Monthly Archives: January 2014

DY2VTSC

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Larry Summers writes.

[we need] policies that restore a situation where reasonable growth and reasonable interest rates can coincide. To start, this means ending the disastrous trends toward ever less government spending and employment each year

The CBO wrote,

By 2038, CBO projects, federal spending would increase to 26 percent of GDP under the assumptions of the extended baseline*, compared with 22 percent in 2012 and an average of 20½ percent over the past 40 years.

Did you two visit the same country?

*The “extended baseline” is an unrealistic scenario, which includes spending cuts that are embedded in current law but unlikely to be retained by Congress. The more realistic “alternative fiscal scenario” projects even higher spending relative to GDP.

Macro Experiments are not Controlled

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Alex Tabarrok writes,

I happen to agree with Krugman that one test is not decisive. The economy is very complex and we don’t have controlled macro-experiments so lots of things are going on at the same time.

Read the whole thing, especially if you do not know the austerity-test controversy to which Alex is referring. And if you want more, you can read Mark Thoma or Scott Sumner either at EconLog or at MoneyIllusion.

My comments.

1. Don’t throw all your eggs at Paul Krugman. Save some for Mark Zandi, of Macroeconomic Advisers Moody’s, who also forecast dire consequences from the sequester.

2. You don’t have to believe the fiscal austerity was a non-event. You can believe that the economy was about to expand rapidly, and trimming the budget deficit held it back. Although, as Alex points out, telling this story makes it a little harder to say that we were in a liquidity trap/secular stagnation. Anyway, believing that austerity held back a boom is just the mirror image of believing that the stimulus worked, and the only reason that unemployment ended up higher than what was predicted without the stimulus is that the economy was in a deeper hole than we thought. The “deeper hole” theory is now the conventional wisdom among Stan Fischer’s 72 Ph.D advisees and their descendants. That is the beauty of macro. Even something that is defined ahead of time as a “test” is not a controlled experiment.

3. Even if you believe that fiscal austerity was a non-event, you do not have to believe that it was “monetary offset” that made it so. I would suggest that the process of business creation and business destruction did its thing without regard to fiscal and monetary policy.

4. Try to explain why nominal interest rates went up. If austerity matters, then interest rates should come down. If monetary offset works the way it does in old-fashioned textbook models, then interest rates should come down even more.

5. In Scott Sumner’s floofy world where the Fed directly controls NGDP expectations, you would expect nominal interest rates to go up with monetary offset. But I am still trying to come up with even a thought experiment that would refute market monetarism. If 2013 had been a down year, it would just have shown that the Fed failed to maintain NGDP expectations. This is uncharitable, but I think of market monetarism as a theory that can only be confirmed, never rejected.*

Is there anyone I haven’t offended yet?

*To be less uncharitable, let Scott speak for himself.

In my view the now famous Krugman “test” of market monetarism is an indication of the pathetic state of modern macro. We are still in the Stone Age. Future generations will look back on us and shake their heads. What were they thinking? Why didn’t they simply create a NGDP futures market? They’ll look back on us the way modern chemists look back on alchemists. It’s almost like people don’t want to know the truth, they don’t want answers to these questions, as then the mystical power of macroeconomists with their structural models would be exposed as a sham. Remember when the Christian church produced bibles and sermons in a language that only the priesthood could understand? That’s macroeconomics circa 2013.

Brad DeLong’s Questions

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His post is here. I will insert my answers.

Why is housing investment still so far depressed below any definition of normal?

In the U.S., politicians shifted from punishing mortgage lenders for making type II errors (turning down borrowers for loans that might have been repaid) to punishing them for making type I errors (lending to borrowers who might default). In addition, politicians interfered with the foreclosure process. This kept markets from returning to normal, and it further discouraged mortgage lending. What good is the house as collateral for a loan in a world where the government keeps the lender from getting at it?

Why has labor-force participation collapsed so severely?

I believe that this is a trend, amplified by the cycle. Many workers are facing stiff competition from foreign labor and from capital. At the same time, the non-wage component of compensation has gone up, because of health insurance costs. These factors put extreme downward pressure on take-home pay for many workers, and they have responded by dropping out of the labor force.

Why the very large spread between yields on safe nominal assets like Treasuries and yields on riskier assets like equities?

