## Wednesday, September 29, 2021

### FiveThirtyEight p-hacking

A correspondent sends me the lovely FiveThirtyEight site,  on how to p-hack your way to scientific glory.

Should I be proud or ashamed that it only took me 30 seconds to get a 1% p value? I fault it though for much too modest an effort, compared to many papers I have read. Include judges, mayors, state legislators. Measure  performance with levels, growth rates, unemployment, inequality, demographic breakdowns, house prices, health measures, investment, exports and more. Control for far more than recessions -- exchange rates, or all the other outcome measures. Let each variable take its turn on right and left hand sides. Instruments...

Have fun

## Monday, September 27, 2021

### Inequality/opportunity survey

I was interested by a simple survey run by the Archbridge Institute on attitudes regarding inequality vs. opportunity, and  equality vs. equity issues.

Reducing inequality, "there should be no Billionaires" is only the top issue for a quarter of people. Equality of opportunity, and help for those on the bottom garner about 60%. The demographic consistency is interesting. Yes, the young and the credentialed skew more left -- our education system is passing on its values. But not nearly as much as you'd think. Minorities are not much different than the rest. Redistributionist opinions are a bit of a luxury belief, but again not as much as you'd think.

The meaning of "equality," the founding concept of our nation (Jefferson) is even more stark. Equity -- end up in the same place -- scores dismally. Even starting in the same place scores dismally. Extra help for the disadvantaged, something I would choose as #2 goal, scores dismally. "Equality before the law and people have a fair chance to pursue opportunity regardless of where they started" is the overwhelming winner. Again, the demographic consistency is surprising relative to the Standard Narrative. And heart-warming.

What is the best way to get ahead economically? Employment, college degree, and family and social support completely drown out even the fable of "well-designed" government assistance programs.

The report goes on like this, with a nice executive summary.

Even around Hoover, I hear passed along a conventional wisdom: Income inequality is a Huge Problem. It will lead to social and political unrest. "We" must do something about it or our country will fall apart.

Not, apparently, according to vast quantities of survey respondents. Opportunity remains a problem in the US, and if I were to design something to appeal to these survey respondents, that's the word I would be using.

### Treasury holdings

Another great graph from Torsten Slok at Apollo

Foreigners hold less, Fed holds more. However, the Fed doesn't really hold Treasurys. The Fed turns Treasurys into interest-paying reserves, which banks hold. And banks turn reserves into bank deposits and other assets which we hold. So it is really a big shift from foreign to domestic holding. At, as a commenter on a previous post reminds us, current interest rates, exchange rates, and rates of other opportunities, which may change. So much for exorbitant privilege?

## Thursday, September 23, 2021

### Hope for California -- housing edition

California has at last passed the first laws overturning some residential zoning restrictions. WSJ coverage here.

From the California YIMBY press release,

“The end of exclusionary, single-unit zoning in California is a historic moment -- we’ve taken a huge step toward making California a more affordable, equitable, and inclusive state.”

...SB 9 ... makes it legal to build duplexes on lots zoned for one house statewide; the law also allows property owners to split their lots into two separate parcels. ...SB 10 ... makes it easier for cities to approve zoning changes for small apartments in neighborhoods currently zoned for single houses.

OK, from WSJ, not yet Libertarian Nirvana,

The law has provisions to prevent the displacement of renters and protect homes in historic districts and fire-prone areas.

And why just two? If you want density how about apartments? But sometimes silence is golden:

Affordable housing advocates also criticized the legislation for not containing provisions that mandate any new homes that are built be affordable.

OK, this is only a small step. California has a huge set of laws and regulations in the way of sensible housing and driving up prices. (Lee Ohanian has a great summary here). But it is noteworthy because California is a one-party progressive state. One expects more and more limitations, with the "affordability crisis" addressed by demands for "affordable" housing, i.e. tiny amounts of absurdly overpriced government-provided houses, or mandates imposed on the few developments allowed to proceed, and then handed out to people on long waiting lists, not young people who want to move to good jobs.   The idea that the way to bring down housing costs is simply to... allow people to build houses, and sell them, is remarkable here. Emphasis on allow, a new concept to the progressive narrative here in California. Not "we," the government,  or "I" the governor "will build housing," but we will allow people including people organized into businesses known as "corporations" and "developers" to build housing. That is truly a major conceptual leap.

