Budget Uncertainty

CBO Director Elmendorf writes,

in some situations, legislators might want to adopt policies with a smaller variance of budgetary effects in order to reduce the risk of large fiscal problems. For example, understanding the extent of uncertainty about future federal spending that arises from uncertainty about lifespans might affect whether policymakers want to index eligibility ages for certain programs to lifespans.

Pointer from Mark Thoma.

A couple years back when some CBO staff invited me to have a discussion of their work, I gave two complaints. One was that their macroeconomic forecasting was treated as “scoring” by the public, and I thought that they needed to make clear the tenuous nature of macro modeling. The other was that I thought that they should be augmenting point forecasting of the budget with scenario analysis.

I think that reporting a number like “forecast variance” would not be helpful to politicians. However, reporting what would happen under particular scenarios, such as increased longevity, higher interest rates, or lower house prices, could be very useful.

A Conflict of Rhetoric

Lawrence Mitchell writes,

A very significant component of success – one that may even be more determinative than hard work – is luck. This is true, even if the advantaged have worked hard to maximize the benefits of that luck. By luck, I mostly mean circumstances of birth and natural talents and abilities (which might well include the propensity to work hard).

Why do the disadvantaged tolerate this situation? The American myth of self-reliance. No matter the vagaries of fortune, we consistently find that Americans at all levels believe in some variant of the Horatio Alger myth – the classic American rags to riches success story – despite strong empirical evidence that belies it.

Pointer from Mark Thoma.

On the other hand, James Otteson writes,

Human beings are capable of being worthy to be free. Human beings become noble, and, I would even suggest, beautiful, by the vigorous use of their faculties and they become dignified when their lives are their own…

This conception of moral agency allows one to be one’s own person, and to stand, or fall, on one’s own individual initiative, without having to beg for personal favors, without having to grovel at the knees of a king or flatter a lord or satisfy the pleasure of the Regulatory Czar. It grants people the freedom to go where their own abilities and initiative–not someone else’s mercy or condescension–can take them. Yet with that freedom comes responsibility for one’s actions. If you succeed, then you reap the benefits–and no one begrudges you your success because it means you have done well both for yourself and for others. If you fail, however, then you may pay the cost and (one hopes) learn from the experience.

…Contrary to widespread opinion, failure is not something that public policy should attempt to eliminate…failure, and experiencing the consequences attendant on having made decisions that led to failure, is an indispensible [sic] part of moral agency.

Those quotes are from Otteson’s recent book, The End of Socialism.

My sense is that these two authors talk past one another. Otteson’s rhetoric emphasizes personal decisions as the determinant of individual success. For Mitchell, it is the opposite–even a “propensity to work hard” is a matter of luck.

I find myself unwilling to accept either extreme. I am inclined to think that Otteson makes the scope of individual moral agency seem too large, and Mitchell makes that scope seem too small. However, I have yet to finish Otteson’s book or to start Mitchell’s.

Coincidentally, Charles Murray writes,

deeper personal qualities account for what we call political polarization, but that one specific dimension—our respective attitudes toward personal responsibility—accounts for a huge proportion of the polarization all by itself.

Read the whole piece.


Those are the symbols for the “real exchange rate,” or the terms of trade, both measured inversely, or “competitiveness,” measured directly. That is, when this expression goes up, the real exchange rate depreciates, the terms of trade worsen, and competitiveness improves. e is the nominal exchange rate. Say that we are Japan, and e is yen/dollar. As e goes up, it means that our exchange rate is depreciating. (I am forever confused by that way of writing e, but that’s how it’s done.) P* is the domestic price index of our trading partners, and P is our domestic price index. Suppose that we (Japan) are relatively deflationary, which means that P*/P is going up. That has the same effect as a currency depreciation.

It appears to me that Japan is experiencing both a nominal currency depreciation (a rise in e) and an increase P*/P. That means that Japan is certainly experiencing a real exchange rate depreciation, or a real deterioration in its terms of trade. It has to give up more Toyotas to import the same amount of beef. In terms of purchasing power in world markets, the Japanese are becoming worse off.

