Wednesday, January 20, 2021

Grumpy economist podcast: free market tests, vaccines and more

The Grumpy Economist podcast is back, and we're going to aim for a once per two week schedule. This week we talk about vaccines, tests, masks, and how free markets would do better than the government, or at least can usefully complement the government. 

I wanted to get to the larger point, at least can we have a free market in toilet paper? Price controls in crises are one of those econ 101 questions that divide economists from everyone else. Don't transfer income by rationing toilet paper in a crisis. Let prices allocate it to who really has got to go, and give the natural disincentive against hoarding. Next time. 

 Link here if the embed above doesn't work. 

Portfolios for long-term investors

Portfolios for long-term investors is an essay that extends a keynote talk I will give Thursday Jan 21 at the NBER "New Developments in Long-Term Asset Management" zoom conference. The link takes you to my webpage with pdf of the essay and the slides for the talk. I'll blog the next draft of the essay, as I want to do it once and I'm sure I'll get lots of comments. 

The conference program is here. You can listen to the conference on YouTube here.  I'm on Thursday 12:30 ET, but many of the other papers look a lot more interesting than mine! 


How should long-term investors form portfolios in our time-varying, multifactor and friction-filled world? Two conceptual frameworks may help: looking directly at the stream of payments that a portfolio and payout policy can produce, and including a general equilibrium view of the markets’ economic purpose, and the nature of investors’ differences. These perspectives can rationalize some of investors’ behaviors, suggest substantial revisions to standard portfolio theory, and help us to apply portfolio theory in a way that is practically useful for investors. 

Sanity in CA housing?

As reported by the Sacramento Bee, its city council voted unanimously to allow four-plexes across the city overturning one-house-per lot zoning. 

It's couched somewhat in the language of diversity, 

City officials said the proposal would help the city alleviate its housing crisis, as well as achieve equity goals, by making neighborhoods with high-performing schools, pristine parks and other amenities accessible for families who cannot afford the rising price tags to buy homes there.

“Everybody should have the opportunity to not only play in Land Park but to live in Land Park,” Mayor Darrell Steinberg said. “That’s the Sacramento that we all uphold, that we love, that we value, and you better believe this drive for inclusion and equity is the driving force of our city and it is going to continue well beyond my tenure here.”

But I applaud that. Yes, the effect of highly restrictive zoning is exactly to drive "diverse" people away. Let's not be hypocrites. 

And ok, we're not waking up in property-rights nirvana either

“We’re going to insist on design quality and scale,” [Mayor] Steinberg said

 in response to comments.  And 

buildings would still have their current height restrictions. There would also be historical protections, limits on how much of a lot size a house could take up and on the amount of square footage.

Ok, baby steps.

Neighborhood association leaders in Land Park and Elmhurs... suggested the city only allow multi-unit houses in certain areas of the city, along commercial corridors and near transit stations.

“No one will have the ability to live in lower-density neighborhoods,” said Maggie Coulter, president of the Elmhurst Neighborhood Association. “The city needs to preserve existing neighborhoods in order to promote home ownership opportunities for everybody.”

Kudos to Sacramento city council for seeing through this complete incoherence, and the obvious flaws of segregating housing to undesirable parts of the city.

The lack of a whisper about "affordable housing" mandates is also refreshing. Maybe sanity can erupt in a one-party state, when discussions are not tinged with partisan derangement syndromes?

Minimum wages. People are not all the same.

The ancient argument over the minimum wage (WSJ) is heating up, another of economics' many perennial answers in search of a question. 

As in the linked article, I think it is a mistake to focus entirely on overall employment of low-skill workers. That is surely an issue. But the wage is one part of a detailed bargain between workers and employers. By putting its thumb on one part of the bargain, the government will ensure that other parts squish out. That's the larger issue. 

Does the job allow flexible hours? Does it provide other benefits -- transportation, employee parking, uniforms? How hard do you have to work? Which workers get the jobs, not how many get jobs overall? 

Thursday, January 14, 2021

Vaccines at NR

I repackaged and rethought some of my earlier thoughts on vaccine allocation and markets vs. government for National Review here. Text here, without the lovely pop-up ads: 

Free Markets Beat Central Planning, Even for COVID-19 Tests and Vaccines January 12, 2021 

Surely, we can’t let there be a free market for COVID-19 tests and vaccines. Indeed, tests and vaccines encapsulate many of the “market failure” parables from introductory economics courses.