This event offers a ray of hope for reform of this dysfunctional state. (I'm in a look for the ray of hope mood this morning.) In a one-party state, issues are discussed within the Party, and coalitions form. It is possible for common sense to prevail. Issues do not have to be infected with poisonous partisanship. Within the party, you can talk about housing rules without breathing the word "Trump."

## Wednesday, September 22, 2021

### Interest rate survey

Torsten Slok passed on a lovely graph, created from the Philadelphia Fed survey of professional forecasters:

It's not just the Fed, whose own forecasts and dot plots have the same characteristics.

Some potential lessons

1) Just you wait. There is the story of the hypochondriac, who when he died at 92 had inscribed on his tombstone "See, I told you I was sick." More serious stories have been told of the 1980s high interest rates, worried for a decade about inflation that could have come but never did. Or the famous "Peso problem," persistently low forward rates that eventually proved to be right.

2) A lot of fun is made in survey research about the "irrational" expectations revealed by surveys. Whether "professionals" are involved is often a used to select between "rational" and "noise" investors in asset pricing studies. Hello, the professionals are just as behavioral as the rest of us. As are the Fed economists whose forecasts look the same. The argument from irrational-looking surveys to let the "experts" run and nudge things never did hold water.

3) Just what do survey forecasts mean? How many of these Wall Street economists, or their trading desks are heavily short 10 year bonds? How many of them lost money on that trade for 20 years running? It's a good bet the same economists work for firms that, to the contrary, have been riding this... well, call it a trend, call it a bubble, call it a golden two decades for long-term bonds. What is the risk premium story for believing long term bonds are about to take a bath, but buying a lot of them anyway?

4) Just what do survey forecasts mean? We ask people "what do you expect," and scratch our heads that they do not reply with numbers that make sense as true-measure conditional means. The event of a sharp raise in rates might come with substantially higher marginal utility, i.e. a very bad event. Reporting risk-neutral measure, probability times marginal utility might make sense for many reasons. Reporting a 40% quantile, shaded to bad news, makes a lot of sense for many reasons. Clients who make money don't complain. Clients who lose money do.

5) Just what do survey forecasts mean?  For most surveys, the interesting thing is not the average but the astounding variation around that average. In theory, asset trading should lead to common expectations. In fact it does not. I would love to see the variation around this mean forecast.

Confessions. I've been ... well, not forecasting, but doom and glooming about a sharp interest rate rise for just as long. And, I have to report, the graph has not yet changed my mind. To some extent, one faces the problem of the value investor, who every time the stock goes down has to say, "now it's an even better deal!" I guess I have company.  See, I told you I was sick?

## Tuesday, September 21, 2021

### Boosters

I was going to write about the FDA's idiotic booster recommendations, and then I found the perfect answer on Marginal Revolution, which I will quote in its entirety for the few readers who don't read MR every day

My first reaction upon hearing that boosters were rejected was to ask the same thing: would these same “experts” say that, because the vaccines are still effective without boosters, vaccinated persons don’t need to wear masks and can resume normal life? Of course not. They use the criterion “prevents hospitalization” for evaluating boosters (2a) but switch back to “prevents infection” when the question is masks and other restrictions. What about those that are willing to accept the tiny risk of side effects to prevent infection so that they can get back to fully normal life? The Science (TM) tells us that one can’t transmit the virus if one is never infected to begin with.

Also, one of the No votes on boosters said that he feared approval would effectively turn boosters into a mandate and change the definition of fully vaccinated. So, it appears that the overzealousness to demand vaccine mandates has actually contributed to fewer people getting access to (booster) vaccines, thus paradoxically contributing to spread. A vivid illustration of the problem with, “That which is not mandatory should be prohibited.”

The biggest problem with public health professionals continues to be (1) elevation of their own normative value judgements — namely that NPIs are no big deal no matter how long they last — which have nothing to do with scientific expertise, (2) leading them to “shade” their interpretation of data to promote their preferred behavioral outcome rather than answering positive (non-normative) questions with positive scientific statements, (3) thus undermining the credibility of public health institutions (FDA, CDC) and leading to things like vaccine hesitancy.

