Friday, September 13, 2019

Bans on fracking and nuclear power

If you want evidence that climate policy has become unhinged from science and quantification, becoming more like a religious cult, look no further than the recent Democratic presidential candidates' proposals to ban fracking immediately and nuclear power soon.

From Michael Cembalest at JP Morgan



I'm not a denier. Yes, carbon is a problem, warming is a problem, and a uniform carbon tax, vast expansion of nuclear energy, more renewables, lots of R&D on them, GMO foods, and geoenginnering are solutions. (If indeed warmer weather is an existential crisis, and if indeed $2 billion of soot in the upper atmosphere solves it, that should at least be on the table.) Actual, quantitative, scientific solutions. They don't atone for our carbon sins.

A ban on fracking and nuclear are not solutions, and will raise carbon emissions.  The US is doing better on carbon reduction than other countries, because of fracking and natural gas.  Unlike Germany, who has followed these policies, we cannot rely on Eastern European coal and Russian gas.

I am delighted to see that despite my fears of how extensive discretionary regulation will silence dissent, Mr Cembalest can still write such a note, with the JP Morgan imprimatur. We'll see how long such heresy  survives more intense financial regulation and "stakeholder" control of corporate boards.   "Eco-authoriarianism" and a "coercive green new  deal"  are already openly advocated, here for example.

Monday, September 9, 2019

More on low long-term interest rates

In an environment with stable inflation, the yield curve should typically be inverted.

Long term investors care about money when they retire, not next month. Most investors are long-term.

If inflation is steady, long-term bonds are a safer way to save money for the long run. If you roll over short-term bonds, then you do better when interest rates rise, and do worse when interest rates fall, adding risk to your eventual wealth. The long-term bond has more mark-to-market gains and losses, but you don't care about that. You care about the long term payout, which is less risky. (Throw out the statements and stop worrying.) So, in an environment with varying real rates and steady inflation, we expect long rates to be less than short rates, because short rates have to compensate investors for extra risk.

If, by contrast, inflation is volatile and real rates are steady, then long-term bonds are riskier. When inflation goes up, the short term rate will go up too, and preserve the real value of the investment, and vice versa. The long-term bond just suffers the cumulative inflation uncertainty. In that environment we expect a rising yield curve, to compensate long bond holders for the risk of inflation.

So, another possible reason for the emergence of a downward sloping yield curve is that the 1970s and early 1980s were a period of large inflation volatility. Now we are in a period of much less inflation volatility, so most interest rate variation is variation in real rates. Markets are figuring that out.

Most of the late 19th century had an inverted yield curve. UK perpetuities were the "safe asset," and short term lending was risky. It also lived under the gold standard which gave very long-run price stability.

(Yes, this argument is about portfolio variance, not beta, and assumes that the bond portfolio is a substantial part of the investor's wealth, or that inflation happens in bad times, at least over the investor's long horizon.)

***

This is a follow-up to low bond yields. That post has several good comments with links to the literature.

On that point, Uri Carl and Anthony Dierks send along this lovely graph from their note which makes the same point as my earlier blog post. The plot is different measures of the time-varying "covariance between Real Activity and Nominal Measures." The covariance changes sign, as I suspected.




Intellectual property and the trade deficit

"The IP Commission estimates that between $200 billion and $500 billion a year of intellectual property is stolen from the U.S." I found this interesting tidbit in The Atlantic interview of Kevin Hassett, ex CEA chair. (HT Marginal Revolution)

Well, suppose China were to pay up, and pay the $200 to $500 billion a year in royalty payments. Where would it get the money from? Hmm. It would have to sell us an additional $200 to $500 billion worth of exports, that's how.  The trade deficit would have to increase.

China could sell us $200 to $500 billion a year of assets instead. Maybe we would like to hold lots of Chinese stocks, bonds, or government bonds rather than buy more boatloads of goods? But if we bought worthwhile Chinese assets, those are only claims on future Chinese profits. And the only use we have for lots and lots of Chinese currency profits is to... buy things in China and send them here. If we bought worthless assets, bonds that default, or stocks whose legal rights evaporate,  then, well, we're back where we started.

Or maybe we don't want to license IP, we just think US owned firms operating in China could make an additional $200 to $500 billion per year profits operating in China without Chinese competition. And what do US owners want to do with $200 to $500 billion of Chinese profits per year? Go on a shopping trip, and put it on boats, sooner or later.

One way or another, the only way that China can properly pay for intellectual property, is to put more stuff on boats and send it to us. Paying for intellectual property must increase the trade deficit.

Being a free trader, I think this is great. The point of trade is to get the imports. The point of intellectual property is to force China to send us boatloads of stuff.

Somehow I don't think the Administration sees it that way. But you can't escape addition.  

Sunday, September 8, 2019

Low bond yields

Why are interest rates so low?


Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward trend since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the extra volatility that past inflation induces. But you can also see that real yields have fallen with the same pattern.

There is lots of discussion. A falling marginal product of capital, due to falling innovation, less need for new capital, a "savings glut," and so forth are common ideas. The use of government bonds in finance, the money-like nature of government debt among other institutional investors and liquidity stories are strong too. And most of the press is consumed with QE and central bank purchases holding down long term rates. I hope the steadiness of the trend cures that promptly.

Along the way in another project, though, I made the following graph:

The blue line is 10 times the growth rate of nondurable + services per capita (quarterly data, growth from a year ago). The red line is the negative of an approximate measure of the real return on 10 year government bonds. I took 10 x (yield - yield a year ago), and subtracted off the CPI.

Look at the last recession. Consumption fell like a rock, while the real return on long-term bonds was great. That real return came from a double whammy: long term bonds had great nominal returns as interest rates fell, and there was a big decline in inflation.  No shock, there is a "flight to quality" in recessions, along with a sharp decline in nominal rates. From a foreign perspective, the rise in the dollar added to the return of long-term bonds. The graph suggests this is a regular pattern going back to the almost-recession of 1987. In every recession, consumption falls, interest rates fall, inflation falls, so the real ex post return on government bonds rises.

Government bonds are negative beta securities. At least measured by consumption or recession betas.  Negative beta securities should have low expected returns. They should be less even than real risk free rates. I haven't seen that simple thought anywhere in the discussion of low long-term interest rates.  

Making the graph, I noticed it was not always thus. 1975, 1980, and 1982 have precisely the opposite sign. These were stagflations, times when bad economic times coincided with higher inflation and higher interest rates. Likewise, countries such as Argentina which go through periodic currency crises, devaluations, and inflations, flights to the dollar, all associated with bad economic times, should have the opposite sign. There is a hint that 1970 was of the current variety.

One could easily make a story for the sign flip, involving recessions caused by monetary policy and attempts to control inflation, vs. recessions involving financial problems in which people run to, rather than from, money in the recession.

In any case, the period of high yields was associated with government bonds that do worse in recessions, and the period of low yields is associated with government bonds that do better in recessions and have a negative beta. I haven't really seen that point made, though I am not fully up on the literature on time-varying betas in bond markets.