But the argument for free markets is not that they are perfect. The argument is that the known alternatives are much worse. And we have seen a catastrophic failure of government at all levels around the world to handle this pandemic, especially in delivering tests and vaccines.

The CDC delayed testing for about two months. While it dithered, it blocked private parties from testing. University labs, for example, were blocked from making and conducting their own tests. During those two months, someone could sell you a thermometer to detect a COVID-19 fever, but if someone tried to sell you anything more effective, the FDA would stop them. Once it finally approved paper-strip tests in November, the FDA insisted that $5 paper-strip tests require a prescription and be bundled with an app, driving the cost to $50. Rapid testing that lets people who are sick isolate, and lets businesses ensure that employees are healthy, is only just becoming widely available, held back for six months by the FDA.

Let’s imagine that the government had not prohibited free-market activities. This is not anarchy, just a lightly regulated sensible market on top of whatever the government wants to do.

Private companies would have developed tests quickly and would have worked to make them faster, better, and cheaper. Why? To make money! Lots of people, businesses, schools, and universities are willing to pay for good, fast testing. Medical companies, knowing they could make a lot of money so long as they beat the competition, would have raced to develop and sell tests. We would have had $5 or less at-home paper-strip tests by late spring. And that would have enabled much of the economy to reopen.

Monday, January 11, 2021

Low Interest Rates and Government Debt

This is a talk I gave for IGIER at Bocconi (zoom, sadly) Jan 11 2021. Olivier Blanchard also gave a talk and a good discussion followed. Yes, some content is recycled, but on an important topic one must go back to refine and rethink ideas. This post has mathjax equations and graphs. If you don't see them, come back to the blog or read the pdf version. Update: Video of the presentations. 

Low Interest Rates and Government Debt
John H. Cochrane
Hoover Institution
Prepared for the IGIER policy seminar, January 11 2021

1. Why are real interest rates so low? (And thus, when and how will that change?)

Figure 1. 10 year US treasury rate and core CPI.

As Figure 1 shows, real and nominal interest rates have been on a steady downward trend since 1980. The size, steadiness and durability of that trend mean that we must look for large basic economic forces. “Savings gluts,” foreign exchange reserves, quantitative easing, lower bounds, forward guidance bond market frictions and so forth may be important icing on the cake, but they are not the cake. They cannot account for such a long-lasting steady trend.

The most basic economics states that the real interest rate equals people’s rate of impatience, plus growth times a coefficient usually thought to be between one and two. The interest rate is also equal to the marginal product of capital. In equations*, \[r = \delta + \gamma g \].  

Figure 2. Real potential GDP growth. 

Figure 2 presents the growth of potential GDP, as one easy way to look at long run growth trends. Potential GDP grew 4.5% in the 1960s, 3% in the 1970s, had a spurt in the late 1990s, and then settled down to less than 2% now. This slowdown in long-term growth is the great and unheralded economic disaster of our time. But that’s for another day.

The most natural explanation for the decline in real interest rates, then, is that growth has declined. A coefficient greater than one brings interest rates down faster than growth rates, opening the question that the interest rate r might even be below the growth rate g.

Sunday, January 10, 2021

FDA vs. Astra-Zeneca; bureaucracy vs. evolution and exponential growth

 From Alex Tabarrok at Marginal Revolution, quoting Marty Makary, M.D., a professor of surgery and health policy at the Johns Hopkins University School of Medicine:

... the FDA needs to stop playing games and authorize the Oxford-AstraZeneca vaccine.  It’s safe, cheap ($2-$3 a dose), and is the easiest vaccine to distribute. It does not require freezing and is already approved and being administered in the United Kingdom.

Sadly, the FDA is months away from authorizing this vaccine because FDA career staff members insisted on another clinical trial to be completed and are punishing the company for inadvertently giving a half-dose of the vaccine to some people in the trial.

It’s like the FDA is holding out, pontificating existing excellent data and being vindictive against a company for making a mistake while thousands of Americans die each day...

