 0.3 \) to make the plot. As you see from \((\ref{three}\)), inflation is a two-sided geometrically-weighted moving average of the nominal interest rate, with positive weights. So the basic picture is not sensitive to parameter values.

The expected and unexpected lines are the same once the announcement is made. This standard model embodies exactly zero of the rational expectations idea that unexpected policy moves matter more than expected policy moves. (That's not an endorsement, it's a fact about the model.)

The Neo-Fisherian hypothesis and sticky prices

A bit of context. In some earlier blog posts (start here) I explored the "neo-Fisherian" idea that perhaps raising interest rates raises inflation. The idea is simple. The nominal interest rate is the real rate plus expected inflation, \[ i_t = r_t + E_t \pi_{t+1} \] In the long run, real rates are independent of monetary policy. This "Fisher relation" is a steady state of any model -- higher interest rates correspond to higher inflation.

However, is it a stable steady state, or unstable? If the nominal interest rate is stuck, say, at zero, do tiny bits of inflation spiral away from the Fisher equation? Or do blips in inflation melt away and converge steadily towards the interest rate? I'll call the latter the "long-run" Fisherian view. Even if that is true, perhaps an interest rate rise temporarily lowers inflation, and then inflation catches up in the long run. That's the "short-run" Fisherian question.

One might suspect that the new-Fisherian idea is true for flexible prices, but that sticky prices lead to a failure of either the short-run or long-run neo-Fisherian hypothesis. The graph shows that this supposition is absolutely false. The most utterly standard modern model of sticky prices generates a short-run and long-run neo-Fisherian response. And reduces output along the way.

Multiple equilibria and other issues 

Obviously, it's not that easy. There are about a hundred objections. The most obvious: this model with a fixed interest rate target has multiple equilibria. On the date of the announcement of the policy change, inflation and output can jump.

Inflation response to an interest rate rise: multiple equilibria

The picture shows some of the possibilities when people learn rates will rise three periods ahead of the actual rise. The solid red line is the response I showed above. The dashed red lines show what happens if there is an additional "sunspot" jump in inflation, which can happen in these models.

Math: You can add an arbitrary \(\lambda_{1}^{-t}\delta_\tau \) to the impulse-response function given by (\(\ref{three}\)), where \(\tau\) is the time of the announcement (\(\tau=-3\) in the graph), and it still obeys equations \( ( \ref{one})-(\ref{two})\). These are impulse response functions and sunspots must be unexepected. So the only issue is the jump on announcement. Response functions are thereafter unique.

A huge amount of academic effort is expended on pruning these equilibria (me too), which I won't talk about here. The bottom two lines show that it is possible to get a temporarily lower inflation response out of the model, if you can get a negative "sunspot" to coincide with the policy announcement.

But I think the plot says we're mostly wasting our time on this issue. The alternative equilibria have the biggest effect on inflation when the policy is announced, not when the policy actually happens. But we do not see big changes in inflation when the Fed makes announcements.  The Fed is not at all worried about inflation past that is slowly cooling as the day of the rise approaches, as these equilibria show. It's worried about inflation or deflation future in response to the actual rate rise.

The graph suggests to me that most of the "sensible" equilibria are pretty near the solid line.

The graph also shows that all the multiple equilibria are stable, and thus neo-Fisherian. At best we can have a short-run discussion. In the long run, a rate rise raises inflation in any equilibrium of this model.

Yeah, there's lots more here -- what about Taylor rules, stochastic exits from the zero bound, off-equilibrium threats, QE, better Phillips curves with lagged inflation terms, habits in the IS curve, credit constraints, investment and capital, learning dynamics, fiscal policy, and so on and so on. This is a blog post, so we'll stop here. The paper to follow will deal with some of this.

And the point is made. The basic simplest model makes a sharp and surprising prediction. Maybe that prediction is wrong because one or another epicycle matters. But I don't think much current discussion recognizes that this is the starting point, and you need patches to recover the opposite sign, not the other way around.

