## Thursday, December 23, 2021

### The Ghost of Christmas Inflation

This is part of an ongoing series of essays on inflation.  This one is at Project Syndicate. The next post is somewhat longer and more academic with the same themes.

The Ghost of Christmas Inflation

Inflation continues to surge. From its inflection point in February 2021 to last month, the US consumer price index has grown 6% – an 8% annualized rate.

The underlying cause is no mystery. Starting in March 2020, the US government created about $3 trillion of new bank reserves (an equivalent to cash) and sent checks to people and businesses. The Treasury then borrowed another$2 trillion or so and sent even more checks. The total stimulus comes to about 25% of GDP, and to around 30% of the original federal debt. While much of the money went to help people and businesses severely hurt by the pandemic, much of it was also sent regardless of need, intended as stimulus (or “accommodation”) to stoke demand. The goal was to induce people to spend, and that is what they are now doing.

Milton Friedman once said that if you want inflation, you can just drop money from helicopters. That is basically what the US government has done. But this US inflation is ultimately fiscal, not monetary. People do not have an excess of money relative to bonds; rather, people have extra savings and extra apparent wealth to spend. Had the government borrowed the entire $5 trillion to write the same checks, we likely would have the same inflation. ## Thursday, December 16, 2021 ### Fiscal theory update Whew. The penultimate draft of The Fiscal Theory of the Price Level is now done, and in the hands of the copy-editors at Princeton. There is still time to send me typos, thinkos, wrong equations, excessive repetition and more! ### Do we live in China? Google/Youtube's "misinformation" policy. You may not "contradict... local health authorities' (LHA) or the World Health Organization." But read the note, they might change their mind, so watch truth/misinformation change in real time. Really? Scientific discussion never contradicts the edicts of "authorities?" Political discussion never does so? HT Martin Bazant's six foot rule lecture ## Sunday, December 12, 2021 ### The ECB's dilemma I have been emphasizing the Fed's dilemma: If it raises interest rates, that raises the U.S. debt-service costs. 100% debt to GDP means that 5% interest rates translate to 5% of GDP extra deficit,$1 trillion for every year of high interest rates. If the government does not tighten by that amount, either immediately or credibly in the future, then the higher interest rates must ultimately raise, rather than lower, inflation.

Jesper Rangvid points out that the problem is worse for the ECB. Recall there was a euro crisis in which Italy appeared that it might not be able to roll over its debt and default. Mario Draghi pledged to do "whatever it takes" including buying Italian debt to stop it and did so. But Italian debt is now 160% of GDP, and the ECB is still buying Italian bonds. What happens if the ECB raises interest rates to try to slow down inflation? Well, Italian debt service skyrockets. 5% interest rates mean 8% of GDP to debt service.

## Friday, December 10, 2021

### FTPL article

I wrote a short-ish article for the Journal of Economic Perspectives on Fiscal Theory of the Price Level. It tries to summarize the 700 page book in a readable article with no equations. Let me know how I'm doing -- comments most welcome.

## Wednesday, December 8, 2021

### Debt Video

This is a short video summarizing papers r<g? and (better) section 6.4 of Fiscal Theory of the Price Level. Do low interest costs on the debt mean the government never has to pay it back? If the government doesn't have to repay debts, why do any of us citizens have to repay debts? Let the government borrow, pay off our student, mortgage, and auto debt. Let it send us checks and we can all stop working, paying taxes, and just order things from Amazon. Hmm. Something is wrong here...

The main point. We have 5% of GDP primary deficits, and bigger coming. A r<g of 1% is a fun possibility for  government with 1% of GDP deficits and 100% debt to GDP. But it still leaves us 4% in the hole, and then the next crisis, pandemic, war, or social security and medicare come along.

Kudos to the Hoover Policy-Ed team (This video on their website, with additional material) and especially Shana Farley and Tom Church, who managed to boil down a complex subject to an understandable video. The animations are impressive. Yes, the guy talking needs acting lessons (it's a lot better at 1.25 speed) and a haircut. Next time...

## Wednesday, December 1, 2021

### Inflation speculation

I'm working madly to finish The Fiscal Theory of the Price Level. This is a draft of Chapter 21, on how to think about today's emerging inflation and what lies ahead, through the lens of fiscal theory. (Also available as pdf). I post it here as it may be interesting, but also to solicit input on a very speculative chapter. Help me not to say silly things, in a book that hopefully will last longer than a blog post! Feel free to send comments by email too.

Chapter 21. The Covid inflation

As I finish this book's manuscript in Fall 2021, inflation has suddenly revived. You will know more about this event by the time you read this book, in particular whether inflation turned out to be transitory,'' as the Fed and Administration currently insist, or longer lasting. This section must be speculative, and I hope rigorous analysis will follow once the facts are known. Still, fiscal theory is supposed to be a framework for thinking about monetary policy, so I would be remiss not to try.