My emphasis. Alex:

See also my post The AstraZeneca Factory in Baltimore. Thousands of people are dying every day. We have a vaccine factory ready to go. The FDA should lifts its ban on the AstraZeneca vaccine.

Alex understates the case. It is not just that "thousands of people are dying every day." It is that we are in the phase of exponential growth, and a new more infectious variant has just arrived bumping up the growth rate further. Every hour of delay means tens of thousands more will die.  

We are in a fight of bureaucracy vs. exponential growth and evolution. Exponential growth and evolution are winning. Just how many thousands have to be on the left side of the trolley switch before the FDA stops allowing Astra-Zeneca to pull it? What's the risk aversion coefficient that justifies months of delay and another clinical trial?  

More deeply, can the FDA ever figure out that the point here is to stop a pandemic? The mentality is traditional: we must provide a perfect vaccine to protect individuals, taking the disease as given, and people who die while we do more studies are worth the cost. That is simply not what's going on right now. The point of the vaccine is to stop a pandemic. The disease is growing exponentially, and mutating and evolving. The externality is everything. I know, it's awfully hard for bureaucracies to innovate and change mindset. Well, sometimes you have to.  

For years the FDA was focused on, don't repeat thalidomide. Drugs must be safe. AIDS forced a hard reckoning. The people who are dying while you wait matter. But this is a third, even harder conceptual change. Stopping the spread of the disease matters. And the FDA does not have the years it took to make the AIDS change of mindset. 

Friday, January 1, 2021

Nothing matters but reproduction rate R

The new strain and the need for speed by Alex Tabarrok on Marginal Revolution makes an excellent point. The new strain is more transmissible. That means the reproduction rate R is higher. For given behavior, the exponential growth is faster. If or where R was a bit below one and the virus contracting, now the virus is spreading exponentially again. 

 "a more transmissible variant is in some ways much more dangerous than a more severe variant. That’s because higher transmissibility subjects us to a more contagious virus spreading with exponential growth, whereas the risk from increased severity would have increased in a linear manner, affecting only those infected."

The recurring failure of our government response to this pandemic has been to get behind exponential growth. Here we go again. Wasted months when the vaccines were known to be safe. Wasted weeks to have thanksgiving dinner rather than  approve vaccine. Snafu after snafu in vaccine distribution. And CDC rationing that is designed to just about nothing to stop the spread. 

Tuesday, December 29, 2020

Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 
"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”
Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired, or decide (Wal-Mart) to sue you for prescriptions you are legally required to fill. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

Thursday, December 24, 2020

Christmas in Quarantine



A merry Christmas -- or whatever you celebrate this time of year -- in quarantine, from a favorite band. 

Wednesday, December 23, 2020

Techsodus/Techsit politics.

The tech industry is fed up and leaving San Francisco in particular, the valley and California in general. Covid, like a war, speeds things up. If you're a young economist you could do worse than study this latest chapter in the (likely) decline of great cities (SF, NY, LA? Chicago?) and the movement of people and industries to friendlier, safer, and more welcoming climates. If you're a young political economist, whether they bring with them the politics that destroyed the places they left behind -- slash and burn progressivism -- will be equally interesting to watch. 

I ran across a great essay on this saga by Mike Solana

The latest fashion is to claim it's immoral for tech founders and companies to leave, after they have "extracted" so much wealth here. Mike skewers this new fashion, pointing out that tech companies and their founders created wealth here.  Microcode is not mined like gold. 

I take extreme issue with the notion that industry leaders have taken something from the “community,” ...This is precisely the opposite of reality. ... They are the network. Technology workers do not “extract” value from the region, they are what makes the region valuable.

...the Bay Area’s nativist, anti-immigration political climate has certainly not created the tech community, which is populated largely by immigrants, be they from out of the state or out of the country 

But he really digs in on the culture and politics that is going to send this golden goose packing to Austin: 

 the technology industry has brought tremendous tax revenue to the Bay Area. The budget of San Francisco literally doubled this decade, from around six billion to over twelve billion dollars. With our government’s incredible, historic abundance of wealth, the Board of Supervisors has presided over: a dramatic increase in homelessness, drug abuse, crime — now including home invasion — and a crippling cost of living that can be directly ascribed to the local landed gentry’s obsession with blocking new construction. ...

