I did two videos last week that blog readers may enjoy.
I did an interview with Luis Garicano in his "capitalism after coronavirus" series
We covered many topics, but the aftermath of the huge government debt now being racked up is possibly the most interesting, at least to me.
Luis is currently a member of the European Parliament. Among many other things he was a PhD student and then professor of economics at the University of Chicago. He's a also a great interviewer. The interview is also available in Spanish, here.
In the latest Goodfellows, Niall, HR and I interview Victor Davis Hanson, about Trump, cancel culture, and the future of universities.
Podcast
Thursday, July 16, 2020
Monday, July 6, 2020
A little financial-econometric history
The issues that have cropped up in applying present value ideas to government
finance, in my last post, caused me to write up a little financial-econometric
history, which seems worth passing on to blog readers. The lessons of the
1980s and 1990s are fading with time, and we should avoid having to re-learn
such hard-won lessons. (Warning: this post uses mathjax to display equations.)
Faced with a present value relation, say \[ p_{t}=E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}, \] what could be more natural than to model dividends, say as an AR(1), \[ d_{t+1}=\rho_{d}d_{t}+\varepsilon_{t+1}, \] to calculate the model-implied price, \[ E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}=\frac{\beta\rho_{d}}{1-\beta\rho_{d} }d_{t}, \] and to compare the result to \(p_{t}\)? The result is a disaster -- prices do not move one for one with dividends, and they move all over the place with no discernible movement in expected dividends.
Faced with a present value relation, say \[ p_{t}=E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}, \] what could be more natural than to model dividends, say as an AR(1), \[ d_{t+1}=\rho_{d}d_{t}+\varepsilon_{t+1}, \] to calculate the model-implied price, \[ E_{t}\sum_{j=1}^{\infty}\beta^{j}d_{t+j}=\frac{\beta\rho_{d}}{1-\beta\rho_{d} }d_{t}, \] and to compare the result to \(p_{t}\)? The result is a disaster -- prices do not move one for one with dividends, and they move all over the place with no discernible movement in expected dividends.
The Surplus Process
How should we model surpluses and deficits? In finishing up a recent article
and chapter 5 and 6 of a Fiscal Theory of the Price Level update, a bunch of observations
coalesced that are worth passing on in blog post form.
Background: The real value of nominal government debt equals the present value of real primary surpluses, \[ \frac{B_{t-1}}{P_{t}}=b_{t}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}. \] I 'm going to use one-period nominal debt and a constant discount rate for simplicity. In the fiscal theory of the price level, the \(B\) and \(s\) decisions cause inflation \(P\). In other theories, the Fed is in charge of \(P\), and \(s\) adjusts passively. This distinction does not matter for this discussion. This equation and all the issues in this blog post hold in both fiscal and standard theories.
The question is, what is a reasonable time-series process for \(\left\{s_{t}\right\} \) consistent with the debt valuation formula? Here are surpluses
The blue line is the NIPA surplus/GDP ratio. The red line is my preferred measure of primary surplus/GDP, and the green line is the NIPA primary surplus/GDP.
The surplus process is persistent and strongly procyclical, strongly correlated with the unemployment rate. (The picture is debt to GDP and surplus to GDP ratios, but the same present value identity holds with small modifications so for a blog post I won't add extra notation.)
Something like an AR(1) quickly springs to mind, \[ s_{t+1}=\rho_{s}s_{t}+\varepsilon_{t+1}. \] The main point of this blog post is that this is a terrible, though common, specification.
Write a general MA process, \[ s_{t}=a(L)\varepsilon_{t}. \] The question is, what's a reasonable \(a(L)?\) To that end, look at the innovation version of the present value equation, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}=\sum_{j=0}^{\infty}\beta ^{j}a_{j}\varepsilon_{t}=a(\beta)\varepsilon_{t}% \] where \[ \Delta E_{t}=E_{t}-E_{t-1}. \] The weighted some of moving average coefficients \(a(\beta)\) controls the relationship between unexpected inflation and surplus shocks. If \(a(\beta)\) is large, then small surplus shocks correspond to a lot of inflation and vice versa. For the AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx 2.\) Unexpected inflation is twice as volatile as unexpected surplus/deficits.
\(a(\beta)\) captures how much of a deficit is repaid. Consider \(a(\beta)=0\). Since \(a_{0}=1\), this means that the moving average is s-shaped. For any \(a(\beta)\lt 1\), the moving average coefficients must eventually change sign. \(a(\beta)=0\) is the case that all debts are repaid. If \(\varepsilon_{t}=-1\), then eventually surpluses rise to pay off the initial debt, and there is no change to the discounted sum of surpluses. Your debt obeys \(a(\beta)=0\) if you do not default. If you borrow money to buy a house, you have deficits today, but then a string of positive surpluses which pay off the debt with interest.