In any case, if we want to understand risk premiums in bond markets, this sort of simple macro story might be a good starting point before layering on institutional complexities.

Saturday, August 24, 2019

Why stop at 100? The case for perpetuities

Issue 100-year Treasurys, advocates the Wall Street Journal.  It mentions a short note deep on the Treasury website that
Treasury’s Office of Debt Management is conducting broad outreach to refresh its understanding of market appetite for a potential Treasury ultra-long bond (50- or 100-year bonds). 
My 2 cents: Why stop at 100? Issue perpetuities! 

(I wrote a whole paper on this a while ago, if you want lots of detail and answers to practical questions. Unfortunately the Treasury website does not say how to send in suggestions, and nobody outreached to me, so this blog post is it.)

Perpetuities are bonds with no principal payment. Each perpetuity pays $1 forever.  If interest rates are 3%, to borrow $100, the government would sell three perpetuities, and then pay investors $3 each year. When the government wants to pay back the debt, it simply buys back the perpetuities on the open market.

A 100 year bond is almost a perpetuity. If the government issues a $100 100 year bond at 3%, only 100/(1.03)^100 = $5.20 of that value comes from the $100 principal payment. 95% of the value of a 100 year bond is already in the stream of coupons. For the investor, they are practically the same security. In particular they have nearly the same sensitivity to interest rate changes.

But perpetuities are better. Most of all: Perpetuities would be much more liquid -- easy to buy, sell, and use as collateral.  The reason is simple. Once 100 year bonds get going, there would be 100 separate and distinct issues outstanding. The 2123 2.6% 100 year bond is a different bond from the 2124 2.7% 100 year bond. If a dealer has an order for the first and an offer for the second, he or she cannot make the trade. If you borrow and sell short the first, you cannot deliver the second in return. This segmentation would make the markets for each bond thinner, and the bid ask spread larger. It would keep a lot of dealers and traders and market makers needlessly in business, which may  be one good reason the financial industry seems largely against the idea.

Perpetuities, by contrast, are a single security. When the government borrows more next year, it is borrowing more of the same security.  There is one, thick, transparent, low-spread market.

A more liquid market would pay lower rates.  Much of the point is for the government to borrow at low rates. Much of the reason government debt has such low interest rates is that it is very liquid -- easy to buy and sell, the "safe haven" in bad  times and so forth. Government debt is somewhat like money, and like money pays less interest in return for its liquidity. Well, then, the more liquid the better!

A 100 year bond would make sense if there were a group of investors sitting around who really wanted to have $3 coupons for 100 years, and then $100 exactly in 100 years, not 101 years, and they were not planning to buy or sell in the meantime. That is not remotely the case. Long term bonds are actively traded. Perpetuities match the varied investment horizons of ultimate investors, and by being more liquid are more flexible.

There is plenty of historical precedent. Perpetuities actually came before long-term bonds. They were the cornerstone of UK finance for the entire 19th century.

One can raise a bunch of practical objections, and if you have them go check out the paper.

Lower costs? The WSJ only advocates 100 year debt on the notion it would give the Treasury a lower borrowing cost when yield curves are inverted. This is a good argument, but more difficult and subtle than the WSJ lets on. The current yield is not the lifetime cost.  The 100 year cost of borrowing with short term bonds depends on what short term interest rates do in the future. If rates go up, it costs eventually more to borrow short. If rates go down it costs less, even if the current yield curve is inverted. In the benchmark "expectations model" yields have already adjusted so the expected cost is the same. The issue is the same to a household deciding between an ARM and a fixed rate mortgage. Even if the current ARM rate is higher than the fixed, if ARM rates go down in the future, the ARM could end up being better.

My paper was part of a conference at Treasury, published by Brookings.  I had a good debate with Robin Greenwood, Sam Hanson, Joshua Rudolph, and Larry Summers who wrote The Optimal Maturity of Government Debt (available here). They argued for borrowing short, not long. A the time the yield curve was steeply upward sloping, and in their simulations they opined that the chance of short rates rising and long rates declining to the point that the cost advantage would invert was small. The current reality has changed that conclusion as now it is the short rates that are higher.

Still, I think this is the wrong way to look at it. The Treasury is not in a great position to play bond trader and figure out where small variations in the yield curve reflect profitable opportunities.

Risk management. Like all investors, though, the Treasury's first question should be risk management, not profit. And there is a great risk facing the US Treasury. We are clearly going to run up a lot more debt before sanity sets in. Go look at the just released CBO Long Term Debt Outlook.


Net interest is already large. What happens if interest rates go up? Yes, they are unbelievably low now. But nobody really knows why. Between "secular stagnation" and "r* has declined" and "savings glut" you can see economists making things up right and left. So, you should not have huge confidence that we will not  return to historically normal interest rates of the last few centuries, or moreover that we will never suffer the kinds of interest rate spikes that happen to highly indebted countries trying to roll over 100% of  GDP  or so debt in a recession,  financial crisis, or war. If interest rates rise sharply, the US Treasury, having borrowed  short, is screwed.  We bought the ARM at a teaser rate.

This,  to me, is the real argument that  the  government should issue lots more long-term debt; 100 years if needed (but please, only every 10 years or so!) or, much better, perpetuities. Buy the fixed rate mortgage, and you keep the house no matter what happens to rates. Let's keep the house. In this discussion with Greenwood et al, they argued that the chance of such an interest rate spike is low. Perhaps, but the insurance is cheap -- and with a flat or inverted yield  curve it's even cheaper.

Borrow long to buy insurance, not just for a good deal.

Update:

In response to a few comments. In the paper I proposed that the Treasury issue 1)  fixed-rate perpetuities -- a security that pays one  dollar forever -- 2) floating-rate perpetuities -- just like Fed reserves, the interest rate adjusts  daily  and the price is always exactly $1.00 3) indexed perpetuities  -- it pays one dollar adjusted for  the CPI (or one of its improved versions) forever. The first eventually replaces all long  term debt, the second eventually replaces all short term debt, and the third replaces TIPS.

The second is really more  important, and I'll do a separate post eventually. If the treasury offered a fixed-value floating-rate instantly transferrable security just like reserves, it would do wonders for the  financial system.



Friday, August 23, 2019

Summers tweet stream on secular stagnation

Larry Summers has an interesting tweet stream (HT Marginal Revolution) on the state of monetary policy. Much I agree with and find insightful:
Can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade?...There is little room for interest rate cuts..QE and forward guidance have been tried on a substantial scale....It is hard to believe that changing adverbs here and there or altering the timing of press conferences or the mode of presenting projections is consequential...interest rates stuck at zero with no real prospect of escape - is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation....The one thing that was taught as axiomatic to economics students around the world was that monetary authorities could over the long term create as much inflation as they wanted through monetary policy. This proposition is now very much in doubt.
Agreed so far, and well put. "Monetary policy" here means buying government bonds and issuing reserves in return, or lowering short-term interest rates. I am still intrigued by the possibility that a commitment to permanently higher rates might raise inflation, but that's quite speculative.

and later
Limited nominal GDP growth in the face of very low interest rates has been interpreted as evidence simply that the neutral rate has fallen substantially....We believe it is at least equally plausible that the impact of interest rates on aggregate demand has declined sharply, and that the marginal impact falls off as rates fall.  It is even plausible that in some cases interest rate cuts may reduce aggregate demand: because of target saving behavior, reversal rate effects on fin. intermediaries, option effects on irreversible investment, and the arithmetic effect of lower rates on gov’t deficits
Central banks are a lot less powerful than everyone seems to think, and potentially for deep reasons. File this as speculative but very interesting. Larry has many thoughts on why lowering interest rates may be ineffective or unwise.

