Monday, August 31, 2015

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.

Monday, August 24, 2015

Phillips art

The Wall Street Journal gets a prize for Art in Economics for their Phillips curve article. Abstract expressionist division, not contemporary realism, alas.

Source: Wall Street Journal
(For the uninitiated: There is supposed to be a stable negatively sloped curve here by which higher inflation comes with lower unemployment. Beyond that correlation, most policy economists read it as cause and effect, higher unemployment begets lower inflation and vice versa. The point of the article is how little reality conforms to that bedrock belief.)

Too much debt, part II

"China to flood economy with cash" reads today's WSJ headline. When you read the article, however, you find it's not quite true. China to flood economy with debt is more accurate.
The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency,

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.
I had hoped the world learned this lesson in the financial crisis. Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders.

Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows.

Inevitably, it seems, another downturn will come, another set of books will have been found to have been cooked, and then we will find out who lent too much money to whom. US investment banks, 2008, strike one. Greece, 2010, strike 2. China, 2015, strike 3? Do we no longer bother closing the barn doors even after the horse leaves?

This story should also give one pause about the wisdom of "macro-prudential" policy, by which wise central bankers are supposed to presciently open and close the spigots of leverage to manage asset prices.

Wednesday, August 19, 2015

Europa hat die Banken missbraucht

An editorial in Süddeutche Zeitung, on Greece, banks and the Euro, summarizing some recent blog posts.

I don't speak German, so I don't know how the translation went, but it sounds great to me:


Die jüngste Griechenland-Krise rückt das größte Strukturproblem des Euro in den Vordergrund: Unter dem Dach einer gemeinsamen Währung müssen Staaten genauso wie Firmen pleitegehen können. Banken müssen international offen sein, sie dürfen nicht vollgepackt sein mit den Schuldtiteln lokaler Regierungen. So war der Euro ursprünglich konzipiert. Leider haben Europas Politiker die erste Prämisse vergessen und sind zur zweiten gar nicht erst vorgedrungen. Jetzt ist es Zeit, beides in Angriff zu nehmen.... 
The English version:

Greek Lessons for a Healthy Euro

The most recent Greek crisis brings to the foreground the main structural problem of the euro: Under a common currency sovereigns must default just like corporations default. And banks must be open internationally, not stuffed with local governments’ debts.

This is how the euro was initially conceived. Alas, europe’s leaders forgot about the first and never got around to the second. It’s time to fix both.

Greenspan for Capital

Alan Greenspan joins the high-capital banking club, in an intriguing FT editorial
If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.
20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.

Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:
...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.

Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.
A double bravo.

However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.

Tuesday, August 18, 2015

The decline in long-term interest rates

Source: Council of Economic Advisers
Long term interest rates are trending down around the world. And it's not just since the great recession and financial crisis. The same trend has been going on for decades.

The Council of Economic Advisers just issued an excellent report surveying our understanding of this question. A blog post summary by Maury Obstfeld and Linda Tesar.

(Many other interesting CEA reports here. Occupational licensing is next on my in box.)

The report is really well done, for explaining the economic issues in clear simple terms, but without hesitating to use a model and an equation when necessary. If you're wondering how to keep your undergraduate or MBA class (heck, your PhD class) busy this week, this report will do the trick.

There is some grumbling in economics circles about the CEA and what role it should play, between Sunday morning talk show cheerleader for the Administration's policies vs. providing dispassionate  economic analysis to the Administration and country. This kind of report is the kind of CEA I cheer for.

I won't summarize the whole thing. Maury and Linda's blog post blog post does a great job of that, and you should just go read it. A few comments however.

Monday, August 17, 2015

Low Hanging Fruit Guarded By Dragons

A nice essay by Brink Lindsey at Cato, analyzing some regulations that are strangling economic growth, with an explicitly bipartisan (multipartisan) appeal.

It's nice because of the unusual focus, not just health, banking, environment, and labor regulation but regulation we don't hear about often enough,
(a) excessive monopoly privileges granted under copyright and patent law; (b) protection of incumbent service providers under occupational licensing; (c) restrictions on high-skilled immigration; and (d) artificial scarcity created by land-use regulation
It takes a while to get going, so skip to p. 7 where the real analysis starts.

I liked especially the analysis of zoning laws, which are the central force behind rising housing prices. They are also curiously damaging to the environment, by forcing people to live far from where they work, and regressive. I say curiously, because tight zoning is so beloved by supposedly green and liberal places, such as Palo Alto.