The MA(1) is a good simple example, \[ s_{t}=\varepsilon_{t}+\theta\varepsilon_{t-1}% \] Here \(a(\beta)=1+\theta\beta\). For \(a(\beta)=0\), you need \(\theta=-\beta ^{-1}=-R\). The debt -\(\varepsilon_{t}\) is repaid with interest \(R\).
Let's look at an estimate. I ran a VAR of surplus and value of debt \(v\), and I also ran an AR(1).
Here are the response functions to a deficit shock:
The blue solid line with \(s=-0.31\) comes from a larger VAR, not shown here. The dashed line comes from the two variable VAR, and the line with triangles comes from the AR(1).
The VAR (dashed line) shows a slight s shape. The moving average coefficients gently turn positive. But when you add it up, those overshootings bring us back to \(a(\beta)=0.26\) despite 5 years of negative responses. (I use \(\beta=1\)). The AR(1) version without debt has \(a(\beta)=2.21\), a factor of 10 larger!
Clearly, whether you include debt in a VAR and find a slightly overshooting moving average, or leave debt out of the VAR and find something like an AR(1) makes a major difference. Which is right? Just as obviously, looking at \(R^2\) and t-statistics of the one-step ahead regressions is not going to sort this out.
I now get to the point.
Here are 7 related observations that I think collectively push us to the view that \(a(\beta)\) should be a quite small number. The observations use this very simple model with one period debt and a constant discount rate, but the size and magnitude of the puzzles are so strong that even I don't think time-varying discount rates can overturn them. If so, well, all the more power to the time-varying discount rate! Again, these observations hold equally for active or passive fiscal policy. This is not about FTPL, at least directly.
1) The correlation of deficits and inflation. Reminder, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =a(\beta)\varepsilon_{t}. \] If we have an AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx2\), and with \(\sigma(\varepsilon)\approx5\%\) in my little VAR, the AR(1) produces 10% inflation in response to a 1 standard deviation deficit shock. We should see 10% unanticipated inflation in recessions! We see if anything slightly less inflation in recessions, and little correlation of inflation with deficits overall. \(a(\beta)\) near zero solves that puzzle.
2) Inflation volatility. The AR(1) likewise predicts that unexpected inflation has about 10% volatility. Unexpected inflation has about 1% volatility. This observation on its own suggests \(a(\beta)\) no larger than 0.2.
3) Bond return volatility and cyclical correlation. The one-year treasury bill is (so far) completely safe in nominal terms. Thus the volatility and cyclical correlation of unexpected inflation is also the volatility and cyclical correlation of real treasury bill returns. The AR(1) predicts that one-year bonds have a standard deviation of returns around 10%, and they lose in recessions, when the AR(1) predicts a big inflation. In fact one-year treasury bills have no more than 1% standard deviation, and do better in recessions.
4) Mean bond returns. In the AR(1) model, bonds have a stock-like volatility and move procyclically. They should have a stock-like mean return and risk premium. In fact, bonds have low volatility and have if anything a negative cyclical beta so yield if anything less than the risk free rate. A small (a(\beta)\) generates low bond mean returns as well.
Jiang, Lustig, Van Nieuwerburgh and Xiaolan recently raised this puzzle, using a VAR estimate of the surplus process that generates a high \(a(\beta)\). Looking at the valuation formula \[ \frac{B_{t-1}}{P_{t}}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}, \] since surpluses are procyclical, volatile, and serially correlated like dividends, shouldn't surpluses generate a stock-like mean return? But surpluses are crucially different from dividends because debt is not equity. A low surplus \(s_{t}\) raises our estimate of subsequent surpluses \(s_{t+j}\). If we separate out
\[b_{t}=s_{t}+E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=s_{t}+\beta E_{t}b_{t+1} \] a decline in the "cashflow" \(s_{t}\) raises the "price" term \(b_{t+1}\), so the overall return is risk free. Bad cashflow news lowers stock pries, so both cashflow and price terms move in the same direction. In sum a small \(a(\beta)\lt 1\) resolves the Jiang et. al. puzzle. (Disclosure, I wrote them about this months ago, so this view is not a surprise. They disagree.)
5) Surpluses and debt. Looking at that last equation, with a positively correlated surplus process \(a(\beta)>1\), as in the AR(1), a surplus today leads to larger value of the debt tomorrow. A deficit today leads to lower value of the debt tomorrow. The data scream the opposite pattern. Higher deficits raise the value of debt, higher surpluses pay down that debt. Cumby_Canzoneri_Diba (AER 2001) pointed this out 20 years ago and how it indicates an s-shaped surplus process. An \(a(\beta)\lt 1\) solves their puzzle as well. (They viewed \(a(\beta)\lt 1\) as inconsistent with fiscal theory which is not the case.)