 Figure 1. CPI through the Covid-19 recession.

Figure 1 presents the CPI through the covid recession. Everything looks normal until February 2021. From that point to October 2021 the CPI rose  5.15% (263.161 to 276.724), a 7.8% annual rate.

What happened, at least through the lens of the simple fiscal theory models in this book? Well, from March 2020 through early 2021, the U.S. government -- Treasury and Fed acting together -- created about $3 trillion new money and sent people checks. The Treasury borrowed an additional$2 trillion, and sent people more checks. M2, including checking and savings accounts, went up $5.5 trillion dollars.$5 trillion is a nearly 30% increase in the $17 trillion of debt outstanding at the beginning of the Covid recession. Table 21.1 and Figure 2 summarize. ($3 trillion is the amount of Treasury debt purchased by the Fed, and also the sum of larger reserves and currency.  Federal debt held by the public includes debt held by the Federal Reserve.)

 M2, debt, and monetary base (currency + reserves) through the Covid-19 recession.

Some examples: In March 2020, December 2020, and again in March 2021, in response to the deep recession induced by the Covid-19 pandemic, the government sent stimulus'' checks, totaling $3,200 to each adult and$2,500 per child. The government added a refundable child tax credit, now up to $3,600per child, and started sending checks immediately. Unemployment compensation, rental assistance, food stamps and so forth sent checks to people. The paycheck protection program'' authorized$659 billion to small businesses. And more. The payments were partly designed as economic insurance, transfers from people doing well during covid to those who had lost jobs or businesses, and efforts to keep businesses from failing. But they were also in large part, intentionally, designed as fiscal-monetary stimulus to boost aggregate demand and keep the economy going. The  massive infrastructure'' and reconciliation'' spending plans occupied the Congress through 2021, adding expectations of more deficits to come.

From a fiscal-theory perspective, the episode looks like a classic fiscal helicopter drop. There is a large increase in government debt, transferred to people, who do not expect that debt to be repaid. It is afiscal shock,'' a decline in surpluses s_t, with no expectation of larger subsequent surpluses. Of course it led to inflation!

## Sunday, November 28, 2021

### Inflation Explainer

Bari Weiss asked me to write a short post for her substack offering some inflation explanations on the occasion of post-Thanksgiving shopping.

It’s Black Friday, ‘70s-Style

Black Friday begins tonight, and Americans, after emerging from our collective turkey coma, will dive into our sacred, national ritual: shopping.

Those who haven’t shopped lately are in for a rude awakening: Many items will be out of stock, delayed or cost a lot more than they used to. Welcome to inflation, back from the 1970s!

As you look for a deal on a Peloton to work off your pandemic paunch, here is a brief explanation about what’s going on with our economy, why so many things are becoming more expensive, why this hurts all of us, and why the government can’t spend its way out of this mess.

Why are prices rising?

The news is full of “supply chain” problems. Shipping containers can’t get through our ports. Car-makers can’t get chips to make cars. Railroads look like the 405 at rush hour.

What’s underlying many of these problems is the fact that businesses can’t find enough workers. There aren’t enough truck drivers, airline pilots, construction workers and warehouse workers in the “supply chain.” Restaurants can’t find waiters and cooks. There are 10 million job openings and only seven million people looking for work. About three million people who were working in March 2020 are no longer working or looking for work.

But supply chains wouldn’t be clogged if people weren’t trying to buy a lot. The fundamental issue is that demand is outstripping supply.

## Tuesday, November 23, 2021

### Grumpy on inflation at CATO

I had a great time at the CATO monetary policy conference last week. A brief view on why we're having inflation and the chance it will continue:

Briefly, a helicopter dropped. The Fed fell flat. And here we go. Grumpy got steamed up on this one.

If the embed doesn't work, try the direct link or the above conference link. Greg Ip moderated well, and stick around for insightful comments from Fernando Martin, Mark Sobel, and David Beckworth.

## Friday, November 19, 2021

### A convenient myth: Climate risk and the financial system

A Convenient Myth: Climate risk and the financial system. At National Review Online.

In an October 21 press release, Janet Yellen — Treasury secretary and head of the Financial Stability Oversight Council (FSOC), the umbrella group that unites all U.S. financial regulators — eloquently summarized a vast program to implement climate policy via financial regulation:

"FSOC is recognizing that climate change is an emerging and increasing threat to U.S. financial stability. This report puts climate change squarely at the forefront of the agenda of its member agencies and is a critical first step forward in addressing the threat of climate change."

You do not have to disagree with one iota of climate science — and I will not do so in this essay — to find this program outrageous, an affront to effective financial regulation, to effective climate policy, and to our system of government.