"Landed gentry." That's really good.  


I wrote an oped for Il Sole 24 Ore on central bank digital currency, as part of a series they are doing. It's here in their premium edition (gated) here on their blog, in Italian on top and English below. Thanks much to Luciano Somoza and Tammaro Terracciano for translation and inspiring the project.


A central bank digital currency (CBDC) is in principle a very good idea. It offers the possibility of very low-cost transactions to households and businesses, especially in securities and international transactions. More excitingly, CBDC offers us a foundation for an efficient and nimble financial system that is completely insulated from recurrent crises. 

But CBDC poses a puzzle, as it undercuts many of governments’ and central banks other questionable objectives. Central banks want to prop up conventional banks, who benefit from taking deposits. And governments are unlikely to want to allow the anonymity that is the great attribute of physical cash. 

One vision for CBDC basically gives everyone access to bank reserves. Reserves are interest-paying accounts that banks hold at the central bank. When bank A wishes to pay bank B, it notifies the central bank, which just changes the numbers in each account on the central bank’s computer. The transaction can be accomplished in milliseconds, and costs basically nothing. Why don’t we have that? We should.

Saturday, December 19, 2020

Bisin on MMT Rhetoric

Alberto Bisin has written an intriguing short review of Stephanie Kelton's The Deficit Myth. Alberto focuses on the rhetoric of MMT and the book. (My review here FYI.) 

MMT's rhetoric is surely its most salient feature. It has been phenomenally successful in terms of gaining attention, and it has eschewed all the traditional rhetoric of economics -- academic articles, conference presentations, monographs full of equations, econometric estimates and tests, or even mountains of charts and graphs, PhD students fanning out to develop it. 

[In response to JZ comment, that is not necessarily good or bad, it's just a fact. The conventional economic rhetoric produces a lot of garbage, too.  Bryan Caplan has a point. The major distinction may be engagement with critics, which happens in conventional discourse and so far has been largely absent with MMT.]  

Kelton's book is unusual in MMT rhetoric for appearing to be one definitive source that would lay it out, following standard rhetoric. The trouble with writing a book is that sometimes people read it carefully, and are emboldened that they aren't missing something in the usual flurry of blog posts tweets and videos. Then the world finds out the ideas in it are empty, the rhetoric artifice rather than explanatory. 

(NB, "rhetoric" has gained an unfortunate pejorative in common usage. I mean no such pejorative. How we structure economic discussion is hugely important. If you have not read Deirdre McCloskey's Rhetoric of Economics article or subsequent books, do so immediately.)    


The book should be seen as a rhetorical exercise. Indeed, it is the core of MMT that appears as merely a rhetorical exercise. As such it is interesting, but not a theory in any meaningful sense I can make of the word. The T in MMT is more like a collection of interrelated statements floating in fluid arguments. Never is its logical structure expressed in a direct, clear way, from head to toe.

Thursday, December 10, 2020

Goodfellows wrap-up

The wrap-up goodfellows for the year, a great conversation with H.R. McMaster and Niall Ferguson, moderated by Bill Whalen who serves up the questions and keeps us on track. >

The podcast version. You can find all the good fellows videos and podcasts here. We'll be back in January. 

Wednesday, December 9, 2020

Debt denial

Our national debt denial is a new essay on debt. Yes, it repackages many themes from previous essays, but debt is important, and I'm refining things through many efforts. This one is better, I think, than previous efforts. 

This appears in a new biweekly column in National Review Online, "Supply and Demand," which I'll be doing with Casey Mulligan. 

In French here


Does debt matter? As the Biden administration and its economic cheerleaders prepare ambitious spending plans, a radical new idea is spreading: Maybe debt doesn’t matter. Maybe the U.S. can keep borrowing even after the COVID-19 recession is over, to fund “investments” in renewable energy, electric cars, trains and subways, unionized public schools, housing, health care, child care, “community development” schemes, universal incomes, bailouts of student debt, state and local governments, pensions, and many, many more checks to voters.

