Tuesday, June 5, 2012

I almost agree with Summers

Larry Summers has an interesting pair of Opeds in the Washington Post and on Reuters. By picking and choosing just a bit, I can find a lot to agree with -- and I can point to the central factual question separating his view and mine.

Interestingly, Larry sides with those of us who think monetary policy is close to ineffective at this moment, and thus neither the problem nor the source of even symptomatic relief.
... one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.
Most importantly, Larry thinks this is a golden moment to lengthen the maturity of government debt
Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the U.S. Treasury, for example, discussions of debt-management policy have had exactly this emphasis. But the Treasury does not alone control the maturity of debt when the central bank is active in all debt markets.
...Any rational business leader would use a moment like this to term out its debt. Governments in the industrialized world should do so too.
I've been screaming this from the rooftops for a few years now. "Lock in low rates" puts it mildly. When markets start to question whether the US will ever address our budget problems, it will be spectacularly better if we have locked in long maturity debt, and are not trying to roll over short term debt. Then long term interest rates can rise, bondholders take a hit, but we don't have a Greek, Spanish or Italian crisis on our hands. It's good insurance, and remarkably cheap at the current moment. The Treasury is trying, weakly. The Fed is offsetting all these efforts by buying up long term debt and selling short term debt.

Where we differ, of course, is on whether the government should simply restructure the existing debt to long maturities, or whether it should use these low rates to go on a borrow and spend binge.  Larry:
... governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more, not less, and investing in improving their future fiscal position even assuming no positive demand stimulus effects of a kind likely to materialize with negative real rates. 
There is a rational argument on both sides: It is correct as a matter of economic theory that if the government can borrow at slightly negative real rates, and invest in projects with positive rates of return, then the government's overall fiscal position is better.

The question is, Are there indeed sizeable positive real return projects that our government can, and will, invest in, and realize positive returns?

Let's be clear, what counts here  to "improve their future fiscal position": Can  the government by borrowing spending $1 now  reap more than $1 of tax revenue or realize more than $1 of spending reduction in the future? By spending $1 more now can and will the deficit really decline by more than $1 in the future, in such a clear and transparent way that bond markets see it and believe it? For this exercise, you don't get to count social benefits, external effects, stimulus and so on -- the acid test is simple: $1 more deficit now, results in more than $1 less deficit later.

And "sizeable" is important too. We are running more than $1 trillion dollars of deficits, and these are set to explode. To "improve our fiscal position" in a noticeable way, we need to cut that deficit by say $100 billion dollars. So, suppose the government can finance at zero percent real rates, and suppose that it can find projects with 5% real rate of return -- an optimistic assumption, especially risk adjusted. Still, to make a $100 billion dent in a $1 trillion deficit, that means the government needs to find $2 trillion of investment projects which give a risk free 5% return!

Where are these investment projects?

I note most of our government's "investment" projects consist of high speed rail, altenrative energy boondoggles, photovolatics that need protection from Chinese imports and so on. Say what you will about side benefits, but none of these projects has a remote chance of returning a positive return to the US Treasury.  The Wall Street Journal recently reviewed health and human services "investment portfolio" to savage effect. If the Treasury gets a cent back on these it will be a miracle. As Larry himself found out when running the stimulus program, shovel-ready projects are hard to find, even if you do not want a positive rate of return to the Treasury but simply want to get money out the door.

So what does Larry have in mind as concrete positive return investments?
They should accelerate any necessary maintenance projects..
..accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt, and then buy space that is currently being leased, will improve the government’s financial position as long as the interest rate on debt is less than the ratio of rents to building values..

Well, that's nice. But first of all, does any of this really produce $1 more deficit today and $1 less deficit in the future? If we do a bunch of maintenance now, does that mean we cut budgets in the future? Or will  that simply mean "great, we don't have to pay for maintenance, we can use this year's budget to do new things?"

But even with that warning in mind, is there really two trillion dollars of maintenance and building leases that can be moved forward? Or is this a drop in the bucket of our budget problems?

That's the real weakness. Larry Summers, who knows the Federal Budget far better than I, writing opeds on positive return government investments, can't come up with more than accelerating maintenance and buying some leased space. How much is that? Is it even $10 billion, not the $2 trillion needed to make a difference in the budget?