## Thursday, November 18, 2021

### Inflation meditation

The discussion about inflation is pretty confused. There is a lot of confusion about aggregate demand vs. individual demand, aggregate supply vs. supply, and about relative prices vs. inflation.

My theme: Inflation is entirely about "demand," not "supply." Fixing the ports, the chips, the pipelines, the labor disincentives, the regulations, are all great and good, and the key to economic growth. But they will not on their own do much to slow inflation. We are having inflation because the government printed up a few trillion dollars, and borrowed a few trillion more, and wrote people checks. People are spending the checks.

At a superficial level this is obvious. If people weren't spending a lot of money, the ports would not be clogged. But it's deeper than that.

Inflation is all prices and wages going up at the same time. Relative price changes are when one price goes up and other prices go down. Reality combines the two, but let's use terms correctly for each element.

Supply shocks cause relative price changes, not inflation. Suppose the ports clog up, and you can't get TVs off the boat from China. Then the price of TVs has to rise relative to other prices. The price of TVs has to go up relative to restaurant food, for example, so people buy fewer TVs and go out to eat more. Or the price of TVs has to go up relative to wages, so people buy less overall.

Now the world is a bit more complex. If prices and wages moved instantly, the price of restaurant food, or wages, would go down, the price of TVs would go up, and the overall price level would not change. In reality the other prices go down slowly. So the price of TVs goes up, and other prices and wages only slowly go down. We measure a little bit of inflation, followed by a slow period of lower measured inflation.

This is one of the mechanisms people have in mind when they refer to supply shocks, and say inflation will be transitory. But that's clearly not what's happening now. Everything is going up, though some things more than others.

Likewise what happens if people decide in a pandemic that they want to buy more TVs and go out to dinner less? That's a relative demand shock. It drives up the price of TVs, and down the price of restaurant food with no inflation. But restaurant prices go down more slowly than TV prices go up, so we measure a bit of inflation and then less inflation. But that's not what's happening now. Restaurant prices are going up too.

"Aggregate supply" is the question, how much more does the economy produce when all prices and wages are moving up at the same rate -- true, pure, inflation? That's a tricky and slippery concept! Sure, if wages rise more than prices, workers might work harder and produce more. If prices rise more than wages, companies might produce more in pursuit of higher profits. Since I told the same story both ways, you can see even this is slippery. But these stories are still about relative prices and wages, not both prices and wages rising together. If prices rise 10% and wages rise 10%, why does anybody do anything different? Welcome to the mysteries of "aggregate supply."

It only makes sense if you think prices or wages were sticky and one or the other was stuck at too low a level. Then a bit of inflation can unstick one of the two, getting the economy back to a more productive level. Aggregate supply is about sticky prices and wages, not about the actual productive capacity of the economy. Another way to see it: Why was the economy not already producing as much as it could, so that money raises output rather than immediately raising inflation? Well, something had to be wrong that inflation could fix, and in macro theory that's "sticky prices."

Yes, this is slippery, but let's not get too far down the rabbit hole. The central point, as intuitive as it sounds, it is not true that unclogging the ports will soak up demand and stop pure inflation. It will lower the relative price of TVs, but that "more supply" doesn't do much about all prices and wages rising together.

All prices and wages rising together means that one thing is falling in value -- money, and government debt. Inflation is a change in the relative price of money and government debt relative to everything else. Inflation comes thus, fundamentally, from the overall supply vs. demand for money and government debt.

We seem, sadly, to be repeating all the confusion on these affairs that prevailed in the 1970s. Oil price "supply" shocks will surely be "transitory." President Biden is sending the FTC to hound the oil companies to lower prices.  Can "guideposts" be far behind? For a thousand years, inflation has led to a witch hunt after "speculators" and "middlemen" and price rising conspiracies. Here we go.

## Tuesday, November 16, 2021

### Academic Freedom at Stanford -- commentary

This is a follow up to a post on the Stanford faculty petition on free speech. I place my comments here, in a separate post. I want to be super-clear that the signatories signed the letter of the last post, and endorse nothing else.

What does it say? Free speech, free inquiry, academic freedom. Period. Not free speech so long as nobody feels hurt. Not free speech so long as you don't disagree with or are viewed as not fully supporting Stanford's policy on Diversity,  Equity, and Inclusion. Not free speech except if you disagree with Stanford's or the County of Santa Clara's covid policies, or Stanford's "sustainability" principles. Not free speech, but limited to your domain of academic expertise, determined by some bureaucratic process. There are other faculty groups and committees working on all these "free-speech but" policies. This group endorsed free speech, period.