The argument is straightforward. Bond investors are willing to lend money to the U.S. at extremely low interest rates. Suppose Washington borrows and spends, say, $10 trillion, raising the debt-to-GDP ratio from the current 100 percent to 150 percent. Suppose Washington just leaves the debt there, borrowing new money to pay interest on the old money. At 1 percent interest rates, the debt then grows by 1 percent per year. But if GDP grows at 2 percent, then the ratio of debt to GDP slowly falls 1 percent per year, and in a few decades it’s back to where it was before the debt binge started.

What could go wrong? This scenario requires that interest rates stay low, for decades to come, and remain low even as the U.S. ramps up borrowing. The scenario requires that growth continues to outpace interest rates. Most of all, this scenario requires that big deficits stop. For at best, this is an argument for a one-time borrowing binge or small perpetual deficits, on the order of 1 percent of GDP, or only $200 billion today.

Yet an end to big borrowing is not in the cards. The federal government borrowed nearly $1 trillion in 2019, before the pandemic hit. It borrowed nearly $4 trillion through the third quarter of 2020, with more to come. If we add additional and sustained multi-trillion-dollar borrowing, and $5 trillion or more in each crisis, the debt-to-GDP ratio will balloon even with zero interest rates. And then in about ten years, the unfunded Social Security, Medicare, and pension promises kick in to really blow up the deficit. The possibility of growing out of a one-time increase in debt simply is irrelevant to the U.S. fiscal position.

Everyone recognizes that the debt-to-GDP ratio cannot grow forever, and that such a fiscal path must end badly.

Monday, December 7, 2020

Free Market Vaccines

Part 1: Who should get the vaccine first? Sell to the highest bidder. The disease and recession go away faster. 

 Part 2: The cost of perfection. The vaccine was invented in a weekend, available in February. In free market land, we would not have had a pandemic, or a recession. 284 thousand people would be alive today. That is the cost of FDA "protection." 

Part 1: Who should get the vaccine first? 

Absolutely nobody* has mentioned in public the free market answer: Sell to the highest bidder. 

(Or just allow some sales to the highest bidder. Don't put people in jail for selling some to the highest bidder,) 

It's not as dumb as it sounds. Sure, there is an externality. A good vaccine policy might be to give it to those most likely to spread it to others, with the goal of swiftly reducing the prevalence of the disease. That argues for giving the vaccine in bars. 

That is not our public policy. The entire discussion centers around who should be protected first, from a disease whose prevalence is taken as given. Old people, nursing homes, health care workers, essential workers -- the argument is not the externality. The argument is entirely who should get the individual benefit of protection from the vaccine.  Just why "to the highest bidder" is wrong is then much less clear. 

The case is stronger than usual, for there is a second way to avoid infection: Stay home. Social distance. Wear protective gear. So the question is not, really, "Who should be protected from the virus?" The question is, really, "Who should get a treatment that allows them to be out and about, risking contact with the virus, rather than protect themselves by traditional means?" It is really mainly an economic benefit, avoidance of the cost of other measures to stay healthy. There is an economic answer: people should be out and about first who generate the most economic benefit from being out. And, therefore, are willing to pay the most to get the vaccine. 

Saturday, December 5, 2020

Hoover is hiring!

Hoover is hiring in its fellows program! This is roughly analogous to an assistant/associate professor position, aimed at new PhDs or people out a few years as postdoc or assistant professor. Information here. Deadline Dec 11. This is a great position for young economists, historians, or political scientists with policy-relevant interests. 

Friday, December 4, 2020

Target the spread?

The Fed wants to control inflation. Now, it targets the nominal interest rate. But to do that it has to guess what the right real interest rate is. Nominal interest rate = real interest rate plus expected inflation.

Guessing the right price is hard for any planner, and guessing the right asset price doubly hard. If the Fed wants to target inflation, why not target the spread between real and indexed bonds, and let the level of interest rates float to wherever they want to go by market forces?

Nominal interest rate - real interest rate = expected inflation. So, if the Fed wants to see 2% expected inflation, why not target the difference between one year TIPS (indexed treasurys) and one year treasurys at 2%? Then expected inflation has to settle down to 2%

Indeed, beyond a target, the Fed could really nail this down with a flat supply curve. The Fed could nail expected inflation at 2% by offering to exchange, say, any amount of one-year zero coupon treasury bonds for 0.98 one-year zero coupon indexed treasurys (TIPS). And leave \(r^\ast\) and a lot of real rate prognosticating in the dustbin.