Saturday, August 15, 2015

The wrong austerity

Bailout deal brings wave of tax hikes - Ekathimerini.com
A barrage of new tax measures are contained in the new bill presented to Greece’s Parliament
...diesel fuel tax for farmers going from 66 euros per 1,000 liters to 200 euros/1,000 liters from October 1, 2015, and to 330 euros by October 1, 2016. Farmers’ income tax to be paid in advance will rise from 27.5 percent to 55 percent. Income tax for farmers is set to rise from 13 to 20 percent for 2016 and to 26 percent for 2017.
Freelancers will be subject to a gradual increase from 55 to 75 percent in advanced tax payments for income earned in 2015, increasing to 100 percent in 2016. The 2 percent tax break for single payments on income tax is also being abolished from January 1, 2015.
Private education, previously untaxed, will be taxed at 23 percent, including the tutoring schools (frontistiria) that most Greeks send their children to but excluding preschools.
Greece’s vital shipping industry will also be subject to new tax rises. Among other measures, tonnage tax is to increase by 4 percent annually between 2016 and 2020. A special contribution by foreign cargo carriers will remain in place until 2019.
"Austerity" has been a contentious and vague word, descending to an all-purpose insult from the pen of Krugman et al.

But on one point I think we can agree. Steep tax increases, especially steep increases in marginal tax rates on people likely to work, save, invest, start new businesses, and hire others, are an especially bad idea right now. The only hope to pay back debt is growth, and this sort of thing just kills growth. Part of growth is also keeping smart young Greeks in the country, which they are leaving in droves.

Friday, August 14, 2015

For better or worse?

Three recent news items and blog posts make a provocative contrast:

Paul Krugman, New York Times,  "The MIT Gang"
It’s actually surprising how little media attention has been given to the dominance of M.I.T.-trained economists in policy positions and policy discourse.... 
James Bartholomew, The Spectator, "British economics graduates have left a trail of misery around the world"
"... the trendy doctrines of our universities have much to answer for" 
(A list that in terms of needless human suffering, is pretty astounding)

Yannis Palaiologos, Politico, Beware of American econ professors!  
World-famous economists — men of Nobel prizes and stellar academic accomplishment — have provided intellectual cover to radicals who appeared at best to be willing to take a stupendously reckless gamble with Greece’s financial, political and geopolitical future, 
To belabor the obvious: Be careful what you wish for.

Summers and the nature of policy advice

Larry Summers has a fascinating editorial in the Financial Times titled "Corporate long-termism is no panacea — but it is a start" You really should read the whole thing and come back for commentary.

The three paragraphs in the heart of the editorial are a tour de force:
Businesses will raise wages to a point where the cost is just balanced by the reduced bill for recruiting and motivating workers. At that point, a further increase in wages does not appreciably change their total costs but higher wages certainly makes their workers better off. So there is a strong case for robust minimum wages.
Never mind centuries of supply and demand, centuries of experience with minimum wages and other price controls, or even the current controversies. Never mind that who works for what business and how many do so is a little bit endogenous. Larry has a new and very clever theory about monopsonistic wage setting in the presence of recruitment and motivation costs.  (One that apparently only holds at the lower end of the wage scale where minimum wages bite?)

Wednesday, August 5, 2015

Greece and Banking

Source: Wall Street Journal; Getty Images
A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog.
Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 
Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.
If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in federally chartered, nationally diversified banks that are immune from state and local government defaults.
Depositors in the eurozone don’t share this privilege....
For the rest, you have to go to WSJ, Hoover (ungated) or wait 30 days until I'm allowed to post it here.

Lucrezia Reichlin and Luis Garicano have an excellent Project Syndicate piece on the same topic.

Writing contest: This is our first paragraph. The Journal's editors thought it was better with latest news first. Which works better?

Saturday, August 1, 2015

Rule of Law in the Regulatory State

About a month ago, I participated in a conference at Hoover, inspired by the 800th anniversary of the Magna Carta. There were lots of interesting papers.

I participated in a panel on "The Future of Freedom, Democracy, and Prosperity" with Arnold Kling and Lee Ohanian, with Russ Roberts moderating, which Russ has posted as an econtalk podcast.

The podcast gained a bit of traction, most recently with nice coverage in a Holman Jenkins Editorial in the Wall Street Journal.

All of which has finally motivated me to a neglected project, which is to polish up the essay I wrote in preparation for the panel. It's longish for a blog post, and you might prefer the formatting of the pdf version here.


The Rule of Law in the Regulatory State

1. Introduction

The United States’ regulatory bureaucracy has vast power. Regulators can ruin your life, and your business, very quickly, and you have very little recourse. That this power is damaging the economy is a commonplace complaint. Less recognized, but perhaps even more important, the burgeoning regulatory state poses a new threat to our political freedom.

What banker dares to speak out against the Fed, or trader against the SEC? What hospital or health insurer dares to speak out against HHS or Obamacare? What business needing environmental approval for a project dares to speak out against the EPA? What drug company dares to challenge the FDA? Our problems are not just national. What real estate developer needing zoning approval dares to speak out against the local zoning board?