[This petition was sent to the president of Stanford on April 13th, 2021]

The signatories of this letter are concerned about the state of academic freedom in American universities. Freedom of expression and open inquiry are vital to the search for truth, which is the core mission of the academic enterprise. To preserve the integrity of our mission, and to signal the importance of free speech in universities everywhere, we urge the president and board of trustees of Stanford to join the more than 80 other universities to publicly endorse the University of Chicago statement on free expression, and to state that it is Stanford university policy.

Sincerely,

The undersigned

*********

The Petition and signatories are here.  185 faculty signed the original; 7 have asked that their names be dropped from the public version.

## Monday, November 15, 2021

### Fed courage.

How Bad Are Weather Disasters for Banks?

Kristian S. Blickle, Sarah N. Hamerling, and Donald P. Morgan

Federal Reserve Bank of New York Staff Reports, no. 990 November 2021

Abstract

Not very. We find that weather disasters over the last quarter century had insignificant or small effects on U.S. banks’ performance. This stability seems endogenous rather than a mere reflection of federal aid. Disasters increase loan demand, which offsets losses and actually boosts profits at larger banks. Local banks tend to avoid mortgage lending where floods are more common than official flood maps would predict, suggesting that local knowledge may also mitigate disaster impacts.

Key words: hurricanes, wildfires, floods, climate change, weather disasters, FEMA, banks, financial stability, local knowledge

### Hoover Fellows

It's time to get those applications in for the Hoover Fellows program

This is a program for young scholars. It's a real job, not a postdoc -- 5 year contract, renewable for another 5 years. No teaching required. It's appropriate for new PhDs but especially for people several years out of PhD.  The current Hoover Fellows are here, an impressive group. We hire in history, political science, and related fields as well as economics. The point is scholarship; you're expected to develop an academic career. It's not a policy job and there are no requirements, though people with interests and research that bear on public policy are obviously going to be a better fit and get more out of being here. There are few rules or strings attached. Take it from me, working at Hoover is a wonderful job!

Please pass the word on to people you may know who would make a good fit.

For those of you who would like to spend a year at Hoover, it's time to apply to the National Fellows program

## Tuesday, November 2, 2021

### Woke week

The institutions of civil society are now thoroughly politicized. "Wokeness" is their ideology and religion,  and mastering an ever-changing arcane vocabulary is now the key to access to the elite, as well as making sure you're not the next one sent to the proverbial Gulag.

I can't keep up with everything in this vein. Still, I've been silent long enough, so I think it's worth passing along interesting tidbits as they come.

A few items on this theme came across the transom last week, that seem fun to share. The American Medical Association issued an official 54 page document instructing all doctors on proper language. (Twitter source with more commentary.)

Mind you, as in other cases, this isn't just opinion -- I'm a radical free speech advocate, say and write what you want. It's the official opinion of a scientific professional society, formerly a-political.

It starts:

I found this document interesting, among other reasons, because I thought I already spoke woke. I thought the left hand column was already the Proper Terminology. They are, after all, already in the mandatory passive voice. How wrong I was! How many more mouthfuls of word salad it is going to take to get through a sentence. Or.. last point, to get an article accepted in a medical journal.

## Wednesday, October 27, 2021

### Transitory Inflation: A Fisherian Fed?

Should the Fed raise interest rates fast? Or should it leave them alone, figuring inflation will be "transitory?"

Lots of models, including ones I play with, predict that a constant unchanging interest-rate peg leads to stable inflation. If there is a fiscal shock, it leads to a one-period price-level jump, but no further inflation, so long as the interest rate stays where it is. The models in the first few chapters of The Fiscal Theory of the Price Level have this feature, also "Michelson Morley, Fisher and Occam.'' Martin Uribe has also written about this issue, here for example.

The simplest example is $i_t = E_t \pi_{t+1}$ $(E_{t+1}-E_t) \pi_{t+1} = -(E_{t+1}-E_t) \sum_{j=0}^{\infty} \rho^j \tilde{s}_{t+j}$ where $$\tilde{s}$$ denotes real primary surpluses scaled by the value of debt. If the interest rate $$i_t$$ does not move, expected inflation does not move. A fiscal shock (negative $$\tilde{s}$$ ) gives a one-period unexpected inflation, devaluing outstanding debt; essentially a Lucas-Stokey state-contingent default. Sticky prices smooth all this out over a year or two.

You can replace the latter with standard new-Keynesian equilibrium-selection rules if you want. This isn't really about fiscal theory; the key is rational forward-looking expectations in the first equation, which also hold in the standard sticky-price extensions. This "Fisherian" property is a common though widely ignored prediction of most new-Keynesian models.

It certainly seems plausible that we are seeing an inflationary fiscal shock, from trillions of money printed up and sent to consumers, while interest rates stay fixed. These models predict that such inflation will indeed be transitory if the Fed does not raise interest rates, and will rise if it does!