6) Financing deficits. With \(a(\beta)\geq1\), the government finances all of each deficit by inflating away outstanding debt, and more. With \(a(\beta)=0\), the government finances deficits by selling debt. This statement just adds up what's missing from the last one. If a deficit leads to lower value of the subsequent debt, how did the government finance the deficit? It has to be by inflating away outstanding debt. To see this, look again at inflation, which I write \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}s_{t}+\Delta E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=\Delta E_{t}s_{t}+\Delta E_{t}\beta b_{t+1}=1+\left[ a(\beta)-1\right] \varepsilon_{t}. \] If \(\Delta E_{t}s_{t}=\varepsilon_{t}\) is negative -- a deficit -- where does that come from? With \(a(\beta)>1\), the second term is also negative. So the deficit, and more, comes from a big inflation on the left hand side, inflating away outstanding debt. If \(a(\beta)=0\), there is no inflation, and the second term on the right side is positive -- the deficit is financed by selling additional debt. The data scream this pattern as well.
7) And, perhaps most of all, when the government sells debt, it raises revenue by so doing. How is that possible? Only if investors think that higher surpluses will eventually pay off that debt. Investors think the surplus process is s-shaped.
All of these phenomena are tied together. You can't fix one without the others. If you want to fix the mean government bond return by, say, alluding to a liquidity premium for government bonds, you still have a model that predicts tremendously volatile and procyclical bond returns, volatile and countercyclical inflation, deficits financed by inflating away debt, and deficits that lead to lower values of subsequent debt.
So, I think the VAR gives the right sort of estimate. You can quibble with any estimate, but the overall view of the world required for any estimate that produces a large \(a(\beta)\) seems so thoroughly counterfactual it's beyond rescue. The US has persuaded investors, so far, that when it issues debt it will mostly repay that debt and not inflate it all away.
Yes, a moving average that overshoots is a little unusual. But that's what we should expect from debt. Borrow today, pay back tomorrow. Finding the opposite, something like the AR(1), would be truly amazing. And in retrospect, amazing that so many papers (including my own) write this down. Well, clarity only comes in hindsight after a lot of hard work and puzzles.
In more general settings \(a(\beta)\) above zero gives a little bit of inflation from fiscal shocks, but there are also time-varying discount rates and long term debt in the present value formula. I leave all that to the book and papers.
(Jiang et al say they tried it with debt in the VAR and claim it doesn't make much difference. But their response functions with debt in the VAR, at left, show even more overshooting than in my example, so I don't see how they avoid all the predictions of a small \(a(\beta)\), including a low bond premium.)
A lot of literature on fiscal theory and fiscal sustainability, including my own past papers, used AR(1) or similar surplus processes that don't allow \(a(\beta)\) near zero. I think a lot of the puzzles that literature encountered comes out of this auxiliary specification. Nothing in fiscal theory prohibits a surplus process with \(a(\beta)=0\) and certainly not \(0 \lt a(\beta)\lt 1\).
Update
Jiang et al. also claim that it is impossible for any government with a unit root in GDP to issue risk free debt. The hidden assumption is easy to root out. Consider the permanent income model, \[ c_t = rk_t + r \beta \sum \beta^j y_{t+j}\] Consumption is cointegrated with income and the value of debt. Similarly, we would normally write the surplus process \[ s_t = \alpha b_t + \gamma y_t. \] responding to both debt and GDP. If surplus is only cointegrated with GDP, one imposes \( \alpha = 0\), which amounts to assuming that governments do not repay debts. The surplus should be cointegrated with GDP and with the value of debt. Governments with unit roots in GDP can indeed promise to repay their debts.
Background: The real value of nominal government debt equals the present value of real primary surpluses, \[ \frac{B_{t-1}}{P_{t}}=b_{t}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}. \] I 'm going to use one-period nominal debt and a constant discount rate for simplicity. In the fiscal theory of the price level, the \(B\) and \(s\) decisions cause inflation \(P\). In other theories, the Fed is in charge of \(P\), and \(s\) adjusts passively. This distinction does not matter for this discussion. This equation and all the issues in this blog post hold in both fiscal and standard theories.
The question is, what is a reasonable time-series process for \(\left\{s_{t}\right\} \) consistent with the debt valuation formula? Here are surpluses
The blue line is the NIPA surplus/GDP ratio. The red line is my preferred measure of primary surplus/GDP, and the green line is the NIPA primary surplus/GDP.
The surplus process is persistent and strongly procyclical, strongly correlated with the unemployment rate. (The picture is debt to GDP and surplus to GDP ratios, but the same present value identity holds with small modifications so for a blog post I won't add extra notation.)
Something like an AR(1) quickly springs to mind, \[ s_{t+1}=\rho_{s}s_{t}+\varepsilon_{t+1}. \] The main point of this blog post is that this is a terrible, though common, specification.
Write a general MA process, \[ s_{t}=a(L)\varepsilon_{t}. \] The question is, what's a reasonable \(a(L)?\) To that end, look at the innovation version of the present value equation, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}=\sum_{j=0}^{\infty}\beta ^{j}a_{j}\varepsilon_{t}=a(\beta)\varepsilon_{t}% \] where \[ \Delta E_{t}=E_{t}-E_{t-1}. \] The weighted some of moving average coefficients \(a(\beta)\) controls the relationship between unexpected inflation and surplus shocks. If \(a(\beta)\) is large, then small surplus shocks correspond to a lot of inflation and vice versa. For the AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx 2.\) Unexpected inflation is twice as volatile as unexpected surplus/deficits.