Data and models

I started with the observation that it would be nice if the model we use to analyze the rate rise gave a vaguely plausible description of recent reality.

The graph shows the Federal Funds rate (green), the 10 year bond rate (red) and core CPI inflation (blue).

The conventional way of reading this graph is that inflation is unstable, and so needs the Fed to actively adjust rates. Inflation is like a broom held upside down, with inflation on the top and the funds rate on the bottom. When inflation declines a bit, the Fed drives the funds rate down to push inflation back up, just as you would follow a falling broom. When inflation rises a bit, the Fed similarly quickly raises the funds rate.

That view represents the conventional doctrine, that an interest rate peg is unstable, and will lead quickly to either hyperinflation (Milton Friedman's famous 1968 analysis) or to a deflationary "spiral" or "vortex."

And this instability view predicts what will happen should the Fed deliberately raise rates. Raising rates is like deliberately moving the bottom of the broom. The top moves the other way, lowering inflation. When inflation is low enough, the Fed then quickly lowers rates to stop the broom from tipping off.

But in 2008, interest rates hit zero. The broom handle could not move. The conventional view predicted that the broom will topple. Traditional Keynesians warned that a deflationary "spiral" or "vortex" would break out. Traditional monetarists looked at QE, and warned hyperinflation would break out.

(I added the 10 year rate as an indicator of expected inflation, and to emphasize how little effect QE had. $3 trillion dollars of bond purchases later, good luck seeing anything but a steady downward trend in 10 year rates.)

The amazing thing about the last 7 years in the US and Europe -- and 20 in Japan -- is that nothing happened! After the recession ended, inflation continued its gently downward trend.

This is monetary economics Michelson–Morley moment. We set off what were supposed to be atomic bombs -- reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened.  

Oh sure, you can try to patch it up. Maybe we discover after the fact that wages are eternally sticky, even for 7 to 20 years while half the population changes jobs, so, sorry, that deflation vortex we predicted can't happen after all. Maybe the Fed is so wise it neatly steered the economy between the Great Deflationary Vortex on one side with just enough of the Hyperinflationary Quantitative Easing on the other to produce quiet. Maybe the great Fiscal Stimulus really did have a multipler of 6 or so (needed to be self-financing, as some claimed) and just offset the Deflationary Vortex.

But when the seas are so quiet, and the tiller has been locked at 0 for seven years, it's awfully hard to take seriously the Captain's stories of great typhoons, vortices, and hyperwhales narrowly avoided by great skill and daring.

Occam's razor says, let us take the facts seriously: An interest peg is stable after all.  The classic theories that predict instability of an interest rate peg -- and consequently that higher rates will lead to lower inflation -- are just wrong, at least in our circumstances (important qualifier follows).

But if those classic theories failed dramatically, what can take their place? Fortunately, I started this post with just one such theory. The utterly standard sticky-price model, sitting in Mike Woodford's and Jordi Gali's textbooks, predicts exactly what happened: inflation is stable under a peg, and thus raising interest rates to a new peg will raise inflation.

The difference between traditional Keynesian or Monetarist models and this modern sticky-price model is deep and essential. In this model, people are forward-looking. In the standard unstable traditional-Keynesian or Monetarist model, people look backward. When written in equations, the traditional "IS" curve (\(\ref{one}\)) does not have \(E_t x_{t+1} \) or \(E_t\pi_{t+1}\) in it, and the "Phillips curve" (\(\ref{two}\)) has past inflation in it,
not expected future inflation.

Forward looking people generates stability, and backward looking people generates instability. If you drove a car by looking in the rear-view mirror, the car may indeed regularly veer off the road, unless the Fed sitting next to you yells about things to come and stabilizes the car. But when people drive looking through the front windshield, cars are quite stable, reverting to the middle of the road when the wind buffets them to one side or the other.

The response function is also consistent with the experience of a few countries such as Sweden which did raise rates and swiftly abandoned the effort. Those rises didn't do much either way to inflation, but they did lower output. Just as the graph says.

