## Tuesday, December 6, 2022

### Fiscal Theory of the Price Level discount coupon

The Fiscal Theory of the Price Level
is now available from Princeton University Press. The official release date is Jan 17, but both hard cover and ebook are available sooner from Princeton. And for a limited time, 30% off! There is also an e-book sale, see the website.

## Friday, December 2, 2022

### Waller courage

While the rest of the Fed climbs on the maybe-anvils-might-fall-from-the sky climate financial risk fantasy, Chris Waller has the courage in Haiku-simple prose to state that the emperor has no clothes.
I cannot support this issuance of guidance on climate change. Climate change is real, but I disagree with the premise that it poses a serious risk to the safety and soundness of large banks and the financial stability of the United States. The Federal Reserve conducts regular stress tests on large banks that impose extremely severe macroeconomic shocks and they show that the banks are resilient.
Granted, in my view stress tests are a lot less reliable. Stress tests didn't uncover the weakness that led to the pandemic bailout, so there is no hope of them assessing climate risk. The Fed is, let us not forget, fresh off of a second huge bailout in a pandemic their stress testers never considered, and a consequent fiscal-policy inflation that their forecasters never imagined. The "transition risk" crowd got the sign wrong on what happens to oil company profits if you restrict fossil fuel investment. A "how did we screw up so badly" effort seems more important. But we need not fight about this issue. Different logic leads to the same conclusion.

Chris is right that it is completely obvious that "climate risk" does not conceivably imperil the financial system, or at least not with more than infinitesimal probability and a lot less than other dangers --- war, sovereign debt collapse, pandemic, etc.

Bravo, Chris. A reckoning of this highly political move will come. Yes, the Biden administration wants a "whole of government" effort to restrict fossil fuels and to subsidize windmills, photovoltaics and electric cars (so long as they are built in the US), but the Fed is supposed to be politically independent. Because, you know, administrations and Congresses change. I suspect caving to this pressure will cost the Fed a lot.

## Monday, November 28, 2022

### California homeless math

From WSJ

California Gov. Gavin Newsom ....recently put a temporary freeze on $1 billion of state grants for city and county homelessness programs....the measures would have reduced homelessness statewide by 2% between 2020 and 2024 [California has] more than 116,000 residents sleeping on the street on any given night. California has dedicated some$15 billion toward the issue since the start of the pandemic.

$15 billion / 116,000 =$129,310.34

2% x 116,000 = 2,320. $1 billion / 2,320 =$431,034.48

## Thursday, November 10, 2022

### The second great experiment update

Our great experiment in monetary economics continues.

The news of the moment is that inflation might--might--be peaking. I just present the CPI to make the point, but there seems to be a lot of news suggesting that inflation is easing off. Jason Furman's twitter is a great source of up to the minute detailed data and analysis suggesting this view.

Of course this could also be a blip like August. And new shocks could come along. But let's explore what peaking might mean.

## Friday, November 4, 2022

### Academic Freedom Conference Opening Statement

Opening remarks, Conference on Academic Freedom

John H. Cochrane

Nov 4 2022

Welcome to the Academic Freedom Conference. I’m John Cochrane, one of the co-organizers of this conference.

First, let us offer thanks. Most of all, we thank the Stanford GSB and its dean Jon Levin for sponsoring this conference, and sticking with us through some turbulence. We also thank the institutions listed here for sponsorship, and several generous donors. We thank the organizing committee, which helped to identify and recruit speakers and consulted extensively. We thank all our speakers, and all of you, especially those who have traveled to be here. Most of all, Ivan Marinovic did all the hard work of putting the conference together. Thank you Ivan!

I am, of course, not going to tell you what to say and not say. But any conversation is more productive if we focus it and try to keep to the point.

We gather as a group that believes academic freedom is important and under threat. But we don’t fully understand the problem or what to do about it. So, we are here to share experiences in different universities, fields, and from a diversity of viewpoints, to understand and define the problem, and to find practical solutions.

We are not here to have a philosophical discussion whether academic freedom is important, and whether it is threatened. We here start from the premise that the core mission of the scholarly community is to uncover new knowledge, to debate and refine knowledge, to pass on knowledge to the next generation, and more importantly to pass on the habits and norms of critical inquiry and scholarly debate that produce true knowledge. We here start from the premise that we are losing academic freedom, and that threatens this core scholarly mission. If those of you listening on zoom or the critics of this conference wish to debate these issues, go ahead and run a different conference. Every biology conference does not start with an evolution vs. creationism debate. Time is short, and focus will make us more productive.

This is a conference on academic freedom, with a lesser emphasis on free speech of political opinions. Cancellation, ostracism, and disciplinary action for political opinions, and canceling outside popular speakers are in the news. But our core question is limitations on the scholarly enterprise of research, teaching, publication, fact-finding, logical analysis, and criticism. This enterprise is damaged when scholars are canceled for political opinions, or opinions on matters like university hiring and admissions. But our focus goes beyond this to emphasize less visible but perhaps more insidious restrictions on academic activity, including direct institutional actions, by self-censorship in fear, or by good people being driven out of the academic enterprise.

This is a conference on academic freedom, and not free speech and censorship in the media, on twitter, and in the general society. That is an important political problem in our democracy, but it’s not the focus of our conference.

This is a conference on academic freedom, and not centrally on the substance of contentious issues. We have some noted speakers who have been criticized for their views. But we’re here primarily to learn from their experience of censorship, not to debate the merits of the particular views and research findings that got them in trouble.

Academic freedom is a problem of institutions. Twitter-mob students are visible. But the key restrictions on academic freedom lie with university leaders, university bureaucracies, hiring and promotion procedures; and beyond universities to funding agencies, professional organizations, and journals. I hope we can discuss and remedy dysfunction in all these institutions.

The nexus between politics and academic freedom is a deep and troublesome question.

We designed this conference to be non-partisan. Truth knows no politics, we thought; it is likely to unsettle verities on all sides, and we know many self-identified leftists as well as rightists and libertarians who are concerned. We don’t know and didn’t ask what your politics are. We did however, make a special effort to invite people who self-identify as politically left or progressive and concerned with academic freedom. We also made a special effort to reach out to many of the people who have criticized some of our speakers; among others Stanford faculty who publicly denounced Jay Bhattacharya and Scott Atlas.

The non-response and refusals from this group was astounding, and surprising to us. If this group does not seem “balanced” to you it is by refusal to participate, not by lack of invitation.

One prominent Stanford professor, active in university academic freedom issues, spoke for many, telling us “I can’t be seen on the program with right-wing nutjobs like.…” and named a few of our speakers. At an academic freedom conference. There’s half the problem in a nutshell.

There are now faculty protest letters and demands in the faculty senate that Stanford distance itself from this conference. Critics involved the media. They complain that we are “closed,” for restricting attendance when the room got full, and for restricting media to preserve space for participants, though these are routine for academic conferences. [The Stanford global energy forum of the last two days is explicitly “invitation only” without complaint, and without Bjorn Lomborg or Steve Koonin.] They complain about some of our speakers’s deplorable, to them, views. People with such views should, apparently, never allowed to speak on anything. They cherry pick one or two hated speakers, to declare us “unbalanced.” But have any of them looked up the other 35 speakers on the program?  The Chronicle of Higher Education declared this conference a “threat to democracy.” Even the Hoover Institution declined to support or co-host this conference, deeming it “too political.”

The attempt failed. Stanford’s leaders have supported us, for which we are grateful, so we are still here. But young untenured faculty figured out they should not be seen here. Several more deregistered from the conference after we decided to stream the proceedings, citing fear of repercussions.

The irony of trying to censor the free speech conference has not occurred to them. The hypocrisy of labeling this and only this conference “political,” and demanding that this and only this conference include “wider voices,” not the long list of highly one-sided political events at Stanford, [for example, the “Gender Equity and Justice Summit”] likewise escapes them. Well, I guess "logic" is not politically fashionable, but do we have to be so obvious about it?

We were naive. Just in setting up a conference to talk about academic freedom, we got to experience part of the problem.