What happened to the idea that the FDA's job is to proclaim only whether a vaccine is safe and effective? Then if you want to take it, that's up to you? (And we could argue about even that, i.e. whether "safe" is enough, whether FDA should have authority to make something unproven illegal, etc.)

I want a booster. Pfizer wants to sell me a booster. The data say it's safe and effective. Way more effective than masks. Period.

They hypocrisy on masks vs. boosters is amazing.

## Monday, September 20, 2021

### Debt ceiling modest proposal -- perpetuities

The debt ceiling dance has started again. Read Treasury Secretary Janet Yellen in the Wall Street Journal

A modest proposal: Issue perpetuities.

The Treasury computes the total amount of debt by its face or principal value, not its market value*. If the Treasury issues a bond that pays $1 coupons each year for 10 years and then pays$100 at maturity, the treasury counts this as $100 additional debt. The Treasury ignores the coupon payments, and how much the bond actually sells for, i.e. how much the Treasury actually borrows, when the bond is auctioned. Now you see my answer: Perpetuities have coupons, but no principal. A perpetuity pays$1 forever. In reality, it pays $1 until the Treasury buys it back. The Treasury could also issue coupon-only debt, just the$2 coupons for 10 years. Or it could issue debt with huge coupons and small principal payments, $2 a year for 10 years and then an additional dollar in year 10, and say debt increases by$1. But perpetuities are great for all sorts of other reasons, so why not use this opportunity?

Perpetuities can have fixed coupon payments or variable coupons. The Treasury could sell a perpetual bond whose interest rate equals SOFR (the new Libor), whatever the Fed is paying on excess reserves, etc. If the Treasury wants to borrow short to harvest temporarily low short-term interest rates, then floating-rate perpetuities do the trick. Of course I would rather also take this moment to start borrowing long, locking in absurdly low interest costs.

The Treasury could lower debt outstanding now, by rolling debt into perpetuities, issuing new perpetuities, and buying debt on the open market, issuing perpetuities in return. Goodbye debt limit.

Too clever? Maybe. OK, undoubtedly yes. But if economics lunchroom talk can consider trillion-dollar coins, we can talk about perpetuities. Or maybe a serious attempt to do this would bring US treasury accounting into the 1960s, with cutting-edge concepts like market values not face values,  duration not average principal maturity, and interest cost concept that goes beyond coupons, so that the debt limit and treasury accounting is more economically meaningful.

Disclaimers:

*I spent some time on google and the Treasury website trying to figure out just how debt subject to limit is calculated, and this is my best guess. If I'm wrong, please write and I'll issue a classic "never mind."

Yes, I am guilty here of having the same answer in response to different questions. See here on why I like perpetuities for other reasons.

## Friday, September 17, 2021

### Inflation, debt, politics, and insurance at Project Syndicate

An essay at Project Syndicate

Inflation in the Shadow of Debt

Today’s inflation is transitory, our central bankers assure us. It will go away on its own. But what if it does not? Central banks will have “the tools” to deal with inflation, they tell us. But just what are those tools? Do central banks have the will to use them, and will governments allow them to do so?

Should inflation continue to surge, central banks’ main tool is to raise interest rates sharply, and keep them high for several years, even if that causes a painful recession, as it did in the early 1980s. How much pain, and how deep of a dip, would it take? The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%. If inflation accelerates further before central banks act, reining it in could require the 15% interest rates of the early 1980s.

Would central banks do that? If they did, would high interest rates control inflation in today’s economy? There are many reasons for worry.

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or$1.7 trillion.

Where will those trillions of dollars come from? Congress could drastically cut spending or find ways to increase tax revenues. Alternatively, the US Treasury could try to borrow additional trillions. But for that option to work, bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest. Even if investors seem confident at the moment, we cannot assume that they will remain so indefinitely, especially if additional borrowing serves only to pay higher interest on existing debt. Even for the United States, there is a point at which bond investors see the end coming, and demand even higher interest rates as a risk premium, thereby raising debt costs even more, in a spiral that leads to a debt crisis or to a sharp and uncontrollable surge of inflation. If the US government could borrow arbitrary amounts and never worry about repayment, it could send its citizens checks forever and nobody would have to work or pay taxes again. Alas, we do not live in that fanciful world.