Obviously, you worry. If the Fed nails the spread at 2%, will everything else really settle down so that expected inflation is 2%? Or is this like holding the tail and hoping the dog will wag? We need to write down a model.

I just wrote such a model. This is part of the long-running fiscal theory of the price level book project. But it is a short independent point which blog readers may enjoy. And, I'm always nervous that I missed something in wild ideas like this (see the whole Neo-Fisherian business) so I enjoy comments.

I start with a really simple version of the model, \begin{align} x_{t} & =-\sigma\left( i_{t}-E_{t}\pi_{t+1}\right) \label{ISspread}\\ \pi_{t} & =E_{t}\pi_{t+1}+\kappa x_{t}.\label{NKspread}% \end{align} Here I have deleted the \(E_{t}x_{t+1}\) term in the first equation, so it becomes a static IS curve, in which output is lower for a higher real interest rate. This simplification turns out not to matter for the main point, which I verify by going through the same exercise with the full model. But it shows the logic with much less algebra. Denote the real interest rate \begin{equation} r_{t}=i_{t}-E_{t}\pi_{t+1}.\label{rdef}% \end{equation} We can view the spread target as a nominal interest rate rule that reacts to the real interest rate, \begin{equation} i_{t}=\alpha r_{t}+\pi^{e\ast}.\label{iar}% \end{equation} The spread target happens at \(\alpha=1\), but the logic will be clearer and the connection of an interest rate peg and interest spread peg clearer if we allow \(\alpha\in [0,1]\) to connect the possibilities.

Eliminating all variables but inflation from \eqref{ISspread}-\eqref{iar}, we obtain \begin{equation} E_{t}\pi_{t+1}=\frac{1-\alpha}{1-\alpha+\sigma\kappa}\pi_{t}+\frac {\sigma\kappa}{1-\alpha+\sigma\kappa}\pi^{e\ast}.\label{pidynsimple}% \end{equation}

For an interest rate peg, \(\alpha=0\), \(i_{t}=\pi^{e\ast}\), inflation is stable -- the first coefficient is less than one -- but indeterminate.

We complete the model with the government debt valuation equation, in linearized form \begin{equation} \Delta E_{t+1}\pi_{t+1}=-\Delta E_{t+1}\sum_{j=0}^{\infty}\rho^{j}% s_{t+1+j}-\Delta E_{t+1}\sum_{j=0}^{\infty}\rho^{j}r_{t+1+j}% ,\label{fiscalclose}% \end{equation} which determines unexpected inflation. We have a simplified version of the standard new-Keynesian fiscal theory model.

(Targeting the spread rather than the level of interest rates does not hinge on active fiscal vs. active monetary policy. In place of \eqref{fiscalclose}, one could determine unexpected inflation from an active monetary policy rule instead. One writes a threat to let the spread diverge explosively for all but one value of unexpected inflation, in classic new-Keynesian style. In place of \(i_{t}=i_{t}^{\ast }+\phi(\pi_{t}-\pi_{t}^{\ast})\), write \(i_{t}-r_{t}=\pi_{t}^{\ast}+\phi (\pi_{t}-\pi_{t}^{\ast})\), where \(\pi_{t}^{\ast}\) is the full inflation target, i.e. obeying \(\pi_{t}^{e\ast}=E_{t}\pi_{t+1}^{\ast}\) and \(\Delta E_{t+1}\pi_{t+1}^{\ast}\) the desired unexpected inflation. )

If the interest rate target responds to the real rate \(\alpha\in(0,1)\), the model solution has the same character. As \(\alpha\) rises, the dynamics of \eqref{pidynsimple} happen faster, so inflation dynamics behave more and more like the frictionless model, \(\kappa\rightarrow\infty\).

At \(\alpha=1\), the spread target \(i-r=\pi^{\ast}\) nails down expected inflation, as we intuited above. Equation \eqref{pidynsimple} becomes \[ E_{t}\pi_{t+1}=\pi^{e\ast}. \] Equation \eqref{fiscalclose} is unchanged and determines unexpected inflation, though the character of discount rate variation changes.