That's the disagreement, make your own judgements. It's easy to think of all sorts of nice-sounding projects -- which Larry curiously doesn't mention. Roads, bridges, education, etc. Perhaps Larry has too much experience with roads and bridges to nowhere, education money down ratholes and so forth; spending that has some use, but does not produce $1.05 of new tax revenue for every $1 spent. 

OK,  I also question a bit analysis like this:
It is more likely that negative feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income.
This particular "negative [sic] feedback loop" is, to put it politely, a mechanism new to economic theory. Maybe it works. But I prefer policy involving trillions of my dollars to be based on well-worked out theories with some basis in rigorous theoretical and empirical analysis, not just the latest interesting story.


  1. I understand that there is significant past due maintenance on water systems, sewers, roads and bridges. Deferring maintenance results in the ultimate cost of repair being higher. If the US is not going to abandon those roads and neighborhoods and let the forest reclaim them then it makes sense to borrow and fix them now. Rather than buying long Treasuries, the Fed could announce that it will be buying long state and municipal bonds issued for infrastructure repairs.

    "Feedback loops" are a standard concept in systems analysis. Anyone who has ever referred to a "spiral" was referring to a feedback loop. Keynesian analysis is based on feedback loops. Any right winger who ever argued that reducing tax rates would increase tax revenue was referring to a feedback loop.

    Unfortunately I think that "negative feedback loop" does not mean precisely what Mr. Summers thinks it means and he might have been better off to just refer to it as a feedback loop.

  2. What about a claim that a medicine reform can be a positive long term investment? Perhaps it also falls into the "maintenance moved forward" category and reduces risks/rates in future? I've got absolutely no numbers to back up this theory, though...

  3. Professor Cochrane,

    On your last point:

    A control theorist would call that a positive feedback loop.

    In a broad sense, the mechanism of positive feedback loops is not new to economics. The concepts of "debt deflation" (Irving Fischer 1933), the "financial accelerator" (Ben Bernanke 1996), and the "financial instability hypothesis" (Hyman Minsky 1992), to name a few, are essentially based on the idea of positive feedback loops.

    So if feedback loops are clearly ubiquitous in the working of the real economy, why, as you imply, is the treatment of that mechanism in economics currently lacking a "basis in rigorous theoretical and empirical analysis"? My guess is that it is related to (what i see as) a lack of proper treatment of disequilibrium dynamics in economic theory. Your thoughts?

    1. Thanks to both of the last comments. I cleaned up the language to reflect them. Yes, Larry's "negative" is a control theorists' "positive" so I added [sic]. And economic theory in general is full of such loops -- like higher marginal tax rates lead to lower output lead to worse deficits, lead to higher marginal tax rates. My point was that this seems like a completely new theory to me, and I am a little incredulous at the willingness of many in our profession to put trillions of dollars on the line based on theories that are merely bright ideas, not even fully worked out with equations. Maybe Larry had something precise in mind; the oped really is a tremendously condensed art form.

  4. How about individual buyouts of pending social security obligations, something similiar to upfront buyouts of pensions.
    - Parker

  5. Why don't you cite your colleague James Heckman's work on the returns to early childhood education? One of the biggest cutbacks during this recession has been on teachers, which seems entirely irrational. Shouldn't we be using this money to actually help our children prepare for the future?

  6. " . . . most of our government's "investment" projects consist of high speed rail, altenrative energy boondoggles, photovolatics that need protection from Chinese imports and so on."

    You are ignoring the govt. investment projects that are routinely in progress all the time: road, bridge, school, hospital and airport construction and reconstruction. You show your partisan bias by choosing energy boondoggles; overlooking, of course, DOD boondoggles -- the Crusader artillery gun, the 2nd engine for the F-35, etc. -- that put Solyndra in the shade for wasteful costs.

    There are many worthwhile public works projects in planning stages that could efficently be moved forward. Surely an economist at Chicago U can present more positive proposals than what you have done here if you wanted to.

    1. Let's calm down, there's nothing partisan here -- Republican boondoggles are just as bad as democratic ones. I don't want corn or oil subsidies either.

      But you have to play by Summer's rules here. Not just "can you think of good projects," not just "does a project have potential social value," but "will this project generate more future tax revenue or save more future spending than it costs?" The government has to make money. The challenge is to spend $1 today and actually have the deficit go down by more than $1 at some point in the future. And all in such a way that it's clear to the bond markets that the deficit reduction will happen.

