## 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 Campbelll-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 real 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 $$v_{t}=\sum_{j=1}^{\infty}\beta^{j-1}\left[ s_{t+j}-\left( r_{t+j}^{n}-\pi_{t+j}+g_{t+j}\right) \right] .\label{pvsy}%$$ 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.
..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.

## Sunday, June 23, 2019

### The rent is too damn high

NPR covered the Democratic candidates' plans to address housing issues:
[Julian] Castro would provide housing vouchers to all families who need help. Right now, only 1 in 4 families eligible for housing assistance gets it. He would also increase government spending on new affordable housing by tens of billions of dollars a year and provide a refundable tax credit to the millions of low- and moderate-income renters who have to spend more than 30% of their incomes on housing.
I'm actually surprised it's as much as a fourth. Most government programs outside medicare and social security attract tiny fractions of the eligible people. Watch out budget if people catch on.
Massachusetts Sen. Elizabeth Warren calls for a $500 billion federal investment over the next 10 years in new affordable housing.... [New Jersey Sen. Cory Booker] would also provide a renters' tax credit, legal assistance for tenants facing eviction and protect against housing discrimination... Sen. Kamala Harris has also introduced a plan for a renters' tax credit of up to$6,000 for families making $100,000 or less. New York Sen. Kirsten Gillibrand has signed on to both the Harris and Warren plans, which have been introduced as legislation. In sum, they're piling on to pay your rent or mortgage. The economic foolishness of all this is painful. Housing is not a single good. It's location, location, location, and also size and condition. This isn't about homelessness. Everyone lives somewhere, so the point is to subsidize larger, better, or more conveniently placed housing. Or, to free up money for people to spend on other things. Economics is about incentives. If the government pays for all your rent past 30% of your income, that's a big incentive to rent a huge apartment and not to earn any extra income. = "Affordable housing," doesn't mean affordable housing, in the same way affordable hamburgers mean affordable hamburgers. It's a catchword for "below-market rate" housing, usually mandated by zoning boards, but now I guess to be paid for by the government. But when you give away something for, by definition, less than the market rate, that means people line up for it. Like scarce rent-controlled apartments, is one more impediment to people moving for better opportunities. Econ 101: What happens if you subsidize demand, but do not unleash supply? Prices go up. Period. It ends up entirely in the pockets of current property owners. There is a good case this happened already. To earn a gazillion dollars in tech, you need to move to the Bay Area. There are only so many houses, so the great gains in productivity end up in the pockets of existing landowners. Aha, you will answer, but they have a fix for that: rent control, now sweeping the nation. We know where that leads. They also answer, as above, the Federal government will start building houses and apartments. I guess millenials are too young, and nobody reads any history any more, but, we and especially Europe have tried this one over and over, to catastrophic failure. Go visit the sites of housing projects, now thankfully torn down, in Chicago. They look like Chernobyl. Go visit the cruddy outskirts of European cities, with government built cement apartment blocks. This is our vision for the "middle class?" In sum, the candidates promise to repeat for housing the immense success of subsidies and supply management and provision that the the government has just accomplished for health care, insurance, and education. It's usually a good idea to figure out what's broken before we start fixing things. That idea never seems to occur to anyone in politics when talking about economic policies. Where is the market failure in home and apartment building? Why is the private sector not building more housing? The answer is pretty obvious -- zoning, building codes, insane permitting processes and so forth. So, the government restricts supply, and prices go up. Then it subsidizes demand, and prices go up some more. Then it puts in price controls. So the plan seems to be to bring the government's huge success with health care and health insurance to the housing market. One tiny ray of light: New Jersey Sen. Cory Booker would provide financial incentives to encourage local governments to get rid of zoning laws that limit the construction of affordable housing. Zoning laws largely keep poor people away from rich people and enforce a lot of racial segregation. But again, "affordable housing" means "housing allocated by politics," and "housing you'd better not leave once you get it, and better not earn too much either." I wish the article just said "limit the construction of housing, which makes it unaffordable!" The usual coexistence of subsidy and restriction plays out almost comically in the "gentrification" issue, politicians wanting to be all things to all people: "It is not acceptable that, in communities throughout the country, wealthy developers are gentrifying neighborhoods and forcing working families out of the homes and apartments where they have lived their entire lives," [said] Vermont Sen. Bernie Sanders,.. Warren would also give grants to first-time homebuyers who live in areas where black families were once excluded from getting home loans. "Everybody who lives or lived in a formerly red-lined district can get some housing assistance now to be able to buy a home," Warren told attendees at the She the People Presidential Forum in Houston this spring. Technically, "Everybody" includes white millennials. I wonder how she will stop that. Calfornia's SB50 proposal to force local zoning to allow development near transit had a similar feature. Yes, we allow development everywhere -- except in poorer neighborhoods most in need of development, which are protected from the evils of new Starbucks and Whole Foods popping up. *** These are tough times to be an economist. As a matter of technocratic policy, this is not hard stuff. Physicists don't have to write blog posts because the candidates want to enshrine the phlogistic theory of heat. Doctors don't have to rail about HHS policy on four humor management. Somehow we are left railing against fallacies understood since the 1700s. It is, of course, no better on the right. The benefits of free trade and migration have also been known since the 1700s. It is just, sadly, that there is no debate on the right at the moment. This is a real weakness of the American political equilibrium, that in a reelection year all the new ideas and analysis come out of the party in opposition. It would be a great time for the Republican Party to try to come to terms with what Trumpism means, how it relates to traditional conservatism, and to hash out ideas like this. Alas, that will not happen. One is tempted to dismiss all this as rhetoric that will settle down in the general election. But I don't think one should take too much comfort. Trump ended up doing a lot of exactly what he said he would do. Politicians often do. On this, I found fascinating a tidbit from Dan Henninger in WSJ, covering a poll of Democrats conducted by Fox News. Fox asked these Democratic voters whether they wanted “steady, reliable leadership” or a “bold, new agenda.” Steady and reliable crushed bold and new by 72% to 25%. Anyone consuming the media every day the past year would have concluded that the Democratic left’s “bold, new agenda” had taken over the Democratic Party lock, stock and barrel. Most of their presidential candidates obviously thought so. How else to explain why Sens. Warren, Harris and Cory Booker instantly saluted Bernie Sanders’s socialized medicine or, even more incredibly, the antic Alexandria Ocasio-Cortez’s multitrillion-dollar Green New Deal? Recall how Nancy Pelosi, whose 70-something sense of political smell is still more acute than her juniors’, called it “the green dream, or whatever.” In fact, when Fox asked these Democrats what they most wanted from their candidate, 74% chose “unite Americans” against just 23% who want to “fight against extreme right-wing beliefs.” Looks like there’s a silent majority inside the Democratic Party, unmoved by the propaganda of social media. These are the parts of the Fox poll, surfacing a nostalgia for steadiness and