I think we cannot avoid the elephant in the room. The threat to academic freedom is political, as it has always been. Free scholarship undermines narratives that sustain or are used to claim political power.  Though in the past this threat has come from both left and right, and though there are some dumb and illiberal restrictions coming from Republican state legislatures, the main threats to academic freedom inside the university, professional societies, and government agencies predominantly come from a particular far-left authoritarian political ideology, and most of the forbidden subjects today threaten their narrative.

Some organizational notes:

You can say what you want, but you can’t talk as long as you want. Please abide by the time limits. Moderators, please be ruthless in enforcing time limits. Please leave ample time for questions and comments from the floor. That discussion is much of the point of this event. I anticipate there will be far more comments than we can accommodate, so I encourage moderators to take a group of 5 or so comments at a time. Panelists, please keep responses short.

Each session will start on time, and end on time. At breaks, please return to the room promptly without being nagged, so we can keep to the schedule and everyone gets a chance to be heard.

Be aware that this conference is streamed, and video will be available later as well. We  originally preferred no recording and Chatham house rules. But various pressures make that impossible, and we realized there is no way to ensure privacy. So, we accepted the loss of spontaneity that a record imposes, in return for the transparency that it provides. It proves what is not said here as much as it records what is said.

Covid still runs among us, and in a group this size there is a good probability that someone is infectious. Let this be a super-spreader event of ideas, but not of disease. If you are not feeling well, please do us all a favor and watch the live stream from out of the room. If you have any doubts, please take a test. (There are a bunch at the sign in desk.) In this tolerant free-speech group, let us respect people’s individual choices to wear a mask.

## Thursday, November 3, 2022

On Friday and Saturday Nov. 4/5, the Stanford GSB Classical Liberalism Initiative will host a two day conference on Academic Freedom. Conference website here, and I copy and paste the schedule below.  The room is beyond full, so we can't issue more in-person invitations. Because of that and the threat of protests (yes, a loud group at Stanford wants to silence the academic freedom / free speech conference),  we will not be able to accommodate walk-ins.

But the event will be live-streamed. If you want to watch, register here and we'll send you a link.

This is a separate effort from the academic freedom declaration I blogged  yesterday, though many of the same organizers are involved.

Academic freedom, open inquiry, and freedom of speech are under threat as they have not been for decades. Visibly, academics are “canceled,” fired, or subject to lengthy disciplinary proceedings in response to academic writing or public engagement. Less visibly, funding agencies, university bureaucracies, hiring procedures, promotion committees, professional organizations, and journals censor some kinds of research or demand adherence to political causes. Many parts of universities have become politicized or have turned into ideological monocultures, excluding people, ideas, or kinds of work that challenge their orthodoxy. Younger researchers are afraid to speak and write and don’t investigate promising ideas that they fear will endanger their careers.

The two-day Academic Freedom Conference, arranged by the organizing committee, aims to identify ways to restore academic freedom, open inquiry, and freedom of speech and expression on campus and in the larger culture and restore the open debate required for new knowledge to flourish. The conference will focus on the organizational structures leading to censorship and stifling debate and how to repair them.

Schedule

## Wednesday, November 2, 2022

Some colleagues and I created an open letter on Academic Freedom. If you share our views, you are invited to sign.

The bottom line: we call for universities and professional associations to adopt and implement the  Chicago Principles of free speech, the Kalven Report requirement for institutional neutrality on political and social matters, and the Shils report making academic contribution the sole basis for hiring and promotion.

We include professional societies. That means you, American Economic Association and American Finance Association: With all your committees on improving the profession, you need one big one to defend the most important and imperiled part of the scholarly enterprise, academic freedom.

The letter, below, is not as comprehensive and detailed as you might like, but we worked to keep it short.

The official letter and list of signatories lives here. If you would like to sign, you can do so by filling out this form. It's moderated so may take a day or two for your signature to show.

We are up to 626 signatures (11/3). When the number stabilizes we'll try to make a public fuss about the letter.

Update: A special plea. I have several responses from left/liberal/democrat colleagues who say they would sign, but don't want to have their names on a letter that doesn't have enough other left/liberal/democrat names on it and does have well known deplorables. (How you know 626 people's politics is beyond me, but ok.) That reaction tells us a big part of the problem.  All along we have tried very hard to reach out to self-described left/liberal/democrat colleagues, who privately bemoan what's going on but are too afraid to be seen in public. But why not fix it: if some of you sign perhaps that will give courage for more of you to sign. Take it over, get together with your friends, add lots of signatures, make this your cause, prove that we can stand together for freedom!

The mission of the university is the pursuit of truth and the advancement and dissemination of knowledge. A robust culture of free speech and academic freedom is essential to that mission: Intellectual progress often threatens the status quo and is resisted. Bad ideas are only weeded out by unfettered critical analysis.

Unfortunately, academic freedom and freedom of speech are rapidly declining in academic institutions, including universities, professional societies, journals, and funding agencies. Researchers whose findings challenge dominant narratives find it increasingly hard to get published, funded, hired, or promoted. They, and teachers who question current orthodoxies, are harassed in person and online, ostracized, subjected to opaque university disciplinary procedures, fired, or canceled by other means. Employment, promotion, and funding are increasingly subject to implicit or explicit political litmus tests, including approval from bureaucrats seeking to impose a social agenda such as specific views of social justice or DEI principles. Activism is replacing inquiry and debate.  An increasing number of simple facts and ideas cannot even be mentioned without risk of retribution.

### We're all supply siders now -- Summers and Poilievre

Larry Summers wrote an interesting oped at the Washington Post. Mostly, he still is of the adaptive-expectations ISLM view that interest rates must exceed current inflation before inflation will decline. (The issue here (blogpost) and here (paper).) But listen to this:

Questions of macroeconomic policy are not about values but judgments about the ultimate effects of various actions. As Fed chair during the early 1980s, Paul Volcker famously tamed out-of-control inflation at the cost of a severe recession. But he did so not because he cared less about unemployment or worker incomes than his predecessors did but because he rightly recognized that delay in containing inflation would only mean more pain down the road.

Would we all recognize common goals, but differences on cause and effect to get there.

That’s why it’s vital that the Federal Reserve not waver. Chair Jerome H. Powell has vowed to impose sufficiently restrictive monetary policy to return inflation to within range of the Fed’s 2 percent target. The more confident that workers, businesses and markets are that the Fed will follow through on that, the less painful the process will be.

Within the conventional monetary policy community, praise for Volcker and the view, basically, that the Fed should focus on inflation and the labor market will take care of itself is sensible, but remarkably Reaganish.

The tidbit that I found most interesting

Finally, the crisis of inflation should not be wasted. A bright spot in the dismal inflation period of the 1970s was the collaboration of Stephen G. Breyer (then counsel to the Senate Judiciary Committee), Sen. Edward M. Kennedy (D-Mass.) and the Carter administration on airline deregulation. In this era, high inflation should be a spur to regulatory changes — from addressing Jones Act increases in shipping costs, to strategic tariffs, to rules that force oil and gas to be transported via truck rather than pipeline, to punitive zoning restrictions — that will both reduce prices and make the economy work better.

As you know I've been preaching that "supply side" growth is the central problem and also the key to reducing inflation. Larry hasn't quite gotten to the latter, but this is the economist most identified with "secular stagnation," "hysteresis" and the view that all we need to do is borrow or print more money and hand it out to create growth. Now deregulation and the supply side is the key to growth.

Larry is starting to sound like a Reagan Republican!  I'm sure he would say circumstances have changed -- that was ZLB (zero lower bound on interest rates), this is inflation. That's a consistent view. But inflation should wake us all up as it has Larry: All the old verities are over, there is only supply now, and that comes mostly from getting out of the way, as Larry recommends, not new "investments" of more borrowed money thrown down ratholes.

***

Pierre Poilievre, the leader of Canada's Conservative party, wrote a great Oped in the National Post. Now that Liz Truss has imploded, perhaps Poilievre will become the international hope for a successful free market libertarian politician.

Finance Minister Chrystia Freeland wants us to believe she has had an epiphany. After years of ignoring my warnings that Liberal deficit spending would cause inflation to balloon, followed by interest rates, she now claims to agree with me in a leaked letter to fellow ministers. Even her boss, Prime Minister Justin Trudeau, is uttering words unthinkable to him not long ago: “fiscal responsibility.”