What to do? A robust approach

I will not follow the standard economists' approach -- here's my bright new idea, the government should follow my advice tomorrow. Is this right? Maybe. Maybe not. I'm working on it, and hoping by that and this blog post to encourage others to do so as well.

But if you're running the Fed, you don't have the luxury of waiting for research. You have to face an uncomfortable fact, which the news out of Jackson hole says they're facing: They don't really know what will happen or how the economy works. Nor does anyone else. They know that their own forecasts and models have been wrong 7 years in a row -- as has everyone elses', except a few bloggers with remarkably spotty memories -- so pinpoint structural forecasts of what will happen by raising rates made by those same models and logic are darn suspect.

A robust policy decision should integrate over possibilities. So as far as I'll go is that this is a decent possibility, and should add to the caution over raising rates. Raising rates if there is a fire -- actual inflation -- might be sensible. Raising rates because of inflation forecasts from models that have been wrong seven years in a row seems a bit diceyer.

Of course, there is a bit of divergence in goals as well. The Fed wants more inflation, so might take this model as more reason to tighten. And if this model is right, the Fed will produce the inflation which it desires and can then congratulate itself for foreseeing!

I like zero.  Zero rates are pretty darn good. Zero inflation is pretty darn good too. We get the Friedman-optimal quantity of money. And more. Financial stability: With no interest cost, people and businesses hold a lot of money, and don’t conjure complex but fragile cash-management schemes. Three trillion dollars of reserves are three trillion dollars of narrow banking. Taxes: You don’t pay taxes on inflationary gains and taxes erode less of the return on investments.  We don't suffer sticky-price distortions from the economy.  Yeah, growth is too slow, but monetary policy has nothing to do with long-run growth.

So, face it, the outcomes we desire from monetary policy are just about perfect. We don't really know how this happened, but we should savor it while it lasts.

This last point might be the main one. The model I showed above is utterly standard, as is the main result. "New-Keynesian" papers about the "zero bound" have been analyzing this state for nearly 20 years. The result that inflation is stable around the steady state is at least 20 years old.  All the effort, however, has been about how to escape the zero bound. But why? If a very low interest peg is stable, and achieves the optimum quantity of money, why not leave it alone? OK, there's this multiple equilibrium technicality, but that hardly seems reason to go back to "normal."

The only real concern is that some hidden force might be building up to upend this delightful state of affairs. That's behind most calls for raising rates. But clearly, nobody knows with any certainty what that force might be or how to adjust policy levers to head it off.

One warning. In the above model, the interest rate peg is stable only so long as fiscal policy is solvent. Technically, I assume that fiscal surpluses are enough to pay off government debt at whatever inflation or deflation occurs.  Historically, pegs have fallen apart many times, and always when the government did not have the fiscal resources or fiscal desire to support them. The statement "an interest rate peg is stable" needs this huge asterisk.

Mankiw and Conventional Wisdom on Europe

Greg Mankiw wrote a week ago in the Sunday New York Times, ably explaining the  conventional view that the Euro is a bad idea, and that even countries as small as Greece (11 million people) need national currencies. Excerpt:

Monetary union works well in the United States. No economist suggests that New York, New Jersey and Connecticut should each have its own currency, and indeed it would be highly inconvenient if they did. Why can’t Europeans enjoy the conveniences of a common currency?

Two reasons. First, unlike Europe, the United States has a fiscal union in which prosperous regions of the country subsidize less prosperous ones. Second, the United States has fewer barriers to labor mobility than Europe. In the United States, when an economic downturn affects one region, residents can pack up and find jobs elsewhere. In Europe, differences in language and culture make that response less likely.

As a result, Mr. Friedman and Mr. Feldstein contended that the nations of Europe needed a policy tool to deal with national recessions. That tool was a national monetary policy coupled with flexible exchange rates. Rather than heed their counsel, however, Europe adopted a common currency for much of the Continent and threw national monetary policy into the trash bin of history.

Making matters worse, however, was the common currency. In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy. Mr. Friedman and Mr. Feldstein were right: The euro has turned into an economic liability that has exacerbated political tensions. For this, the European elites who pushed for the currency union bear some responsibility.