unity, that should upset the Trump campaign, not Mr. Biden’s 10-point lead 16 months before the election. Mr. Henninger did not add that Mr. Biden is the one who should be listening hardest. He is currently drifting fast to the left. The poll tells us that this time, my friends, the answer is not blowin' in the wind. I hope more people listen. ## Sunday, June 16, 2019 ### Real estate ups and downs In a delightfully YIMBY "Americans Need More Neighbors" the New York times gets it almost all right. Housing is one area of American life where government really is the problem. The United States is suffering from an acute shortage of affordable places to live, particularly in the urban areas where economic opportunity increasingly is concentrated. And perhaps the most important reason is that local governments are preventing construction. It goes on, even noting flagrant progressive hypocrisy Increasing the supply of urban housing would help to address a number of the problems plaguing the United States. Construction could increase economic growth and create blue-collar jobs. Allowing more people to live in cities could mitigate inequality and reduce carbon emissions. Yet in most places, housing construction remains wildly unpopular. People who think of themselves as progressives, environmentalists and egalitarians fight fiercely against urban development, complaining about traffic and shadows and the sanctity of lawns. It noticed the sordid racial past of zoning restrictions ... many residents said they were surprised to learn that single-family zoning in Minneapolis, as in other cities, had deep roots in efforts to enforce racial segregation. Cities found that banning apartment construction in white neighborhoods was an effective proxy for racial discrimination, and the practice spread after it was validated by the Supreme Court in 1926. Heavens, it even allows for the freedom to spend money, as long as it's not subsidized People should be free to live in a prairie-style house on a quarter-acre lot in the middle of Minneapolis, so long as they can afford the land and taxes. But zoning subsidizes that extravagance by prohibiting better, more concentrated use of the land. Usually I would expect the NYT to jump on the opposite bandwagon and prohibit such houses. The NYT even realizes that more market-rate apartments is the best way to provide more low priced housing OK, the Times being the Times, it has to argue for some vast new subsidy, Governments need to provide subsidized housing for people who cannot afford market-rate housing. But here too, it gets a lot right. The bulk of the long oped is not about repeating the disaster of public housing projects, or more "affordable housing" mandates. It's just about build -- move the supply curve to the right. Berating its own a little more, it recognizes substitution and depreciation ...advocates for affordable housing should be jumping up and down and screaming for the construction of more high-end apartment buildings to ease demand for existing homes. Those new buildings are filled with people who would otherwise be spending Saturdays touring fixer-uppers in neighborhoods newly named something like SoFa, with rapidly dwindling populations of longtime residents. Today’s market-rate apartments will gradually become more affordable, just as new cars become used cars. Meanwhile, in progressive political reality, and lest you get too optimistic, the Wall Street Journal, in a spectacularly mis-titled article, covers New York State's new rent control law. The title is "New York Passes Overhaul of Rent Laws, Buoying Wider Movement to Tackle Housing Crunch" It's not an overhaul, it's a massive expansion, and it will not tackle the housing crunch, but it will make it spectacularly worse. The New York legislation brings increased power to tenants in roughly one million rent-regulated apartments in New York City. It makes it more difficult for the owners of those apartments to increase rents, while enabling more tenants to sue landlords for rent overcharges. Also, tenants around the state will have more protections against eviction. Proposals to limit rents are advancing in a number of state legislatures, including in California, where a statewide cap on rent passed the California Assembly in May, and in Oregon, which passed the nation’s first statewide rent control in February, limiting annual rent increases to 7% plus local inflation. The times will probably get its way on housing subsidies, already a popular idea here in California. Imagine a subsidy for any house or rent above 30 percent of your income, plus a continued block on new construction. It's interesting that economists spend a lot of attention on the minimum wage, and less on rent control plus housing supply restrictions. I guess nobody has made a big stir with a diff in diff regression claiming that rent control doesn't shrink housing supply. Perhaps someone should, just to ge the outrage going. And, if you're wondering about the wealth tax, it's here. A limit on rents is a pure tax on the landlord's property, transferring its value to the current renter, but destroying much of that value along the way. ## Friday, June 7, 2019 ### Futures forecasts Torsten Slok at DB updates this lovely graph on occasion. Here's what it means. Fed fund futures are essentially bets on where the Federal funds rate will be at various points in the future. Thus, you can read from the dashed lines the market's guess about where the federal funds rate will go -- assuming that the bets are priced to have an even chance of winning or losing. Reading it that way, the market was systematically wrong from 2009 to 2016. It's something like springtime in Chicago -- this week, 40 degrees and raining. Next week, 75 and sunny. Week after week after week. In 2017, the market finally changed expectations to say, no, fed funds rates are not rising -- just in time to miss the actual rise in federal funds. Now, as in the blue line, market forecasts say there will be a big decline. But, as Torsten points out, why would the market be right today? So what does this graph mean? Are market practitioners really that dumb? After all, there is a lot of money to be made here. When the graph is upward sloping -- as the entire yield curve was upward sloping from 2009-2016 -- and so long as rates don't rise, you can make a fortune borrowing short and lending long. And vice versa. In short, the difference between forward rate (right end of dashed lines) and spot rate (current fed funds rate) does a lousy job of forecasting where the spot rate will go -- and thus, mechanically, is a good signal of the extra return, positive or (lately) negative you will get by holding long-term bonds. The pattern is actually widespread and longstanding. Starting in the late 70s and early 1980s, Gene Fama wrote a series of papers on it, short term bonds, money markets, foreign exchange, and (a favorite of mine) long term bonds (with Rob Bliss). Campbell and Shiller also found it in long term bonds, which Monika Piazzesi and I extended. Piazzesi and Swanson show the pattern in federal funds futures. There are three potential stories: One: the market is dumb. People are dumb. Well, that's a nice story that can "explain" just about anything. But if you're so smart why are you not rich. Behavioral finance isn't that empty, and searches for common patterns in dumbness. However this graph is the opposite of the usual behavioral claim, extrapolative expectations, excess belief in momentum. If there is a rejectable hypothesis in behavioral finance, this graph seems to reject it. (I welcome corrections to that statement in the comments.) Two: there is a risk premium and it varies over time. For most of 2009-2015, the economy was depressed. People needed a good promised return, a coin more than 50/50, to hold the risk of long term bonds. Once we exit the recession, the opposite pattern holds. Long term bonds should pay less than short term bonds, and maybe now the yield curve is finally waking up to that pattern. Naturally, I'm attracted to this story, but I admit it's a bit strained late in the upslope period. Three: exit and entry to recessions is something like a rare event, a Poisson process. Such a process is like computer failure. The chance of the event is always the same, and does not increase as the length of time goes by. Recovery could happen any time. In a second paper that's what Piazzesi and I seemed to find for this pattern in bond markets. The market forecasts are right, in fact, and we just got 7 tails in a row. That is a speculative idea, and needs quantification. Whatever the story, here is the fact: futures prices are not