\(a(\beta)\) captures how much of a deficit is repaid. Consider \(a(\beta)=0\). Since \(a_{0}=1\), this means that the moving average is s-shaped. For any \(a(\beta)\lt 1\), the moving average coefficients must eventually change sign. \(a(\beta)=0\) is the case that all debts are repaid. If \(\varepsilon_{t}=-1\), then eventually surpluses rise to pay off the initial debt, and there is no change to the discounted sum of surpluses. Your debt obeys \(a(\beta)=0\) if you do not default. If you borrow money to buy a house, you have deficits today, but then a string of positive surpluses which pay off the debt with interest.
The MA(1) is a good simple example, \[ s_{t}=\varepsilon_{t}+\theta\varepsilon_{t-1}% \] Here \(a(\beta)=1+\theta\beta\). For \(a(\beta)=0\), you need \(\theta=-\beta ^{-1}=-R\). The debt -\(\varepsilon_{t}\) is repaid with interest \(R\).
Let's look at an estimate. I ran a VAR of surplus and value of debt \(v\), and I also ran an AR(1).
The blue solid line with \(s=-0.31\) comes from a larger VAR, not shown here. The dashed line comes from the two variable VAR, and the line with triangles comes from the AR(1).
The VAR (dashed line) shows a slight s shape. The moving average coefficients gently turn positive. But when you add it up, those overshootings bring us back to \(a(\beta)=0.26\) despite 5 years of negative responses. (I use \(\beta=1\)). The AR(1) version without debt has \(a(\beta)=2.21\), a factor of 10 larger!
Clearly, whether you include debt in a VAR and find a slightly overshooting moving average, or leave debt out of the VAR and find something like an AR(1) makes a major difference. Which is right? Just as obviously, looking at \(R^2\) and t-statistics of the one-step ahead regressions is not going to sort this out.
I now get to the point.
Here are 7 related observations that I think collectively push us to the view that \(a(\beta)\) should be a quite small number. The observations use this very simple model with one period debt and a constant discount rate, but the size and magnitude of the puzzles are so strong that even I don't think time-varying discount rates can overturn them. If so, well, all the more power to the time-varying discount rate! Again, these observations hold equally for active or passive fiscal policy. This is not about FTPL, at least directly.
1) The correlation of deficits and inflation. Reminder, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =a(\beta)\varepsilon_{t}. \] If we have an AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx2\), and with \(\sigma(\varepsilon)\approx5\%\) in my little VAR, the AR(1) produces 10% inflation in response to a 1 standard deviation deficit shock. We should see 10% unanticipated inflation in recessions! We see if anything slightly less inflation in recessions, and little correlation of inflation with deficits overall. \(a(\beta)\) near zero solves that puzzle.
2) Inflation volatility. The AR(1) likewise predicts that unexpected inflation has about 10% volatility. Unexpected inflation has about 1% volatility. This observation on its own suggests \(a(\beta)\) no larger than 0.2.
3) Bond return volatility and cyclical correlation. The one-year treasury bill is (so far) completely safe in nominal terms. Thus the volatility and cyclical correlation of unexpected inflation is also the volatility and cyclical correlation of real treasury bill returns. The AR(1) predicts that one-year bonds have a standard deviation of returns around 10%, and they lose in recessions, when the AR(1) predicts a big inflation. In fact one-year treasury bills have no more than 1% standard deviation, and do better in recessions.
4) Mean bond returns. In the AR(1) model, bonds have a stock-like volatility and move procyclically. They should have a stock-like mean return and risk premium. In fact, bonds have low volatility and have if anything a negative cyclical beta so yield if anything less than the risk free rate. A small (a(\beta)\) generates low bond mean returns as well.
Jiang, Lustig, Van Nieuwerburgh and Xiaolan recently raised this puzzle, using a VAR estimate of the surplus process that generates a high \(a(\beta)\). Looking at the valuation formula \[ \frac{B_{t-1}}{P_{t}}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}, \] since surpluses are procyclical, volatile, and serially correlated like dividends, shouldn't surpluses generate a stock-like mean return? But surpluses are crucially different from dividends because debt is not equity. A low surplus \(s_{t}\) raises our estimate of subsequent surpluses \(s_{t+j}\). If we separate out
\[b_{t}=s_{t}+E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=s_{t}+\beta E_{t}b_{t+1} \] a decline in the "cashflow" \(s_{t}\) raises the "price" term \(b_{t+1}\), so the overall return is risk free. Bad cashflow news lowers stock pries, so both cashflow and price terms move in the same direction. In sum a small \(a(\beta)\lt 1\) resolves the Jiang et. al. puzzle. (Disclosure, I wrote them about this months ago, so this view is not a surprise. They disagree.)