I am a big euro fan. This seems a good moment to explain why I don't accept this conventional view, despite its authority from Milton Friedman to Marty Feldstein and Greg Mankiw and even to Paul Krugman.

Short: I am also a big meter fan. I don't think each country needs its own measure of length, or to shorten it when local clothiers are having trouble and would like to raise cloth prices.

Longer: This conventional view is deeply old-Keynesian. In this view, each region, including ones as small as Greece (11 million) or Ireland (4.6 million), less than the Los Angeles metro area (13 million), suffers "demand" shocks, which governments must actively offset with fiscal stimulus or monetary policy.

This strikes me as one of those many stories that people repeat all the time until they believe it, but whose foundations are seldom examined.  (There is a "thesis topic" label here for such examination. Comparisons of US states to European countries on these dimensions seems fruitful.)

What are these local demand shocks for small open economies in the eurozone? "Aggregate demand" is, well, aggregate, not regional.  Changing fortunes of local industries is more what we call "supply," not "demand." For small open economies (LA) much "demand" comes from other cities and states, not local.

What is this "fiscal union," apparently providing countercyclical Keynesian stimulus at the right moment?  In the US, we have Federal contributions to social programs such as unemployment insurance. Europe has the common agricultural policy and many other subsidies. We do not have systematic, reliably countercyclical, timely, targeted, and temporary local fiscal stimulus programs. Just how big is the local cyclical variation in state or local level government spending or transfers? (And why does fiscal union matter so much anyway? If you're a Keynesian, then local borrow and spend fiscal stimulus should be plenty. The union matters only when countries near sovereign default and can't borrow.)

The local and cyclical qualifiers matter. Yes, both US and Europe have some pretty large cross-subsidies. But most of these are permanent. The rest of the nation subsidizes corn ethanol to Iowa year in and year out. Social security payments come year in and year out, and transfer money from states with workers to those with retirees. Monetary policy has at best short-run effects, so the argument for currency union has to be about local cyclical, recession-related variation in economic fortunes, not permanent transfers.

And Federal fiscal transfers only started in the 1930s. We had a currency union in 1790, and no substantial Federal fiscal transfers at all until the 1930s. How did we get along all this time?

A sense in which this is a centrally old-Keynesian argument is that Greg is not making a second, common, and also wrong (in my view) case for national currencies: the view that currency union demands central bailouts of sovereign debt.  No, Greg (and the conventional wisdom he echoes) has in mind only the necessity of Keynesian countercyclical policy. Aphorisms such as "currency union demands fiscal union" are dangerous, as they have many meanings.

So, this conventional view presumes that there really are big regional "demand" shocks; that there is a big, important Keynesian fiscal multiplier, even away from the zero bound, and that our government really does a lot of recession-related fiscal transfers, larger than Europe's (agricultural subsidies, etc.) and that the US pre WWII was a disastrous too-large currency area. I'm not convinced on any of these points.

(To be sure, I will admit a multiplier of about one for state to state transfers. If the federal government takes money from the citizens of New York, and sends the money to people in Florida,  businesses will move from New York to Florida to follow the money and GDP will rise in Florida. And decline in New York.)

Consider Greece, "In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy." So, Greece's GDP is falling because of "tight fiscal policy?" Calamitous regulation, corruption, closed markets, and now closed banks, frozen payments are not relevant? Tight fiscal policy? Greece is still running primary deficits. After blowing through one and a half GDP's worth of what are now transfers from the rest of the EU, they've run through another half a GDPs' worth, and GDP collapses more. Really, Greece's economic problems are.... a lack of adequate borrowing and spending? And all Greece needs is one more devaluation, and suddenly will be shipping Porsches to Stuttgart in return for worthless pieces of paper rather than the other way around?