The question is just how bad this is? The economy is growing, unemployment is at an all time low, inflation is nonexistent, the dollar is strong. Larry and I grew up in the 1970s, and monetary affairs can be a lot worse.

Yes, the worry is how much the Fed can "stimulate" in the next recession. But it is not obvious to me that recessions come from somewhere else and are much mitigated by lowering short term rates as "stimulus." Many postwar recessions were induced by the Fed, and the Great Depression was made much worse by the Fed. Perhaps it is enough for the Fed simply not to screw up -- do its supervisory job of enforcing capital standards in booms (please, at last!) do its lender of last resort job in financial crises, and don't make matters worse.

But how bad is it now? Here Larry and I part company. Larry is, surprisingly to me, still pushing "secular stagnation"
Call it the black hole problem, secular stagnation, or Japanification, this set of issues should be what central banks are worrying about...We have come to agree w/ the point long stressed by Post Keynesian economists & recently emphasized by Palley that the role of specific frictions in economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand. 
The right issue for macroeconomists to be focused on is assuring adequate aggregate demand.  
My jaw drops.


The unemployment rate is 3.9%, lower than it has ever been in a half century. It fell faster after about 2014 than in the last two recessions.



Labor force participation is trending back up.



Wages are rising faster and faster, especially for less skilled and education educated workers.



 There are 8 million job openings in the US.

Why in the world are we talking about "lack of demand?

Thursday, August 22, 2019

Inflation, and history

Phil Gramm and John Early have an excellent WSJ oped on inflation measurement.

Many conventional inflation measures are  overstated by around 1% per year, because they don't capture quality change well. When the iPhone 22 comes out, and costs (say) the same as the iPhone 21, that looks like there is no inflation. But the iPhone 22 has dozens of new features, so you're really getting "more phone," and there is deflation. Think of all the things like mapping that are now free. It's not just tech. Houses are bigger and better, cars are much better and safer, and lots of services are now free
No price index takes account of the fact that each month more than twice as many people get medical advice from WebMD as visit the doctor’s office in America. 
The people who make price indices try hard to account for quality, but the result is still biased.

Now for many uses we don't get too upset about this, just as a clock that's always 5 minutes fast is still useful. In particular, for spotting trends in inflation, is it rising or falling, a steady 1% bias doesn't make much difference.

Where it does make a big difference is when you cumulate inflation over a long period of time. We  do that in the politically charged question, is the average American better off now than his or her parents were in 1975, and if so how much? Now whether 1% per year times 44 years is more inflation or better stuff matters a lot.
When corrected for documented price overstatements, real average hourly earnings from 1975 to 2017 are shown to have risen some 52%, not 6%—an additional $6.77 an hour. Real median household income increased 68%, not 21%—$17,060 more annually. 
And published poverty incidence fell by almost half. Combined with the 67% drop in poverty that comes from accounting for all government transfers, poverty incidence sank from 12.3% to about 2%. 
In the political debate over the fate of the "middle class" these are huge differences. The mantra-repeated narrative that the "middle class" hasn't advanced at  all  since the 1970s is simply not true. (Quotes because I reject the idea that we are a class society,  and hence the use of this word.)

Monday, August 19, 2019

Gold Oped

Now that 30  days have passed, I can post the whole July 18 gold oped in the Wall Street Journal.

Some of President Trump’s potential nominees to the Federal Reserve Board have expressed sympathy for a return to the gold standard. Conventional monetary-policy experts deride the idea—and not wholly without reason. The gold standard won’t work for a 21st-century monetary and financial system. It is possible, however, to emulate its best features without actually restoring the gold standard.

The idea behind the gold standard is simple: The government promises that if you bring in, say, $1,000 in cash, you can trade it for one ounce of gold, and vice versa. By pegging the dollar to something of independent value, it promises to solve the problem of inflation or deflation. And we don’t need central-bank wizards to run things anymore.

Yet the aim of monetary policy isn’t to stabilize the dollar price of gold; it is, rather, to stabilize the prices of all goods and services. The price of gold has varied from $1,000 to $1,800 an ounce in the past 10 years. Had the Fed fixed that price, critics say the price of everything else would have had to vary this much.

Wednesday, August 14, 2019

Geoengineering fun

Eli Dourado writes of four intriguing geoengineering schemes: (HT Marginal Revolution's incomparable links.)

1. Bring back the Wooly Mammoth



The short version: Siberia used to be grassland, maintained by wooly mammoths. Grassland is colder than forests. Our ancestors killed off the wooly mammoths, and the trees took over. The permafrost is melting, which will be a huge climate amplifier. What to do?

Nikita Zimov ... is director of Pleistocene Park, a 144 km² grassy Siberian reserve founded by his father, gonzo scientist Sergey Zimov. The Zimovs have spent the past two decades ripping up trees and reintroducing grazing herds, including bison, moose, wild horses, yaks, and reindeer.
The plan is working. Nikita Zimov says the permafrost, which is at around –3º outside the park, is 17º colder (!) inside the park. 
Better yet bring back the wooly mammoth! Or rather play with elephant and wooly mammoth DNA until we get a half way new animal that can go restore the Siberian grasslands, and let it evolve a bit.
Mammoths provided the Pleistocene with the valuable services of grazing, trampling snow and moving it around to get to the grass below, and uprooting trees. Nothing will make a mammoth happier, it is thought, than ripping a tree out of the icy ground, just as modern elephants enjoy doing the same in the warmer ground of Africa. Based on everything we know, mammoths were a critical part of the Siberian Steppe ecosystem, and their extinction at human hands is what caused the forests to take hold.
I love the image of genetically engineered half wooly mammoths playfully ripping trees out of Siberia, eating grasses, and trampling ground to save the permafrost.