The cost of government is driving up the cost of living. A half-trillion dollars of inflationary deficits have sent more dollars chasing fewer goods, which always leads to higher prices.

We're all FTPLers (fiscal theory of the price level) now, some sooner than others. A clear explanation of how central banks create money and buy treasury debt follows. Then

the Bank of Canada must pay interest — at the going rate. Because rates are now rising, the central bank is now losing money and will need a bailout from the federal government for the first time in history — something I predicted would happen two years ago.

Fiscal constraints on monetary policy. Nice.

Liberals like to say that all this inflation is the result of the Russian invasion of Ukraine. But less than 0.3 per cent of Canada’s trade is with those two countries, and the things that they produce are things we already have — food and energy. In fact, the higher commodity prices should have helped our resource-heavy economy, but for the fact that the Trudeau government has hit farmers with fertilizer tariffs and carbon taxes and blocked or bungled every single pipeline or LNG export terminal proposed in seven years.

Beside my thread, but an important point. His bottom line

Instead of creating more cash, we need our economy to produce more of what cash buys: more food, energy and homes. That means removing gatekeepers that have made Canada the second slowest country in all the OECD to get a building permit. As prime minister I would challenge all three levels of government to work together to offer the fastest building permits in the OECD. This would mean going from 250 days to 28 days to beat the now first-placed South Korea....We would remove taxes and tariffs on farmers’ fuel and fertilizer....Finally, we would reform our taxes to reward work, savings, and investment so our workers and businesses can produce more of the goods we need.

Simply put, we would stop creating cash and start creating more of what cash buys: food, homes, energy, manufactured goods and more. That is the only path to bigger buying power for paycheques and savings.

FTPL and deregulation-focused supply side growth. Well, us free market libertarians are like Chicago Cubs fans, there's always hope!

### Ip on FTPL

Greg Ip gives nice coverage of fiscal theory of the price level in the Wall Street Journal..

I'm sad he left out Eric Leeper's defining work, which really even more than Sargent and Wallace started modern FTPL. Eric described monetary policy with interest rates, not money supplies, and integrated FTPL with the now dominant new-Keyensian tradition.

Naturally I'm a bit rankled by

But FTPL is frustratingly difficult to apply to real life.

and

A theory that doesn’t predict inflation but explains it only after the fact by invoking hard-to-measure attitudes isn’t that satisfying, and certainly no better than mainstream macroeconomic models.

Well, that also means no worse than mainstream models. And I was publicly warning of inflation in April 2021, though I'm too much of an academic to make much of one data point. The FTPL analysis of the ZLB is, I think more convincing.

Yes it would be nice if FTPL could tell you just when too much debt is too much. It would also be nice if the theory of finance could tell you just what a stock should be worth. And it would be nice if any theory, or the Fed itself, did a good job of predicting inflation.

A nice nugget,

fiscal stimulus had some role in pushing inflation up, and as the Fed raises interest rates to combat that inflation, it will worsen deficits. Britain had to abandon deficit-financed tax cuts over fears they would drive inflation and interest rates higher. French Finance Minister Bruno Le Maire recently warned: “Central banks’ restrictive policies are ineffective if public finances continue to expand.”

It seems we're all FTPLers now.

But I'm whining. For the length it's excellent. This is a hard topic and most journalists get things wrong.  And I am grateful for the publicity.

## Friday, October 28, 2022

### Economics Art

I was researching the European Stability Mechanism this morning for a paper on the evolution of the euro, and I ran across this gem of economics art on the ESM webpage.

Put on your mechanical engineer hat for a moment. This is a set of gears that literally cannot turn. To say nothing of the wisdom of putting belts on gears. Perhaps this is a subtle cry for help?

(The ESM is sort of europe's internal IMF that can lend money to strapped governments with conditions.)

## Tuesday, October 25, 2022

### Truss Tragedy

The Liz Truss Tragedy

The former British prime minister’s downfall holds important lessons for growth-minded policymakers in the United States, Europe, and elsewhere. While her diagnosis of the country’s economic problem was spot on, she fatally mismanaged both the politics and the messaging of her policy response.

STANFORD – Liz Truss’s stint as British prime minister is over, but she was right that the United Kingdom needs growth. Her downfall is tragic, because growth is the only path out of the country’s economic dilemma.

The UK is surprisingly poor. Its GDP per capita is just $43,000, compared to$60,000 in the United States. The average British home is one-third the size of the average US home. Worse, the country’s economy is not growing. Its GDP per capita is lower than it was in 2007. Productivity – the underlying source of economic growth – has been flat for over a decade.

The UK desperately needs supply-side reforms. Surging inflation tells us that demand-side stimulus is a spent force.

### Inflation Expectations

From Torsten Slok at Apollo Global Management. The picture says it all, but Torsten's commentary is especially good:

Inflation will be coming down over the coming quarters. This is what the Fed is predicting, that is what the consensus is expecting, and that is what we are predicting. The problem is that this has been the forecast ever since inflation started going up in April 2021, see chart below. Given how systematically wrong inflation forecasts have been over the past 18 months, there are good reasons to be cautious about the current forecast.

It is also how market expectations have evolved. Is inflation inherently unpredictable? Are we collectively in thrall of the same wrong model? Does "expectation" mean the same thing in models and surveys? Are market risk premiums really important?

## Friday, October 14, 2022

### More UK finance regulatory failure

In previous blog posts here and here, I criticized UK financial regulators for missing simple leverage and margin requirements in UK pension funds. To be clear, I don't criticize the people. The point is, if after 10 years of intense regulation, a group of really smart and dedicated people can't see plain old leverage, the whole project of regulating risks is broken. And it's not just the UK. The Fed bailed out money market funds in 2020. Again.

I insinuated the regulators were not paying attention. I was wrong. It turns out they were paying attention. Which makes the failure all the more stark.

In Friday's Wall Street Journal, Greg Ip writes

In 2018, the Bank of England investigated whether a big rise in interest rates would trigger a cascade of forced selling by bond investors, destabilizing the financial system. The answer was no,

That they did think about it, and they missed it anyway is even more damning for the regulate-risks project.

### Nobels and financial crises

(At National Review)

What This Year’s Nobel Economists Can Teach Us about Financial Crises

This week, economists are celebrating the Nobel Prize given to Ben Bernanke, Doug Diamond and Phil Dybvig for their work on banking.

Bernanke pointed out that banks matter. In the Great Depression, banks failed, and there was nobody left who knew how to make new loans. The economy contracted, not just for lack of money or for animal spirits of investors, but for lack of credit. Diamond and Dybvig wrote the classic economic model of bank runs, which shows how banks can fail even when they are “illiquid” rather than “insolvent.” The logic works like this: The bank has invested our money in illiquid projects, so if I suspect others are going to run to get their money out, I run to get mine out first before it’s all gone.

But it is no insult to say that these are not eternal verities. The papers were written about 40 years ago. Each was the launching pad for a vast and important investigation. Indeed, Nobel Prizes largely recognize that sort of lasting influence on subsequent work. But that subsequent investigation opens new possibilities. Newton is no less profound for having been followed by Einstein. Each also sought to understand the world as it was, which is how one should start. But there are other possibilities for how the world might be — and how it might be better.

## Monday, October 10, 2022

### Mind the store

On the same page in today's WSJ:

One third of DC bus riders don't bother to pay the fare. Also in New York

The State Department is so dysfunctional that processing visa requests takes years

In New Delhi, an appointment for a nonimmigrant visitor visa takes more than 800 calendar days, or nearly three years; for a student visa, nearly 450 days. The Cato Institute found that more than half of U.S. embassies and consulates world-wide have a waiting time greater than six months for a visitor or business visa appointment, compared with 1% before the pandemic. More than 1 in 4 have a waiting time of a year or more.

In March Congress enacted the EB-5 Reform and Integrity Act of 2022 to streamline the immigrant-visa process for foreign investors who commit significant capital to the U.S. But that reform is swamped by slow administration. U.S. Citizenship and Immigration Services advises applicants that 80% of cases (excluding Chinese nationals, who take even longer to process) are resolved within 52 months, or nearly 4½ years.