Greg passes on the labor mobility story. Here too I'm dubious and curious to see numbers. The story is also told that there is less and less labor mobility in the US, especially of people leaving dying regions. And there are lots of Polish-plumber stories from Europe, that open borders leads to lots of migration.  Here again, cyclical migration, on the scale for which  monetary policy can substitute, seems unlikely. How big are business-cycle frequency migration flows across states in the US vs. Europe?

Again, the US  until 1933 poses an interesting challenge. Your school stories of westward migration were not a business cycle frequency response to demand shocks. And when people traveled by horse or foot, the vast majority of Americans never moved more than 20 miles from where they were born. The costs of labor mobility in Europe today are vastly smaller than the costs of labor mobility in the US 19th century.

Conversely, and perhaps more centrally, I  less trusting of the stabilizing influence of central banks. Dispassionate omniscient central banks can, in theory, wisely spot demand shocks and cleverly devalue currencies to offset them, while not responding to supply shocks, political demands, and so forth. The same technocrats could quietly redefine the meter as needed to let tailors respond to shocks without changing prices.

But the history of small-country central banks is not so reassuring. Grece and Italy's repeated devaluations and inflations did not bring great prosperity.

Joining a common currency is a pre-commitment against bad monetary policy as well as foreswearing of hypothetical good monetary policy. Political forces seldom think there's enough stimulus.  When Greece and Italy they joined the euro, they basically said, defaulting and inflating now will be extremely costly. They were rewarded for the precommitment with very low interest rates. They blew the money, and are now facing the high costs they signed up for. But that just shows how real the precommitment was.

Micro, macro and politics interconnect. The case for separate currencies is to protect the economy from sticky wages, sticky prices, and sticky people. But none of these stickinesses are written in stone. A plausible answer to my question about pre-new deal US is that prices and wages were not sticky (whatever that means) before the era of regulation. Well, that is a loss, and only very imperfectly addressed by artful devaluation of the currency.  Not every block can have its own currency, so local and industry variation within a country remains hobbled by sticky prices, wages, and people. If sticky wages,  prices and people are the central economic problem, we ought to have a lot of policies to unstick them. We do the opposite, and Europe even more so. The very social programs that Greg implicitly praises for fiscal stimulus tie people to location and undermine labor market flexibility.

The strongest case for a separate currency might come from a small economy like Chile, which sells one product (copper), subject to big price fluctuations, and otherwise is pretty closed, and has institutions with sticky nominal wages that it doesn't want to fix. When the price of copper declines, price times marginal product of labor declines, so real wages should decline, and the value of haircuts provided to copper miners should decline as well. Chile may prefer to keep nominal wages steady and let the exchange rate rather than wage rate discourage imports.

But even Chile exports a lot more than copper these days. Texas is still booming despite a large decline in oil prices. The same argument does not hold for company towns within the US, which do not use their own currency. Stanford  has extremely sticky wages (tenure), and suffers "demand" shocks, (positive lately), without offsetting fiscal stimulus and tremendous labor immobility. It takes a year to hire faculty. But nobody thinks Stanford should have its own currency, and periodically devalue that currency. Why not? Because we are open.

So I think a lot of the conventional view seems to think implicitly of fairly closed economies, operating in parallel. But Europe's economies are open. Moreover, the whole point of the eurozone is to open them further. Small open economies are much worse candidates for their own currency.

Surely each block should not have its own currency, nor each city. We'd probably all agree that very small countries should not -- Luxemburg, say. So the question is really whether the Greece that Greece wants to be -- more open than today -- is effectively of the same size.

So, to sum up, Greg's article very nicely summarizes the conventional view. Recognize that this conventional view is deeply old-school Keynesian, both in its view of fluctuations, the need for constant "demand" management, and the success of "demand" managers to do their job. There is room for disagreement on that theory, and more productively on the underlying facts Greg passes on.

Behavioral Public Choice

In a number of blog posts, (here ) I've complained about the lack of behavioral public choice theory, and highlighted some efforts in that direction.

Much behavioral economics documents that people do stupid things, and then jumps to the conclusion that parternalistic government can do things for us better. But wait, those government functionaries are also human, also behavioral, and placed in group and social settings that psychology as well as economics warns us are particularly prone to bad outcomes.