2. Project Vesta.
 mine large volumes of a (usually) green mineral called olivine, crush it up, and spread the resulting green sand on beaches all over the world, especially in the tropics where the water is warmest. 
It soaks up carbon dioxide and ends up on the sea floor, and eventually subjected into the mantle. That's where carbon dioxide ends up now, just much faster. And green beaches are kinda cool.
...One ton of olivine applied in Vesta’s process removes around 1.25 tons of CO₂ from the atmosphere. Olivine is superabundant, making up about half of Earth’s upper mantle...[ calculation follows ] that works out to around $9.04 per ton of CO₂ removed from the atmosphere and ocean.
$10 per ton is a great price. Many other hot ideas are $100 per ton or more.
what if we wanted to offset cumulative anthropogenic emissions since 1751? As of 2017, that was close to 1.6 trillion tons of CO₂. 1.6T × $9.04 = $14.46T through 2017. Adding $360B for each of 2018 and 2019, we arrive at a one-time cost of $15.18T for offsetting all human emissions since the dawn of the industrial revolution, which if done over 10 years, would cost 1.7% of global GDP.
3. Prometheus fuels

Short version: a chemical process that allows you to create ethanol and then other fuels from any electricity source, including nuclear, solar, etc. Fuels can be stored and transported, so the intermittent nature of much "clean" fuel doesn't matter.

4. The billion oyster project

Bring huge oysters back to New York Harbor. Ok, not much climate action but pretty cool

*******

Cool, but like other sensible adaptation and geoengineering projects, you can tell this is going nowhere in today's environmental politics, right? Genetically engineer a new frankenspecies of mammoth and set it loose to breed? Spread green rocks on all the worlds beaches? How unsightly! You've got to be kidding right? Well, no, if the climate really is a planetary emergency.

Two little sentences from Eli are worth quoting here:
Some environmentalists don’t like geoengineering because it seems too easy: 
Indeed. Suppose we found a technical solution that did not require an uprooting of all society, "climate justice," a federal takeover of this that and the other. (Nuclear power, GMO foods, green beaches, and wooly mammoths.) How would the Green New Dealers react? Thanks, problem solved, we'll go back to other things? I doubt it.

Most deeply
 it ignores the sins of humanity, for which we must atone. 
That is indeed much of the mood on the climate left -- and the reason all sorts of technocratic solutions are going nowhere politically.

Eli makes a brave ethical argument for his GMO wooly mammoths:
..our climate impact started much earlier, during the Paleolithic era, when we hunted megafauna to extinction and therefore altered critical ecosystems. .. But in fact, using genetic engineering to revive megafauna that we wiped out to restore ecoystems that benefit the climate also atones, if that is the right way of looking it at. Hunting these magnificent creatures to extinction was our original climate sin.
Good luck with that. Maybe we should instead charge the mammoth head on: just get past the atoning for sins business and get on with solving the carbon problem in the most effective way.

Letter 2 from Argentina

Alejandro Rodrigues writes again from Argentina (previous post)


"This  graph shows the evolution of peso denominated fixed income mutual funds. On Monday (after the elections) this funds suffered withdrawals of 6% of the total shares. Net assets fell by more as prices plummeted (-5%). On Tuesday, shares fell by 6% again but prices remained constant. On Monday, Money Market funds suffered withdrawals (drop in shares) of 16% although they didn't break the buck (on average). "

I gather from other discussions that Argentinians are trying to move assets fast to dollars. That is consistent with this drop in Peso denominated fund assets. (Though of course for every seller there is a buyer -- I wonder who the private parties (non funds) are that are buying Peso fixed income assets!)

There is an interesting dynamic here. The chance of a new regime with terrible economic policies rises. It causes a rush to dollars. People suspect that the new regime will impose capital controls.  The  government has trouble rolling over its own currency debt, as interest rates rise. That makes the fiscal situation worse.

In short, the chance of a bad government taking over can provoke a crisis that makes the chance of a bad government taking over larger. Or perhaps Argentines will break the usual electoral patterns.


The Reader's Guide to Optimal Monetary Policy

The Reader's Guide to Optimal Monetary Policy is a snazzy new website created by Anthony Diercks and Cole Langlois at the Federal Reserve Board.  Screenshot: 


Who said 2% inflation is a good idea? The graph shows publication date on the horizontal axis, the optimal inflation rate on the y axis, and the size of the circle is the number of citations. 

The sizeable number of dots around -4% reflect the "Friedman rule" idea. (Sadly, the graph doesn't include Friedman. It only goes back to 1990.) The idea here is that the nominal interest rate should be zero, so you earn the same on money as on bonds. Then there is no reason to economize on holding cash. Most of these were written when real rates were thought to be around 4%, so you need 4% deflation to get a nominal interest rate of zero. Ah, the good old days. 

More dots show up around zero. These are mostly "sticky price" models. Now there are costs to changing prices. So the economy works best when people don't have to change prices at all, 0% inflation.   

Note the paucity of papers at 2%, the Fed's inflation target. This is a nice testament to the honesty of  the Fed and its researchers.

The website allows you to graph many other issues, search for papers and so on. If you hover over a paper you get a great little two-sentence summary of the paper's main idea. If you click, you get the abstract and link to the paper. Have fun. Trigger warning: you may end up wasting a good deal of time. 

Monday, August 12, 2019

Whither the Fed?

Steve Williamson has an excellent long essay, "Is the Fed Doing Anything Right?" on the current state of monetary policy.

Why is the Fed lowering rates?

(If you're impatient, skip to the ** of the most interesting and provocative points)

Steve starts with an Ode to Rules. It would be nice if the Fed acted more stably and predictably, leaving less room for the interpretation that they're just changing their minds, or panicking, or giving in to Trump tweets.

So Steve phrases the question nicely: what has changed since last September, when the Fed seemed fully on a "normalization" path? What is the "data" in a "data-dependent" policy?
They decided (with a couple of dissents) to reduce the target range for the fed funds rate by 0.25% to 2.00-2.25%. That seems to represent a change of plan, since in September 2018, the median FOMC member was thinking that the fed funds rate by the end of 2019 would be 3%. So, something important must have changed since last September. What was it?
From the FOMC statement and Powell's presser after the meeting, it seems there were 5 things bothering the committee: 
1. Weak global growth.
2. Trade policy uncertainty.
3. Muted inflation.
4. The neutral rate of interest is down.
5. The natural rate of unemployment is down.
Go see Steve's graphs. There really is not much case that the US economy is slowing down.
Typically central banks lower interest rates in the face of observed decreases in aggregate economic activity - somewhere. But we haven't seen any such thing. Must be some very weird policy rule at work here.
That's a bit overstated. Central banks do react too forecasts. But most central banks, including ours, react cautiously knowing just how unreliable forecasts are.
 I can certainly understand that there's "trade policy uncertainty." More like "Trump uncertainty," I think. But that's been with us since January 2017. And for North America, which we could argue is more relevant for the US, the trade uncertainty is actually lower than it was in September. The USMCA was signed by Mexico, Canada, and the US on November 30, 2018, though it is as yet not ratified. Brexit anxiety is with us of course, but again that's nothing new. So, I think you have to be more specific if you want to make a general case about policy uncertainty. And what's the hurry? You can't wait for resolution?
The uncertainty work is interesting (a great recent example). But if uncertainty really is an economic problem, it should be reflected in today's investment, investment plans (a great measure) hiring, durables purchases stock prices, and other forward-looking measures. Moreover, it's not clear that the Fed should offset uncertainty as trade. They are "supply" shocks. (Previous post)

The one thing that has changed a bit is inflation.
.."muted" is as a good a word as any for that, relative to the 2% inflation target. The Fed's chosen measure - headline PCE - is at 1.4%, and stripping out food and energy gives us 1.6%. Not low, certainly, and well within what you might think is reasonable tolerance, but definitely below target.
But, putting Steve's point in stronger voice, , 0.4% variation in inflation over nearly a year is tiny in historical context, certainly not the sort of things that usually reverse a steady tightening project.