5) Surpluses and debt. Looking at that last equation, with a positively correlated surplus process \(a(\beta)>1\), as in the AR(1), a surplus today leads to larger value of the debt tomorrow. A deficit today leads to lower value of the debt tomorrow. The data scream the opposite pattern. Higher deficits raise the value of debt, higher surpluses pay down that debt. Cumby_Canzoneri_Diba (AER 2001) pointed this out 20 years ago and how it indicates an s-shaped surplus process. An \(a(\beta)\lt 1\) solves their puzzle as well. (They viewed \(a(\beta)\lt 1\) as inconsistent with fiscal theory which is not the case.)
6) Financing deficits. With \(a(\beta)\geq1\), the government finances all of each deficit by inflating away outstanding debt, and more. With \(a(\beta)=0\), the government finances deficits by selling debt. This statement just adds up what's missing from the last one. If a deficit leads to lower value of the subsequent debt, how did the government finance the deficit? It has to be by inflating away outstanding debt. To see this, look again at inflation, which I write \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}s_{t}+\Delta E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=\Delta E_{t}s_{t}+\Delta E_{t}\beta b_{t+1}=1+\left[ a(\beta)-1\right] \varepsilon_{t}. \] If \(\Delta E_{t}s_{t}=\varepsilon_{t}\) is negative -- a deficit -- where does that come from? With \(a(\beta)>1\), the second term is also negative. So the deficit, and more, comes from a big inflation on the left hand side, inflating away outstanding debt. If \(a(\beta)=0\), there is no inflation, and the second term on the right side is positive -- the deficit is financed by selling additional debt. The data scream this pattern as well.
7) And, perhaps most of all, when the government sells debt, it raises revenue by so doing. How is that possible? Only if investors think that higher surpluses will eventually pay off that debt. Investors think the surplus process is s-shaped.
All of these phenomena are tied together. You can't fix one without the others. If you want to fix the mean government bond return by, say, alluding to a liquidity premium for government bonds, you still have a model that predicts tremendously volatile and procyclical bond returns, volatile and countercyclical inflation, deficits financed by inflating away debt, and deficits that lead to lower values of subsequent debt.
So, I think the VAR gives the right sort of estimate. You can quibble with any estimate, but the overall view of the world required for any estimate that produces a large \(a(\beta)\) seems so thoroughly counterfactual it's beyond rescue. The US has persuaded investors, so far, that when it issues debt it will mostly repay that debt and not inflate it all away.
Yes, a moving average that overshoots is a little unusual. But that's what we should expect from debt. Borrow today, pay back tomorrow. Finding the opposite, something like the AR(1), would be truly amazing. And in retrospect, amazing that so many papers (including my own) write this down. Well, clarity only comes in hindsight after a lot of hard work and puzzles.
In more general settings \(a(\beta)\) above zero gives a little bit of inflation from fiscal shocks, but there are also time-varying discount rates and long term debt in the present value formula. I leave all that to the book and papers.
(Jiang et al say they tried it with debt in the VAR and claim it doesn't make much difference. But their response functions with debt in the VAR, at left, show even more overshooting than in my example, so I don't see how they avoid all the predictions of a small \(a(\beta)\), including a low bond premium.)
A lot of literature on fiscal theory and fiscal sustainability, including my own past papers, used AR(1) or similar surplus processes that don't allow \(a(\beta)\) near zero. I think a lot of the puzzles that literature encountered comes out of this auxiliary specification. Nothing in fiscal theory prohibits a surplus process with \(a(\beta)=0\) and certainly not \(0 \lt a(\beta)\lt 1\).
Update
Jiang et al. also claim that it is impossible for any government with a unit root in GDP to issue risk free debt. The hidden assumption is easy to root out. Consider the permanent income model, \[ c_t = rk_t + r \beta \sum \beta^j y_{t+j}\] Consumption is cointegrated with income and the value of debt. Similarly, we would normally write the surplus process \[ s_t = \alpha b_t + \gamma y_t. \] responding to both debt and GDP. If surplus is only cointegrated with GDP, one imposes \( \alpha = 0\), which amounts to assuming that governments do not repay debts. The surplus should be cointegrated with GDP and with the value of debt. Governments with unit roots in GDP can indeed promise to repay their debts.
The filibuster and partisanship
The Wall Street Journal reports that the movement among Senate Democrats to get rid of the filibuster entirely is gaining steam. I think this is a bad idea and will lead to more polarized politics.
Why are our politics so polarized? One answer is that elections are more and more winner take all. The more it is winner take all, the more incentive there is for scorched-earth tactics to win, or to keep from losing.
Imagine a not so distant future in which winning an administration and both houses of Congress by 50.5% means a party can pass any legislation it likes, pack the Supreme Court or better yet impeach the lot and replace them, take control of the Department of Justice and FBI, swiftly jail anyone involved with the previous administration, take control of voting law and regulation, further hand out money to political organizations on its side, and by regulation and high taxes force businesses and wealthy individuals to its side. One person, one vote, one time.