Inflation is not zero, but it is an unpredictable process, which in some sense is as close as we can get with an expected inflation target. Output and real and nominal rates then follow \begin{align*} x_{t} & =\frac{1}{\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \\ r_{t} & =-\frac{1}{\sigma\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \\ i_{t} & =\pi^{e\ast}-\frac{1}{\sigma\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \end{align*} A fiscal shock here leads to a one-period inflation, and thus a one-period output increase. Higher output means a lower interest rate in the IS curve, and thus a lower nominal interest rate. The real and nominal interest rate vary due to market forces, while the central bank does nothing more than target the spread.

Of course we may wish for a more variable expected inflation target -- many model suggested it is desirable to let a long smooth inflation accommodate a shock. It's easy enough, say, to follow \(\pi_{t}^{e\ast}% =E_{t}\pi_{t+1}=\pi_{t}\) and even have a random walk inflation. Or, \(\pi _{t}^{e\ast}=p^{\ast}-p_{t}\) to implement an expected price level target \(p^{\ast}\) with one-period reversion to that target. Or \(\pi_{t}^{e\ast }=\theta_{\pi}\pi_{t}+\theta_{x}x_{t}\) in Taylor rule tradition. The point is not to defend a constant peg, but that a spread target is possible and will not explode in some unexpected way.

The same behavior occurs in the full new-Keynesian model, which is also the sort of framework one would use to think about the desirability of a spread target. I simultaneously allow shocks to the equations and a time-varying spread target. The model is \begin{align} x_{t} & =E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1})+v_{xt}\label{xspread}\\ \pi_{t} & =\beta E_{t}\pi_{t+1}+\kappa x_{t}+v_{\pi t}\label{pispread} \end{align} Write the spread target as \[ i_{t}-r_{t}=\pi_{t}^{e\ast}. \] With the definition \[ r_{t}=i_{t}-E_{t}\pi_{t+1}, \] we simply have \[ E_{t}\pi_{t+1}=\pi_{t}^{e\ast}. \] As in the simple model, the spread target directly controls equilibrium expected inflation. Unexpected inflation is set by the same government debt valuation equation \eqref{fiscalclose}. The other variables given inflation and unexpected inflation follow \[ x_{t}=\frac{1}{\kappa}\left( \pi_{t}-\beta\pi_{t}^{e\ast}-v_{\pi t}\right) \] \begin{equation} r_{t}=i_{t}-\pi_{t}^{e\ast}=-\frac{1}{\sigma}\left( \pi_{t}-\pi_{t}^{e\ast }\right) +\frac{\beta}{\sigma}\left( \pi_{t}^{e\ast}-E_{t}\pi_{t+1}^{e\ast }\right) +\frac{1}{\sigma}\left( v_{xt}+v_{\pi t}-E_{t}v_{\pi t+1}\right) \label{rit} \end{equation}

Following inflation, output still has i.i.d. deviations from the spread target, plus Phillips curve shocks. The real rate and nominal interest rate also have only i.i.d. deviations from the spread target, plus both IS\ and Phillips curve shocks. Output is not affected by IS shocks. The endogenous real rate variation \(\sigma r_{t}=v_{xt}\) offsets the IS shock's effect on output in the IS equation \(x_{t}=E_{t}x_{t+1}-\sigma r_{t}+v_{xt}\). This is an instance of desirable real rate variation that the spread target accomplishes automatically. (To obtain \eqref{rit} first-difference \eqref{pispread} and then substitute \(x_{t}-E_{t}x_{t+1}\) from \eqref{xspread}.)

I conclude, it could work. The Fed could target the spread between indexed and non-indexed debt. Doing so would nail down expected inflation. The Fed could then let the level of real and nominal rates float according to market forces. If every other price that has ever been set free is any guide, real and nominal interest rates would float around a lot more than anyone expects.