Thursday, July 30, 2015

Asset Pricing Part II

Asset Pricing Part II, the second half of my online PhD class in asset pricing, starts up next week. Part I and Part II are separate and independent courses, and you don't need a lot of the material of Part I to do Part II. This is a "summer school" session set up especially for PhD students in finance.

Syllabus:

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, volatilty 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.

Tuesday, July 28, 2015

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.

Monday, July 27, 2015

Ben-Gad and the Minotaur

Michael Ben-Gad has a smashing review, "Into the Labyrinth", of Yanis Varoufakis' The Global Minotaur (Disclaimer: I have not read it and don't intend to.) It's a great piece of writing as well as a cogent analysis. Some excerpts:
"The idée fixe that dominates The Global Minotaur, and apparently dominated Mr Varoufakis’s squabbles with the other Eurogroup ministers of finance, is that some countries are inherently more productive than others and therefore always generate current account surpluses, while others always generate deficits, and fixed exchange rates or monetary unions only exacerbate this imbalance. Hence, for the world economy to function, the surpluses need to be recycled though a system of regular transfer payments from the core to the periphery.
Why do these imbalances emerge? According to the theory of comparative advantage as formulated by David Ricardo in the early 19th century, different countries specialise in the production of particular goods and then exchange them for others, and trade is mutually beneficial even if some countries are more efficient at producing all goods. Mr Varoufakis’s theory rejects all this. Instead, he argues, some countries are destined to specialise in the production of goods and services, while others on the periphery will forever specialise in consuming them. Put into layman’s terms, what this means is that the people of Germany, the Netherlands, and Finland produce cars, wooden clogs, or mobile phones and sell them to the people of Greece, who pay for it all with money – and to make this trade sustainable the cash needs to be regularly replenished in an endless loop by the people of Germany, the Netherlands, and Finland.
This is a story we hear quite often beyond Mr. Varoufakis -- that a currency union requires countries to be similar, with similar productivity. I'm glad to see it so effectively skewered. In Ricardo's famous example, Portugal sells wine to Britain, which sells wool to Portugal, even if one is better at both than the other. They were on a common currency, gold.

Wednesday, July 22, 2015

Monetary Testimony

I was invited to testify at the Subcommittee on Monetary Policy and Trade of the House Financial Services Committee on Wednesday. I had only done this once before and it was a very interesting experience.

The proposed bills my fellow panelists (John Taylor, Don Kohn, and Paul Kupiec) and I were testifying on  were the Centennial Monetary Commission Act of 2015 and the Federal Reserve Reform Act of 2015. The bills, transcripts, and all testimony are here.

Minimum wage and mechanization


A while ago I opined that higher minimum wages might lead companies like McDonalds to substitute to machines. A former student sends me:
here's a photo I took in the McDonald's on the Champs-Élysées, Paris, of the screens where customers can place their orders and pay. After a short wait, you pick up your burger and fries at the counter.
I did not ask just why he is eating at McDonalds in France!

Tuesday, July 21, 2015

A Capital Fed Ruling

The Fed just released it's latest missive to the big banks, and the answer is capital, lots more capital.

Three cheers for the Fed.

They are increasingly understanding that no matter how much they try to micromanage asset decisions, it's impossible to regulate away risk from the top. And "liquidity" will vanish the minute it's needed. Joke version -- liquidity standards are like requiring everyone on an airplane to carry a thousand bucks, so they can buy a parachute if the engines blow up. Just who will be buying "liquid" assets in the next crash?

So,  just raise capital, lots more capital, and slowly let the rest fade away.

A minor complaint: The Fed did it right but said it  wrong.
..under the rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital...
No, capital is not "held." Capital is issued. Capital is a source of funds, not a use of funds. Capital is not reserves.  Please all, stop using the word "hold" for capital.
"A key purpose of the capital surcharge is to require the firms themselves to bear the costs that their failure would impose on others," Chair Janet L. Yellen said. "In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability."
Issuing (not holding!) more capital does not make firms "bear costs." Firms never bear costs. They pass costs on to customers, workers, shareholders, or (especially for banks!) the government.  The slight argument for higher "costs" is that equity gets to leverage with less subsidized too-big-to-fail debt; that's not a cost, that's a reduction in subsidy. If (if) the cost of equity capital is high by some MM failure, then equity receives higher returns and borrowers pay higher costs. This is a surprising quote. Ms. Yellen is usually accurate in such matters.

But that's a minor complaint. I'd rather they raise capital and explain it wrong rather than the other way around. And of course, I'd rather they keep going. I'm also a skeptic that big banks are "systemic" and little banks are not, and thus should be allowed to continue with sky high leverage. But we'll get there.