Marginal revolution highlights an interesting new paper that breaks in to this field, Behavioral public choice: The behavioral paradox of government policy by Ted Gayer and W. Kip Viscusi. A quote:

In this article we examine a wide range of behavioral failures, such as those linked to misperception of risks, unwarranted aversion to risk ambiguity, inordinate aversion to losses, and inconsistencies in the tradeoffs reflected in individual decisions. Although such shortcomings have been documented in the behavioral literature, they are also reflected in government policies, both because policymakers are also human and because public pressures incorporate these biases. The result is that government policies often institutionalize rather than overcome behavioral anomalies.

I haven't read it, but it seems interesting, and the field seems wide open. The defense of freedom never was that freedom is perfect, merely that government control is worse.

I am interested that behavioral economics seems so focused on mistakes of individual decision making, as nicely summarized in the quote. In fact the most obvious thing about humans is that we are social animals, not that we are poor individual decision-makers. I would think that behavioralists would be bringing social psychology more than individual decision making to economics. But maybe this just reveals how little I know about either.

Calomiris and sticky prices

Charles Calomiris has a very interesting Forbes oped on Greece, with a much deeper insight.

My proposal begins with government action to write down the value of all euro-denominated contracts enforced within Greece. This “redenomination” would make all existing contracts – wages, pensions, deposits, and loans – legally worth only, say, 70% of their current nominal value. This policy would kill several birds with one stone. It would significantly reduce pensions, relieving fiscal pressure and satisfying troika demands for fiscal sustainability. It would do so in a way that would also mitigate the purchasing power consequences for pensioners, because an across-the-board redenomination would lower prices throughout the economy, making the reduction in nominal pensions more bearable. By applying redenomination to deposits and loans, banks’ health would be revived – their loans would now be payable and therefore more valuable, and their net worth would consequently rise. The 30% wage reduction would further reduce fiscal problems and make Greek producers competitive, and operate as an “internal devaluation” to raise demand for Greek products and tourism. Most importantly, this internal devaluation – by solving the problems of fiscal deficits, non-competitiveness and bank insolvency – would inspire confidence in Athens’ ability to stay within the eurozone, which should bring deposits back into the banking system to fuel a rebirth of lending.

I think this is about half right, but a very good idea lies in here.

"an across-the-board redenomination would lower prices throughout the economy"? Not necessarily. Why would any store lower prices just because it gets to lower wages and rent? Prices are not a "contract."

Thus, the redenomination should probably come with a (say) one week price control. Every price must be lowered 30% over what it was the previous day, for a week,  Just long enough for each store to see that its competitors and suppliers has also really lowered prices.  Then stores can do what they want.

The deeper issue here is just what is the price and wage stickiness that so infects macroeconomic thinking. Why is "internal devaluation" by price and wage adjustment so much harder than "external devaluation" by exchange rate adjustment? Our formal models have costs of changing prices. Yet the actual costs of changing prices are tiny.

I think a "coordination problem" is more likely. The baker doesn't want to lower his price because he still pays the same price for wheat and yeast; the farmer doesn't want to lower his price because he pays the same price for fuel, and so forth. This web of prices is of course thousands of times more complex than that story. That's why it takes so long for everyone to agree on lower prices together.

At times, however, prices and wages do change, overnight, with no cost at all. When countries join the euro, every store changes price -- and the symbol next to it -- overnight. That fact alone should tell us that menu costs, though a nice formalism, are not the real microeconomic foundation of price and wage stickiness. And there is a potential role for a government to coordinate price changes.

What Charles is proposing, then, is exactly the same sort of overnight price and wage change that happened on admission to the euro. If you think prices and wages are "overvalued" in Greece, and a "devaluation" is all it takes for Thessaloniki to start exporting Porsches to Stuttgart, then an overnight, coordinated, price and wage change is a very nice alternative policy that we might start taking more seriously.