I lean toward a Minsky-Kindleberger answer. During the Great Moderation, confidence in financial intermediation grew. We thought that banks had discovered new ways to manufacture riskless, short-term assets out of risky, long-term investment projects. Then came the financial crisis, and distrust of financial intermediation soared. This made it harder to convince people that you could provide them with riskless, short-term assets backed by risky, long-term projects.

Why didn’t the housing bubble of the mid-2000s produce a high-pressure economy and rising inflation?

It took place in the context of the long-term trend to displace many American workers with capital and with foreign labor. The bubble took us off that trend and the crash put us back on it.

To what extent was the collapse of demand in 2008-2009 the result of the financial crisis and to what extent a simple consequence of the collapse of household wealth?

Great question. It appears that the collapse of household wealth is a sufficient explanation. But if so, then what was the point of TARP and the other bailouts? Of course, putting on my PSST hat, I would reject a phrase like “collapse of demand.” I would say instead that in the wake of the financial crisis, the psychology of existing businesses was that it was a good time to shore up profits by trimming the work force, and the psychology of entrepreneurs was that it was not a good time to try to obtain funding for new businesses.

Why has fiscal policy been so inept and counterproductive in the aftermath of 2008-9?

Not a question that I can answer, given that we disagree on what constitutes inept and counterproductive.

Why hasn’t more been done to clean up housing finance (in America) and banking finance in Europe)?

Politicians care about what happens on their watch. That is why you can count on them to bail out failing financial firms (“Yes, we should worry about moral hazard. But risk some sort of calamity because of a visible financial bankruptcy? Not on my watch.”) That is why you can count on them not to institute major financial reforms. (“Of course, we need a new design here. But do something that could cause short-term disruption to some constituents? Not on my watch.”)

Incidentally, I diagnosed the “not on my watch” bias toward bailouts way back in 2008. Also in September of 2008, I wrote,

Five years from now, we could find ourselves with no exit strategy. My guess is that we’ll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo.

You can read Robert Waldmann’s answers here. Pointer from Mark Thoma.

Social Reasoning

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Julian Baggini writes,

Most neuroscientists believe we have a dedicated system for social reasoning, quite different to the one that is used for non-social thinking. What’s more, when one system is on, the other turns off. Lieberman explains how the social system fulfils three core tasks. First, it must make connections with others, which involves feeling social pains and pleasures, such as those of rejection or belonging. Second, it must develop mind-reading skills, in order to know what others are thinking, so as to predict their behaviour and act appropriately. Finally, it must use these abilities to harmonise with others, so as to thrive safely in the social world.

Read the whole essay, which reviews three books on social psychology and philosophy.

I had not heard about this dichotomy between social reasoning and non-social thinking. Where can I find out more? One possibility that leaps to my mind: in thinking about politics, do progressives and conservatives have social reasoning turned on and non-social thinking turned off, but with libertarians it is the other way around?

One of the books reviewed in the essay, Joshua Greene’s Moral Tribes, looks like something that could relate to my Three Languages of Politics. However, I get the impression is that degenerates into a plea for the author’s version of utilitarianism.

Ben Bernanke’s Valedictory

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He says,

The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions

The Bagehot policy is to lend freely, at a penalty rate. If you lend freely at a penalty rate, you effect financial triage. Banks that are fine don’t borrow. Banks that are insolvent go under anyway. And banks that are temporarily illiquid use your loans to recover. Instead, if all you do is lend freely, then you are simply handing out favors, which turns banking into an exercise in favor-seeking.

He goes on to say,

Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.

This is a popular story among Keynesians now. It was not in the textbooks before the crisis.

Scott Sumner will be disappointed to see that Bernanke does not believe in the theory of monetary offset.

What is Financial Repression?

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Ken Rogoff and Carmen Reinhart are still paying attention to sovereign debt. In fact, there are so many links in this paper to recent work of theirs that surely another book is in the offing. Here, they write,

the current stage often ends with some combination of capital controls, financial repression, inflation, and default. This turn of the pendulum from liberalization back to more heavy-handed regulation stems from both the greater aversion to risk that usually accompanies severe financial crises, including the desire to prevent new ones from emerging, as well as from the desire to maintain interest rates as low as possible to facilitate debt financing. Reinhart and Sbrancia (2011) document how, following World War II (when explicit defaults were limited to the losing side), financial repression via negative real interest rates reduced debt to the tune of 2 to 4 percent a year for the United States, and for the United Kingdom for the years with negative real interest rates. For Italy and Australia, with their higher inflation rates, debt reduction from the financial repression “tax” was on a larger scale and closer to 5 percent per year. As documented in Reinhart (2012), financial repression is well under way in the current post-crisis experience.