That's extreme, but our political system has headed a lot in this direction already. As the stakes in each election get higher, do not be surprised that the scorched-earth partisanship and polarization of politics gets stronger.
The first function of a democracy is a peaceful transition of power. That requires losers to accept their fate, acknowledge the legitimacy of the outcome, regroup and try again. And they have to be able to do that. We are not a pure democracy. We are set up as a republic, with elaborate protections for electoral minorities. The point is to keep those electoral minorities from rebelling. Union first, "progress" second.
The filibuster is a small and imperfect part of this protection. It evolved by tradition, not design. It has a sordid racial history, being used for decades by southern democrats to block civil rights legislation. To work, both sides had to accept certain rules of the game. You use it only to block core issues of great importance. You do not use it as willy-nilly obstructionism. It has to be costly to those who use it. It, and other protections could be improved for sure. But we need somehow the space that a narrow election loss does not mean utter defeat and devastation.
Like the other protections for electoral minorities, it has already been mostly torn down, as the WSJ reports. But if, say, Republicans can shove guns, immigrant deportation, and abortion prohibition down Democratic throats with a tiny majority, or Democrats can shove unions, wealth taxes, and national health insurance down Republican throats with a tiny majority; if, more importantly, either party can take a tiny majority to entrench their hold on power and disenfranchise the other, we have not seen anything yet in the partisanship and polarization department.
Why are our politics so polarized? One answer is that elections are more and more winner take all. The more it is winner take all, the more incentive there is for scorched-earth tactics to win, or to keep from losing.
Imagine a not so distant future in which winning an administration and both houses of Congress by 50.5% means a party can pass any legislation it likes, pack the Supreme Court or better yet impeach the lot and replace them, take control of the Department of Justice and FBI, swiftly jail anyone involved with the previous administration, take control of voting law and regulation, further hand out money to political organizations on its side, and by regulation and high taxes force businesses and wealthy individuals to its side. One person, one vote, one time.
That's extreme, but our political system has headed a lot in this direction already. As the stakes in each election get higher, do not be surprised that the scorched-earth partisanship and polarization of politics gets stronger.
The first function of a democracy is a peaceful transition of power. That requires losers to accept their fate, acknowledge the legitimacy of the outcome, regroup and try again. And they have to be able to do that. We are not a pure democracy. We are set up as a republic, with elaborate protections for electoral minorities. The point is to keep those electoral minorities from rebelling. Union first, "progress" second.
The filibuster is a small and imperfect part of this protection. It evolved by tradition, not design. It has a sordid racial history, being used for decades by southern democrats to block civil rights legislation. To work, both sides had to accept certain rules of the game. You use it only to block core issues of great importance. You do not use it as willy-nilly obstructionism. It has to be costly to those who use it. It, and other protections could be improved for sure. But we need somehow the space that a narrow election loss does not mean utter defeat and devastation.
Like the other protections for electoral minorities, it has already been mostly torn down, as the WSJ reports. But if, say, Republicans can shove guns, immigrant deportation, and abortion prohibition down Democratic throats with a tiny majority, or Democrats can shove unions, wealth taxes, and national health insurance down Republican throats with a tiny majority; if, more importantly, either party can take a tiny majority to entrench their hold on power and disenfranchise the other, we have not seen anything yet in the partisanship and polarization department.
Sunday, July 5, 2020
Magical monetary theory full review
I approached this task with an open mind. What I had heard of MMT has some overlap with fiscal theory of the price level, on which I work, and I hoped to see some commonality.
I was disappointed.
The review:
Modern monetary theory, known as MMT, erupted suddenly into the public consciousness when it won the attention of high-profile politicians including Bernie Sanders and Alexandria Ocasio-Cortez and their media admirers. Its central proposition states that the U.S. federal government can and should freely print money to finance a massive spending agenda, with no concern about debt and deficits.
What is MMT? Its advocates have told us in essays, blog posts, videos and tweets what MMT says about this and that, but what is its logic and evidence? As a monetary theorist who is also skeptical of conventional wisdom, I looked forward to a definitive exposition from Stephanie Kelton’s “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy.”
Ms. Kelton, a professor of economics at Stony Brook University and senior economic adviser to Bernie Sanders’s presidential campaign, starts with a few correct observations. But when the implications don’t lead to her desired conclusions, her logic, facts and language turn into pretzels.
True, the federal government can spend any amount by simply printing up the needed money (in reality, creating bank reserves). True, our government need never default since it can always print dollars to repay Treasury bonds. But if the government prints up and spends, say, $10 trillion, will that not lead to inflation? Ms. Kelton acknowledges the possibility: “If the government tries to spend too much in an economy that’s already running at full speed, inflation will accelerate.”
So how do we determine if the economy is running at full speed, or full of “slack,” with unemployed people and idle businesses that extra money might put to work without inflation? Ms. Kelton disdains the Federal Reserve’s noninflationary or “natural” unemployment rate measure of slack as a “doctrine that relies on human suffering to fight inflation.” Even the recent 3.5% unemployment is heartlessly too high for her.