      I'm having trouble thinking of hundreds of billions of dollars of real projects that our real government, and its future real spending habits, can undertake to achieve that goal. You're not. Good for you. The point of the post is to outline the differences, and outline the challenge for proponents to document.

    2. Well in just a few minutes I can suggest some public works projects that should easily pay a 2% return on USG borrowed funds:

      1.) The new tunnel under the Hudson from NJ to NYC

      2.) Rebuilding the terminals at LaGuardia, O'Hare, JFK, etc, etc.

      3.) Rebuilding the PA Turnpike.

      4.) Finishing and operating Yucca Mtn

      And even if, for some reason, you cannot find a 2% real return in the above group (and the USG can even charge tolls, rent, etc. if you wish), you should consider that many millions of people will live more comfortable and productive lives for a century or two as a result of the above projects.

      BTW: Since when does the USG "have to make money"? You may never hear it at U. Chicago, but I would suggest a preferable goal of government would be to implement policies so that people and businesses make the money.

    3. John, state and local governments have been shedding jobs. The Krugmanites claim that high unemployment level depress individuals' human capital potential to such an extent that it would be a positive expected value project to stop this from happening. So, just send money to state and local governments so that they do not shed jobs as much as they have been and/or rehire those people. I think it makes sense. Try getting a semi-professional job in your field if you have been unemployed for more than 2 years. It's quite tough.

    4. I don't feel sorry for Mr. Entitled, a semi-professional who has been unemployed for two years. He's more than capable of taking a lower paying job. He is not entitled to his current wage or job or standard of living. I do, however, empathize with Mr. Worker, an unskilled laborer who is unemployed because the government codified into law that he only accept jobs at wages employers aren't willing to pay. I also empathize with Mrs. Entrepreneur, who wants to start a business but can't afford to pay "employment taxes" imposed on her through various regulations. Or MidSize Corp, that doesn't have the apparatus in place for navigating red-tape that Crony, Inc. does.

      The problems are structural. I don't see how stimulating bureaucrats with $70k/year to fill out paperwork produces positive return for those who actually produce things, except in the most indirect, second-order kinds of ways.

  7. You believe that "monetary policy is close to ineffective at this moment, and thus neither the problem nor the source of even symptomatic relief."

    What monetary policy do you mean? If you mean the monetary policy of using interest rate cuts to signal the Fed's willingness to stabilize aggregate demand shortfalls, then yes, because we're at the zero lower bound, that policy no longer works, because the Fed's signaling mechanism is broken.

    What about a different monetary policy, that of targeting stable 5% growth in nominal incomes? If the Fed were to announce that they had such a target, and that they were willing to engage in unlimited easing until they hit that target, then inflation expectations would increase, leading to increased demand, leading to lower unemployment. And of course, having a long-term target of 5% NGDP growth would keep long run inflation expectations under control just as well as the Fed's current flexible inflation targeting regime, because they're usually identical policies. In normal times 2-3% real growth is accompanied by ~2% inflation, so there's no reason to believe that the Fed would adopt an easier monetary policy stance during boom times than they have in the past.

    And because the Fed's promise of engaging in large scale QE until we return to trend NGDP growth is credible, market forces would actually do the heavy lifting of raising asset prices and goosing demand, without the need for much Fed action. See Switzerland's recent action to peg the swiss franc to the euro for a great example of a central bank's communication leading to market reaction that obviates the need for direct intervention.

    Which leads me to ask again, why do you oppose NGDP targeting, if it promises to be a form of monetary stimulus that would once and for all terminate the ZLB problem? Not only that, but relying on monetary policy means we get no more ill-advised "fiscal stimulus" nonsense. I would think that conservative economists everywhere would be jumping at the chance to rely on monetary policy to solve this crisis. What am I missing?

    1. I don't so much "oppose" NGDP targets, as I think they are ineffective. If the Fed wants higher NGDP what is it supposed to do? QE you say. OK, that means buy a bunch of 0% treasuries and give banks 0% reserves instead. But banks are sitting on $1.5 trillion excess reserves already. This strikes me as taking green m&ms giving you red m&ms and thinking it will help your diet. At the moment, I don't think the problem is overly tight monetary policy, and I don't think there is a darn thing monetary policy can or should do.