However, like all lower-rates-to-lower-inflation arguments, there are lots of warnings here. In particular, the "transitory" inflation could last a long time once we put in sticky prices. The trick only works if the Fed is completely committed to not raising rates, to waiting as long as it takes for inflation to settle back down on its own.  If people suspect the Fed will raise rates, inflation rises. There are lots of temporary forces that go in the other direction. And there may be more fiscal shocks -- I sort of see one brewing in Congress -- so we may not be done with the unexpected inflation term.

FTPL section 5.3 has a long discussion of all the preconditions for lower interest rates to bring down inflation, which still obtain. But we haven't been talking about this issue much since the low-inflation zero-bound era ended, and the discussion that maybe determined, permanent, pre-announced interest rate rises could eventually bring up inflation. The opposite sign works as well.

In these models, with a few more ingredients than I show above, the Fed can also lower inflation by raising rates. Raising rates gives a temporary inflation decline before going the other way. So, the Fed has to raise rates, push inflation down, then quickly get on the other side. That's the historical pattern, and what it will likely do.  But it's only honest, and fun, to remember the prediction of the opposite possibility and to think about how it might work out.

******

Update. A second try, with more English. The government, Fed and Treasury, basically printed up about $5 trillion of new cash and treasury debt -- these are largely perfect substitutes so the composition doesn't really matter -- with no change at all in plans to repay debt. By simple FTPL, a 25% increase in debt with no increase in expected future surpluses generates a 25% rise in the price level, 25% cumulative inflation. It basically defaults on outstanding debt and transfers that value to the recipients of stimulus. But then it ends. If there is no more issue of nominal debt, without additional surpluses, then there is no more inflation. Additional issues of nominal debt can come from more unbacked fiscal expansion, or it can come from monetary policy. Monetary policy also puts extra government debt (same thing as interest-paying reserves) out there, with (of course) no change in fiscal policy. So there is the FTPL case for "transitory."In the long run, no change in interest rate puts no extra government debt in the system, and higher nominal interest rates must mean eventually higher inflation and hence more unbacked government debt in the system. ## Tuesday, October 26, 2021 ### Central bank expansionism A keynote talk at the FGV EPGE (Brazilian School of Economics and Finance) 60th anniversary conference, program here. Direct link to my talk here (YouTube). (I start at about 4:00 if you're impatient). I plan to turn these thoughts in to an essay at some point. All the conference videos here The theme: Central banks, and especially the US Fed, are spinning out of control. I trace the history of this expansion, and how little steps taken here and there mushroomed. The decision in 2008 to regulate assets rather than pursue equity-financed banking, and buying huge amounts of assets, are small steps that mushroomed. They are the moment that central banks became the proverbial two year old with a hammer. The end, the natural meaning of "whole of government" approaches, must be the end of central bank independence and their complete politicization. ## Monday, October 25, 2021 ### Supply The Revenge of Supply, at Project Syndicate Surging inflation, skyrocketing energy prices, production bottlenecks, shortages, plumbers who won’t return your calls – economic orthodoxy has just run smack into a wall of reality called “supply.” Demand matters too, of course. If people wanted to buy half as much as they do, today’s bottlenecks and shortages would not be happening. But the US Federal Reserve and Treasury have printed trillions of new dollars and sent checks to just about every American. Inflation should not have been terribly hard to foresee; and yet it has caught the Fed completely by surprise. The Fed’s excuse is that the supply shocks are transient symptoms of pent-up demand. But the Fed’s job is – or at least should be – to calibrate how much supply the economy can offer, and then adjust demand to that level and no more. Being surprised by a supply issue is like the Army being surprised by an invasion. The current crunch should change ideas. Renewed respect may come to the real-business-cycle school, which focuses precisely on supply constraints and warns against death by a thousand cuts from supply inefficiencies. Arthur Laffer, whose eponymous curve announced that lower marginal tax rates stimulate growth, ought to be chuckling at the record-breaking revenues that corporate taxes are bringing in this year. Equally, one hopes that we will hear no more from Modern Monetary Theory, whose proponents advocate that the government print money and send it to people. They proclaimed that inflation would not follow, because, as Stephanie Kelton puts it in The Deficit Myth, “there is always slack” in our economy. It is hard to ask for a clearer test. But the US shouldn’t be in a supply crunch. Real (inflation-adjusted) per capita US GDP just barely passed its pre-pandemic level this last quarter, and overall employment is still five million below its previous peak. Why is the supply capacity of the US economy so low? Evidently, there is a lot of sand in the gears. Consequently, the economic-policy task has been upended – or, rather, reoriented to where it should have been all along: focused on reducing supply-side inefficiencies. One underlying problem today is the intersection of labor shortages and Americans who are not even looking for jobs. Although there are more than ten million listed job openings – three million more than the pre-pandemic peak – only six million people are looking for work. All