**

Here though, Steve's most interesting and provocative points start.
"But, suppose we thought that the only problem here is a slightly-below-target inflation rate. What would the corrective action be?"
...
The traditional answer, of course, is, lower interest rates.
and assuming there is a stable Phillips curve, everyone knows that lower nominal interest rates imply lower real interest rates in the short run. And lower real interest rates, as everyone knows, makes "aggregate demand" go up. Further, as everyone knows, output is demand-determined, so output therefore goes up. Then, by Phillips curve logic, inflation goes up.
But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as we can see in this exchange
The exchange  is really good on both sides. Don't underestimate AOC. She rather brilliantly and knowledgeably led Powell down the road to admit the Phillips curve has died, so unemployment doesn't cause inflation any more. Then she smoothly went right to the (false) implication that any policy previously criticized as being inflationary will not cause inflation. She mentioned minimum wages, but green new deal, free college, medicare for all and a  fiscal blowout cannot be far behind. Powell didn't take the bait, but it's wiggling on the hook.

What about the Phillips curve? Inflation seems to have nothing to do with unemployment (or is it vice versa??) Japan and Europe, as well as our own 10 years of slow growth, seem testament to the falsity of the proposition that lower interest rates spark inflation.

Powell seems to be telling AOC what his staff told him, which is that the Phillips curve is currently very flat. The Phillips curve is still there though, or so Powell seems to think, though he seems a little confused about how the whole thing works. ... 
you can see that in the presser with Powell. The reporters are trying hard to understand what the Fed is up to, Powell is struggling to explain it, and everything is coming out muddled. For example, this exchange: [JC: I edited for clarity] 
MICHAEL MCKEE. ...How does cutting interest rates lower, or how does cutting interest rates keep that going since the cost of capital doesn’t seem to the issue here.= 
CHAIR POWELL. You know, I really think it does, and I think the evidence of my eyes tells me that our policy ... supports confidence, it supports economic activity, household and business confidence, and through channels that we understand. So, it will lower borrowing costs. ... since we noted our vigilance about the situation in June, you saw financial conditions move up...You see confidence, which had troughed in June....You see economic activity on a healthy basis. It just, it seems to work through confidence channels as well as the mechanical channels that you are talking about.
Steve comments scathingly:
Well, there's no confidence channel running from Powell to me, that's for sure.... Powell started off well when he was appointed. He opted for press conferences after every FOMC meeting, reduced the wordiness of FOMC statements, and generally seemed to be communicating well. But this decision makes clear what his limitations are. Powell is an attorney whose experience with monetary policy comes from sitting on the FOMC since 2011. You may think that puts you at the center of things. Sorry, it doesn't. There's a lot Powell doesn't know, and it shows.
True, a "confidence channel'' is something of a new idea, though quite common in central banking circles. We just need to give more and better speeches. All we have to fear is fear itself. But if one accepts an "uncertainty channel" certainly "confidence" can be interpreted as "belief in the Fed put," or other beliefs about future Fed policy.

I think Steve's personal attack on Powell is unwarranted.  Here and in other speeches I see someone who does a darn good job  of digesting fancy macroeconomics, and distinguishing the nuggets of wisdom from the craziness. Many (most) trained PhD economists are no better at steering the ship. You don't necessarily want a PhD hydrodynamicist at the wheel in a storm.

Most of all "There is a lot Powell doesn't know, and it shows" seems to me totally unwarranted. Just what is there to "know" about the Phillips curve? I would much rather have Powell's healthily acknowledged uncertainty than a PhD economist who thinks he or she "knows" how the Phillips curve really works.

(As a reminder, the Phillips curve is not standard economics. It is an empirical correlation that gained causal status by its repetition. Tight labor markets should coincide with higher real wages, wages higher than prices. But there is no natural logic that tight labor markets should coincide with higher wages and prices overall.)

Steve himself goes on to prove just how little anyone "knows" about the Phillips curve and the proper direction of policy right now:
So what's going on here? The Fed announced a normalization plan.. What's that mean? Normal means that short-term nominal interest rates are high enough to be consistent with 2% inflation over the long term. ... That's just the logic of Irving Fisher, which we all learned as undergrads. But, if the nominal interest rate is too low on average, then inflation will be too low, on average. That's abundantly obvious given the post-1995 Japanese experiment. Late last year, the FOMC was thinking that a normal fed funds rate is about 2.5-3.0%. I think that's about right. Basically, they aborted normalization. And, if the FOMC thinks an important goal is hitting 2% inflation, it should have kept its target fed funds rate range constant, or moved it up. [My emphasis]
Steve acknowledges here participation in the great neo-Fisherian heresy, which I flirt with as well. The equations of our best models scream it. Japan and Europe scream it, and their comparison with the US.

Maybe yes, maybe no. But Neo-Fisherians have no business criticizing the Fed chair for uncertainty and a bit of muddiness about how the Phillips curve works, or how interest rates affect inflation!

Steve goes on to discuss the end of QE and IOER, with interesting facts. The "floor system" does seem to be falling apart. I think the answer is simple: if you want to peg rates, peg rates: offer anyone to deposit at 2.00%, and offer anyone to borrow (with treasury collateral) at 2.25%. The Fed wants only the former, to limit quantities, and to offer different rates to different institutions according to their favor with the Fed. All a topic for another day.

Letter from Argentina

My friend Alejandro Rodriguez, at Universidad del CEMA, sends the following report:
Oops we did it again. Macri (the current president) lost in the open primary elections (all parties present their candidates in an open  general election so it is like a very big poll). The formula Alberto Fernandez- Cristina Fernandez (the ex president who ruled between 2007 and 2015 is the candidate to vice president) is expected to win in October. 
The peso is falling like a rock (down 25%) and interest rates are up by 1000 bps. The Central Bank has to 1.3 trillion ARS (22 billion USD at the current FX) in short term debt (all expires in the next 5 days). Today it has to roll 250 billion ARS and in the first round it only managed to roll 14 billion ARS. Argentine. 
Argentina stocks in NY are down 50% to 60% and President Macri will adress the nation at 16:30 local time. The Central Bank has a lot of internatinal reserves (over 60 billion USD) but nearly 1/4 are the counterpart of dollar deposits at commercial banks. The remaining reserves are mostly borrowed from the IMF and China... We can surely screw over the IMF but I don't think that messing up with the Chinese is a smart move... so nobody knows how much fire power the Central Bank has to hold the FX. I don't know what can be done to stop a major currency crisis which might in turn into a debt crisis (if we are not in one already).