In sum, for higher interest rates to reduce inflation, higher interest rates must be accompanied by credible and persistent fiscal tightening, now or later. If the fiscal tightening does not come, the monetary policy will eventually fail to contain inflation.

This is a perfectly standard proposition, though it is often overlooked when discussing the US and Europe. It is embodied in the models used by the Fed and other central banks. [Previous post here on just what that means.] It was standard IMF advice for decades.

Successful inflation and currency stabilization almost always includes monetary and fiscal reform, and usually microeconomic reform. The role of fiscal and microeconomic reform is to generate sustainably higher tax revenues by boosting economic growth and broadening the tax base, rather than with sharply higher and growth-reducing marginal tax rates. Many attempts at monetary stabilization have fallen apart because the fiscal or microeconomic reforms failed. Latin-American economic history is full of such episodes.

Even the US experience in the 1980s conforms to this pattern. The high interest rates of the early 1980s raised interest costs on the US national debt, contributing to most of the then-large annual “Reagan deficits.” Even after inflation declined, interest rates remained high, arguably because markets were worried that inflation would come surging back.

So, why did the US inflation-stabilization effort succeed in the1980s, after failing twice before in the 1970s, and countless times in other countries? In addition to the Fed remaining steadfast and the Reagan administration supporting it through two bruising recessions, the US undertook a series of important tax and microeconomic reforms, most notably the 1982 and 1986 tax reforms, which sharply lowered marginal rates, and market-oriented regulatory reforms starting with the Carter-era deregulation of trucking, air transport, and finance.

The US experienced a two-decade economic boom. A larger GDP boosted tax revenues, enabling debt repayment despite high real-interest rates. By the late 1990s, strange as it sounds now, economists were actually worrying about how financial markets would work once all US Treasury debt had been paid off. The boom was arguably a result of these monetary, fiscal, and microeconomic reforms, though we do not need to argue the cause and effect of this history. Even if the economic boom that produced fiscal surpluses was coincidental with tax and regulatory reform, the fact remains that the US government successfully paid off its debt, including debt incurred from the high interest costs of the early 1980s. Had it not done so, inflation would have returned.

The Borrower Ducks

But would that kind of successful stabilization happen now, with the US national debt four times larger and still rising, and with interest costs for a given level of interest rates four times larger than the contentious Reagan deficits? Would Congress really abandon its ambitious spending plans, or raise tax revenues by trillions, all to pay a windfall of interest payments to largely wealthy and foreign bondholders?

Arguably, it would not. If interest costs on the debt were to spiral upward, Congress would likely demand a reversal of the high interest-rate policy. The last time the US debt-to-GDP ratio was 100%, at the end of World War II, the Fed was explicitly instructed to hold down interest costs on US debt, until inflation erupted in the 1950s.

The unraveling can be slow or fast. It takes time for higher interest rates to raise interest costs, as debt is rolled over. The government can borrow as long as people believe that the fiscal reckoning will come in the future. But when people lose that faith, things can unravel quickly and unpredictably.

Will and Politics

Fiscal policy constraints are only the beginning of the Fed’s difficulties. Will the Fed act promptly, before inflation gets out of control? Or will it continue to treat every increase of inflation as “transitory,” to be blamed on whichever price is going up most that month, as it did in the early 1970s?

It is never easy for the Fed to cause a recession, and to stick with its policy through the pain. Nor is it easy for an administration to support the central bank through that kind of long fight. But tolerating a lasting rise in unemployment – concentrated as usual among the disadvantaged – seems especially difficult in today’s political climate, with the Fed loudly pursuing solutions to inequality and inequity in its interpretation of its mandate to pursue “maximum employment.”

Moreover, the ensuing recession would likely be more severe. Inflation can be stabilized with little recession if people really believe the policy will be seen through. But if they think it is a fleeting attempt that may be reversed, the associated downturn will be worse.

One might think this debate can be postponed until we see if inflation really is transitory or not. But the issue matters now. Fighting inflation is much easier if inflation expectations do not rise. Our central banks insist that inflation expectations are “anchored.” But by what mechanism? Well, by the faith that those same central banks would, if necessary, reapply the harsh Volcker medicine of the 1980s to contain inflation. How long will that faith last? When does the anchor become a sail?