told, the number of people working or looking for work has fallen by three million, from a steady 63% of the working-age population to just 61.6%. We know two things about human behavior: First, if people have more money, they work less. Lottery winners tend to quit their jobs. Second, if the rewards of working are greater, people work more. Our current policies offer a double whammy: more money, but much of it will be taken away if one works. Last summer, it became clear to everyone that people receiving more benefits while unemployed than they would earn from working would not return to the labor market. That problem remains with us and is getting worse. Remember when commentators warned a few years ago that we would need to send basic-income checks to truck drivers whose jobs would soon be eliminated by artificial intelligence? Well, we started sending people checks, and now we are surprised to find that there is a truck driver shortage. Practically every policy on the current agenda compounds this disincentive, adding to the supply constraints. Consider childcare as one tiny example among thousands. Childcare costs have been proclaimed the latest “crisis,” and the “Build Back Better” bill proposes a new open-ended entitlement. Yes, entitlement: “every family who applies for assistance … shall be offered child care assistance” no matter the cost. The bill explodes costs and disincentives. It stipulates that childcare workers must be paid at least as much as elementary school teachers ($63,930), rather than the current average ($25,510). Providers must be licensed. Families pay a fixed and rising fraction of family income. If families earn more money, benefits are reduced. If a couple marries, they pay a higher rate, based on combined income. With payments proclaimed as a fraction of income and the government picking up the rest, either prices will explode or price controls must swiftly follow. Adding to the absurdity, the proposed legislation requires states to implement a “tiered system” of “quality,” but grants everyone the right to a top-tier placement. And this is just one tiny element of a huge bill. Or consider climate policy, which is heading for a rude awakening this winter. This, too, was foreseeable. The current policy focus is on killing off fossil-fuel supply before reliable alternatives are ready at scale. Quiz: If you reduce supply, do prices go up or go down? Europeans facing surging energy prices this fall have just found out. In the United States, policymakers have devised a “whole-of-government” approach to strangle fossil fuels, while repeating the mantra that “climate risk” is threatening fossil-fuel companies with bankruptcy due to low prices. We shall see if the facts shame anyone here. Pleading for OPEC and Russia to open the spigots that we have closed will only go so far. Last week, the International Energy Agency declared that current climate pledges will “create” 13 million new jobs, and that this figure would double in a “Net-Zero Scenario.” But we’re in a labor shortage. If you can’t hire truckers to unload ships, where are these 13 million new workers going to come from, and who is going to do the jobs that they were previously doing? Sooner or later, we have to realize it’s not 1933 anymore, and using more workers to provide the same energy is a cost, not a benefit. It is time to unlock the supply shackles that our governments have created. Government policy prevents people from building more housing. Occupational licenses reduce supply. Labor legislation reduces supply and opportunity, for example, laws requiring that Uber drivers be categorized as employees rather than independent contractors. The infrastructure problem is not money, it is that law and regulation have made infrastructure absurdly expensive, if it can be built at all. Subways now cost more than a billion dollars per mile. Contracting rules, mandates to pay union wages, “buy American” provisions, and suits filed under environmental pretexts gum up the works and reduce supply. We bemoan a labor shortage, yet thousands of would-be immigrants are desperate to come to our shores to work, pay taxes, and get our economy going. A supply crunch with inflation is a great wake-up call. Supply, and efficiency, must now top our economic-policy priorities. ********* Update: I am vaguely aware of many regulations causing port bottlenecks, including union work rules, rules against trucks parking and idling, overtime rules, and so on. But it turns out a crucial bottleneck in the port of LA is... Zoning laws! By zoning law you're not allowed to stack empty containers more than two high, so there is nowhere to leave them but on the truck, which then can't take a full container. The tweet thread is really interesting for suggesting the ports are at a standstill, bottled up FUBARed and SNAFUed, not running full steam but just can't handle the goods. Disclaimer: To my economist friends, yes, using the word "supply" here is not really accurate. "Aggregate supply" is different from the supply of an individual good. Supply of one good increases when its price rises relative to other prices. "Aggregate supply" is the supply of all goods when prices and wages rise together, a much trickier and different concept. What I mean, of course, is something like "the amount produced by the general equilibrium functioning of the economy, supply and demand, in the absence of whatever frictions we call low 'aggregate demand', but as reduced by taxes, regulations, and other market distortions." That being too much of a mouthful, and popular writing using the word "supply" and "supply-side" for this concept, I did not try to bend language towards something more accurate. ## Saturday, October 16, 2021 ### Build back sausage Inspired by Casey Mulligan's blog post, I went to read some of the "Build Back Better" bill. (Is it just me, or doesn't "Build Back Better" sound a lot like "Make America Great Again?") Heavens, not the whole thing -- that's way beyond me. I just read the first half of the child care tax credit, starting on p. 241. I was also inspired by PBS, which, coincidentally, I'm sure, announced last week a Child Care Crisis. Well, what is the federal government going to do about this "crisis?" Following media coverage, I thought this was mostly a line on your income taxes. I was wrong. p. 251 (d) ESTABLISHMENT OF BIRTH THROUGH FIVE CHILD CARE AND EARLY LEARNING ENTITLEMENT PROGRAM.