At the same time, Japan has become more competitive. Japanese consumers will be inclined to import less beef. Toyota will find itself able to export more cars.

The question I have is this: when does Japan succeed in inflating away some of its debt? In terms of world purchasing power, it is already doing so. Japanese holders of government bonds are earning negative returns relative to the cost of a consumption basket. But that does not help the government. The government needs an increase in yen-denominated tax revenue.

Possibly related: Brad DeLong writes,

That process–the rise in domestic nominal prices and wages, and the larger fall in the nominal value of the currency–may derange the price system and so disrupt aggregate supply. The new equilibrium may be one in which the real depreciation of the currency is expansionary in the sense that it tends to push real aggregate demand above potential output. But the economy may nevertheless be in depression, if the process of getting to the new equilibrium has entailed nominal price swings large enough to have been sufficiently disruptive to the market-mediated division of labor. Weimar 1923.

Pointer from Mark Thoma.

I see that as the crux of the issue. If investors lose confidence in Japan’s bonds, the Japanese government loses its ability to borrow. When you lose the ability to borrow and you are running large deficits, watch out.

UPDATE: Read Tyler Cowen’s post on this topic.

Chris Dillow on a Basic Income

He writes,

A lowish basic income satisfies the right’s desire that there be only limited redistribution. But it would compel people to find low-paid and unpleasant work.

Pointer from Mark Thoma.

Dillow believes that a basic income should be high enough so that a person could turn down low-paid and unpleasant work. I am confident that I could not persuade him otherwise, but all I can say is that I disagree. The summers I spent in an electronics factory were much better for my morale than the summers that I spent idle. And if my daughters faced the choice of a future cleaning hotel rooms or a future living on welfare checks, I honestly would think of them as better off cleaning hotel rooms.

In fact, one of the arguments against a negative income tax is that there is some evidence that labor supply is highly inelastic, so that even with high implicit marginal tax rates poor people choose to work. That evidence would suggest that many people share my preferences about the dignity of having a job and earning one’s living.

If the studies are correct, then lowering the implicit marginal tax rate will induce only a small increase in labor supply. I happen to think that in the long-run, perhaps meaning the multi-generational long run, the labor supply elasticity is higher than the studies show. However, even if I am wrong about that, I would still prefer lowering the marginal tax rate on ethical grounds. Let government policy reinforce the work ethic, rather than exploit it.

Inflation Defies Fundamentals

Jan Groen writes,

Another issue is how to find the right variables to predict future inflation. Economists often use the Phillips curve relationship, with inflation depending inversely on unemployment—that is, lower unemployment puts upward pressure on wages and, eventually, on inflation. But while an unemployment rate variable is common, it isn’t clear that this is the best gauge. Stock and Watson (1999) and Wright (2009) consider a broader range of possible “economic slack” variables and then use different ways to condense the information in these variables to predict future inflation. Generally, these approaches do as well as or better than autoregressive models. Atkeson and Ohanian (2001), however, conduct a similar exercise but focus on the post-1985 period, which—up to the advent of the Great Recession—was a period typified by remarkably low and stable inflation in the United States. Using the Chicago Fed National Activity Index (CFNAI), which summarizes information across many activity variables, they show that the resulting inflation forecasts are worse than when one just relies on current inflation to forecast future inflation.

Links omitted. Pointer from Mark Thoma.

Standard macro theory includes a “tight” model of inflation. You might have a Phillips Curve in which inflation depends on unemployment. Or you might prefer a monetarist formulation, in which inflation depends on money growth.

However, if you rely on these relationships in the real world, your predictions for inflation will be awful. Think of your forecast as a weighted average of

a) inflation tomorrow will be what it was yesterday; and
b) inflation tomorrow will be determined by measures of economic slack and/or money growth

If you put any significant weight on (b), you will be hosed.