A military or foreign-policy analogy is helpful. Fighting inflation is like deterring an enemy. If you just say you have “the tools,” that’s not very scary. If you tell the enemy what the tools are, show that they all are in shiny working order, and demonstrate that you have the will to use them no matter the pain inflicted on yourself, deterrence is much more likely.

Yet the Fed has been remarkably silent on just what the “tools” are, and just how ready it is to deploy those tools, no matter how painful doing so may be. There has been no parading of materiel. The Fed continues to follow the opposite strategy: a determined effort to stimulate the economy and to raise inflation and inflation expectations, by promising no-matter-what stimulus. The Fed is still trying to deter deflation, and says it will let inflation run above target for a while in an attempt to reduce unemployment, as it did in the 1970s. It has also precommitted not to raise interest rates for a fixed period of time, rather than for as long as required economic conditions remain, which has the same counterproductive result as announcing military withdrawals on specific dates. Like much of the US government, the Fed is consumed with race, inequality, and climate change, and thus is distracted from deterring its traditional enemies.

An amazing opportunity to avoid this conundrum beckons, but it won’t beckon forever. The US government is like a homeowner who steps outside, smells smoke, and is greeted by a salesman offering fire insurance. So far, the government has declined the offer because it doesn’t want to pay the premium. There is still time to reconsider that choice.

Higher interest rates raise interest costs only because the US has financed its debts largely by rolling over short-term debt, rather than by issuing long-term bonds. The Fed has compounded this problem by buying up large quantities of long-term debt and issuing overnight debt – reserves – in return.

The US government is like any homeowner in this regard. It can choose the adjustable-rate mortgage, which offers a low initial rate, but will lead to sharply higher payments if interest rates rise. Or it can choose the 30-year (or longer) fixed-rate mortgage, which requires a larger initial rate but offers 30 years of protection against interest-rate increases.

Right now, the one-year Treasury rate is 0.07%, the ten-year rate is 1.3%, and the 30-year rate is 1.9%. Each one-year bond saves the US government about two percentage points of interest cost as long as rates stay where they are. But 2% is still negative in real terms. Two percentage points is the insurance premium for eliminating the chance of a debt crisis for 30 years, and for making sure the Fed can fight inflation if it needs to do so. I am not alone in thinking that this seems like inexpensive insurance. Even former US Secretary of the Treasury Lawrence H. Summers has changed his previous view to argue that the US should move swiftly to long-term debt.

But it’s a limited-time opportunity. Countries that start to encounter debt problems generally face higher long-term interest rates, which forces them to borrow short-term and expose themselves to the attendant dangers. When the house down the street is on fire, the insurance salesman disappears, or charges an exorbitant rate.

Bottom line

Will the current inflation surge turn out to be transitory, or will it continue? The answer depends on our central banks and our governments. If people believe that fiscal and monetary authorities are ready to do what it takes to contain breakout inflation, inflation will remain subdued.

Doing what it takes means joint monetary and fiscal stabilization, with growth-oriented microeconomic reforms. It means sticking to that policy through the inevitable political and economic pain. And it means postponing or abandoning grand plans that depend on the exact opposite policies.

If people and markets lose faith that governments will respond to inflation with such policies in the future, inflation will erupt now. And in the shadow of debt and slow economic growth, central banks cannot control inflation on their own.

*********

PS, I don't know if the ads that come up on project syndicate are common or are tailored to me. In either case, if you know me at all, you will find the ad choice rather humorous. PS asked me to write because they felt the need for some intellectual diversity, and I guess it shows!

## Friday, September 10, 2021

### Inflation in the shadow of debt

(Note: This post uses mathjax equations. If you see garbled latex code, come to the original source.)

The effect of monetary policy on inflation depends crucially on fiscal policy.

In standard new-Keynesian models, of the type used throughout the Fed, ECB, and similar institutions, for the central bank to reduce inflation by raising interest rates, there must be a contemporaneous fiscal tightening. If fiscal policy does not tighten, the Fed will not lower inflation by raising interest rates.

The warning for today is obvious: Fiscal policy is on a tear, and not about to tighten any time soon no matter what central banks do. An interest rate rise might not, then, provoke the expected decline in inflation.