good forecasts (true-measure conditional means) of where interest rates are going. That fact is true not just of Fed Funds futures, but interest rates in general. Update: Torsten sends along an updated chart, going further back in history. ## Thursday, June 6, 2019 ### Institutionalized nonsense When, last week, the Treasury issued its currency manipulation report, I thought it was a joke. Treasury put Germany and Italy on its "monitoring list" of countries suspected of "currency manipulation." Germany and Italy are, of course, part of the Euro, the whole point of which is that they cannot, individually, "manipulate" their currencies, whatever that means. It is precisely this inability to devalue -- to "manipulate" the Drachma to regain "competitiveness" (another meaningless term) -- that conventional wisdom bemoaned of Greece. I had a little chuckle, envisioning some frustrated mid-level Treasury economist bemoaning the trade and currency idiocy floating around Washington, putting this little message in a bottle to see if anyone noticed the reductio ad absurdum. If so, hello there, somebody noticed. But then read the report. ## Thursday, May 30, 2019 ### Fed Nixes Narrow Banks Redux J. P. Koning at AEIR writes well on the Fed's efforts to quash narrow banks, more clearly than my previous efforts here here and here As a quick review: Narrow banks take your money and invest it 100% in interest-paying reserves at the Fed. They are completely immune from runs, failures, and financial crises. You would get a lot higher interest than the big banks currently pay. The Fed should be giving them a non-systemic medal. Instead, the Fed is fighting them tooth and nail. the Fed is floating the idea of destroying the narrow-bank business model before it can ever be tested in the market. J.P. clearly goes through the Fed's proffered objections, demolishing each in turn. The financial stability concern makes no sense -- after all, they can buy treasury bills directly or buy treasury - backed money market funds. Reserves are that, with instant rather than one day settlement, or money market funds that now are allowed to invest in reserves. J.P is, I think, a little too polite. He writes, ### An Apocalyptic View of Central Banks In the department of genuinely terrible, and terrifying, ideas, I just got the a request from Simon Youel, the Media and Policy Officer at Positive Money, regarding the appointment of Mark Carney's successor as Governor of the Bank of England. Positive money is organizing a "joint letter to the Financial Times, calling on the Chancellor to appoint someone who’ll foster a pluralistic policy-making culture at the central bank." The proposed letter: Applicants to be the next Governor of the Bank of England are asked to commit to an eight year term lasting until 2028. By then the world will be a very different place. Three key trends will shape their time in post. Firstly, environmental breakdown is the biggest threat facing the planet. The next Governor must build on Mark Carney’s legacy, and go even further to act on the Bank’s warnings by accelerating the transition of finance away from risky fossil fuels. Secondly, rising inequality, fuelled to a significant extent by monetary policy, has contributed to a crisis of trust in our institutions. The next Governor must be open and honest about the trade-offs the Bank is forced to make, and take a critical view of how its policies impact on wider society. Thirdly, the UK economy is increasingly unbalanced and skewed towards asset price inflation. Banks pour money into bidding up the value of pre-existing assets, with only £1 in every £10 they lend supporting non-financial firms. The next Governor must seriously consider introducing measures to guide credit away from speculation towards productive activities. As the world around it changes, the function of the Bank itself must evolve. Its current mandate and tools are increasingly coming into question, and a future government may assign the bank with a new mission. The next Governor must meet this with an open mind, not seek to preserve the status quo. To equip the Bank to meet the challenges of the future, the new Governor will also need to ensure it benefits from a greater diversity of backgrounds, experience and perspectives throughout the organisation. The Bank of England’s own stated purpose is to promote the good of the people. We need a Governor genuinely committed to serving the whole of society, not just financial markets. ## Tuesday, May 28, 2019 ### Cost divergence  Source: Marginal Revolution This lovely picture is from Why are the prices so D*mn High? by Eric Helland and Alex Tabarrok. (It's covered in Marginal Revolution: The Initial post, Bloat does not explain the rising cost of education, and an upcoming summary on health care.) Bottom line: objects got cheap, people got expensive. Technology, automation, globalization (thank you China), and quality improvement made goods cheaper. People, especially skilled people, got more expensive. All of which should make you feel good if you're a person and especially a skilled person. The source of the relative rise in the cost of education and health care is less clear. Looking around at a typical university, school system, or hospital suggests massive bloat and inefficiency. Alex suggests not: I assumed that regulation, bloat and bureaucracy, monopoly power and the Baumol effect would each explain some of what is going on. After looking at this in depth, however, my conclusion is that it’s almost all Baumol effect. ## Thursday, May 23, 2019 ### Refreshing YIMBY at NYT Farhad Manjoo writes an excellent YIMBY (yes in my back yard) essay in the New York Times, remarkably placing the blame squarely where it belongs -- progressive politics. Across my home state [California], traffic and transportation is a developing-world nightmare. Child care and education seem impossible for all but the wealthiest. The problems of affordable housing and homelessness have surpassed all superlatives — what was a crisis is now an emergency that feels like a dystopian showcase of American inequality. Just look at San Francisco, Nancy Pelosi’s city. One of every 11,600 residents is a billionaire, and the annual household income necessary to buy a median-priced home now tops$320,000. Yet the streets there are a plague of garbage and needles and feces, and every morning brings fresh horror stories from a “Black Mirror” hellscape: Homeless veterans are surviving on an economy of trash from billionaires’ mansions. Wealthy homeowners are crowdfunding a legal effort arguing that a proposed homeless shelter is an environmental hazard. A public-school teacher suffering from cancer is forced to pay for her own substitute.
At every level of government, our representatives, nearly all of them Democrats, prove inadequate and unresponsive to the challenges at hand. Witness last week’s embarrassment, when California lawmakers used a sketchy parliamentary maneuver to knife Senate Bill 50, an ambitious effort to undo restrictive local zoning rules and increase the supply of housing.
He notices the same hypocrisy that struck me walking past the "all are welcome here" signs in Palo Alto:
Then there is the refusal on the part of wealthy progressives to live by the values they profess to support at the national level. Creating dense, economically and socially diverse urban environments ought to be a paramount goal of progressivism... Urban areas are the most environmentally friendly way we know of housing lots of people. We can’t solve the climate crisis without vastly improving public transportation and increasing urban density. ...
Yet where progressives argue for openness and inclusion as a cudgel against President Trump, they abandon it on Nob Hill and in Beverly Hills. This explains the opposition to SB 50, which aimed to address the housing shortage in a very straightforward way: by building more housing. ...
Reading opposition to SB 50 and other efforts at increasing density, I’m struck by an unsettling thought: What Republicans want to do with I.C.E. and border walls, wealthy progressive Democrats are doing with zoning and Nimbyism. Preserving “local character,” maintaining “local control,” keeping housing scarce and inaccessible — the goals of both sides are really the same: to keep people out.