My own inclination, which I think is close to that of the late Fischer Black, is to treat both money and the average level of prices as consensual hallucinations. As far as money goes, we accept currency and abstractions representing currency today because we expect that other people will accept them tomorrow. The prices that we charge today are based on prices that we expect to face tomorrow. These habits and beliefs are extremely sticky, and they are usually self-validating.

Let me put it this way:

the average behavior of prices is an emergent phenomenon, not a phenomenon that is controlled top-down through the manipulations of the central bank.

Read that several times, until you appreciate the heresy.

I do subscribe to a fiscal theory of hyperinflation. If the government runs deficits and loses the ability to fund those deficits with long-term borrowing, then it has to go on a money-printing frenzy that will destroy the emergent properties of money and prices.

Along those lines, I am curious as to what will happen in Japan. The fiscal and monetary authorities there would like to engineer a moderate level of inflation. What they seem to be doing strikes me as sufficient to generate hyperinflation. So far, a consensual hallucination of zero inflation seems to be holding.

I think that economists should be very modest and humble in claiming to understand inflation.

Is Housing a Great Investment?

Robert Shiller has always said no. But Katharina Knoll, Moritz Schularick, and Thomas Steger write,

Real house prices have approximately tripled since 1900, with virtually all of the increase occurring in the second half of the 20th century

Pointer from Mark Thoma. They are looking at house price data from around the world. They say that transportation improved more rapidly before 1950, and that increased the effective supply of land. Since then, the slowdown in transportation improvement and tighter land-use regulations have raised land prices.

I still want to know why their data appears to be so different from Shiller’s.

Larry Summers on Upward-Sloping AD

He writes,

Notice that as Keynes, Tobin and subsequently Brad Delong and I have emphasized, wage and price flexibility may well exacerbate the problem. The more flexible wages and prices are, the more they will be expected to fall during an output slowdown leading to an increase in real interest rates. Indeed there is the possibility of destabilizing deflation with falling prices leading to higher real interest rates leading to greater output shortfalls leading to more rapidly falling prices and onwards in a vicious cycle.

Read the whole thing. There were many sentences I wanted to excerpt. Pointer from Mark Thoma.

In AS-AD, if your Y-axis is inflation rather than the price level, then AD slopes upward. That is, the more inflation you have, the lower the real interest rate, and the higher is AD. If AD gets steeper than AS, then have a nice day. Because if that happens, then a “favorable” supply shift leads to lower employment and output. One way to interpret secstag is as a claim that we have been experiencing an AD curve that is upward-sloping and steeper than AS.

Keep in mind that Summers and other mainstream macro economists talk about potential GDP as if it were some tangible quantity, rather than a made-up number. In mainstream macro, we all work in a GDP factory, and the factory has a capacity that we call potential GDP.

The PSST story rejects that. It says that we produce many different types of output, and we only have the potential to produce the output for which we have discovered patterns of sustainable specialization and trade. If we could discover other patterns of sustainable specialization and trade, we could produce a different mix of output, and perhaps this would raise the level of GDP. But raising GDP by discovering patterns of specialization and trade is akin to raising GDP by discovering a practical cold fusion technology. Complaining about the economy operating below potential is like complaining that we do not have cold fusion.

Related: Tyler Cowen on the difficulty of disentangling AD from AS. Plus Scott Sumner commenting on Tyler Cowen.

Some Uncharitable Thoughts

Regarding Mark Thoma’s links from the other day.

1. Will Americans ever vote for a far-reaching wealth tax?–Roger Farmer.

No, but we will have one, anyway.

2. Enhance Stability by Improving Culture–William Dudley.

Look who’s talking.

3. Is mortgage credit too tight?–Calculated Risk.

Not by the standards currently set by politicians. If you tell banks you have zero tolerance policy for making type I errors (making loans that eventually default), you have to expect many type II errors (passing up good loans). Of course, 10 years ago, the political pressure was the opposite.

Clarify the Connection

1. Melinda Pitts, John Robertson, and Ellyn Terry have a chart that seems to me to show that much of the decline in labor force participation in recent years can be accounted for by population aging, disability, and young people attending school.