(Can anyone find the 2012 paper? It’s not listed in the references.)

Reinhart’s story is that once upon a time, countries emerged from WWII with a lot of sovereign debt. They used financial repression to keep interest rates low, and they got out from under that debt. Then they liberalized, and the financial sectors went crazy, growing rapidly and fueling bubbles. Then the crash came, governments took on a lot of debt again, and now we are back in the cycle of financial repression.

As a story, this is cute. But I cannot buy into it, at least for the United States. Re-read my history of U.S. government debt. Most of the reduction in the ratio of debt to GDP from 1946-1979 was due to the government running primary surpluses in the 40’s, 50’s, and 60’s. That is, if you took out interest payments, outlays were below revenues. The negative real interest rates were during the Great Stagflation, and they only reduced the debt/GDP ratio by a small amount.

Also, I am not sure where the financial repression is coming from today. Reinhart cites risk-based capital requirements that favor sovereign debt, but we have had those since before the financial crisis.

I think my larger issue is that I am unclear about the concept of financial repression. Some possibilities.

1. Financial repression consists of regulations that subsidize purchases of government debt and/or penalize risky private investment. In this case, the interest-rate differential between private securities and government securities is wider than normal. How does one distinguish this from a shift in the risk premium due to market psychology?

2. Financial repression reduces the amount of financial intermediation. But what does that mean?

To me, financial intermediation consists of the financial sector holding long-term, risky assets and issuing short-term, risk-free liabilities. The nonfinancial corporate sector and the household sector get to issue long-term, risky liabilities and to hold short-term, risk-free assets. The household sector ultimately owns the equity in the nonfinancial corporate sector and in the financial sector. The government, through deposits insurance and ad hoc bailouts, has in some sense written put options on firms in the financial sector, and as taxpayers we are on the hook for those put options.

If the government comes up with regulations that make it more difficult for the financial sector to expand and exploit its put options, then you might call that financial repression. But in that case, it is not clear that financial repression is a bad thing.

Forecasts for 2014

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Politico asks several economists for forecasts. What ensues is mostly ideological axe-grinding. In contrast, Dean Baker plays it straight, and makes an actual forecast.

There is also some serious downside risk in the stock market. Its valuation is definitely high right now, although I wouldn’t necessarily say it is a bubble. Nonetheless, if people are expecting another year of large gains, then they must be smoking something strong. The real story is likely to be with the social media companies. When you have a start-up with no clear business plan, like Snapchat, that can sell for $3 billion, you know things have gotten nutty. Some of these companies will no doubt survive and be profitable, but it takes a lot of profits to justify a $3 billion market cap, to say nothing of the $34 billion for Twitter or $130 billion for Facebook. These prices will come back to earth, and 2014 is as good a year as any for it to happen.

Pointer from Menzie Chinn.

I am nervous about the stock market also. But my main prediction is for increased ideological axe-grinding.

Challenges for Libertarians

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Pete Boettke has an essay on “Fearing Freedom” in the latest Independent Review. In an ungated earlier version, he writes,

The problem that confronts the modern classical liberal, Buchanan (2005) postulates, is not the managerial socialism of the 20th century, nor even the Nanny State of paternalistic socialism, but the desire on the part of the population to remain in the infantile state of demanding a parent to protect them from the vagaries of life and provide them with economic security.

This is an interesting idea to play with. On the one hand, I think there is a lot of truth to it. Recall that George Lakoff, in Moral Politics, says that progressives believe that government should act as a “nurturant parent.” He contrasts this with what he calls the conservative’s “strict father” model of the state.

On the other hand, I am not sure that we can use this idea in everyday political arguments. Nobody is going to say, “Oh, yes, you’re right. I have wanted to remain in an infantile state, and now I see the error of my ways.”

I also do not think it will work to say that the state is a bad parent. Most people do not think that the failings of their parents are enough to justify running away from them or denying them respect. Even if you get somebody to agree that the state is a bad parent, they are more likely to hope that the state can become a better parent than to say that they want to weaken the state/parent.