“We’re saying we welcome immigration, we welcome refugees, we welcome outsiders — but you’ve got to have a $2 million entrance fee to live here, otherwise you can use this part of a sidewalk for a tent,” said Brian Hanlon, president of the pro-density group California Yimby. It's an obvious point. But it's great to hear this point in the New York Times. An internal reflection on hypocrisy is much more effective than an outside charge. I don't agree with everything. He starts with a good point, One continuing tragedy is the decimation of local media and the rise of nationalized politics in its place. Yes, everyone here in California is so consumed with Trump Apolexy that they don't even notice what the city council is doing. But Manjoo chalks the fundamental problem up to larger representation for rural states in the Senate. Hmm. If the same people who vote for San Francisco zoning have more power to push their agenda on the whole country, I don't see how that makes it better. Still I see hope. California is a one party state, and the one party is slowly waking up to the fact that it must govern too. Slogans about the great progressive future are fine in opposition, but once you've been in total charge for a while, you do start to own it. After trying everything else, California is slowly waking up to the fact that we have found the problem and it is us. Subsidies, vouchers, "affordable housing" mandates will never make a dent. Just Let Them Build some housing. It took Nixon to go to China. I was very happy to see the Obama administration recognize the havoc caused by occupational licensing restrictions. The YIMBY self-reflection is not over yet. ## Tuesday, May 21, 2019 ### Clemens on minimum wage Jeff Clemens offers a "roadmap for navigating recent research" on minimum wages in a nice CATO policy analysis. A review and a doubt. He discusses the recent claims that minimum wages don't hurt low-skilled people. This is an impressive and readable account of a vast literature. It's not as easy as it seems to evaluate cause and effect in economics. Evidence from small increases in the minimum wage over short time intervals in some locations in good economic times may not tell you the effects of large increases over longer time intervals in all locations in bad economic times. The "new conventional wisdom," of small effects, Jeff reports, ignores a lot of the more recent work, and especially work that uses "data from individual-level administrative records" rather than "aggregate data and survey data," work that runs "experiments whenever possible," and work that "transparently analyzes compact historical episodes in the U.S. experience" (P. 8) ## Thursday, May 16, 2019 ### Two Videos My Hoover colleague Russ Roberts just finished a nice video on inequality: Among other takeaways, he stresses that the people who were rich in 1980 are not the same people or even families who are rich now. It is not true that "the rich got richer." He also tracks individuals through time, and poor individuals got richer to. There is a lot more economic mobility in the US than the standard talking points. The video is part of Hoover's Policy Ed initiative, and comes with lots of background information. I'll be curious to hear your comments. A few months ago I went to the Friedberg Economic Institute to give an evolving talk I call "Free to grow" bringing together various themes of this blog and other writing. It's not nearly as polished as Russ's, and I'm still struggling to keep it under 10 hours! (Click here to see the video.) The Friedberg Institute is a nascent free-market oriented organization in Israel. It mostly sponsors talks and classes for undergraduates, and for alumni of their program. As a result it is forming a club of sorts of talented and interesting young Israelis interested in economic freedom. If you're in Israel, check it out, and if you're invited to talk there, accept! ## Tuesday, May 14, 2019 ### Almost sane housing supply California, despite being a one-party state, is actively debating SB50 that would over-ride local zoning laws and allow construction of apartment buildings, especially near transit areas. This is almost a remarkable outbreak of sanity. In a divided government, one can keep touting slogans. But when one party takes over, apparently permanently, they do have to actually govern, and eventually some reality must sink in. Housing in California is ridiculously expensive. After California tried everything else -- "affordable housing" mandates on developers, subsidies, rent controls, public housing, and so forth -- it is finally facing the fact -- we need to just let people build. Given that California will not allow more land to be devoted to housing -- wisely, in my view -- and given that the first generation housing stock was built cheaply, using a lot of land for little house, the natural place to allow people to build is up: replace small single family houses on large lots with apartments, townhouses, or even single family houses on smaller lots. The problem here is local zoning laws, building laws and various impeding regulations, which are more or less designed to preserve enormously expensive museums of 1950s suburbia. So SB50 overrides local laws. The end result, though is saddled by a trip through the progressive sausage factory. I recommend Joe DiStephano's analysis with beautiful maps. The first stop was rather clever: wrap it in green. "You can build" was never going to fly in California. So the original effort, SB25, restricted the effort to areas near transit. Who can object to allowing apartments near transit, so people can get out of their cars? Moreover, with this twist, SB25 put the kibosh on one standard local trick for restricting construction, requirements for lots of onsite parking. The transit clause extends to "high quality bus corridors." Now in one sense that's great. Other than nostalgia and cuteness, and outside places like New York City, buses are much better transit options. But one of the main reasons buses are great is that it is much easier to move a bus line than to move a rail line. You can be on a "high quality bus corridor" tomorrow. "Jobs rich areas" are now included. Allowing people to live nearer where they work is better than any "transit" idea. That too is a little strange though. If people were allowed to build housing, jobs would locate there quickly. Housing first redevelopment is not too hard an idea. Alas, the bus and jobs exemption only waive density and parking, and allow cities to keep height limits and other zoning restrictions. Which they will do. Then it descends into madness, and an invitation to endless litigation. "Sensitive communities" are exempt. That means (still quoting Joe), "‘High Segregation & Poverty’ or ‘Low Resource’ in TCAC Opportunity Maps," "Other local areas determined by each regional government through a collaborative process," and "Tenant-Occupied and Rent Controlled parcels." California will write a law allowing the construction of apartment buildings, and conversion of houses to multifamily units, yet will specifically exempt the areas most obviously in need of redevelopment. Once upon a time governments granted subsidies and tax breaks for redeveloping such places. Minorities and poor people will instead be condemned to live in rotten housing and rotten neighborhoods. Heaven forbid a few apartments get built near transit stops, some yuppies move in, grocery stores and coffee shops grow to serve them, and the rest of the neighborhood. Joe's maps tell the story. Where in LA will California allow apartments? Not in the places that need redevelopment! Perhaps if people could build apartments, these might become "jobs rich areas!" As its local governments are devoted to maintaining museums of suburbia, the state government is devoted to preserving museums of poverty, racial segregation, and lack of businesses and services. (To be fair, the state law only over rides local zoning laws. There is nothing that stops the city of LA from allowing development with or without SB50.) As a classic example of how we got in to this mess, consider the instant reaction on the Menlo Park nextdoor.com Now, if we do a little Bayesian Improved Surname Geocoding -- not perfect, but good enough for the Justice Department to sue auto dealers -- we can conclude that the author is white, wealthy, lives in a house worth at least$3 million dollars, and a reliable progressive Democrat, bleeding hearts over climate change and inequality. Yet this post is worthy of the darkest anti-immigrant keep-the-poor-out    climate-denying right-winger. All the people who rehab the $3 million single family houses to$6 million single-family houses in Menlo Park drive in from 50 miles away, as do those who mow the lawns, wait the tables and so on. The young bright kid from Fresno who might get his break working here has little hope of finding a place to live. I guess there is a lot of hypocrisy going around these days, but this is pretty glaring.