Pointer from Mark Thoma.

2. James Pethokoukis has a chart showing that the number of people on food stamps has remained really, really high.

I would interpret (1) as saying that we are in a “nothing to see here, move along” sort of labor market. Given that the unemployment rate is normal, if labor force participation is just following natural demographic trends, then the economy is pretty much ok.

I would interpret (2) as saying that there is something to see here. With unemployment down, we should be seeing people fall off the food stamp rolls.

Are senior citizens, people on disability, and young students going on food stamps in droves? Are people who are still in the labor force and working staying on food stamps in droves?

I am not trying to make a point. I genuinely do not know how to connect these dots in the data. For those of you who follow algebra, we have

FS = food stamp recipients
POP = total population
UNEMP = employedunemployed
LF = Labor force

Then FS/POP = (LF/POP)(UNEMP/LF)(FS/UNEMP). We know that FS/POP is unexpectedly high, but LF/POP is low, and UNEMP/LF has come down. So FS/UNEMP must be quite high, right?

The Problem of Big Banks

Stephen G. Cecchetti and Kermit L. Schoenholtz write,

Imagine the following simple approach (like that of Acharya et al). Let the capital structure of a bank’s long-term liabilities be clearly stated and then honored if and when necessary. That is, think of the bank as having a hierarchy of long-term debt ranging from the most senior (call it tranche A) to the most subordinated (tranche Z for zombie!). Whenever a bank’s capital position is deficient – say, because the market value of its equity sinks below a threshold ratio to its book assets – the resolution authority automatically makes some of the debt into new equity, starting with the Z tranche and then climbing up the alphabet until there is sufficient capital to return the bank above the regulatory minimum. Provided that there is sufficient long-term debt to absorb the losses, the concern remains a going one. (The resolution authority could still replace management and shut down risky activities in an effort to prevent a serial failure.)

Pointer from Mark Thoma. This is an alternative to the idea of divesting the firm’s assets according to a “living will.” The authors write,

But let’s not overstate the attractiveness or simplicity of the phoenix plan. No scheme can eliminate policy discretion, as crises often lead governments to change the rules on the fly (think of the 2008 TARP legislation that followed the failure of Lehman).

The way I read this, we really cannot get back to the rule of law if we have too-big-to-fail banks. That is what I will be arguing in two weeks. These institutions will be given special treatment, particularly in a crisis. In 2008, AIG was eviscerated in order to provide a liquidity injection to Goldman Sachs, Deutsche Bank, and others. Does anyone think that the decisions would have come out the same if the Treasury Secretary had been a proud alumnus of AIG rather than of Goldman Sachs?

Some of my other thoughts for the panel.

1. Suppose that we were to limit any financial institution to $250 billion in liabilities that are not backed by capital. Currently, the largest banks in this country seem to have over $1 trillion in liabilities.

2. What can you not do with a $250 billion portfolio? What would such a bank be precluded from doing, other than buying another huge bank?

3. I think it is pretty hard to know for certain the extent of economies of scale and scope in banking. However, my intuition is that the big banks did not get where they are today through natural market competition. In other industries, dominant firms are characterized by focused excellence. Intel is very good at designing and manufacturing chips. Walmart is very good at logistics. What is JP Morgan Chase very good at? Citigroup?

Another characteristic of dominant firms in competitive markets is that they grow by doing more of what they are good at. In contrast, banks grow primarily through mergers and acquisitions.

4. How much does too-big-to-fail matter? Well, try to imagine what the computer industry would look like if the government had designated the dominant firms as of 1970 as too big to fail. We would still have Wang and DEC, but I doubt that we would have Apple or Microsoft.

5. If we imagine banks without TBTF, then it is likely that at times in the past the stock prices of some of the large banks would have been very low, which would have halted their growth through acquisitions and perhaps forced management to divest poorly-managed business lines in order to appease shareholders.

We cannot have large banks without TBTF. We cannot have TBTF without an unfair playing field and mockery of the rule of law. So we should break up large banks.