Here is a very stripped down model to show the point. \begin{align*} x_t & = E_t x_{t+1} - \sigma(i_t - E_t \pi_{t+1}) \\ \pi_t & = \beta E_t \pi_{t+1} + \kappa x_t \\ i_t &= \phi \pi_t + u_t \\ \Delta E_{t+1}\pi_{t+1} & = - \sum_{j=0}^\infty \rho^j \Delta E_{t+1} \tilde{s}_{t+1+j} + \sum_{j=1}^\infty \rho^j \Delta E_{t+1}(i_{t+j}-\pi_{t+1+j}) \end{align*} The first two equations are the IS and Phillips curves of a standard new-Keynesian model. The third equation is the monetary policy rule.

The fourth equation stems from the condition that the value of debt equals the present value of surpluses. This condition is also a part of the standard new-Keynesian model. We're not doing fiscal theory here. Fiscal policy is assumed to be "passive:" Surpluses adjust to whatever inflation results from monetary policy. For example, if monetary policy induces a big deflation, that raises the real value of nominal debt, so real primary surpluses must raise to pay the now larger value of the debt. Since it just determines surpluses given everything else, this equation is often omitted, or relegated to a footnote, but it is there. Today, we just look at the surpluses. Without them, the Fed's monetary policy cannot produce the inflation path it desires.

Notation: $$\Delta E_{t+1} \equiv E_{t+1}-E_t$$, $$\rho$$ is a constant of approximation slightly less than or equal to one, $$\tilde{s}$$ is the real primary surplus relative to debt. For example, $$\tilde{s}=0.01$$ means the surplus is 1% of the value of debt, or 1% of GDP at current 100% debt to GDP. The last term captures a discount rate effect. If real interest rates are higher, that lowers the present value of surpluses. Equivalently, higher real interest rates raise the interest costs in the deficit, requiring still higher primary surpluses to pay off debt. (Reference: Equation (4.23) of Fiscal Theory of the Price Level.) $$x$$ is the output gap, $$\pi$$ is inflation, $$s$$ is the real primary surplus, $$i$$ is the interest rate, and the Greek letters are parameters.

Now, suppose the Fed raises interest rates $$\{i_t\}$$ following a standard AR(1). with coefficient $$\eta = 0.6$$. However, there are multiple $$\{u_t\}$$ which produce the same path for $$\{i_t\}$$, each of which produces a different inflation path $$\{\pi_t\}$$. Each of them also produces a different fiscal response $$\{s_t\}$$. So, let's look for given (AR(1)) interest rate $$\{i_t\}$$ path at the different possible inflation $$\{\pi_t\}$$ paths, their associated monetary policy disturbance $$\{u_t\}$$ and their associated fiscal underpinnings.

The top left panel shows a standard result. The interest rate in blue rises, and then returns following an AR(1). Here, the 1% interest rate rise causes a 1% inflation decline, shown in red. I use $$\eta=0.6, \sigma = 1, \kappa = 0.25, \beta = 0.95, \phi = 1.2$$ The monetary policy disturbance $$u_t$$, dashed magenta.  is even larger than the actual inflation rise, but $$i_t = \phi \pi_t + u_t$$ and  the disinflation in $$\pi_t$$ bring the interest rate to a lower value.