Also echoing the local zeitgeist and how-did-we-get-in-to-this-mess thoughts is the ongoing saga of the Flintstone House. NYT here, and a good article at the Guardian If you've ever driven down 280, you've seen this cool house. It was recently sold, and the new owner took up the Flintstones theme:

Before:
After:
More great pictures at SF Curbed. How utterly cool, you undoubtedly think. What did the city do, make it a historic landmark to preserve it? No, the city is suing Ms. Fang, the owner, for landscaping without permits and "community input."

From the Guardian
... the tastemakers of Hillsborough have not extended their favor to the experimental stylings of William Nicholson, the architect...It was in response to the Nicholson’s construction of the Flintstone house in 1976 that the town first established its Architecture and Design Review Board (ADRB), ... established “so there would never be another home like that built in Hillsborough”.
...Mrs Fang claims that she attempted to work with town of Hillsborough to obtain the proper permits for her landscaping work, ..she says she feels like the town is playing with her like a cat with a mouse – “play, play, play, bite, until I die” – and claims she has interacted with the town 44 times while attempting to comply. At one point, the town lawyer pressured her to paint all the mushrooms a single color, she says. “Every time I complied with their request, they moved the goalpost,” she says.
"Design review," which produces Disneyland replicas of craftsman houses and bland identical French farmhouses, allows its executors to stymie permits with endless arbitrary whimsical requests for esthetic changes.

Bottom line, any residual meaning of "private property" is vanishing in California.

(I received a few comments from fellow libertarians last time I wrote about these issues. Shouldn't communities have the right to pass whatever restrictions they want? If they want to preserve a $5 million per house replica of 1950s suburbia, and wall out the unwashed masses, hypocrisy aside, why should the state stop them? I counter, this is not libertarianism, the defense of private rights, this is untrammeled majoritarianism, by which your neighbors via the city strip you of your right to sell your house to the highest bidder, do what you want with it, and strip the ambitious kid from Fresno who wants to move here of his right to be supplied by a competitive marketplace. It's also a monstrous inefficiency. A neighbor who is hurt by$500 from his dislike of looking at your property can destroy millions of value to you. Anyway, it's a longer discussion which I acknowledge here without getting in to it. )

## Monday, May 13, 2019

### Free Solo and Economic Growth

We recently watched "Free Solo", the great movie about Alex Honnold's free (no aids, no ropes) solo climb of El Capitan. Among many other things, it got me thinking about economic growth.

The abilities of modern day rock climbers are far beyond those of just a generation ago. The Wikipedia history of El Capitan starts with a 47 day climb in 1958, using pitons, ropes, and all sorts of equipment, and continues through development of routes and techniques to Alex's three hour romp up the face.

Why wasn't it done long before? There is essentially no technology involved. Ok, a bit. Alex is wearing modern climbing boots, which have very sticky rubber. But that's it. And reasonably sticky rubber has been around for a few hundred years. There is nothing technological that stopped human beings from climbing much like this thousands of years ago. Alex, transported to 1890, might not have free soloed El Capitan without his current boots, but he would have climbed a lot more big walls than anyone else.

Clearly, there has been an explosion in human ability to climb rocks, just as there has been in human productivity, our knowledge of how to do things, in more prosaic and more economic activities. And, reading the history, the rate of improvement has grown over time.

## Friday, May 10, 2019

### Financial Inflation?

Torsten Slok sends this lovely picture of the S&P500 and the price index for portfolio management and investment advice services. Torsten explains that "50% of the decline in core PCE inflation since the peak in July has been driven by financial services, and with the stock market rebounding, we should expect to see the financial services component move higher again."

What's going on? I think it's this: Most portfolio management payments are a percent of value -- you pay a fee, say 1%, of the total value of the portfolio. When the stock market goes down 10%, you pay 10% less in fees. Now, the BEA's job is to figure out, did you get 10% less quantity -- did you get 10% less "valuable advice" for that fee? You're not an idiot, so you're paying 1% off the top of your wealth annually, a third of Senator Warren's dreaded wealth tax, for something of value, the BEA figures. Or did the "price" of financial services go down 10%? Evidently, the BEA assumes the price, not the quantity changed, so the "price" of financial services tracks the stock market.

This is of course nonsense. On the other hand, I have no better idea how to separate 1% management fees into a "price" or a "quantity" (or, heaven forbid, a "quality improvement"). The number of people working to provide you financial advice didn't change 10%. Though, in the long run, it will if the market stays down. How should, or does, the PCE handle rents, or dividend payments? I don't know.

I went back to the documentation for how the PCE is constructed to try to understand these questions and see if my hunch is correct, but I failed to understand anything in there. (I got lost in the "commodity flow method," see p. 5-27.) I would value comments from people who understand this stuff.

Overall, I think the lesson is that our measures of inflation are pretty noisy. First we throw out food and energy. Now it looks to me that "core" should throw out management-fee based financial services, or at least assume that the price is fixed (1% sounds like a fixed price) rather than the quantity. Do real estate and other commissions do the same thing and the price index rises and falls with the price of housing? What's next?

(The point of throwing out food and fuel is not that they don't matter but a feeling that the core CPI today is a better guide of where the overall CPI will be in the future. A more thorough analysis of which components are better forecasters of overall CPI would be welcome.)

Maybe an inflation measure that is less comprehensive but better measured isn't such a terrible idea. Maybe the Fed worrying about 1.8% vs. 2% inflation is not such a good idea.