Wednesday, August 7, 2019

Trade and the Fed


Nina Karnaukh of Ohio State sent along this lovely graph of the 6 month Fed Funds futures around the beginning of August. Read this as the market's guess about what is happening to the Federal Funds rate over the next 6 months.

The first drop in price occurs with the FOMC announcement 2 PM July 31. The price drop is equivalent to a a rise in expected future interest rates of about 5 basis points or 0.05%. This has been read as market disappointment that the Fed did not signal more future rate cuts.

The subsequent price spike is this,


That statement caused a 10 bps rise in price, i.e. decline in expected interest rate.  The natural interpretation: The markets expect the  Fed to lower rates in a trade war, either directly or in response to the economic damage the trade war will cause.

I had read the Fed's recent actions as just a case of late expansion jitters, perhaps with a mild response  to slightly lowered inflation. But this is clear evidence that the market sees the Fed reacting to trade news.

************

Should central banks offset trade wars? I think this is a question nobody is asking but it needs to be asked. Central banks including the US Fed and ECB seem to take for granted that any reduction in economic activity demands "stimulus" to offset it. But stimulus can only provide "aggregate demand." What if the problem is "aggregate supply" -- an economy humming along at full demand, and then someone throws a wrench in the works, be it a trade war, a bad tax code, or a regulatory onslaught? (I'll stop using quotes, to signal my dislike for these terms.)

Conventional wisdom ways that central banks should not offset reductions in aggregate supply. You can fight a lack of aggregate demand, but monetary policy cannot fight a decline in aggregate supply. The first job of a central bank should be to distinguish demand from supply shocks, so it can react to the former, but not to the latter.  This standard wisdom emanates from the 1970s, where central banks kept rates low to offset the effects of oil price shocks -- supply shocks -- and ended up producing worse recessions and inflation.

Yet expressing this view at central banks these days, people stare at me with blank expressions. Distinguish... supply... from... demand... shocks....why would we do that? The view from about 1960s Keynesianism that all fluctuations in output, employment and prices come from demand, seems to have flowered again.

Now, in this conventional (i.e. 1980 Keynesianism vs 1965 Keynesianism) view the problem with offsetting a "supply" shock is that the monetary stimulus causes inflation. And now we have inflation once again drifting slightly lower. So perhaps the trade war is a "demand" shock? It's hard to see how though.

More plausibly, perhaps the policy uncertainty about the trade war is causing a decline in "demand." Why build a factory if any day now another tweet  could render it unprofitable? The prospect of a trade war -- or the kind of serious political and trade turmoil that would follow Tianamen II in Hong Kong -- is a "confidence" shock. But the uncertainty is genuine. A rise in risk premium in an uncertain environment is genuine. People should hold off building factories that depend on a Chinese supply chain until we know if there is going to be a trade war. Unless the Fed is stepping more and more into the role of psychologist in chief, to decree that such fears are irrational, it's not obvious that the Fed should try to goose investment by artificially lowering the short term rate in response to a  rise in trade fears.

A second possibility arises from more 1980s economics. A "supply" or productivity shock also lowers the expected return on investment. So the real  interest rate should decline in response to such a shock. That is another reason perhaps for some interest rate decline in response to a negative supply shock. But how much? This still does not justify the same response to all sources of output decline, or (in our case) fear of output decline that has not happened yet.

The other possibility is that the Fed is now watching the exchange rate, as most other central banks do. The one thing that still does seem to work is that raising interest rates raises the value of the currency. The trade war raises the value of the dollar, and the US clearly wants to manipulate the dollar back down again.

Wednesday, July 24, 2019

Notes from a nameless conference

Martin Gurri at the fifth wave writes a very intresting "notes from a nameless conference." (HT Marginal Revolution). A few choice quotes, but do read the whole thing.
..In their hundreds if not thousands, I was swarmed by people of good will who were also smart, articulate, and hyper-educated.  They craved, sincerely, to help the disadvantaged and save the earth.  The words “science” and “reason” were perpetually on their lips, as if they held the copyright for these terms – which, in a sense, they did.  And if they were a bit defensive, a tad obtuse, their intentions were the purest I could imagine. 
So why, by their own admission, do they no longer inspire trust? 
I have met their kindred before, in other glittering places.  They run the institutions that hold center stage in our society, but look on the world as if from a walled mountain fortress, where every loud noise from beyond is interpreted as risk and threat.  They disagree about minutia, but mostly move in lockstep, like synchronized swimmers, with word and thought.  They are earnest but extraordinarily narrow.  In a typical complaint, one speaker blamed the public for hiding in an “information bubble” – yet it occurred to me, as I sat through the conference, that the bubble-dwellers controlled the microphones there. 
The same unmodulated whine about present conditions circled around and around, without even the ambition to achieve wit, depth, or originality: 
The internet is the enemy:  of rationality, of democracy, of truth.  It must be regulated by enlightened minds. 
The public resembles an eight-year-old who is always fooled by tricks and lies.  For its own protection, it must be constrained by a Guardian class. 
Populism is the spawn of lies.  Even if it wins elections, it is never legitimate, and must be swept away by a higher authority. 
Climate change is a scientific mandate for torturous economic and political experiments, implemented by experts.  To deny this is worse than error – it’s a crime against humanity. 
Hate speech, offensive words, fake news, deep fakes, privacy violations, information bubbles, bitcoin, Facebook, Silicon Valley, Vladimir Putin, Donald Trump, Brexit:  all must be controlled, criminalized, exploded, broken up, exposed, deposed, or repeated until the right answer is obtained. 
None of this was up for discussion.  None of it was uttered with the least semblance of self-awareness.  In the same breath, a speaker called for the regulation of the web and the education of children in “tolerance.”  If I had pointed out the contradiction, the speaker, I’m certain, would have denied it.  Tolerance, for her, meant the obliteration of opinions she disliked.
In fact, each narrative loop I listed above ends with the elites happily in charge, and the obliteration of the wretched present.  If we wish to understand why trust evaporated in the first place, consider the moral and political assumptions behind this rhetorical posture
Martin does not really strike home the central contradiction here. Though "threat to democracy" is also a constant mantra, this movement is in fact profoundly anti-democratic. Us the self appointed aristocracy, must run things in the interest of the little people -- and we must change the rules of the game so the benighted little people never vote wrong and replace us.