This is a bit of a "thesis topic" suggestion. I think we need a model of price stickiness as a coordination failure that is as simple and tractable as the standard, but false, Calvo fairy or menu cost models. Coordination failure models might also result in the sort of backward-looking stickiness that Phillips curves in the data seem to show.

Why just a week? Well, the macroeconomic presumption here is that Greece is suffering some sort of "imbalance" or "overvaluation" or "sticky wage." If that's right, one week at the right prices and wages should stick. Each individual store or person would then be reluctant to raise prices without the others going along. If prices jump right back up again after a week, however, without the help of government coordination, then we weren't so imbalanced to begin with, and the problem is really structural not monetary.

I rather suspect that tourist prices are set by competition with Sicily, not local wage stickiness, but it would be interesting to see. Prices of imported goods will also likely jump right back up. Fine.

Charles doesn't mention prices, but he does mention debts. This is a lot harder, as a debt "redenomination" is not just a method to solve a coordination problem and lower all prices and wages relative to German ones going forward, it is a huge transfer of wealth and a technical default.

If you run a coffee shop and charged 2 euros for a cappuccino yesterday, having all the coffee shops change to 1.5 euros overnight (for a week) is one thing. But changing the mortgage payment is another. One is a price. The other is a default.

Charles sneaks off into the economic passive voice here  "By applying redenomination.." which is always a sign of trouble ahead.  Most lenders, especially international ones, will go straight to court on that one.

I also do not follow how "applying redenomination to deposits and loans, banks’ health would be revived – their loans would now be payable and therefore more valuable, and their net worth would consequently rise." Before redenomination: Assets: 50 euros mortgages, 50 euros greek government bonds. Liabilities: 99 euros deposits, 1 euro equity. After redenomination: all numbers cut by 1/3. How is the bank any healthier? All ratios (capital, leverage) are the same.

So I think the proposal has the right spirit but a slightly wrong focus.

Charles continues

Although redenomination would accomplish a great deal, by itself it is not enough. As simple economic theory (formally known as the the Balassa-Samuelson Theorem) tells us Greece will only be a viable long-term member of the eurozone if it can match the long-term productivity growth of Germany and other members. To do so requires it to undertake major reforms to labor laws and competition policies, and to wage a credible war on corruption. 

I disagree pretty strongly here. If "eurozone" means a free trade agreement and a common currency, that can survive just fine with vastly different productivity levels (it already does) and consequently different productivity growth rates. Productivity across locations in the US varies enormously. Ricardo and absolute vs. comparative advantage was all about free trade under the gold standard (common currency) between countries of different "competitiveness" or productivity levels. Perhaps he means eurozone as an area that promises fiscal transfers to produce an equal standard of living everywhere. If so, good luck.

But that Greece's only hope to avoid becoming the next Venezuela is  "major reforms to labor laws and competition policies, and to wage a credible war on corruption" is spot on. In or out of the euro, in our out of the EU, in the end money and trade freedom are small parts of economic growth.

China crash?

Meanwhile, on the other side of the world, China is doing everything in the textbook to ignite a "bubble."

I dislike that usually undefined term, which carries a lot of normative baggage. But there are a set of steps that governments often take unwittingly and are later criticized for. China's doing them on purpose. And these steps quite often precede large market declines.

Short sales ban: Financial Times: "opened a probe into market manipulation"  ... "The investigation is likely to focus on short selling."  The usual witch hunt, with Chinese characteristics. Owen Lamont has a splendid paper on what often follows short-sales bans. The weekend before TARP and Lehman, the US instituted a short-sales ban on bank stocks, just in case there was someone out there who did not know banks were in trouble and they should sell now. Europe instituted a CDS selling ban in the first PIGS crisis...

Lending to encourage highly leveraged speculation: Wall Street Journal: "Under the planned move, China’s central bank will indirectly help investors borrow to buy shares in a market that had already seen a rapid buildup in debt from so-called margin financing." Procyclical credit supply is named by just about every account of a "bubble" followed by a crash.

Prices depend on supply and demand. As well as increasing demand, limit supply: "A halt to new stock listings."