Update:

A reader asks why I'm so persnickety about language. In this case, it's important. I think everyone recognizes that more capital leads to more financial stability. When an equity-financed bank loses money, share prices decline, but there are no failures or freezes. However, if you think capital is "held," and it "costly," then you think that banks shifting to issuing equity or retaining dividends to obtain funds has a cost to the economy, and regulators should require as little capital as possible. If you recognize that capital is issued, does not tie up funds, does not reduce the amount available for lending, then your mind is open to obtaining financial stability with lots and lots more capital.

Saturday, July 18, 2015

The other Smith on Growth

In a recent Bloomberg piece, "Growth Fantasy of Tax Cuts and Small Government" Noah Smith took on my recent blog posts on 4% growth. In the first, I outlined the historical evidence that yes, the US has grown at 4% quite often. In the second, I outlined the standard smorgasbord of free-market policies which I suggested would increase our growth, at lest by inducing a substantial level shift.

Noah's main point is that in my blog posts I did not make any substantive quantitative claims that moving our country from the Republic of Paperwork to Adamsmithia would return the US to the kind of growth we saw in the 60s, late 80s and 90s. True enough.

My surprise in reading Noah is that he provided no alternative numbers and no alternative policies.  Well, if you don't think Free Market Nirvana will have 4% growth, at least for a decade as we remove all the level inefficiencies, how much do you think it will produce, and how solid is that evidence? He rambled a bit about the predictive value of some state scoring efforts, but that's all quite beside the central point -- how much growth could the best imaginable economic policy, at a national level, produce?

More deeply, Noah suggests no alternative policies. He does not claim that more government wage controls,  unions, stricter labor laws (Uber drivers must be employees) heavier and more politicized regulation, cartelizing more industries beyond health and finance, raising taxes to confiscatory levels, larger welfare state, boondoggle public works and so on -- the alternative path in the current policy debate -- will get us back to 4% growth.

So, one must only conclude that Noah -- and others voicing the same it's-not-possible complaint -- believes 4% growth is not possible. 2% or less is the new normal. Sustained growth, of the sort that made us all healthier and wealthier, if not wiser, than our grandparents, is a thing of the past. So all we can do now is fight to carve up a shrinking pie, retreat from an increasingly chaotic world, and pretend that carving up the pie will not shrink it further.

I am surprised at this pessimism, both economic and political. If the absolute best economic policies anyone can imagine -- and, again, Noah offered no alternatives -- cannot return us to 4% growth and sustain that growth, why bother being economists? They do not call us the "dismal science" because we think the current world is close to the best of all possible ones, and all there is to do is haggle over technical amendments to rule 134.532 subparagraph a and hope to squeeze out 0.001% more growth. Usually, the role of economists is to see the great possibilities that every day experience does not reveal. ("Dismal" only refers to the fact that good economics respects budget constraints.)

Similarly, the next US presidential election looks to be an argument over growth vs. redistribution. I doubt that many Americans are so willing to abandon hope so soon.  Even Hilary Clinton's latest speech took the view that reducing inequality would raise growth -- a novel argument (relative to 250 years since Adam Smith) that invites similar theoretical and quantitative evaluation, but at least one that does not give up on growth.

Noah's tired pot-shot has been going on a long time. In 1980 Ronald Reagan announced some pretty radical growth-oriented policies, at least by the standards of the time. (Not much new since Adam Smith, of course.) The standard liberal commentators made the standard objections: voodoo economics, numbers don't add up, it will take generations of unemployment to lower inflation, the debt will explode, and so forth. (Plus, the Soviet Union will be there forever, we might as well get along.)  Reagan offered optimism; won, malaise ended, we won the cold war, and there was an economic boom. One would think the tired argument would have less force by now, or that the pessimists would have found a better one.

Thursday, July 16, 2015

Learning and New Keynesian Models.

John Barrdear at the Bank of England just posted an interesting paper, Towards a New Keynesian theory of the price level. Like Garcia Schmidt and Woodford, it changes the information structure of the standard model to avoid the standard model's problems.
Modifying the standard New-Keynesian model to replace firms' full information and sticky prices with flexible prices and dispersed information, and imposing mild and plausible restrictions on the monetary authority's decision rule, produces the striking results that (i) there exists a unique and globally stable steady-state rate of inflation, despite the possibility of a lower bound on nominal interest rates; and (ii) in the vicinity of steady-state, the price level is determinate (and not just the rate of inflation), despite the central bank targeting inflation. ... The model admits a determinate, stable solution with no role for sunspot shocks when the monetary authority responds by less than one-for-one to changes in expected inflation, including under an interest rate peg....
I haven't read this one yet either. I'm posting for anyone following these issues. Like Garcia Schmidt and Woodford, I also hope that others will read the papers and help to figure out if they really work as advertised.