One of my favorite ideas, competitive government, comes across in this metaphor as though it means competitive parents. Nobody thinks that the way to solve the problem of bad parents is to introduce competition into the process and let you choose your parents.

At an intellectual level, of course, we can try to attack the analogy between the state and parents. But it me be difficult to dislodge the analogy at a gut level.

John Cochrane Interview

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Self-recommending, but I also read it and recommend it. Tyler and Scott have commented on it already.

if we purge the system of run-prone financial contracts, essentially requiring anything risky to be financed by equity, long-term debt, or contracts that allow suspension of payment without forcing the issuer to bankruptcy, then we won’t have runs, which means we won’t have crises. People will still lose money, as they did in the tech stock crash, but they won’t react by running and forcing needless bankruptcies.

This sounds somewhat radical to me. On the one hand, you want to allow some financial intermediation, which I might define as opaque financial institutions that hold risky, long-term assets and issue riskless short-term liabilities. On the other hand, you don’t want bank runs. What I would like to see are deposit-like contracts in which under certain conditions penalties may be imposed for rapid withdrawals. In the middle of a bank run, you can withdraw your money, but you lose, say 10 cents on the dollar. That sort of contract would have saved AIG, for example. When Goldman and the other firms that held credit defaults swaps written by AIG wanted to make withdrawals (termed “collateral calls”) they would have had to think twice about it. I made this suggestion in real time, back in 2008.

The interview has many great sound bites, but my favorites are these:

I think coming up with new theories to justify policies ex post is a particularly dangerous kind of economics.

and

the need for special savings accounts for medicine, retirement, college, and so on is a sign that the overall tax on saving is too high. Why tax saving heavily and then pass this smorgasbord of complex special deals for tax-free saving? If we just stopped taxing saving, a single “savings account” would suffice for all purposes!

Of course, we are getting a lot of the “particularly dangerous kind of economics” in the wake of TARP and the stimulus. I wish that the new theories were being developed to better account for reality, whether or not they serve to justify policy.

Finally,

Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. Yet all of macroeconomics still talks about the level of interest rates, not credit spreads, and about the willingness to substitute consumption over time as opposed to the willingness to bear risk. I don’t mean to criticize macro models. Time-varying risk premiums are just technically hard to model. People didn’t really see the need until the financial crisis slapped them in the face.

I think of Minsky as offering a useful theory of time-varying risk premiums, but that is probably not what John has in mind.

I have not given you all of the good material in the interview, by any means.

Puzzling Through Brad DeLong

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He writes,

if we combine the costs of idle workers and capital during the downturn and the harm done to the US economy’s future growth path, the losses reach 3.5-10 years of total output.

That is a higher share of America’s productive capabilities than the Great Depression subtracted

Pointer from Reihan Salam.

Brad goes on to say that conventional macroeconomists know how to fix this, but the evil, heartless plutocrats will not let conventional macroeconomic policy be followed.

I am really struggling to follow his reasoning. I may be wrong, but I think this is how he arrives at the insinuation that what is taking place now is worse than the Great Depression.

1. If you graph U.S. output, the Great Depression shows up as a deviation from trend, but you get back to trend. From a a long-term perspective, there is an adverse shift in the timing of output, but not much in terms of permanently foregone output.

2. Assume that in the future, the U.S. is not going to get back to trend. When you cumulate this shortfall relative to trend, it will be really huge.

If I have this right, then my comments would be:

a) it is the assumption of no return to trend that drives the calculation of such a large loss. The cumulative loss would diminish considerably under an assumption that we do return to trend.

b) if we are not going to return to trend, then it seems to me that Brad has to explain why this does not constitute a supply shock. The conventional macroeconomic theory says that permanent phenomena are supply shocks, not demand shocks. I realize that Larry Summers has floated the idea of “secular stagnation” on the demand side, but if this has already become a generally accepted thesis then I missed the memo.

c) Brad’s political economy appears to assume that rich people knew that we were suffering from secular stagnation five years before Larry did.

One of the points that I emphasize in my book (which is almost finished, by the way), is that the last few years we have seen a lot of on-the-spot macroeconomic theorizing that differs considerably from what was taught prior to the crisis. That’s fine. We need it. If you feel like stoning to death DSGE models and their kin, I’m happy to join in. But by the same token, I believe that new, outside-the-box thinking has to be marketed as tentative and speculative, not as scientific truth that only the evil or ignorant would deny.