And more. Quartz offers "A complete list of the Chinese government’s stock-market stimulus (that we know about)" including  "People’s Bank of China will “provide liquidity assistance” to China Securities Finance Corp., a company owned by the stock regulator. The company will use the money to lend to brokerages, which could then make loans to investors to buy stocks."

This scenario often ends badly.

The only thing I can think of that can actually stop a crash is for the central bank to directly print money to buy stocks. And not just a little bit. A pre-announced and limited quantity won't work. The US QE took billions to alter bond prices a few basis points at most. One has to commit to a price floor and a "do what it takes" amount of money, no matter how large or inflationary. I don't know of it ever being tried. It will be interesting to see if China goes that far. They could hide the fact with extensive bailouts of people "borrowing" to buy stocks, or otherwise cover losses or promise to cover losses.

Of course, the right strategy is to leave it alone. The whole point of stocks is that they go down on occasion, without runs, without defaults, and without financial distress. Unless the people and institutions holding them are highly leveraged. Didn't we just learn this lesson?

Asset Pricing Summer School

I’m going to offer my online course “Asset Pricing” over the summer. The intent is a “summer school” for PhD students, either incoming or between the first year of foundation courses and the second year of specialized finance courses.

At least one university is going to use this more formally: Require completion of the class for their PhD students (either incoming or between first and second year,) and organize a TA and group meetings around the class. We have found that this sort of social organization helps a lot for students to get through online classes.

The course offers a free “certificate” for achieving a certain grade level in the class, which gives an incentive to actually do the problems. Faculty can tie achievement of the “certificate’ to whatever carrots and sticks they want to offer. For example, one instructor is going to treat achievement of the “certificate” as an assignment for his fall PhD class, and include it in the grade.

Since the class covers most of the basics, this structure may free a faculty member teaching next year to focus the PhD classes on more advanced material. It’s also useful as a “flipped classroom,” allowing the faculty member to spend less time on algebra and derivations, and more on intuition, extensions, and current research.

This session won’t have TAs on my part, though I will monitor the forums and attend to glitches as they crop up.

The class is free. To sign up or see the classes, follow these links

Part 1: https://www.coursera.org/course/assetpricing
Part 2: https://www.coursera.org/course/assetpricing2

The class experience consists of watching short lecture videos, doing the assigned reading, answering quzzes and fairly extensive problem sets, and taking an exam. The course has discussion forums which are quite useful.

The class starts next Monday, June 8. It is open for registration now, and will be open for students to see materials and start work by the end of the week. Part 1 (7 weeks) ends July 27, and Part 2 (7 weeks) ends Sept 14. The two parts may be taken independently. Students not wishing a grade may use these materials freely and just do whatever parts seem interesting. I've also set up the grading pretty flexibly to allow people to adjust their schedules rather than follow the week by week rigid schedule.

This is a bit late notice, but I hope blog readers will pass on notice to PhD students or prospective ones, and to faculty members who are teaching PhDs in the fall and might find this resource useful.

The syllabus:

Part I
Week 1 Stochastic Calculus Introduction and Review. dz, dt and all that.
Week 2 Introduction and Overview. Challenging Facts and Basic Consumption-Based Model
Week 3 Classic issues in Finance. Equilibrium, Contingent Claims, Risk-Neutral Probabilities.
Week 4 State-Space Representation, Risk Sharing, Aggregation, Existence of a Discount Factor.
Week 5 Mean-Variance Frontier, Beta Representations, Conditioning Information.
Week 6 Factor Pricing Models -- CAPM, ICAPM and APT.
Week 7 Econometrics of Asset Pricing and GMM.  Final Exam

Part II
Week 1 a) The Fama and French model b) Fund and performance evaluation.
Week 2 Econometrics of classic linear models.
Week 3 Time series predictability, volatility and bubbles.
Week 4 Equity premium, macroeconomics and asset pricing.
Week 5 Option Pricing.
Week 6 Term structure models and facts.
Week 7  Portfolio Theory and Final Exam