— (1) IN GENERAL.—The Secretary is authorized to administer a child care and early learning entitlement program under which families, ... shall be provided an opportunity to obtain high-quality child care services... (2) ASSISTANCE FOR EVERY ELIGIBLE CHILD.—Beginning on October 1, 2024, every family who applies for assistance under this section...shall be offered child care assistance... A new entitlement. Forever. How much is this going to cost, I wonder? Oh, good, p. 249 ## Wednesday, October 6, 2021 ### Sowell Nobel? There is less than a week to go before the Economics Nobel Prize. Dear Nobel Committee: How can you not give the prize to Tom Sowell this year? Tom's work evidently merits a Nobel purely as a contribution to economics, covering many issues. But we can't ignore what year it is, and what's going on in the world. Indeed, in the Physics and Chemistry prizes this year, as well as Nordhaus' climate-economics Nobel, the Prize committees show they care about research that applies to hot-button problems. Race is a screaming issue of our time. How can you not give the prize to the living economist who has written the most penetrating economic analysis of race? Oh, yes, he's free-market, and thus characterized as conservative. His deeply fact-based research is uncomfortable to The Narrative. For example, groups that white people cannot tell apart have profoundly different outcomes in the US. Nigerian immigrants are among the highest achieving ethnic groups in the US. West Indians do well. Asians of different waves of immigration and different countries -- Chinese, Laotians, Vietnamese -- show profound differences. Tom has thousands of such facts, impeccably documented. But you're the Nobel Committee. You care about Science, not about cheers from the Davos crowd. You care about issues that are important, as you should, but you do not care about embracing one or the other political narrative's answers to those questions. You care about the reputation of your Prize, for courageously recognizing great research, even if its surprising conclusions upset established orders. And, to your credit, you have given the prize to economists of widely different political enthusiasms through the years. You're not, say, the American Economics Association, whose statement from the American Economic Association Executive Committee, still up on its website, and referenced in mandatory DEI training, reads We encourage all economists to seek out existing scholarship on race, stratification economics, and related topics. To get us started, our AEASP and CSMGEP colleagues and students are compiling a reading list on racism and the experience of Black Americans. Members of the AEA Executive Committee have pledged to continue to educate themselves in part by reading works from the list and to seek to integrate work by diverse authors in course syllabi, and we ask all economists to make the same pledge. The officially-endorsed reading list, though updated, to this day brazenly omits Sowell. Or Walter Williams. Or Glenn Loury. Or Roland Fryer. (Committee, if you're looking for others to share the prize, here are some suggestions!) If you must, as you sometimes do, you may shrink from controversy by pairing the prize, Hayek and Myrdal; Fama and Shiller. But give Tom the prize. Yes, Tom's work is empirical, neither full of equations of theory or econometrics. (Though Knowledge and Decisions is an excellent pice of theory.) Tom writes books. Well, maybe it's time to celebrate persuasive fact-based books as well as the more standard approaches, as you also have done in the past. While Tom is hardy, he is 91. None of us last forever. Nor does your opportunity to recognize one of the most important economists of our time. This is the year. ******** Update: If you don't know Tom, and don't want to face an overwhelming volume of primary sources, his Wikipedia page is not bad. Twitter commenters complain that he appears on Fox News. Well, Paul Krugman appears in the New York Times. Within a respectable range, really, we need to start keeping political commentary separate from scientific contribution, like other hobbies. ## Tuesday, October 5, 2021 ### What's in the reconciliation bill? A conversation with Casey Mulligan. A podcast discussion with Casey Mulligan. What's in the reconciliation bill? How will it work? Link to the podcast page, with lots of other formats. Yesterday Casey tweeted that he had read the entire 2,400 page bill. Casey does this sort of thing, as explained in his book "Your'e hired." I have been trying to figure out what's in it for a while. The media coverage is basically absent. (See this great Marginal Revolution post and Bloomberg column (gated, sadly) by Tyler Cowen.) I tried downloading the actual bill too, but promptly fell asleep. (Casey has some good hints on how to read it.) But here we are, about to embark on a huge set of new federal programs, really larger than anything since the Johnson Administration, and there is essentially no description of what they are, no debate on how they will work, and especially (my hobby horse) what incentives and disincentives they provide. Many of the previous welfare-state programs were disastrous for the supposed beneficiaries. How are we going to avoid that again? At most we talk about top line numbers. I'm a debt hawk, but if we could heal the planet, end all inequity, bring full social racial and gender justice, wipe out poverty, give every American a life of dignity, prosperity, and opportunity for a mere$3.5 trillion, I'm in. Double it. The real question is whether any of this will happen.