Every era’s monetary and financial institutions are unimaginable until they’re real

Every era’s monetary and financial institutions are unimaginable until they’re real, writes Tyler Cowen in an excellent Bloomberg.com essay on the anniversary of Bretton Woods. (MR link)

Our ancestors' experience with paper money leading quickly to massive inflation would leave them agape at our completely unbacked fiat money and floating exchange rates which has led only to mild inflation.
...fast forward [from the gold standard] to the current day. Currencies are fiat, the ties to gold are gone, and most exchange rates for the major currencies are freely floating, with periodic central bank intervention to manipulate exchange rates. For all the criticism it receives, this arrangement has also proved to be a viable global monetary order, and it has been accompanied by an excellent overall record for global growth. 
Yet this fiat monetary order might also have seemed, to previous generations of economists, unlikely to succeed. Fiat currencies were associated with the assignat hyperinflations of the French Revolution, the floating exchange rates and competitive devaluations of the 1920s were not a success, and it was hardly obvious that most of the world’s major central banks would pursue inflation targets of below 2%. Until recent times, the record of floating fiat currencies was mostly disastrous.
As Tyler points out, even 20 years ago the standard opinion was that the euro would not work.
Another surprising monetary innovation would be the euro. Both Milton Friedman and Paul Krugman warned that the euro was unlikely to succeed and persist. Yet it has proven more durable than many people expected, and there does not seem to be an end in sight. This kind of a common fiat currency, spread across so many nations, is without precedent in world history.
(I quibble with that one: Gold coins were an international currency, and throughout history coins have been shared among countries. Our own "dollar" comes from the common colonial use of a Spanish coin.)

The sovereign default issue remains, but that less-than-desired  inflation remains the euros' problem would have been a big surprise. That countries like Greece and Italy would, so far, choose the hard path of staying on the euro rather than take the sugar high of another devaluation is indeed a political if not an economic surprise.

Bretton Woods' system, including fixed exchange rates, the IMF, a dollar sort of pegged to gold but you can't have gold, dollar reserves, and extensive capital controls is as archaic to us as it was radical to pre WWII thinking.

Tyler only hints at the main message:
 Looking forward, don’t assume the status quo will hold forever, but rather prepare to be shocked....
So as you consider the legacy of Bretton Woods this week, remember that core lesson: There will be major changes in monetary and institutional arrangements that no one can even imagine right now. Assume the permanency of the status quo at your peril.
My main point is to underline that hint.

We forget how recent our own monetary certainties are,. Well into the 1970s, mainstream Keynesian economists thought that inflation came from "wage price spirals" and administered prices, and that central banks were pretty irrelevant. Milton Friedman was a radical upstart. He won, dramatically, on the importance of central banks. Yet too his focus on money growth rates died out with the 1980s. The current consensus view that central banks have the power to control inflation, and the power, ability, and duty to stabilize the economy, all by setting short term rates, is an idea that only took shape in the late 1980s and 1990s.

And that is falling to pieces all around us. That no "deflation spiral" breaks out at the zero bound undermines that view entirely. The death of the Phillips curve, the antithesis of the 1970s -- strong output and employment with puzzlingly low inflation -- the endless inflation below central bank targets, all stand witness. (And be careful what you wish for! Strong growth with low inflation is pretty darn nice!)

Intellectually, we grope to maintain the illusion of an all-powerful central bank, whose asset purchases and Delphic pronouncements about its future actions powerfully steer the economy. But the feeling that perhaps Friedman won too much, and that central banks are not nearly as powerful as they seem (other the power to screw things up, which they retain!)  is getting stronger and stronger.

The only thing that is sure is that our current doctrines will look as archaic 20 years from now as Bretton Woods, and the 1950s-60s Keynesian consensus, do today. That humility -- and the hard and and critical thinking it ought to provoke -- are indeed great lessons of this anniversary.

Every era’s monetary and financial institutions are unimaginable until they’re real. And so will be the next era's institutions.






Monday, July 22, 2019

Everything is f***d

The most hilarious course syllabus I've seen in a while, from Professor Sanjay Srivastava at the University of Oregon.


...


....

The point is serious,  going well beyond the replication problem. Meta-analyses just repeat the same mistakes a hundred times.

"Office hours: Held on Twitter at your convenience." I love it.

Saturday, July 20, 2019

New Papers

I've been remiss about blogging lately while I finished two new papers, "The Fiscal Roots of Inflation," and "The Value of Government Debt." I'm posting here for those who might  be interested, and I appreciate  comments.

Both papers apply asset pricing variance decompositions to questions of government finance and inflation. The inflation paper is  part of the long-running fiscal theory of the price level project. (Note: this post uses MathJax which may not show properly on all devices.)

I start by deriving an analogue to the Campbell-Shiller linearization of the return identity:
\[ \beta v_{t+1}=v_{t}+r_{t+1}^{n}-\pi_{t+1}-g_{t+1}-s_{t+1}. \] The log debt to GDP ratio at the end of period \(t+1\), \(v_{t+1}\), is equal to its value at the end of period t, \(v_{t}\), increased by the log nominal return on the portfolio of government bonds \(r_{t+1}^{n}\) less inflation \(\pi_{t+1}\), less log GDP growth \(g_{t+1}\), and less the primary surplus \(s_{t+1}\). The "surplus" in this linearization is the surplus to GDP ratio, divided by the steady state debt to GDP ratio. It's not a log, so it can be negative. \(\beta = e^{-(r-g)}\) is a discount rate corresponding to the steady state real rate \(r\) less GDP growth rate \(g\).

Iterating forward, the present value identity is \begin{equation} v_{t}=\sum_{j=1}^{\infty}\beta^{j-1}\left[ s_{t+j}-\left( r_{t+j}^{n}-\pi_{t+j}+g_{t+j}\right) \right] .\label{pvsy}% \end{equation} I simplify by using \(\beta=1\) as the point of linearization. 1 vs. 0.99 doesn't make any significant difference for empirical purposes.

Now apply standard asset pricing ideas. To focus on inflation, in "Fiscal Roots" I take the time \(t+1\) innovation of the present value identity, \(\Delta E_{t+1}\equiv E_{t+1}-E_{t}\). Rearranging, we have the unexpected inflation identity, \begin{align} & \Delta E_{t+1}\pi_{t+1}-\Delta E_{t+1}\left( r_{t+1}^{n}-g_{t+1}\right) \label{Epiintro}\\ & =-\sum_{j=0}^{\infty}\Delta E_{t+1}s_{t+1+j}+\sum_{j=1}^{\infty}\Delta E_{t+1}\left( r_{t+1+j}^{n}-\pi_{t+1+j}-g_{t+1+j}\right) .\nonumber \end{align} A decline in the present value of surpluses, coming either from a change in expected surpluses or a rise in their discount rates, must result in a lower real value of the debt. This reduction can come about by unexpected inflation, or by a decline in nominal long-term bond prices. The value of debt drops out, which is handy and simplifies matters.

Thursday, July 18, 2019

All that glitters is not gold

I wrote a Wall Street  Journal Oped on the gold standard, partly in response to last week's Oped by James Grant (whose "PhD standard" is a great quip) and Greg Yp's excellent column on Judy Shelton and gold.