A central part of the immigration problem is that asylum claims languish in courts for years. And regular criminal courts also take years. Either spend the money to administer the laws, or change the laws (immigration and visas in particular) to not require administration that we can't provide.

These are just two tips of the iceberg of general incompetence in many parts of our government.  Not all: I've had some pleasant interactions with very well run low-level government offices lately. It can be done.

Wanted for the elections: politicians who will campaign simply to administer competently and remedy dysfunction. Efficient government offices, court systems, transit systems and so forth are also crucial infrastructure. Don't lead new grand causes, just mind the store.

## Thursday, October 6, 2022

### UK finance fable update

Update to my previous post on the UK treasury imbroglio:

The Bank of England explains, saying about as much as I did. Pension funds levered up, lost money when treasury prices fell, needed to post collateral, and then started selling en masse. The explanation starts with lovely central-bankerese (my italics):
Against the backdrop of an unprecedented [really? Literally never?] repricing [translation: fall in prices] in UK assets, the Bank announced a temporary and targeted intervention on Wednesday 28 September to restore market functioning in long-dated government bonds and reduce risks from contagion to credit conditions for UK households and businesses.

It goes on to a hilarious graph to explain how you lose money when you borrow to lever up a portfolio:

Why is this so funny? Notice on the left hand side a gap between assets and liabilities, yet in the fourth bar there is a positive "capital" bar.  Accounting 101, assets = liabilities, including capital. I guess UK regulations operate differently.

But enough fun, let's get to the point. In answer to my question, roughly "you're supposed to be this great gargantuan regulator, how could you miss something so simple?," the bank offers, deep in the report, this:
The FPC has previously identified underlying vulnerabilities in the system of market- based finance, a number of which were exposed in the ‘dash for cash’ episode in March 20202. The Bank and the FPC strongly support and engage with the important programme of domestic and international work to understand and, where necessary, address those vulnerabilities.

The FPC conducted an assessment of the risks from leverage in the non-bank financial system in 2018, and highlighted the need to monitor risks associated with the use of leverage by LDI funds.

It's so nice you've been studying this. But then double, how did this happen?

## Tuesday, October 4, 2022

### Out of the box risks

Policy Tensor on the consequences of a Russian nuke (HT Marginal Revolution) was very interesting:

Consider the least escalatory option, that of a “demonstration detonation”: Russian forces air-burst (to avoid the nuclear fallout that results from a ground detonation) a tactical nuclear weapon with sub-kiloton yield (ie, no bigger than a big conventional weapon) over uninhabited territory somewhere in south-eastern Ukraine. This would be consistent with Russia’s “escalate-to-deescalate” doctrine ... What happens then?

Precisely because it is such a dramatic break with precedent, even a demonstration detonation would radically change the character of the Russo-Western conflict over Ukraine. New Yorkers and Berliners etc, are likely to flee the cities. Everywhere, in Europe and America, supermarkets would likely empty within hours. Many local authorities may institute civil defense measures, even as federal governments everywhere urge calm. A widespread breakdown of law and order would be a real possibility; especially in America, where it would be attended by partisan passions and finger-pointing....

Not to bash a hobby horse, but the Fed, SEC, FDIC and so forth are now obsessed with climate risk to the financial system. Chatting with colleagues at the Fed, it is astonishing how much and how detailed the research is in to climate (really weather) scenarios, much of this directed by higher-ups.

Today I will not criticize that effort. Maybe pianos do fall from the sky.  What is striking to me, verified in every conversation I have with people in these institutions (please prove me wrong!) is that nobody at these institutions is doing any analysis of any other risk.

This seems like a useful one, for example. Any nuclear explosion is going to make the ATMs go dark. Is anyone at the Fed gaming this out? What if (when) China blockades Taiwan? What about a massive cyberattack on the banking system, a deliberate attempt to cause a run (Russian disinformation that a major bank has had all its account information wiped out, get your cash now)? A new pandemic that looks more like 1350 than the flu?

## Monday, October 3, 2022

### Sowell Nobel Redux

Nobel Prize season is around the corner. Last year, I blogged in favor of Tom Sowell. I update, with some edits.

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. Race is a forefront 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?

Yes, he's a free-market economist, 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, about facts, about logic, 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.

## Friday, September 30, 2022

### A familiar finance fable in UK bonds

Guy Adams in the Daily Mail has an intriguing story of what's going on in UK bond markets.  It's intriguing because it's so utterly familiar. And it reveals that all the masses of regulation and armies of regulators aimed at preventing exactly this sort of thing from happening again and again have failed again.

UC pensions take in contributions when people are young, invest them, and then pay out fixed amounts when people get old. They hold large quantities of government bonds, currently 1.5 trillion pounds per Adams. That's a good strategy: if you have fixed payments to make, invest in risk free assets that provide fixed payments, and ignore the mark to market. But it fell apart in a classic way.

Leverage

As often is the case, however, they didn't have enough assets to pay out the promises. So... Lever up! Pensions used their government bonds as collateral, borrowed money, and invested that money in more government bonds or, to a lesser extent, in stocks or other investments.

## Thursday, September 29, 2022

### Supply and inflation

Mark Perry recently updated a fabulous chart:

Not all inflation is the same.

Some interpretations, from Mark. Tradeable (international competition) / non tradeable; government intervention / free market; durable goods / services:

a. The greater (lower) the degree of government involvement in the provision of a good or service the greater (lower) the price increases (decreases) over time, e.g., hospital and medical costs, college tuition, childcare with both large degrees of government funding/regulation and large price increases vs. software, electronics, toys, cars and clothing with both relatively less government funding/regulation and falling prices. As somebody on Twitter commented:

Blue lines = prices subject to free-market forces. Red lines = prices subject to regulatory capture by government. Food and beverages are debatable either way. Conclusion: remind me why socialism is so great again.

b. Prices for manufactured goods (cars, clothing, appliances, furniture, electronic goods, toys) have experienced large price declines over time relative to overall inflation, wages, and prices for services (education, medical care, and childcare).

c. The greater the degree of international competition for tradeable goods, the greater the decline in prices over time, e.g., toys, clothing, TVs, appliances, furniture, footwear, etc.

*Thank goodness the government doesn’t subsidize TVs or toys, or toy TVs.

*Almost every line that went up, has had some type of government involvement, while the lines going down have more to do with capitalism.

*And as always, the more regulated, the more expensive things become.

There is a big distributional impact here. Less well off people buy more blue stuff, rich people more red stuff.

The implications for greater protection, less immigration, industrial policy, and subsidies are pretty clear.

Update:

I have been sloppy, about one of my own pet peeves. This graph is about relative prices, not about inflation.

## Sunday, September 25, 2022

### WSJ stability oped -- full text

Now that 30 days have passed, I can post the full text of "Nobody Knows How Interest Rates Affect Inflation" in the Wall Street Journal August 25. A previous post has a summary with pretty pictures.

***

A grand economic experiment is under way. Can the Federal Reserve contain inflation without raising interest rates much higher than they are now?

Conventional wisdom says that as long as interest rates are below the rate of inflation, inflation will rise. Inflation in July was 8.5%, measured as the one-year change in the consumer price index. The Fed has raised the federal funds rate only from 0.08% in March to 2.33% in August. According to the conventional view, that isn’t nearly enough. Higher rates are needed, now.

This conventional view holds that the economy is inherently unstable. The Fed is like a seal, balancing a ball (inflation) on its nose (interest rates). To keep the ball from falling, the seal must quickly move its nose.

In a newer view, the economy is stable, like a pendulum. Even if the Fed does nothing, so long as there are no more shocks, inflation will eventually peter out. The Fed can reduce inflation by raising interest rates, but interest rates need not exceed inflation to prevent an inflationary spiral. This newer view is reflected in most economic models of recent decades. It accounts for the Fed’s projections and explains the Fed’s sluggish response. Stock and bond markets also foresee inflation fading away without large interest-rate rises.

So which view is correct? In normal times, it’s hard to tell. Whether seal or pendulum, inflation and interest rates move up or down together in the long run, and they jiggle around each other in the short run.