Now, let's calculate the implied "passive" surplus response. I use $$\rho=1$$. With a 1% disinflation, the present value of surpluses must rise by 1%. However, the real interest rate rises substantially and persistently. From a present value point of view, that higher discount rate devalues government debt, an inflationary force.  From an ex-post point of view the higher real rates lead to years of higher debt service costs. Viewed either way, the constant-discounted sum of surpluses must rise by even more than one percent. In this case, the sum of surpluses must rise by 3.55, meaning 3.55 percent of debt or 3.55 percent of GDP at 100% debt to GDP ratio, or about $700 billion dollars. What if Congress looks at that and just laughs? Well, the Fed must do something else. The top right panel has a different disturbance process $$\{u_t\}$$. This disturbance produces exactly the same path of interest rates, shown in blue. But it produces half as much initial deflation, -0.5%. The disinflation also turns to slight inflation after 3 years. With less disinflation, there is less need to produce a larger value of government debt, so the sum of surpluses must only rise by 2.23%. The bottom left shows a case that inflation does not decline at all, though again the path of interest rates is exactly the same. This occurs with a different disturbance $$\{u_t\}$$ as shown. Finally, in the bottom right, it is possible that this interest rate rise produces 0.5% inflation. In this case, fiscal policy produces a slight deficit. The case of no change in surplus or deficit occurs between 0% and 0.5% inflation. To reiterate the point, the observable path of interest rates is exactly the same in all four cases. In a new-Keynesian model, the difference is the dynamic path of the monetary policy disturbance. Different underlying disturbances then produce the different inflation outcomes, and the different requirements for the "passive" fiscal policy authorities. Of course (I can't help myself here) to a fiscal theorist the $$\{u_t\}$$ business is meaningless. Congress' choice to match the Fed's tightening with its own tightening produces the deflationary path, and if Congress does not do so, we get an inflationary path. Looked at either way, in a totally standard new-Keynesian model, the effects of an interest rate rise depend crucially on fiscal policy. If fiscal policy does not agree to tighten along with an interest rate rise, the interest rate rise will not produce lower inflation. Hat tip: This point emerged out of discussions with Eric Leeper on his 2021 Jackson Hole paper on fiscal-monetary interactions. The next post, an essay at Project Syndicate, provides larger context. ********** Update: Nicolas Caramp and Dejanir Silva have a very nice paper "Fiscal Policy and the Monetary Transmission Mechanism" that makes this point in a very well worked out model, including quantitative calibration and HANK models. ********** Calculations. To produce the plots I write the monetary policy rule in a different form $i_t = i^\ast_t + \phi ( \pi_t - \pi^\ast_t)$ $i^\ast_t = \eta i^\ast_{t-1} + \varepsilon_t$ Then I can specify directly the interest rate AR(1) in $$i^\ast_t$$, and the initial inflation in $$\pi^\ast_t$$. These forms are equivalent. Indeed, I construct $$u_t = i^\ast_t - \phi \pi^\ast_t$$ in order to plot it. I use the analytical solutions for inflation given an interest rate path derived 26.4 of Fiscal Theory, $\pi_{t+1}=\frac{\sigma\kappa}{\lambda_{1}-\lambda_{2}}\left[ i_{t}+\sum _{j=1}^{\infty}\lambda_{1}^{-j}i_{t-j}+\sum_{j=1}^{\infty}\lambda_{2}% ^{j}E_{t+1}i_{t+j}\right] +\sum_{j=0}^{\infty}\lambda_{1}^{-j}\delta_{t+1-j}.$ $\lambda_{1,\ 2}=\frac{\left( 1+\beta+\sigma\kappa\right) \pm\sqrt{\left( 1+\beta+\sigma\kappa\right) ^{2}-4\beta}}{2},$ Matlab code: T = 50; sig = 1; kap = 0.25; eta = 0.6; bet = 0.95; phi = 1.2; pi1 = [-1 -0.5 0 0.5]; lam1 = ((1+bet+sig*kap)+ ((1+bet+sig*kap)^2-4*bet)^0.5)/2; lam2 = ((1+bet+sig*kap)- ((1+bet+sig*kap)^2-4*bet)^0.5)/2; lam1i = lam1^(-1); delt = pi1 - sig*kap/(lam1-lam2)*lam2/(1-lam2*eta); tim = (0:1:T-1)'; pit = zeros(T,1); pit(2) = sig*kap/(lam1-lam2)*lam2/(1-lam2*eta) ; % t=1 pit(3) = sig*kap/(lam1-lam2)*(1/(1-lam2*eta)) ; for indx = 4:T; pit(indx) = sig*kap/(lam1-lam2)*... (eta^(indx-3)/(1-lam2*eta) + lam1i*(eta^(indx-3)-lam1i^(indx-3))/(eta-lam1i) ); end; pim = [pit*(1+0*pi1) + [0*delt;(lam1i.^((0:T-2)')).*delt]]; it = [0; eta.^(0:1:T-2)']; um = it*(1+0*pi1) - phi*pim; rterm = sum(it(2:end-1,:)-pim(3:end,:)); sterm = rterm-pim(2,:); disp('r'); disp(rterm); disp('s'); disp(sterm); if 0; % all together figure; C = colororder; hold on plot(tim,pim,'-r','linewidth',2); plot(tim,um,'--m','linewidth',2); plot(tim,it,'-b','linewidth',2); plot(tim,0*tim,'-k') axis([ 0 6 -inf inf]) end; figure; % 4 panel plot for indx = 1:4; subplot(2,2,indx); hold on; plot(tim,pim(:,indx),'-r','linewidth',2); if indx == 1; text(1.8,-0.7,'\pi','color','r','fontsize',18) text(1,0.7,'i','color','b','fontsize',18); text(2.4,1,'u','color','m','fontsize',18) end plot(tim,um(:,indx),'--m','linewidth',2); plot(tim,it,'-b','linewidth',2); plot(tim,0*tim,'-k') title(['\Sigma s = ' num2str(sterm(indx),'%4.2f')],'fontsize',16) axis([ 0 6 -1 1.5]) end if eta == 0.6 print -dpng nk_fiscal_1.png end ### Sowell on grand movements A correspondent sends me this gem from Tom Sowell: This was written in 1995. So no, he was not talking about any of the great causes that inundate us today. He was writing about causes in the 20th century going back to eugenics. But it seems both prescient and timeless. Source The Vision of the Anointed, link takes you to Google books where you can read a lot of it. ## Tuesday, September 7, 2021 ### Climate economics An essay on climate economics at National Review *** Climate policy is ultimately an economic question. How much does climate change hurt? How much do various policy ideas actually help, and what do they cost? You don’t have to argue with one line of the IPCC scientific reports to disagree with climate policy that doesn’t make economic sense. Climate policy is usually framed in terms of economic costs and benefits. We should spend some money now, or accept reduced incomes by holding back on carbon emissions, in order to mitigate climate change and provide a better future economy. But the best guesses of the economic impact of climate change are surprisingly small. The U.N.’s IPCC finds that a (large) temperature rise of 3.66°C by 2100 means a loss of 2.6 percent of global GDP. Even extreme assumptions about climate and lack of mitigation or adaptation strain to find a cost greater than 5 percent of GDP by the year 2100. Now, 5 percent of GDP is a lot of money —$1 trillion of our $20 trillion GDP today. But 5 percent of GDP in 80 years is couch change in the annals of economics. Even our sclerotic post-2000 real GDP grows at a 2 percent annual rate. At that rate, in 2100, the U.S. will have real GDP 400 percent greater than now, as even the IPCC readily admits. At 3 percent compound growth, the U.S. will produce, and people will earn, 1,000 percent more GDP than now. Yes, that can happen. From 1940 to 2000, U.S. GDP grew from$1,331 billion to \$13,138 billion in 2012 dollars, a factor of ten in just 60 years, and a 3.8 percent compound annual growth rate.