Pegging the dollar to gold won't  stop inflation or deflation.  Inflation was already quite volatile in the 19th  century, and it would be worse today:
What determines the value of gold relative to all goods and services? In the 19th century, gold coins were used for many transactions. People and businesses had to keep an inventory of gold coins in proportion to their expenditures. If the value of gold rose relative to everything else (deflation), people gained an incentive to spend them, and thereby drive up the prices of everything else. If the value of gold fell (inflation), people needed more of it, so they spent less and drove down other prices. This crucial mechanism linked the price of gold to all other prices. 
That link is now completely gone. Other than jewelry and some minor industrial uses, there is nothing special about gold, and little linking the price of gold to all other prices. If the Fed pegged the price of gold today, the price of everything else would just wander away. The Fed might just as effectively peg the price of chewing gum. A monetary anchor is a good thing, but the anchor must be tied to the ship. Gold no longer is. 
Broader commodity standards face the same problem. Traded commodities are such a small part of the economy that the relative price of commodities can swing widely with little effect on inflation.
In particular, if the value of gold goes up, you have deflation, which many people are  worried about today. The gold standard did nothing to stop the sharp  deflation  of the 1930s.

Gold is not really a monetary promise, it's a fiscal promise:
If people demanded more gold from the government than it had in reserve, the government had to raise taxes or cut spending to buy more gold. More often, the government would borrow to get gold, but governments must credibly promise to raise taxes or cut spending to borrow. This fiscal commitment ultimately gave money its value, not the sometimes-empty promise to exchange money for gold. Taxes ultimately back all government money. The gold standard made this fiscal commitment visible and testable. 
It is possible, though, to answer gold standard advocates critiques of current affairs without a return to gold
..the U.S. could enact a policy today that emulates the good features of the gold standard. I call it the CPI standard. First, Congress and the Fed would agree that “price stability” in the Fed’s mandate means precisely that, not perpetual 2% inflation. The Fed’s mandate would be to keep the consumer-price index (or a suitably improved index) as close as possible to a stated value. 
Second, the CPI target would bind fiscal policy (Congress and the Treasury) as well as monetary policy (the Fed). Inflation would require automatic fiscal tightening and deflation would trigger loosening, just as a gold-standard government trying to defend its currency must tighten fiscally to raise its gold reserves. 
Third, the government would emulate the promise to trade gold for notes in modern financial markets. There are many ways to do this, but the simplest is to commit to trade regular debt for inflation-indexed debt at the same price. Under this system, inflation would cost the government money and force a fiscal tightening in the same way gold once did. And vice versa—the system would forestall deflation as well. 
 I conclude
Gold-standard advocates offer a cogent critique of current monetary policy, but a return to gold is unfeasible. A stable CPI, immune from both inflation and deflation, backed by the same fiscal commitments that underlay gold, is worth taking seriously.
As usual, I have to wait 30 days to post the whole thing.

Sunday, June 30, 2019

The Phillips curve is still dead

Greg Mankiw posted a clever graph a month ago, which he titled "The Phillips Curve is Alive and Well."


No, Greg, the Phillips curve is still as dead as Generalissimo Franco.

The lines, in case you can't see them are the employment-population ratio 25-54, and the average hourly earnings of production and nonsupervisory employees. Wait a minute, the Phillips curve, as it appears in contemporary macroeconomics, is a relation between inflation, a coordinated rise in prices and wages,  not real wages or hourly earnings, and unemployment or the output gap, not the employment-population ratio. How does the traditional Phillips curve look? Here is unemployment vs. CPI inflation

and here is inflation vs. the GDP gap:



Here is "core" (less food and energy) inflation vs. unemployment:


Except for one little blip in the depths of the 2009 recession. The Phillips curve is dead. (Long live the Phillips curve, the crowd sings nonetheless.) Inflation trundles along, ignoring unemployment or the output gap.

What's going on? Primarily, I think Greg goes deeply wrong in looking at average hourly earnings, or wages for short. The whole art and magic of the Phillips curve is about inflation, the rise in both prices and wages.  Greg's graph is perfectly sensible microeconomics. The labor market is tight, demand for labor is high, you have to pay people more to get them to work. The rise in wages is a rise in real wages, a rise in wages relative to prices.

Similarly, one might imagine tight product markets, with strong demand, as a time that output prices and measured inflation would rise relative to wages.

The puzzle and promise of the Phillips curve is the idea that tighter labor markets, traditionally measured by the unemployment rate, correlate with higher wages and prices. That takes more doing. Typically, you have to think that workers are fooled into working for what they think are higher real wages, and only later discover that prices have gone up too. And you have to think that firms rather mechanically raise prices passing on higher labor costs, and keep selling things when they do. Despite the intuitive appeal of tight markets leading to rising prices and wages, that simple intuition is wrong to describe a correlation between tight markets and both prices and wages, which is what the Phillips curve is and was.

The employment-population ratio is a little bit curious but less so. Much modern labor economics doesn't focus on unemployment.

What is happening should be cause for celebration by the way -- real wages are rising. From growth to inequality to the hand-wringing about declining labor share, it's hard to find anything bad to say about that!

Greg's "Phillips curve" also does not extend backwards. Here's what happens if. you push the data slider to the left on Greg's graph, going back to the 1960s rather than start in 1990:




Greg's correlation is absent in the heyday of the Phillips curve. Greg's alive Phillips curve was born in 1990.  (What you're seeing is, of course, the rise in labor force participation, particularly among women, until 1990.) That's why the traditional (ex ante!) Phillips curve really was about gap measures

The conventional inflation-unemployment Phillips curve also died just about contemporaneously with the Generalissimo:


The negative correlation which Phillips noted around 1960 turned to a positive, or stagflationary correlation in the 1970s. One nice negatively correlated data point in the disinflation of 1982 is it.

The policy world, including the Fed, ECB, and related institutions, continues to believe in the Phillips Curve, and as causation not just correlation: tight labor markets cause inflation. But its evident death is causing some unsettled feelings for sure.

*****

Catching up on Greg's blog, I also found a lovely and sage quip:
Washington Post columnist Robert Samuelson argues "It’s time we tear up our economics textbooks and start over." He uses my book as a prime example. Perhaps not surprisingly, I disagree. My summary of Samuelson's article: Economics textbooks should be more like economics journalism, says an economics journalist.
There is so much "starting over" in the air -- modern monetary magic on the left, neo-mercantilism on the right -- that understanding long settled questions is indeed what education should be about. (And not just the sharing of untutored opinions.)
Textbook writers, on the other hand, emphasize those things that are true, important, and unknown to the typical reader (an 18 year old college freshman). Newness has little relevance. The lessons of Adam Smith do not apply only to the 18th century, the lessons of David Ricardo do not apply only to the 19th century, and the lessons of John Maynard Keynes do not apply only to the 20th century. They are timeless ideas that may not make good news stories but should be central to introductory economics. Just as Newtonian mechanics should remain central to introductory physics.
Well, I think Keynes will go the way of phlogiston, but I agree with the point, and anyway a good 19th century scientist should know what phlogiston is.


****

Update:

Or maybe we should call it the Phillips Cloud. Here is the traditional inflation vs. unemployment graph, for the 1990-today sample and then the whole postwar period



Some economists run a regression line here, and proclaim the Phillips curve to be flat. They conclude, unemployment is incredibly sensitive to inflation -- just a bit more inflation would make a lot of jobs. I conclude it's just mush.