Advocates for the conventional view argue that the Fed raised interest rates too little in response to inflationary shocks in the 1970s. Only when the Fed raised interest rates substantially above inflation for several years in the early 1980s, provoking two deep recessions, did inflation finally subside. The sooner we get to it, they say, the better.

Advocates for the stable view point to recent decades of steady inflation at zero interest rates in the U.S., Europe and Japan. When deflation appeared and central banks couldn’t move rates much below zero, conventional analysts warned of a “deflation spiral.” It never happened. Why should an inflation spiral break out now?

In both theories, expected inflation matters: If people expect higher inflation next year, they buy or raise prices today. The central assumption behind the unstable inflation-spiral theory is that people expect next year’s inflation to be pretty much the same as last year’s inflation—what economists call “adaptive expectations.” A driver who looks in the rearview mirror to judge where the road is will quickly veer off to one side or another.

The central assumption behind the stable theory is that people think more broadly about future inflation. They’re not clairvoyant, but they don’t ignore useful information and aren’t much worse at forecasting inflation than, say, Fed economists are. If a driver looks forward through the windshield, even a dirty windshield, the car tends to get back on the road.

Economists don’t know for sure whether the economy is stable or unstable, whether inflation can fade away without interest rates substantially above inflation. In that light, the Fed’s actions make some sense. If you really don’t know how interest rates affect inflation, it’s natural to raise rates slowly. Inflation may subside on its own. If not, you can keep raising rates.

If inflation fades, the conventional view will be seriously undermined. If it spirals, absent other shocks, the new view is in trouble. But a good experiment requires everyone to leave the test tube alone. Unfortunately, we are likely to see some new shock: a virus, a war, a financial crisis or a fiscal blowout. Inflation will then rise or fall for reasons having nothing to do with spirals, stability and interest rates.

Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar of the Cato Institute. His book “The Fiscal Theory of the Price Level” is out in January.

Update:

Economists wondering what the heck I'm talking about and where are the equations should read "Expectations and the Neutrality of Interest rates."

## Friday, September 23, 2022

### Brexit might not have been such a bad idea after all -- EU insanity

I was for Fixit, not Brexit. The EU is a great idea. They put together articles of confederation, empowering an out of control bureaucracy. OK, we did that too, minus the bureaucracy part. Try again, with a real constitution, a real federal government, clear separation of powers, checks and balances, and a careful list of limitations, not long vague aspirations.

Europe has not taken that suggestion, nor the hint offered by the Brits leaving. The latest evidence is a tiny puff in this hurricane of hot air, which I found on this tweet

That sounds interesting, in a waste time on twitter while procrastinating getting to work sort of way. And I was encouraged--EC bureaucracies looking for outside advice, breaking out of the bubble seems like a good idea. Hey, maybe I'll apply, I thought.

I followed the link to the official announcement and it offers in a nutshell what's going on in EU "policy-making," (and a hint why I hate that word)

The latest communication on industrial policy strategy (COM(2021) 350final) has shifted the attention towards an ecosystem approach to industrial policy, focusing on industrial ecosystems and their complex interconnections related, among other things, to entrepreneurship (and SMEs), innovation, skills, value creation and social impact.
After mulling over the obvious reality of war, supply chains, etc.
..a reactive stance is not sufficient and needs to be complemented by a forward-looking reflection aimed at properly considering externalities and risk factors to be prepared for - and therefore more and more resilient against - possible additional challenges (for instance in terms of disruptions and shortages but also new, far from impossible health crises), remaining consistent with crucial long-term objectives. Progress is more than innovation and EU competitiveness, more than continuous growth and geopolitical predominance. [Who are you kidding?] It is also quality of life, sustainable production and energy generation, digitally advanced (but also digitally safe and fair) infrastructure, “enlightened” decision-making at corporate level eventually influenced by well-informed choices at consumer level.
My emphasis. The subject is a bit mysterious in all these passive sentences, but I believe it is "EU industrial policy." I'm glad it will take on scare-quote enlightened decision making at the corporate level and allow eventually for some "well-informed" choices "at the consumer level." That's you with the pitchforks.
This may imply putting into question traditional policy yardsticks such as the focus on industrial sectors as done with the shift towards an ecosystem approach, [the focus on] on the overarching principle of economic efficiency as a first best for resources allocation e.g. by factoring in risks associated to critical strategic dependencies, or the focus on traditional stakeholders (for instance, by including a wider set of actors, in a truly ecosystem mindset going beyond industrial activity and including other relevant players, such as universities, research centres, and even the role of local communities). This may be more effectively inspired by policy missions, rather than sectoral or even social cleavages.
Well, no wonder they need some outside economists if they're going to perfectly foresee "critical strategic dependencies" in the "ecosystem," such as, oh, maybe Russia might turn off the gas some day.  "Policy missions, rather than sectoral or even social cleavages?" I have no idea what that means.

This may also imply some reshuffling in policy priorities, for instance by having some ethical yardsticks considered upfront (namely, but not only, with respect to innovation),

"by having ethical yardsticks considered upfront." Don't you love passive voice? "namely... with respect to innovation" is truly chilling. That means, before you can innovate, the great directorate of industrial policy will decide if your innovation is "ethical," as it affects "stakeholders" and the "industrial ecosystem." What is the chance James Watt's steam engine will make it past that?

by enshrining sustainability considerations (and related externalities often ignored in the past) in trade-offs underlying corporate choices, by thoroughly considering social impact of public and private investment as a major element of choice.

Passive means us. Can any investment get past this? Oh yes,

“Social cheerleading” and “greenwashing” should become strictly unfeasible, starting from becoming easily detectable. This may imply rethinking the incentives and mechanisms to better align public goals and private behaviour. It may also imply refining our metric to measure progress.

Heavens, we wouldn't want to have any greenwashing here.

If addressed only from a national perspective, all the challenges and reflections above would seem and would be unsurmountable. A truly coordinated European approach exploiting the potential of the Single Market would be of the utmost importance...

Now you know why the Brits left.

What follows is a non-exhaustive list of examples of themes of interest to DG GROW within the broad areas defined above: [edited here]
• Industrial policy in the Single Market: moving forward avoiding fragmentation and minimising short-term losses
Aha, so industrial policy involve "short term" losses!
• A mission-oriented Single Market to increase ownership, generate momentum and help prioritising actions aimed at improving its functioning
Ownership can be transferred, but how can ownership be increased? Otherwise as empty a sentence as I've seen in a long time.
• Strategic dependencies, monitoring risks and building supply chains resilience
Yes, you did such a great job on that one by banning fracking and decommissioning nuclear power.
• Dependencies and the search for new economic models
Just savor the empty words. Or are they Orwellian and full of meaning?
• Unlocking the green business case; the role of the Single Market
• Investment needs to leap forward

A Great Leap Forward? How are you going to leap forward given the previous page that says, basically, all investment must stop?

• New metrics to measure economic progress
We haven't dug ourselves into a 20 meter hole. It's only a tenth of a furlong!

I am tempted to apply. I offer this: "Cut the BS, get out of the way, quit and get some real jobs. The pretense of technocratic competence to understand and manipulate such a huge Rube-Goldberg view of the world is just laughable." Send the 15,0000 euro check to Hoover.

I originally thought this would be illegal. But on a little research, the Lisbon Treaty, which was supposed to improve the EU, takes a big step backwards.
The Lisbon Treaty introduced in its Art. 3 new language into primary law that expresses the ambition to give the EU a stronger social dimension.1 In comparison to its predecessor provision of Art. 4 (1) of the Treaty Establishing the European Community, which solely relied on the ‘principle of an open market economy with free competition’, the basic objectives of the EU were broadened. Art. 3 TEU now includes objectives that come across as a promise to rebalance market and non-market values through the foundational provisions of the European Union. In line with other wide-ranging objectives, like fighting social exclusion, this article includes the eye-catching sentence that the EU aims for ‘a highly competitive social market economy’ that seeks to achieve ‘full employment and social progress’
Liz Truss may struggle to convince the UK that to fix supply you have to fix supply (great WSJ commentary by Joe Sternmberg here) but at least she knows where to go. Europe still seems lost in the fog.