      Switzerland has a third tool -- beyond lowering rates, and qe. It can peg an exchange rate. I don't think it's realistic for the US to say we're going to peg at 2 euros if (IF) we wanted to inflate. I also don't think deliberate inflation is how you solve structural problems. Again, if tight money isn't the problem, loose money isn't the answer.

    2. Professor Cochrane,

      Thank you so much for your reply. I'm a lay reader, not an economist. I'm trying to figure out what the economics profession thinks about the causes and solutions of our country's economics problems. Thanks to blogs, this is possible in a way I couldn't even conceive of just a couple years ago.

      If I may, one follow-up question. How do we determine whether monetary policy is "tight" or "easy"? The only explanation I could find comes from NGDP targeting evangelist Scott Sumner:

      "Here is what Mishkin's best-selling text says about indicators of monetary policy:

      It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.

      Mishkin then argues that:

      Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.
      In my view, the expected growth rate in NGDP is the best indicator of whether monetary policy is too loose or too tight. But even if we end up targeting inflation instead, it is essential that policymakers engage in "level targeting." This does not necessarily mean keeping prices absolutely level — you could target a price-level path that rises at 2 percent per year. But it does require that policy have a "memory," and make up for past under- or over-shooting of the target. The most devastating demand shocks are those that change the expected trajectory of NGDP and inflation many years out into the future."

      So, someone like Sumner would say that money actually is too tight now, for two reasons (1) because NGDP growth recently has actually been too slow, I believe below 4%, and (2) because a massive AD shock has taken our NGDP growth far below trend, so we need to catch up at least partway there (I guess because so many people have been unemployed for so long that some of the unemployment has become structural).

      Do you have a different view?

  8. How to avoid / get out of economic crises:

    Irresponsible people advocate 'Stimulus' i.e. low tax rates and high govt spend

    Responsible people advocate 'Austerity' i.e. High tax rates and low govt. spend

    What we really need is 'Reforms' i.e. Low tax rates and low govt. spend

    What do politicians give us in reality? High tax rates and high govt. spend :-(

    1. Very nice. But we need a better word for your "responsible" category. They're responsible, but they're misguided, because they forgot the horrible disincentives that their high tax rates are causing, which kills their economies and the promised high revenues. UK experience with the 50% income tax was sadly predictable.

    2. Irresponsible people ignore shades of gray and label people with broad brushstrokes.

      Nobody I know actively wakes up and say's "I'm going to be irresponsible today" (except the teenagers I know). People have generally well thought out reasons for their positions - including the "Stimulus" crowd.

  9. Are you suggesting that the US government should go into the business of making monkey? In that case it is easy - borrow at the privileged rates and set up an independent sovereign investment fund with diversified risk.

    At $2t you can diversify your risk so that you can get an average return above the cost of interest. You could buy 51% (or controlling interest) of the top companies with massive potential tax liabilities and bring the money on-shore and paid to the government. You get tax revenue, plus the value of the asset you purchase (the tax would be a freebie on top of the investment).

    You do not need to think up the projects, just do due diligence and let the capitalists that you own do what they do best.

    Such a fund(s) might be setup along these lines:
    + Maximum investment cap of 50.01% (so the 49.99% of actual capitalists vote and participate in company as per normal business expectations)
    + Return above cost of financing
    + Silent partner (non voting) except for enforcement of US tax law (onshoreing of financial transactions)
    + Non political (including appointments)
    + Guarantee of failure (i.e. the government should not bail-out these companies if they fail, if the independent fund wants to rescue the company they have to make a business decision).

    With $2t you can buy about 1/7th of the NYSE.

  10. Ibignell made the comment I was going to.

    It seems to me this would have the further advantage of what we might call "crowding in". The government borrows a trillion dollars and buys a trillion dollars in stock. Let's suppose there is 100% crowding out there---it's like the same people sell stock and buy long government bonds.

    With this increased demand for stock, though, the price of equity rises. That makes supplying it more profitable, so potential private investment projects which used to have a negative return now have a positive one. So each dollar of government borrowing results in an *increase* in private investment.

    I have a feeling there's some fatal flaw in what I've just said--- maybe having 100% crowding out and having an increase in stock prices is incompatible--- but the general idea ought to be worked out by somebody.

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