The result is almost, but not quite, a holy grail of monetary economics. The gold standard has a lot of appeal, as the Fed needs only exchange dollars for gold at a set rate and do no other grand financial central planning. Alas, the value of gold relative to everything else varies too much. We would like something like a CPI standard, which automatically stabilizes the price of everything else in terms of dollars. But the Fed can't buy and sell a basket of the CPI. Indexed bonds (or CPI futures) are nearly the same thing. And here the Fed just trades one year nominal debt for one year real debt. But it's not quite a CPI standard since it only sets expected inflation, not actual inflation. We still need fiscal policy, or new-Keynesian off equilibrium threats, to pick unexpected inflation. Still, guaranteeing that long-sought "anchoring" of expectations seems like a first step.

What else could go wrong? Well, this is just the first simple model, but it's a step. Obviously it depends on the forward looking Phillips curve. So in that sense it may be best as a longer run target and a regime, in which rational expectations and forward looking behavior are good assusmptions, rather than trying to set expected inflation at a daily horizon or try to do something one time that surprises markets.

I would advise the Fed to start paying a lot more attention to the spread. Next, work on increasing the liquidity of indexed debt. Ideally the Treasury should fix debt markets, vastly simplifying TIPS. I've argued for tax free indexed and non-indexed perpetuities, which would be ideal. But the Fed could and should start offering indexed and nominal term financing, for many reasons. If the Fed is going to buy a lot of long-dated Treasurys, it shold issue term liabilities not just floating-rate overnight reserves. Issing term indexed liabilites is a good next step, and there's nothing more liquid than Fed liabilities! Then start gently pushing the spread to where the Fed wants the spread to go. Start buying and selling bonds to push the spread around. Get to the point of a flat supply curve slowly. Heavens, the Fed doesn't trust interest rate targets and QE enough yet to offer a flat supply curve!

Walter Williams and Economics

 "For 40 years Walter was the heart and soul of George Mason’s unique Department of Economics. Our department unapologetically resists the trend of teaching economics as if it’s a guide for social engineers. This resistance reflects Walter’s commitment to liberal individualism and his belief that ordinary men and women deserve, as his friend Thomas Sowell puts it, “elbow room for themselves and a refuge from the rampaging presumptions of their ‘betters.’

My emphasis on the two best parts. This paragraph is from Don Boudreaux' WSJ oped for Walter Williams. The highlighted phrases (my emphasis) stuck out to me as a brilliant encapsulation of where economics research and practice has gone, as well as teaching, in the last few decades. A guide for social engineers, indeed. Most papers end up with "policy conclusions" that amount to intensely complex advice for all-powerful (yes) and all-knowing (ha) "policy-makers" aka social engineers. Economics was once more about how people searching for a little elbow room are empowered to help themselves and their neighbors. 

Walter Williams passed this week and Ed Lazear passed last week. I am not only saddened by their loss, but that stirring bits of  the Chicago - UCLA - George Mason economic philosophy seems to take place increasingly in obituaries.   

One tidbit

Wednesday, November 25, 2020


 400 years ago, a group of intrepid migrants signed the Mayflower Compact

IN THE NAME OF GOD, AMEN. We, whose names are underwritten, the Loyal Subjects of our dread Sovereign Lord King James, by the Grace of God, of Great Britain, France, and Ireland, King, Defender of the Faith, &c. Having undertaken for the Glory of God, and Advancement of the Christian Faith, and the Honour of our King and Country, a Voyage to plant the first Colony in the northern Parts of Virginia; Do by these Presents, solemnly and mutually, in the Presence of God and one another, covenant and combine ourselves together into a civil Body Politick, for our better Ordering and Preservation, and Furtherance of the Ends aforesaid: And by Virtue hereof do enact, constitute, and frame, such just and equal Laws, Ordinances, Acts, Constitutions, and Offices, from time to time, as shall be thought most meet and convenient for the general Good of the Colony; unto which we promise all due Submission and Obedience. IN WITNESS whereof we have hereunto subscribed our names at Cape-Cod the eleventh of November, in the Reign of our Sovereign Lord King James, of England, France, and Ireland, the eighteenth, and of Scotland the fifty-fourth, Anno Domini; 1620.

My emphasis. We have much to be thankful for. But perhaps the top of the list should be the blessings of self-government, which has fostered an unimaginable human flourishing. 

Yes, our society and government remain imperfect. But our "civil Body Politick" remains the best hope for continued improvement. 

This, more than inventing a big turkey dinner, seems like the best way to thank the Pilgrims.