This is of course likely to go nowhere, to just employ PhD economists to write reports nobody reads. But who knows, having missed a real estate bust, a sovereign debt crisis, a pandemic, an energy crisis and a war, the ECB is doubling down on climate change stress tests, so you never know what foolishness can actually make it into policy.

And it's not all so bad. Ukrainians look East vs. West. A bunch of bureaucratic tomfoolery looks a whole lot better than what Vlad the Impaler has to offer. Go Europe. Some day, fixit.

## Wednesday, September 21, 2022

### Gramm, Early and the Unfixable Problem

Phil Gramm and John Early have a new WSJ oped, based on their smashing new book. Both are based on an astounding fact: The numbers used by the Census Bureau, and countless following researchers, to define income inequality and poverty do not include taxes, which reduce income of the rich, and transfers, which increase income of the poor. The latter, obviously, matters to just how many Americans fall in the Census Bureau's definition of poverty.

Specifically, in the oped, the new refundable tax credit cannot, by arithmetic, do anything to alleviate measured child poverty because

"the income numbers used to calculate the official poverty rates don’t count refundable tax credits as income to the recipients. "

This is wonderful for advocates of ever larger transfer programs, as it creates a problem that can never be measured to be fixed!

The more general issue

The Census Bureau fails to count two-thirds of all government transfer payments to households in the income numbers it uses to calculate not only poverty levels but also income inequality and income growth. In addition to not counting refundable tax credits, which are paid by checks from the U.S. Treasury, the official Census Bureau measure doesn’t count food stamps, Medicaid, the Children’s Health Insurance Program, rent subsidies, energy subsidies and health-insurance subsidies under the Affordable Care Act. In total, benefits provided in more than 100 other federal, state and local transfer payments aren’t counted by the Census Bureau as income to the recipients

The book goes on to show how this startling omission overturns just about everything you've heard from the hyperventilating classes about income inequality. Granted, spending zillions on rotten health insurance that people value much less than a dollar per dollar is not quite the same as cash, but there are lots of cash or cash equivalent transfers in there.

A question I do not know the answer to: Do means-tested programs count as "income" the transfers from other means-tested programs? If a program is only available to, say, those with less than $50,000 per year income, does that figure include any other means-tested programs? Even the ones that send cash, rather than in-kind transfers such as rent, energy, and health insurance subsidies? I suspect largely no. If not, the incentives for means-tested programs are far worse than even they appear. Facts welcome. One might easily respond that ok, but evil capitalism created wider pre-tax pre-transfer inequality, and only by the grace of larger and larger transfers has some measure of stability been restored. Well, which is the cause and which is the effect -- wider pre-tax pre-transfer inequality, or the large expansion of means-tested programs, all of which add to the stupendous marginal tax rates facing Americans with less opportunity? The book goes on to argue convincingly the latter. I'll cover that later. Noting here, they anticipate the argument. ## Thursday, September 15, 2022 ### Fisherian Intuition Interest rate neutrality is easy to state in equations but hard to digest intuitively. The equation says that interest rate = real rate plus expected inflation, $i_t = r + E_t\pi_{t+1.}$In one direction this is easy: If people expect a lot of inflation, then they demand higher nominal $$i_t$$ interest rates to compensate for the declining value of the dollar. That leaves the real $$r$$ interest rate unchanged. (Note: this post uses mathjax equations. If you can't see them, come to the original.) But in our economy the Fed sets the nominal interest rate and the rest must adjust. In the short run with sticky prices and other frictions the real rate may change, but eventually the real rate is set by real things and expected inflation must rise. We can study that long run by leaving out the sticky prices and other frictions, and then expected inflation rises right away. Rises. Higher interest rates raise inflation. How does that really work? What's the economic force? Standard intuition says overwhelmingly that higher interest rates cause people to spend less which lowers inflation. The equations seem like they're hiding some sort of sophistry. (Fed Chair Powell explains the standard view well while sparring with Senator Warren here. The clip is great on several dimensions. No, the Fed cannot increase supply. No, none of what Senator Warren talks of will make a dent in supply either. The elephant in the room, massive fiscal stimulus, is not mentioned by either party. Just why each is silent on that is an interesting question.) This is a lovely case that individual causality goes in the opposite direction of equilibrium causality. That happens a lot in macroeconomics and can cause a lot of confusion. It also is an interesting case of mistaking expected inflation for unexpected inflation. Along with confusing relative prices for inflation, that's common and easy to do. Hence this post. ## Wednesday, September 14, 2022 ### Email feed restored A while ago, Google turned off the ability to receive the Grumpy Economist, and all the other blogger blogs, by email. I have now figured out how to restore it. I moved over to follow.it. If the import of the old email feed worked as it is supposed to, you're receiving this in your email once again. If not, you can click on the huge button to the right to get Grumpy by email. (I'll figure out how to make that prettier sooner or later.) I also announce each new blog post on twitter, and if you prefer that you can click the twitter link to follow me there. Follow.it encourages me to pass along all the "great additional features" you can use, here. You can now "define filters and more delivery channels, e.g... receive your news via Telegram, news page etc. (many others to follow soon)." Thanks to several devoted readers who wrote to complain, nudging me to figure this out. If it still doesn't work, either comment here or email me directly. If I link "Feedburner alternative" and "Feedburner replacement" to follow.it, they give me a$10 USD credit. Done!

More substance on the way soon!

Update

You will receive an email that looks like this. It invites you to click a link. This is a legitimate email.

## Friday, September 9, 2022

### Energy Agony

Two era-defining articles popped up in today's Wall Street Journal.

In "the coming global crisis of climate policy," Joseph Sternberg writes

...Anyone who still thinks climate change is a greater threat than climate policy to financial stability deserves to be exiled to a peat-burning yurt in the wilderness.

...the world’s central banks and other regulators are in the middle of a major push to introduce various forms of climate stress testing into their oversight. ...The fad is for quantifying, with preposterous faux-precision, the costs of reinsuring flood risks, or fire, or the depressed corporate profits of a dystopian hotter future.

Well, if you seek “climate risk” to financial stability, look around you. It has arrived, although in exactly the opposite manner to what our current crop of eco-financiers predicted....

The U.K. may be facing a wave of business bankruptcies exceeding anything witnessed during the post-2008 panic and recession...The culprit is energy prices...Matters are probably worse in Germany,...

Banks and other financial firms inevitably will find themselves right at the edge of the water if or when a tsunami of energy-price bankruptcies washes ashore.

## Thursday, September 8, 2022

### Expectations and the Neutrality of Interest Rates

Expectations and the Neutrality of Interest Rates is a new paper. It's an essay, really, expanding on a lunch talk I was privileged to give at the Minneapolis Fed "Foundations of Monetary Policy" conference in honor of the 50th anniversary of Bob Lucas' 1972 "Expectations and the Neutrality of Money."

Abstract:

Lucas (1972) is the pathbreaking analysis of the neutrality and temporary non-neutrality of money. But our central banks set interest rate targets, and do not even pretend to control money supplies. How is inflation determined under an interest rate target?

We finally have a complete theory of inflation under interest rate targets, that mirrors the long-run neutrality and frictionless limit of monetary theory: Inflation can be stable and determinate under interest rate targets, including a k percent rule, i. e. a peg. The zero bound era is confirmatory evidence. Uncomfortably, long-run neutrality means that higher interest rates eventually produce higher inflation, other things (and fiscal policy in particular) constant.

With a Phillips curve, we have some non-neutrality as well: Higher nominal interest rates raise real rates and lower output. A good model in which higher interest rates temporarily lower inflation is a harder task. I exhibit one such model. It has the Lucas property that only unexpected interest rate rises can lower inflation. A better model, and empirical understanding, is as crucial to today's agenda as Lucas (1972) was in its day.

Much of this is contentious. The issues are crucial for policy: Can the Fed contain inflation without dramatically raising interest rates? Given the state of knowledge, a bit of humility is in order.

The link also has slides, if you like those. In one slide, I managed to put together the 54 year project to (finally) produce a full theory of inflation under interest rate targets:

## Friday, September 2, 2022

### Apartment inflation

This beautiful graph comes from calculatedriskblog.com. (Courtesy Andy Atkeson who used it in a nice discussion of a great paper by Ivan Werning at the Minneapolis Fed Foundations of Monetary Policy conference.)