## Thursday, May 9, 2019

### Rent Control Poem

"kevinsch" posts an remarkable essay on rent control on a  Seattle city council blog (HT Marginal Revolution).
I’m not an economist, not a landlord, nor a renter. But since we’re having this debate, I went to the UW Library and pulled the literature on rent control so I could understand the issues, the studies, and what the experts conclude.  Here’s what I found.
1. Within the community of economists there is broad consensus that rent control is a bad idea. The consensus is on par with the scientific community on climate change, and the medical community on the safety of vaccinations.
Given the widespread move to introduce rent controls on the left coast, savor that.
2. There are two documented benefits of rent control: it decreases economic displacement for people living in rent-controlled housing, and it can reduce the volatility of rental pricing in cities where there is sufficient stock of rental housing.
3.  There is a very long list of documented harms that rent control causes. It provides a strong disincentive to build more rental housing. It drives landlords to reduce spending on maintaining their units until the quality of the housing has drawn down to the point where it matches the allowed rent. And thus by reducing property values, it reduces property tax revenues. It reduces mobility for renters, causing them to stay in their rent-controlled housing rather than move when a better job or the needs of their family require it. It misallocates the total housing stock by encouraging people to stay in housing that doesn’t match their needs.  It encourages rental property owners to convert apartments to condominiums, thereby reducing the rental housing stock. It inevitably leads to a “cluster” of regulations piled on top to try to legislate away all of rent control’s problems. And it doesn’t help the people with the greatest need, but rather the people most capable of gaming the system.
It's remarkable that someone who is not an economist could so quickly find all these subtle effects. Yes, most people quickly get that landlords will not keep up apartments, and builders won't build them. But most people don't quickly get the disincentives for renters not to "move when a better job or the needs of their housing require it." Or that it leads not to nirvana for the low income renter, but helps "the people most capable of gaming the system." I would only add that it really hurts the young ambitious person of limited means who wants to move to town to get that upward-mobility job.

4.  In many cities with rent control, tenants see annual rent increases at the maximum amount allowed, because landlords understand that if they skip a year they will never catch up.
5.  Rent control’s harms can be mitigated in part through an aggressive public/social housing program that creates a large quantity of units using public funds. However, in those places it’s unclear that rent control itself is adding much value beyond the significant value that the public housing program alone delivers.
OK, Kevinsch is not an economist so I'll let this pass. The history of aggressive public/social housing programs in US cities are an absolute disaster.

More deeply, he missed the underlying cause of the problem -- building, zoning, and land-use restrictions. Supply meets demand. If builders were allowed to build cheap apartments for modest renters, they would do so. If builders were allowed to build expensive apartments for high-income renters, who then would move out of buildings suitable for low rent apartments, they would do so.
6.  As this paper says, rent control “confers its benefits early, and extracts its costs late.” That’s one of the reasons it’s such an attractive policy idea.
Well, it confers benefits to renters early. The loss of property value to landlords is instant, but apparently nobody cares about them. The "one time" capital tax is always tempting.
Ditto, say, Socialism and Venezuela.
8. And finally, as this research paper suggests, economists have been thorough at convincing themselves that rent control is a bad idea, and inept at convincing anyone else.
This is a gem. And so true. Like, say, tariffs. I wish I knew just how to fix that despite the immense effort and millions of dollars going in to better dissemination of economic ideas.

The essay goes on, and it's worth reading the whole thing.

There is a lesson here. Why do our governments, and especially local governments, so often wander into terrible economic policies? The "education" theory says they just don't know basic economics, and don't have any competent policy advice. If they and their staff could just be "educated" things would get better. (And if we could break through all the competing parties who also want to "educate" politicians.) The "interest" theory, more typical among public choice economists, views political outcomes as the result of power, not ideas. Rent control wins when incumbent renters who want to stay put win the political battle over landlords, mobile renters, and potential newcomers, and invoke whatever ideas butter the toast of their cause.

That the city council of Seattle has available such amazingly good policy advice speaks to the latter, sad to say for those of us in the "education" business.

The third view is that ideas still matter at the larger level.  A bad idea like rent control requires the asset of the general voter. Yes, incumbent renters who know how to work the system may win the political battle over landlords, property owners, people who want to move to the city and rent, and mobile renters or those not good at working the system, who will lose.  But the larger mass of homeowners, condo owners, and non-controlled renters must go along. They don't have a personal interest, other than a general desire to feel good by helping those who face higher rents, so they don't have much reason to study the issue. If the general electorate understood how bad rent control is for their city, and most of the people they want to help, perhaps economic policy would be better. There is hope for ideas.

## Wednesday, May 8, 2019

### Jenkins on ACA

Holman Jenkins "Obamacare is popular because it failed" from a week ago is worth savoring and has an interesting new idea.

On Obamacare's failure:
ObamaCare’s user cohort now consists almost entirely of willing “buyers” who receive their coverage entirely or largely at taxpayer expense. It also consists of certain users who take advantage of the coverage for pre-existing conditions and stop paying once their condition has been treated....

There is also a political judgment here that people will not stand for a visible tax, but will stand politically, or perhaps be too stupid to notice, the much larger shadow price of direct controls. They won't pay $5 at the pump for gas, but will stand for banning cars. I don't think that's true. I don't think the left thinks it's true either. The way the Green New Deal and even the IPCC reports now bundle carbon reduction with a vast left-wing political agenda, and a rather Orwellian drive to silence criticism confirms it. ## Sunday, May 5, 2019 ### Smith, MMT, and science in economics Many blog readers have asked for my opinions of "Modern Monetary Theory." I haven't written yet, because I try to read about things in some detail, ideally from original sources, before reviewing them, which I have not done. Life is short. From the summaries I have read, some of the central propositions of MMT draw a false conclusion from two sensible premises. 1) Countries that print their own currencies do not have to default on excessive debts. They can always print money to pay off debts. True. 2) Inflation in the end can and must be controlled by raising taxes or cutting spending, sufficiently to soak up such printed (non-interest-bearing) money. True. The latter proposition is the heart of the fiscal theory of the price level, so I would have an especially tough time objecting. It does not follow that the US need not worry about deficits, and may happily borrow tens of trillions to finance all sorts of spending. Borrow$50 trillion or so. When bondholders revolt, print money to pay off the bonds. When this results in inflation, raise taxes to soak up the money. OK, but this latter step is exactly raising taxes to pay off the bonds. Moreover, if bondholders see that the plan is to pay off bonds with printed money, they refuse to buy or roll over bonds in the first place and the inflation can happen right away.

This may reflect a common confusion between today's money with the new money that pays off debt. It would only take $1.5 trillion in extra taxes or lower spending to retire current currency (non-interest bearing government debt) outstanding. But that's not the task after the great bond bailout. Then we have to raise taxes or cut spending by, in my example, the$50 trillion printed to pay off the bonds. Large debts are either paid or defaulted, and inflation is the same thing economically as default. Period. (Currency boards run in to some of the same problem. Backing today's currency is not enough to avoid devaluation, if one does not back all the debt which promises to pay currency.)

I must admit some amusement that Keynesian commentators, having urged fiscal stimulus and decried evil "Austerians" for years, are apoplectic to be passed on the left. But that does not make the ideas of those passing on the left any more right.  There is also a different and interesting strain of thought, exemplified by recent writings by Larry Summers and Olivier Blanchard, that the current low interest rate environment might allow for somewhat, but not unlimited, extra borrowing. Those ideas are completely different analytically. I hope to cover them in a later blog post.

Noah Smith and guru-based theory

But, as I said, I have not studied MMT, so perhaps I'm missing something. Enter Noah Smith, who has delved in to figure out just what MMT is and whether or how it hangs together.