“MMT urges us to think of slack more broadly.” OK, but how? She offers only one vaguely concrete suggestion: When evaluating spending bills, “careful analysis of the economy’s . . . slack would guide lawmakers. . . . If the CBO [Congressional Budget Office] and other independent analysts concluded it would risk pushing inflation above some desired inflation rate, then lawmakers could begin to assemble a venue of options to identify the most effective ways to mitigate that risk.” She doesn’t otherwise define slack or even offer a conceptual basis for its measurement. She just supposes that the CBO will somehow figure it out. She doesn't mention that the CBO now calculates a measure, potential GDP, which does not reveal perpetual slack. And she later excoriates the CBO for its deficit hawkishness.
Really her answer is: Don’t worry about it. She simply asserts that “there is always slack in the form of unemployed resources, including labor.”
We’re not talking about a little slack either. Ms. Kelton’s “people’s economy” starts with the full Green New Deal and moves on to a federal job for anyone, free health care, free child care, the immediate cancelation of student debt, free college, “affordable housing for all our people,” national high-speed rail, “expanded Social Security,” “a more robust public retirement system,” “middle-class tax cuts,” and more. How much does this add up to? $20 trillion? $50 trillion? She offers no numbers. How is it vaguely plausible that the U.S. has this much productive capacity lying around going to waste?
In a book about money, the inflation of the 1970s and its defeat are astonishingly absent. History starts with Franklin Roosevelt—a hero for enacting the New Deal but a villain for paying for it with payroll taxes rather than fresh dollars. Ms. Kelton praises John F. Kennedy, too. He “pressured unions and private industry, urging them to keep wage and price increases to a minimum to avoid driving inflation higher. It worked. The economy grew, unemployment fell sharply and inflation remained below 1.5 percent for the first half of the decade.”
The second half of that decade—Lyndon Johnson’s Great Society and Vietnam War spending, inflation’s breakout, Richard Nixon’s [1971] disastrous price controls—is AWOL. Did we not try MMT once and see the inflation? Did not every committee of worthies always see slack in the economy? Did not the 1970s see stagflation, refuting Ms. Kelton’s assertion that inflation comes only when there is no “slack”? Don’t look for answers in “The Deficit Myth.”
Victory over inflation under Ronald Reagan and Margaret Thatcher goes likewise unmentioned. History starts up again when Ms. Kelton excoriates Thatcher for saying that government spending has to be paid for with taxes. She insinuates, outrageously, that Thatcher deliberately lied on this point in order to “discourage the British people from demanding more from their government.”
If spending can be financed by printing money, “why not eliminate taxes altogether?” Ms. Kelton begins consistently. She criticizes Sens. Bernie Sanders and Elizabeth Warren for claiming that they need to raise taxes to pay for spending programs. But then why raise taxes? Taxes exist to decapitate the wealthy, not to fund spending or transfers: “We should tax billionaires to rebalance the distribution of wealth and income and to protect the health of our democracy.”
She offers a second answer, more subtle, and revealingly wrong. She starts well: “Taxes are there to create a demand for government currency.” This is a deep truth, which goes back to Adam Smith. Soaking up extra money with fiscal surpluses [higher taxes or less spending] is, in fact, the ultimate control over inflation. But then arithmetic fails her. To avoid inflation, all the new money must eventually be soaked up in taxes. The new spending, then, is ultimately paid for with those taxes.
What about the debt? Ms. Kelton asserts the government can wipe it out. Again, she starts correctly: The Fed could purchase all of the debt in return for newly created reserves. She continues correctly: The Fed could stop paying interest on reserves. But in conventional thinking, these steps would result in a swift inflation that is equivalent to default. Ms. Kelton asserts instead that these steps “would tend to push prices lower, not higher.” She reasons that not paying interest would reduce bondholders’ income and hence their spending.
The mistake is easy to spot: People value government debt and reserves as an asset, in a portfolio. If the government stops paying interest, people try to dump the debt in favor of assets that pay a return and to buy goods and services, driving up prices.
What about all the countries that have suffered inflation, devaluation and debt crises even though they print their own currencies? To Ms. Kelton, developing nations suffer a “deficit” of “monetary sovereignty” because they “rely on imports to meet vital social needs,” which requires foreign currency. Why not earn that currency by exporting other goods and services? “Export-led growth . . . rarely succeeds.” China? Japan? Taiwan? South Korea? Her goal posts for “success” must lie far down field.
The problem is that “the rest of the world refuses to accept the currencies of developing countries in payment for crucial imports.” Darn right we do. Her solution: more printed money from Uncle Sam—a “global job guarantee.”
She also advises small and poor countries to cut themselves off from international commerce. They should develop “efficient hydroponic and aquaponics food production” and install “solar and wind farms” rather than import cheap food and oil. They should refuse international investment, with the “classical form of capital controls” under Bretton Woods as an ideal. “We share only one planet,” she writes, yet apparently that planet must have hard national borders.