The central lines that don't move so much are the average rent. This is the quantity used by the Bureau of Labor Statistics to compute the consumer price index. The blue and yellow lines are the rent of new leases.

The first thing this informs is the economic theory of "sticky prices." Apartment rents are a classic "sticky price;" the rent is fixed in dollar terms for a year. So, landlords deciding how much rent to charge, and people deciding how much they're willing to pay,  balance rents now vs. higher rents in the future. If everyone believes that inflation will be 10% over the next year, then it makes sense to raise the rent 5% now, and to pay the 5% higher rent, because  the savings at the end of the year balance the cost in the beginning. (Obviously, the economics are much more subtle than this, but you get the idea.) And Voila', you see it.

The graph also says there is some predictability and nomentum to inflation. Inflation should not be a surprise to forecasters. If you see rents on new leases much above average rents, it's a pretty good bet that average rents will be rising in the future! This kind of phenomenon may be under exploited in formal inflation forecasting.

And, on the continuing speculation whether inflation will go away with interest rates still substantially below current inflation, the graph does seem a leading indicator that the rational expectations model is winning.

Clarification: Of course, the graph says nothing about causality; did new leases rise sharply because people expected inflation in average leases, or did new leases rise for other reasons, and we're just seeing the old theorem that marginal  > average when average is rising. But it is consistent with the expectations story, and illuminates that story nicely.

## Thursday, August 25, 2022

### WSJ inflation stability oped -- with pictures

"Nobody Knows How Interest Rates Affect Inflation" is a new oped in the Wall Street Journal August 25. (Full version will be posted here Sept 25). It's a distillation of two recent essays, Expectations and the Neutrality of Interest Rates and Inflation Past, Present, and Future and some recent talks.

The Fed has only very slowly raised interest rates in response to inflation:

Does the Fed's slow reaction mean that inflation will spiral away, until the Fed raises interest rates above inflation? The traditional theory says yes. In this theory, inflation is unstable when the Fed follows an interest rate target. Unstable:

In this view, the Fed must promptly raise interest rates above inflation to contain inflation, as the seal must move its nose more than one for one to get back under the ball. Until we get interest rates of 9% and more inflation will spiral upward.

The view comes fundamentally from adaptive expectations. Inflation = expected inflation - (effect of high real interest rates, i.e. interest rate - expected inflation). If expected inflation is last year's inflation, you can see inflation spirals up until the real interest rate is positive.

But an alternative view says that inflation is fundamentally stable. Stable:

Econometric tests aren't that useful -- inflation and interest rates move together in the long run in both views, and jiggle around each other. Episodes are salient. The unstable view points to the 1970s:

The Fed reacted too slowly to shocks, the story goes, letting inflation spiral up until it finally got its nose under the ball in 1980, driving inflation back down again. But the stable view points to the 2010s:

It's exactly the opposite situation. Deflation broke out. The Fed could not move interest rates below zero. The classic analysis screamed "here comes the deflation spiral." It didn't happen. Wolf. If the deflation spiral did not break out, why will an inflation spiral break out now?

Not elsewhere: As I look at these, I start to have additional doubts about the classic story of the 1970s. The Fed did move interest rates one for one. Inflation did not simply spiral out of control. For example, note in 1975, inflation did come right back down again, even though interest rates never got above inflation. The simple spiral story does not explain why 1975 was briefly successful. Each of the waves of inflation also was sparked by new shocks.

Who is right? I don't pound my fist on the table, but stability, at least in the long run, is looking more and more likely to me. That says inflation will eventually go away, after the price level has risen enough to inflate away the recent debt blowout, even if the Fed never raises rates above inflation. In any case, it looks like we have another really significant episode all set up, to add to the 1970s and 2010s. If inflation spirals, stability is in trouble. If inflation fades away and interest rates never exceed inflation, the classic view is really in trouble. The ingredients are stirred, the test tube is on the table...

But, that's a conditional mean. A new shock could send inflation spiraling up again, just as may have happened in the 1970s. New virus, China invades Taiwan, financial crisis, sovereign debt crisis, another fiscal blowout -- if the US forgives college debt, why not forgive home loans? Credit cards? -- all could send inflation up again, and ruin this beautiful experiment.

## Tuesday, August 9, 2022

### Climate policy numbers

Most legislation or regulation that spends hundreds of billions of dollars aimed at a purpose is extensively analyzed or scored to that purpose. OK, the numbers are  often, er, a bit unreliable, but at least proponents go through the motions and lay out assumptions one can examine and calculate differently. Tax and spending laws come with extensive analysis of just how much the government will make or spend. This is especially true when environment is concerned. Building anything requires detailed environmental assessments. An environmental review typically takes 4.5 years before the lawsuits begin.

In this context, I'm amazed that climate policy typically comes with no numbers, or at least none that I can find readily available in major media. We're going to spend an additional \$250 billion or so on climate policies in the humorously titled "inflation reduction act." OK,  how much carbon will that remove, on net, all things included, how much will that lower the temperature and when, how much and when will it quiet the rise of the oceans?

Finally, I have seen one number, advertised in the Wall Street Journal

Our contributor Bjorn Lomborg looked at the Rhodium Group estimate for CO2 emissions reductions from Schumer-Manchin policies. He then plugged them into the United Nations climate model to measure the impact on global temperature by 2100. He finds the bill will reduce the estimated global temperature rise at the end of this century by all of 0.028 degrees Fahrenheit in the optimistic case. In the pessimistic case, the temperature difference will be 0.0009 degrees Fahrenheit.

## Saturday, August 6, 2022

### The Fiscal Theory of Inflation

We often summarize that the fiscal theory is a theory of the price level: The price level adjusts so that the real value of government debt equals the present value of surpluses. That characterization seems to leave it to a secondary role. But with any even tiny price stickiness, fiscal theory is really a fiscal theory of inflation. The following two parables should make the point, and are a good starting point for understanding what fiscal theory is really all about. This point is somewhat buried in Chapter 5.7 of Fiscal Theory of the Price Level

Start with the response of the economy to a one-time fiscal shock, a 1% unexpected decline in the sum of current and expected future surpluses, with no change in interest rate, at time 0. The model is below, but today's point is intuition, not staring at equations. This is the continuous-time version of the model, which clarifies the intuitive points.

 Response to 1% fiscal shock at time 0 with no change in interest rates

The one-time fiscal shock produces a protracted inflation. The price level does not move at all on the date of the shock. Bondholders lose value from an extended period of negative real interest rates -- nominal interest rates below inflation.

What's going on? The government debt valuation equation with instantaneous debt and with perfect foresight is $V_{t}=\frac{B_{t}}{P_{t}}=\int_{\tau=t}^{\infty}e^{-\int_{w=t}^{\tau}\left( i_{w}-\pi_{w}\right) dw}s_{\tau}d\tau$ where $$B$$ is the nominal amount of debt, $$P$$ is the price level, $$i$$ is the interest rate $$\pi$$ is inflation and $$s$$ are real primary surpluses. We discount at the real interest rate $$i-\pi$$. We can use this valuation equation to understand variables before and after a one-time probability zero "MIT shock."

With flexible prices, we have a constant real interest rate, so $$i_w-\pi_w$$. Thus if there is a downward jump in  $$\int_{\tau=t}^{\infty}e^{-r \tau}s_{\tau}d\tau$$, as I assumed to make the plot, then there must be an upward jump in the price level $$P_t$$, to devalue outstanding debt. (Similarly, a diffusion component to surpluses must be matched by a diffusion component in the price level.) The initial price level adjusts so that the real value of debt equals the present value of surpluses. This is the standard understanding of the fiscal theory of the price level. Short-term debt holders cannot be made to lose from expected future inflation.

But that's not how the simulation in the figure works, with sticky prices. Since now both $$B_t$$ and $$P_t$$ on the left hand side of the government debt valuation equation cannot jump, the left-hand side itself cannot jump. Instead, the government debt valuation equation determines which path of inflation $$\{\pi_w\}$$ which, with the fixed nominal interest rate $$i_w$$, generates just enough lower real interest rates $$\{i_w-\pi_w\}$$ so that the lower discount rate just offsets the lower surplus.  Short-term bondholders lose value as their debt is slowly inflated away during the period of low real interest rates, not in an instantanoues price level jump.