Five percent of GDP is only two to three years of lost growth. Climate change means that in 2100, absent climate policy or much adaptation, we will live at what 2097 levels would be if climate change were to magically disappear. We will be only 380 percent better off. Or maybe only 950 percent better off.

Northern Europe has per capita GDP about 40 percent lower than that of the U.S., eight times or more the potential damage of climate change. Europe is a nice place to live. Many Europeans argue that their more extensive welfare states and greater economic regulation are worth the cost. But it is a cost, which makes climate change look rather less apocalyptic.

## Thursday, September 2, 2021

### ESG catch 22

The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment. It's a form of boycott. The cost of capital is the expected return. If it works, it raises expected returns of disfavored industries, and lowers the expected return of favored ones.

Yet ESG advocates claim that you do not have to trade return for virtue, that you can even make alpha by ESG investing!

If that is the case, it means ESG investing does not work! Take your pick.

Why do ESG advocates care? It seems perfectly normal to say, "Look, this little boycott is going to cost you something but it's worth it to save the planet and other social goals." The problem is, most funds are handled by intermediaries who are not allowed to lose a little money on your behalf in return for their idea of virtue, for the simple reason that it may not be your idea of virtue. A mutual fund marketed this way cannot sell to a pension fund, even if the mutual fund and pension fund managers all agree completely on what environment, social, and governance criteria are valid, because neither knows that the recipients of pension fund money have the same preferences. Our laws and regulations occasionally do make some sense!

But if you don't lose money on ESG investing, ESG investing doesn't work. Take your pick.

(HT, thoughts resulting from Jonathan Berk and Jules van Binsbergen's paper on ESG returns.)