By weight, however, most of the book is not about monetary theory. It’s rather a recitation of every perceived problem in America: the “good jobs deficit,” the “savings deficit,” the “health-care deficit,” the “infrastructure deficit,” the “democracy deficit” and—of course —the “climate deficit.” None of this is original or relevant. The desire to spend is not evidence of its feasibility.
Much of “The Deficit Myth” is a memoir of Ms. Kelton’s conversion to MMT beliefs and of her time in the hallways of power. She criticizes Democrats, including President Obama and his all-star economic team, for their thick skulls or their timidity to state her truth in public. Republicans, such as former House Speaker Paul Ryan, are just motivated by dark desires to keep the people down and enrich big corporations and wealthy fat cats. President Trump’s tax cuts are a “crime.” How insightful.
In a revealing moment, Ms. Kelton admits that “MMT can be used to defend policies that are traditionally more liberal . . . or more conservative (e.g., military spending or corporate tax cuts).” Well, if so, why fill a book on monetary theory with far-left wish lists? Why insult and annoy any reader to the right of Bernie Sanders’s left pinkie?
Writing the book to “defend” an immense left-wing spending agenda destroys her argument. If you could only feel her singular empathy for the downtrodden, if you could, as she does, view the federal budget as a “moral document,” if you could just close your eyes and need it to be true as much as she does, your “Copernican moment” will arrive, and logic and evidence will no longer trouble you.
That effect is compounded by her refusal to abide by the conventional norms of economic and public-policy discourse. She cites no articles in major peer-reviewed journals, monographs with explicit models and evidence, or any of the other trappings of economic discourse. The rest of us read and compare ideas. Ms. Kelton does not grapple with the vast and deep economic thinking since the 1940s on money, inflation, debts, stimulus and slack measurement. Each item on Ms. Kelton’s well-worn spending wish list has raised many obvious objections. She mentions none.
Skeptics have called it “magical monetary theory.” They’re right.
****
Update. To "jabmorris" and "rob." How could you possibly know if I have or have not read the book? As a matter of fact, I read every word of it. You offer a false accusation of impropriety, that you could not possibly know anything about, instead of a shred of fact or logic. This seems about par for the course in MMT land.
Wednesday, July 1, 2020
New "Fiscal theory of the price level" draft.
I posted a new draft of The fiscal theory of the price level, a slowly emerging book manuscript. It's heavily revised through Chapter 6.
Chapter 5 has a much better treatment of sticky price models. The mechanics of writing new-Keynesian + fiscal theory models are really easy. Invitation: there is a great paper-writing recipe in here! Chapter 6 includes empirical work, also ripe for extension. Both chapters summarize recent papers A fiscal theory of monetary policy with partially repaid long term debt and The fiscal roots of inflation.
I've clarified and emphasized a point that's been floating around but not clearly enough: governments who borrow (deficits) do convince markets that they will subsequently repay debts (surpluses) at least in part. The surplus process has an s-shape, not an AR(1) shape. If governments do not do so, then they cannot raise revenue from bond sales, and they cannot finance deficits by selling debt. The evident fact that they do both is some of the strongest evidence for an s-shaped surplus process. Much fiscal theory analysis, apparent rejections, and puzzles come down to ruling out this (with hindsight) simple fact, and also forgetting some lessons of 1980s time-series econometrics.
The book draft is up to solicit comments, which I welcome, best by private email. The links take you to a new website. I discourage browsing around for the moment as it is heavily under construction. I can't access my Booth website anymore, so a new one is coming but slowly.
Update: LAL, yes, thanks. (I can't seem to post comments on my own blog, so I have to answer here.)
Chapter 5 has a much better treatment of sticky price models. The mechanics of writing new-Keynesian + fiscal theory models are really easy. Invitation: there is a great paper-writing recipe in here! Chapter 6 includes empirical work, also ripe for extension. Both chapters summarize recent papers A fiscal theory of monetary policy with partially repaid long term debt and The fiscal roots of inflation.
I've clarified and emphasized a point that's been floating around but not clearly enough: governments who borrow (deficits) do convince markets that they will subsequently repay debts (surpluses) at least in part. The surplus process has an s-shape, not an AR(1) shape. If governments do not do so, then they cannot raise revenue from bond sales, and they cannot finance deficits by selling debt. The evident fact that they do both is some of the strongest evidence for an s-shaped surplus process. Much fiscal theory analysis, apparent rejections, and puzzles come down to ruling out this (with hindsight) simple fact, and also forgetting some lessons of 1980s time-series econometrics.
The book draft is up to solicit comments, which I welcome, best by private email. The links take you to a new website. I discourage browsing around for the moment as it is heavily under construction. I can't access my Booth website anymore, so a new one is coming but slowly.
Update: LAL, yes, thanks. (I can't seem to post comments on my own blog, so I have to answer here.)
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