Noah interestingly characterizes MMT as  "Guru-based theory." Noah:

## Friday, April 12, 2019

### Perpetually wrong forecasts

Torsten Slok of Deutsche Bank sends along the following fascinating graphs

The titles seem a little off. Yes, the market is expecting rate cuts (forward rate) but the market has been exactly wrong about everything for 10 years (and longer) first forecasting the recovery that never came, then forecasting much slower interest rate rises than actually happened.  Survey expectations seem to match the forward curves well except perhaps at the very end.

Mechanically, a rising forward curve and rates that never rise means you earn a lot of money in long term bonds. It's a "risk premium" Monika Piazzesi and Eric Swanson point out this pattern is common. The same pattern holds in longer term bonds, as well known since Fama and Bliss. An upward sloping term structure indicates higher expected returns on long term bonds, and vice versa. And it makes some sense. In recessions, people don't want to hold risks, so we expect a premium for riskier assets. In booms, as interest rates rise, people are more willing to take risks.

Still it's unsettling for lots of reasons. Why did the forward curve suddenly flatten exactly when interest rates finally took off? Another interpretation is something like a Poisson process in the end of recessions, in which the chance of fast recovery is independent of how long you've been in a recession, rather than arriving slowly and predictably. That makes it rational to continue these expectations persist despite continual disappointment, and to change forecast quickly once the long-awaited fast growth arrives.

## Monday, April 8, 2019

### Meer On Minimum Wage

David Henderson posts a thoughtful draft op-ed by Jonathan Meer on minimum wages. Two talents of  great economists are to recognize that averages hide big differences among people, and to imagine all the avenues of substitution and unintended effects of a regulation. The oped excels:

Substitution:
when the minimum wage is raised, employers offset increased labor costs by reducing benefits like the generosity of health insurance. Other benefits, like free parking or flexibility in scheduling, are more difficult to measure but are also likely to be cut back. Employers will likely expect more work effort when they are forced to pay more, changing the nature of jobs. And in the longer run, economists have found that employers shift towards automation and expecting customers to do more things themselves– reducing job growth in ways that aren’t always obvious. This damage takes time to be seen, which is one reason minimum wage hikes, like rent control, often seem appealing.
Who gets jobs?
When debate focuses on the total number of jobs lost or gained, it hides this potentially nasty distribution of the benefits: a recent college graduate with a barista job may get a few more dollars an hour, but the high school dropout finds it harder to get and keep a job. ...
The teenage children of well-off families, earning money to buy video games, are treated the same as single moms struggling to get by. When wages are set at an artificially high rate, why should an employer take a risk on the single mother who needs the occasional shift off to take her kids to the doctor? The kid from a disadvantaged background who needs some direction on how to treat customers appropriately? Or the recently released felon trying to work his way back into the community? Why should employers bother with them when there are plenty of lower-risk people who are willing to work at those artificially high wages?
It will get much worse in the next recession...Those at the margins of the workforce will be left further behind. Low-wage jobs aren’t easy, don’t pay well, and are rarely fun. But not being able to find work at all is far worse.
Despite the lowest unemployment rates in decades, only 39% of adults without a high school degree had a full-time job in 2018 – and among young African-Americans dropouts, it’s a shocking 26%. It’s hard to believe that the best way to help them find work and start climbing the job ladder is to put the first rung out of reach, making it difficult for them to find work and driving them to illegal employment with few protections.
We should never minimize the struggles of low-income families to get ahead. But good intentions are no substitute for good policy. Minimum wage proponents mean well, but the unintended consequences hurt the worst-off the most.
Jonathan isn't just making this up as us bloggers tend to do. He points to "The Minimum Wage, Fringe Benefits, and Worker Welfare, with Jeffrey Clemens and Lisa B. Kahn
...state-level minimum wage changes decreased the likelihood that individuals report having employer-sponsored health insurance. Effects are largest among workers in very low-paying occupations,
and Dropouts Need Not Apply: The Minimum Wage and Skill Upgrading
workers employed in low-paying jobs are older and less likely to be high school dropouts following a minimum wage hike.... job ads in low-wage occupations are more likely to require a high school diploma following a minimum wage hike,
Related, Zachary S. Fone, Joseph J. Sabia, Resul Cesur find exactly the predicted substitution into criminal activity
find that raising the minimum wage increases property crime arrests among those ages 16-to-24, with an estimated elasticity of 0.2. This result is strongest in counties with over 100,000 residents and persists when we use longitudinal data to isolate workers for whom minimum wages bind. Our estimates suggest that a $15 Federal minimum wage could generate criminal externality costs of nearly$2.4 billion.
Hat tip to David Henderson, who posted the draft oped and a link to the excellent Jonathan Meer - James Galbraith debate, and to the indefatigable Marginal Revolution. I saw an early draft of the oped, and hoped Meer would be able to publish it, at least somewhere like WSJ. It's not too late!

Update:

Jonathan passed on this tidbit from Obenauer & von der Nienburg, “Effect of Minimum-Wage Determinations in Oregon,” July 1915, yes 1915
“The belief was very prevalent among store women that the minimum wage had wrought only harm to them as a whole. The experienced women contended that formerly they had gotten through the day without any hurry or strain. If it was necessary to work a few minutes overtime, they did so willingly. Now, they said, they are under constant pressure from their supervisors to work harder; they are told the sales of their departments must increase to make up for the extra amount the firm must pay in wages.”
Plus ça change...

Overall, it's a shame that economists have bought the popular discourse that all that matters are "jobs," as if it were 1933, not the vast range of the terms of employment -- how hard you have to work, hours, tasks, flexibility, side benefits, overtime, and so forth.

## Friday, March 29, 2019

### Operating Procedures

The Fed sets interests rates. But how does the Fed set interest rates? The Fed is undergoing a big review of this question. We had a little workshop at Hoover, in preparation for the larger May 3 Strategies for Monetary Policy conference, which provokes the following thoughts.

Issue

Here is the issue.

The graph plots the demand for reserves, as a function of the interest rate on other short-term assets such as overnight federal funds, Libor, money market rates, and so on.

(Reserves are accounts that banks have at the Fed. The Fed sets the interest rates on such accounts.)

The lower horizontal line is the rate the Fed pays on reserves.

If the interest rate on other similar assets (overnight federal funds, Libor, repo rates) is above the interest rate on reserves, then banks should want to get rid of reserves. However, reserves are useful, as money is useful, so banks are willing to hold some even when they lose interest on reserves by doing so. The greater the interest costs -- the greater the difference between the rate banks can lend at and the rate they get on reserves -- the more they work hard to avoid holding reserves. At the end, there are legal and regulatory requirements to hold reserves.