Well, Casey read the bill and knows what's in it! Tune in to find out..

PS, I hope to get the podcast going more regularly this fall,

Update:

A summary and review from David Henderson.

Casey writes a detailed blog post on BBB disincentives.

### "Non-profit" housing at NYT

Every now and then the old New York Times resurfaces, with detailed reporting, actual facts, whether or not they support The Narrative. Such is the case with an article I recommend, Housing Boss Earns $1 Million to Run Shelters Despite a Troubled Past, by Amy Julia Harris Since 2017, ... the city has awarded more than$352 million to a nonprofit run by Mr. [Jack A.] Brown to operate shelters. The money is meant to help homeless people regain their footing in life, but it has benefited Mr. Brown, too.

The nonprofit has channeled contracts worth at least $32 million into for-profit companies tied to Mr. Brown, allowing him to earn more than$1 million a year, The New York Times found. Millions more have gone to real estate companies in which he has an ownership interest.

...In addition to serving as the chief executive of the nonprofit he founded, CORE Services Group, Mr. Brown started a security guard company that polices his shelters, a maintenance company that makes repairs in them and a catering company that feeds the residents, records showed. Mr. Brown heads each of them, collecting total compensation that tops $1 million. He is the highest-paid shelter operator in New York, according to a review of available records. Mr. Brown, 53, has profited in other ways: Along with partners, he owns two companies that have rented buildings to CORE, and his mother, sister, aunt and niece have all worked at the nonprofit, in addition to his brother, who has collected a six-figure salary. At the same time, residents at one of the largest shelters in Mr. Brown’s operation, Beach House in Queens, said they lived with vermin infestations, creeping mold and violent fights in the hallways. The last part of the article goes on about Mr. Brown. I have to say I admire the man's cleverness. He starts and closes companies with alacrity, always one step ahead. I am reminded of the famous railroad robber barons, like the one whose name adorns my university, who ran railroads that received massive federal subsidies, but also ran construction companies hired by the railroads to do the work. That's where they made their money, and economic historians still haven't untangled the web. But Mr. Brown is not a lone individual, he's just the human face of the story. As the article makes clear, this is the systematic pattern in the business: An investigation by The Times, based on hundreds of pages of legal filings, business records and tax documents, as well as interviews with homeless people, city officials and shelter employees, found that under the cloak of charity, executives at nonprofits have collected large salaries, spent their budgets on companies that they or their families controlled and installed relatives in high-paying jobs. One landlord started a nonprofit that handed out millions of dollars to real estate and maintenance companies that he and his family owned. A Bronx shelter operator was charged earlier this year with laundering kickbacks through a consulting company run by his family. A former board member of another homelessness organization is under criminal investigation after the city said the group paid millions of dollars to a web of for-profit entities he secretly oversaw. Now, perhaps the gloss of blaming problems in well-meaning programs on malfeasant individuals got this past the the Times' editors. But ponder just how much this story undermines the Standard Progressive Narrative. Most of all, it is these days fashionable to view "for profit" companies as evil, and "non-profits" as morally and ethically superior. For example, When Mayor Bill de Blasio came into office, he criticized a small group of landlords for charging the city exorbitant rates to house people in squalid rooms while doing little to curb homelessness. In 2017, the mayor pledged to open dozens of new shelters that would be managed by nonprofit groups. Their mission, he said, would be altruistic rather than driven by financial gain. You only have to read a little between the lines that the whole system of city grants to "non-profits" is completely and inherently corrupt. Non-profit means a) tax exemption b) no pesky shareholders to ask questions and unseat bad management. Alas, the desire for gain remains in the human spirit. The war on for-profit universities has a similar tone. ...This year, the city has directed$2.6 billion to nonprofits to operate homeless shelters, and officials already know they have a problem with some of them.

...About 77,000 homeless people live in New York City,

$2.6b/77k =$34,000. (The right number should be the number in this housing, which the article does not give.) Well, that's better than San Francisco, where we add a zero.

## Monday, October 4, 2021

### Portfolio podcast

I did a Rational Reminder podcast and video, focusing on portfolio theory, but also a tour through asset pricing. My hosts Benjamin Felix and Cameron Passmore were unusually well prepared and asked great questions! Video below, or go here for video, podcast, and transcript for people (like me) who read more than listen.

## 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.

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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.

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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.

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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