In this sticky-price model, the price level cannot jump or diffuse because only an infinitesimal fraction of firms can change their price at any instant in time. The price level is continuous and differentiable. The inflation rate can jump or diffuse, and it does so here; the price level starts rising. As we reduce price stickiness, the price level rise happens faster, and smoothly approaches the limit of a price-level jump for flexible prices.

In short, fiscal theory does not operate by changing the initial price level. Fiscal theory determines the path of the inflation rate. It really is a fiscal theory of inflation, of real interest rate determination.

The frictionless model remains a guide to how the sticky price model behaves in the long run. In the frictionless model, monetary policy sets expected inflation via $$i_t = r+E_t \pi_{t+1}$$ or $$i_t = r+\pi_t$$, while fiscal policy sets unexpected inflation $$\pi_{t+1}-E_t\pi_{t+1}$$ or $$dp_t/p_t-E_t dp_t/p_t$$.  In the long run of my simulation, the price level does inexorably rise to devalue debt, and the interest rate determines the long-run expected inflation. But this long-run characterization does not provide useful intuition for the higher frequency path, which is what we typically want to  interpret and analyze.

It is a better characterization of these dynamics that monetary policy---the nominal interest rate---determines a set of equilibrium inflation paths, and fiscal policy determines which one of these paths is the overall equilibrium, inflating away just enough initial debt to match the decline in surpluses.

 Response to 1% deficit shock at time 0 with no change in interest rate

This second graph gives a bit more detail of the fiscal-shock simulation, plotting the primary surplus $$s$$, the value of debt $$v$$, and the price level $$p$$. The surplus follows an AR(1). The persistence of that AR(1) is irrelevant to the inflation path. All that matters is the initial shock to the discounted stream of surpluses. (I make a big fuss in FTPL that you should not use AR(1) surplus process to match fiscal data, since most fiscal shocks have an s-shaped response, in which deficits correspond to larger surpluses. However, it is still useful to use an AR(1) to study how the economy responds to that component of the fiscal shock that is not repaid.)

To see how initial bondholders end up financing the deficits, track the value of those bondholders' investment, not the overall value of debt. The latter includes debt sales that finance deficits. The real value of a bond investment held at time 0, $$\hat{v}$$, follows $d \hat{v}_t = (r \hat{v}_t + i_t - \pi_t)dt.$ I plot the time-zero value of this portfolio, $e^{-rt} \hat{v}_t.$ As you can see this value smoothly declines to -1%. This is the quantity that matches the 1% by which surpluses decline. (I picked the initial surplus shock $$d\varepsilon_{s,t}=1/(r+\eta_s)$$ so that $$\int_{\tau=0}^\infty e^{-r\tau}\tilde{s}_t d\tau =-1.$$ )

 Response to interest rate shock at time 0 with no change in surpluses

The third graph presents the response to an unexpected permanent rise in interest rate. With long-term debt, inflation initially declines. The Fed can use this temporary decline to offset some fiscal inflation. Inflation eventually rises to meet the interest rates. Most interest rate rises are not permanent, so we do not often see this long-run stability or neutrality property. The initial decline in interest rates comes in this model from long-term debt. As the dashed line shows, with shorter-maturity debt inflation  rises right away. With instantaneous debt, inflation follows the interest rate exactly.

Again, in this continuous-time model the price level does not move instantly. The higher interest rate sets off a period of lower inflation, not a price-level drop.

With long-term debt the perfect-foresight valuation equation is $V_{t}=\frac{Q_tB_{t}}{P_{t}}=\int_{\tau=t}^{\infty}e^{-\int_{w=t}^{\tau}\left( i_{w}-\pi_{w}\right) dw}s_{\tau}d\tau.$ where $$Q_t$$ is the nominal price of long-term government debt. Now, with flexible prices, the real rate is fixed $$i_w=\pi_w$$. With no change in surplus $$\{s_\tau\}$$, the right hand side cannot change. Inflation $$\{\pi_w\}$$ then simply follows the AR(1) pattern of the interest rate. However, the higher nominal interest rates induce a downward jump or diffusion in the bond price $$Q_t$$. With $$B_t$$ predetermined, there must be a downward jump or diffusion in the price level $$P_t$$. In this way, even with flexible prices, with long-term debt we can see an instant in which higher interest rates lower inflation before long run'' neutrality kicks in.

How does the price level not jump or diffuse with sticky prices? Now $$B_t$$ and $$P_t$$ are predetermined on the left hand side of the valuation equation. Higher nominal interest rates $$\{i_w\}$$ still drive a downward jump or diffusion in the bond price $$Q_t$$. With no change in $$s_\tau$$, a spread $$i_w-\pi_w$$ must open up to match the downward jump in bond price $$Q_t$$, which is what we see in the simulation. Rather than an instant downward jump in price level, there is instead a long period of low inflation, of slow price level decline, followed by a gradual increase in inflation.

Again, the frictionless model does provide intuition for the long-run behavior of the simulation. The three year decline in price level is reminiscent of the downward jump; the eventual rise of inflation to match the interest rate is reminiscent of the immediate rise in inflation. But again, in the actual dynamics we really have a theory of \emph{inflation}, not a theory of the \emph{price level}, as on impact the price level does not jump at all. Again, the valuation equation generates a path of inflation, of the real interest rate, not a change in the value of the initial price level.

The general lessons of these two simple exercises remain:

Both monetary and fiscal policy drive inflation. Inflation is not always and everywhere a monetary phenomenon, but neither is it always and everywhere fiscal.

In the long run, monetary policy completely determines the expected price level. As the inflation rate ends up matching the interest rate, inflation will go wherever the Fed sends it. If the interest rate went below zero (these are deviations from steady state, so that is possible), it would drag inflation down with it, and the price level would decline in the long run.

One can view the current situation as the lasting effect of a fiscal shock, as in the first graph. One can view the Fed's option to restrain inflation as the ability to add the dynamics of the second graph.

Don't be too put off by the simple AR(1) dynamics. First, these are responses to a single, one-time shock. Historical episodes usually have multiple shocks. Especially when we pick an episode ex-post based on high inflation, it is likely that inflation came from several shocks in a row, not a one-time shock. Second, it is relatively easy to add hump-shaped dynamics to these sorts of responses, by standard devices such as habit persistence preferences or capital accumulation with adjustment costs. Also, full models have additional structural shocks, to the IS or Phillips curves here for example. We analyze history with responses to those shocks as well, with policy rules that react to inflation, output, debt, etc.

The model  I use for these simple simulations is a simplified version of the model presented in FTPL 5.7.

\begin{aligned}E_t dx_{t} & =\sigma(i_{t}-\pi_{t})dt \\E_t d\pi_{t} & =\left( \rho\pi_{t}-\kappa x_{t}\right) dt\ \\ dp_{t} & =\pi_{t}dt \\ E_t dq_{t} & =\left[ \left( r+\omega\right) q_{t}+i_{t}\right] dt \\ dv_{t} & =\left( rv_{t}+i_{t}-\pi_{t}-\tilde{s}_{t}\right) dt+(dq_t - E_t dq_t) \\ d \tilde{s}_{t} & = -\eta_{s}\tilde{s}_{t}+d\varepsilon_{s,t} \\ di_{t} & = -\eta_{i}i_t+d\varepsilon_{i,t}. \end{aligned}

I use parameters $$\kappa = 1$$, $$\sigma = 0.25$$, $$r = 0.05$$, $$\rho = 0.05$$, $$\omega=0.05$$, picked to make the graphs look pretty. $$x$$ is output gap, $$i$$ is nominal interest rate, $$\pi$$ is inflation, $$p$$ is price level, $$q$$ is the price of the government bond portfolio, $$\omega$$ captures a geometric structure of government debt, with face value at maturity $$j$$ declining at $$e^{-\omega j}$$, $$v$$ is the real value of government debt, $$\tilde{s}$$ is the real primary surplus scaled by the steady state value of debt, and the remaining symbols are parameters.

Thanks much to Tim Taylor and Eric Leeper for conversations that prompted this distillation, along with evolving talks.