In the flat zone, banks are satiated in reserves. Reserves don't have any marginal liquidity value. But banks are happy to hold arbitrary quantities as an asset so long as the interest on reserves is above or equal to what they can get elsewhere.

If banks can borrow at less than the interest on reserves, they would do so and demand infinite amounts. Therefore, competition among banks should drive those rates up to the interest on reserves.  Similarly, if rates banks can lend at are higher than interest on reserves then banks should compete to lend, driving other rates down to the interest on reserves. Therefore, the Fed by setting the interest on reserves sets the overall level of overnight interest rates.

Questions

Here are the questions:

1) Where should the supply of reserves be? This is the biggest question the Fed is asking right now. The three vertical lines in the graph are three possibilities.

The Fed currently fixes the supply of reserves, which is referred to as the "size of the balance sheet," so the lines are vertical. The Fed raises the supply of reserves by buying assets such as treasuries or other assets, "printing money," i.e. creating reserves, in return for the assets. The balance sheet shows the assets (e.g. Treasuries) against liabilities (reserves and cash). Yes, the Fed is nothing more than an enormous money market fund, offering fixed value floating rate accounts which it backs by treasury and other securities.

The debated is couched as "floor system" vs. "corridor system."  A "floor system" refers to the two supplies on the right, where there are so many reserves that the other interest rates will equal the rate on reserves.

There are two floor-system variants: abundant reserves, with the supply well to the right, and minimalist reserves, with the supply of reserves set to the smallest possible level, where the demand curve just hits the lower bound, "satiation" in reserves. The latter seems to be where the Fed is heading -- a minimal-reserves floor system.

In a "corridor system," the Fed has an upper and lower band for the market interest rates it wants to target. Historically this was the Federal funds rate, which is the rate at which banks lend reserves to each other overnight. It tries to place that interest in the middle of the band, by artfully putting the supply of reserves in the downward sloping component. This is how the Fed operated before 2008.

The rate at which the Fed is willing to lend reserves also provides an upper bound, which I'll get to in a minute.

2) If there is going to be a corridor, which rate should the Fed care about? The (justly) moribund federal funds rate? The overnight general collateral repo rate? Libor? One advantage of the abundant floor, is that the Fed can stay quiet about all this and let the market sort out just what kind of overnight lending it prefers.

3) If there is a band, how wide should the range between the upper and lower bound be?  1%? 0.5? 0.25%? 0.01%?

3) How free should lending and borrowing be? Who gets access to interest paying reserves, and how much interest do they get? Who can borrow reserves, and on what therms -- what collateral is acceptable, is it overnight or term borrowing, does such borrowing incur formal regulatory attention or informal "stigma"?

4) What assets should the Fed buy on the other side of the balance sheet, or accept as collateral if it lends reserves?  Just short-term treasuries? (My favorite) The current mix of long term treasuries and mortgage-backed securities? Or, perhaps, follow the ECB and BOJ and buy corporate bonds and stocks, many countries debts, or lend newly created reserves to banks and count the loans as assets?

The motivations here are, I think, as much political as economic, and it's better to acknowledge that. (We should understand the Fed can't do that in writing, but we can!) Having touted QE as extraordinary accommodation the Fed is under big pressure to stop stimulating. It's too late to say that QE was mostly symbolic. Having seen the Fed buy all sorts of securities, congresspeople are coming up with dandy ideas for new things the Fed can "invest" in by printing money. Having paid banks about a quarter point more than they can get anywhere else, and indeed allowed a pleasant little arbitrage to go on, the Fed is under pressure to pay other investors the same. Congress is even more full of ideas for who the Fed should lend to, and how the Fed should use its expanded regulatory powers to channel credit here and deny credit there.

"Normalization" is a pretty meaningless economic term to me -- why is whatever the Fed was doing in 2007 "normal," why is it good? But "normalization" is a tremendously useful marketing banner. We're going back to "normal," so leave us alone with your bright ideas. Well, fine, but let us quietly  go to a new normal that incorporates all the interesting things we've learned in the last 10 years.

I like the "floor" system, with abundant reserves. The great lesson of the last 10 years is, we can live the Friedman rule. We can have money that pays full interest, so that holding money has no opportunity cost, and this will not cause inflation. This is genuinely new knowledge. Liquidity is free! There is no need for people to waste time and effort on cash management. Liquidity is good for financial stability too: Banks holding huge reserves don't fail.

I go beyond the abundant floor: The Fed should not target the supply of reserves at all. The supply curve of reserves should be horizontal.  The Fed should just say, "bring us your treasuries, and we'll give you reserves and pay the IOER rate." Or, "Bring us your reserves and you can have treasuries."

Why? Well, if you want to target a price, you offer to buy and sell freely at that price. If you want to target an interest rate, target an interest rate. We have seen limited arbitrage between reserves and other assets due to lack of competition in banking and Fed restrictions, who can hold reserves, and the fixed supply.

I see no economic or financial harm whatever from arbitrary expansion of the Fed's balance sheet, if the assets are all short-term Treasuries. Reserves are just overnight, electronically transferable government debt. If the banking system wants more overnight debt and less three week to six month debt, let them have what they want. I see no reason to artificially starve the economy of overnight debt.  The Fed offers free exchange between cash and reserves; the government as a whole should offer free exchange between short term treasuries and overnight treasuries, i.e., reserves.

To accommodate the economy's desire for ample reserves, and the Fed's desire not to provide them, the Treasury should offer the same asset, and the Fed should encourage this and work with the Treasury to make it happen.

Specifically, the treasury should issue overnight, fixed-value ($1), floating-rate, electronically-transferable debt. Let's call it treasury electronic money. Legally, this is treasury debt that any individual or financial institution can hold, just as they can hold treasury bills or treasury coins. Functionally, these are interest-paying reserves. Like reserves, but not even like T bills, these can be bought or sold immediately: Owners can transfer their ownership of$1 worth of treasury money to someone else on the treasury website, and owners can sell $1 worth of treasury money and have the money wired (i.e. the treasury sends$1 of reserves to the owner's bank) instantly. (Details here.)

Given the Fed's resistance to narrow banking, and the potential of treasury electronic money to undercut bank's (subsidized) deposit financing, I suspect the Fed's first instinct would be to fight such an innovation. The Fed should overcome that instinct and welcome a solution to the problem of providing lots of liquid assets without the (genuine, below) downsides the Fed feels about a large balance sheet.

I agree with critics that the composition of the Fed's assets should return quickly to short-term treasuries only, and in my ideal world to just this treasury electronic money. That is mostly for political economy reasons outlined below. Other assets should be on the balance sheet in emergencies only.

If the Fed feels the need to buy long-term treasurys or take them as collateral, issuing reserves in return, because of a shortage of safe assets, that means the Treasury has not issued enough short-term liquid treasurys. There are simpler ways to fix that problem.