Monday, June 5, 2023

Stephens at Chicago; effective organizations

Brett Stephens gave a great commencement speech (NYT link, HT Luis Garicano) at the University of Chicago. One part stood out to me, and worthy of comment. Bret starts with the problem of Groupthink:

Why did nobody at Facebook — sorry, Meta — stop Mark Zuckerberg from going all in on the Metaverse, possibly the worst business idea since New Coke? Why were the economists and governors at the Federal Reserve so confident that interest rates could remain at rock bottom for years without running a serious risk of inflation? Why did the C.I.A. believe that the government of Afghanistan could hold out against the Taliban for months but that the government of Ukraine would fold to the Russian Army in days? Why were so few people on Wall Street betting against the housing market in 2007? Why were so many officials and highly qualified analysts so adamant that Saddam Hussein had weapons of mass destruction? Why were so many people convinced that overpopulation was going to lead to catastrophic food shortages, and that the only sensible answers were a one-child policy and forced sterilizations?

Oh, and why did so many major polling firms fail to predict Donald Trump’s victory in 2016?

Conspicuous institutional failures are the question of our age We could add the SBV regulatory fiasco, the 2007 financial regulatory failure, the CDC FDA and numerous governments under Covid,  and many more.  Systemic incompetence doesn't just include disasters, but ongoing wounds from the Jones act to California's billions wasted on obviously ineffective homeless spending. 

Thursday, May 25, 2023

Work requirements

The debate over work requirements for social programs is hot and heavy. I'll chime in there as I don't think even the Wall Street Journal Editorial pages have stated the issue clearly from an economic point of view.  As usual, it's getting obfuscated in a moral cloud by both sides: How could you be so heartless as to force unfortunate people to work, vs. how immoral it is to subsidize indolence, and value of the "culture" of self-sufficiency. 

Economics, as usual, offers a straightforward value-free way to think about the issue: Incentives. When you put all our social programs together, low income Americans face roughly 100% marginal tax rates. Earn an extra dollar, lose a dollar of benefits. It's not that simple, of course, with multiple cliffs of infinite tax rates (earn an extra cent, lose a program entirely), and depends on how many and which programs people sign up for. But the order of magnitude is right. 

The incentive effect is clear: don't work (legally). As Phil Gramm and Mike Solon report

Since 1967, average inflation-adjusted transfer payments to low-income households—the bottom 20%—have grown from $9,677 to $45,389. During that same period, the percentage of prime working-age adults in the bottom 20% of income earners who actually worked collapsed from 68% to 36%.

36%. The latter number is my main point, we'll get to cost later. Similarly, the WSJ points to  a report by Jonathan Bain and Jonathan Ingram at the Foundation for Government Accountability that

there are four million able-bodied adults without dependents on food stamps, and three in four don’t work at all. Less than 3% work full-time.


Incentives are a budget constraint to government policy, hard and immutable. Your feelings about people one way or another do not move the incentives at all. A gift of money with an income phase-out leads people to work less, and to require more gifts of money.  That's just a fact. 

What to do? 

Wednesday, May 24, 2023

Hoover Monetary Policy Conference Videos

The videos from the Hoover Monetary Policy Conference are now online here.  See my previous post for a summary of the conference. 

The big picture is now clearer to me. Phil Jefferson rightly asked, what do you mean off track? Monetary policy is doing fine. Interest rates are, in his view, where they should be. He argued the case well. 

But now I have an answer: The Fed has had three significant institutional failures: 1) Its inflation target is 2%, yet inflation exploded to 8%. The Fed did not forecast it, and did not see it even as it was happening. (Nor did many other forecasters, pointing to deeper conceptual problems.) 2) In the SVB and subsequent mess, the Fed's regulatory apparatus did not see or do anything about plain vanilla interest-rate risk combined with uninsured deposits. 3) I add a third, that nobody else seems to complain about: In 2020 starting with treasury markets, moving on to money market funds, state and local financing,  and then an astonishing "whatever it takes" that corporate bond prices shall not fall, the Fed already revealed that the Dodd-Frank machinery was broken. (Will commercial real estate be next?) 

Yet there is very little appetite for self-examination or even external examination. How did a good institution, filled with good, honest, smart and devoted public servants fail so badly? That's not "off-track" that's a derailment. 

Well, two sessions at the conference begin to ask those questions, and the others aimed at the same issues. Hopefully they will prod the Fed to do so as well, or at least to be interested in other's answers to those questions. 

(My minor contributions: on why the Taylor rule is important here, where I think I did a pretty good job; and comments on why inflation forecasts went so wrong at  1:00:16 here.)

Bradley Prize speech, video, and thanks

The videos and speeches of the Bradley prize winners are up. My video here (Grumpy in a tux!), also the speech which I reproduce below. All the videos and speeches here (Betsy DeVos and Nina Shea) My previous interview with Rick Graeber, head of the Bradley foundation. 

Bradley also made a nice introduction video with photos from my childhood and early career. (A link here to the introduction video and speech together.) And to avoid us spending all our talks on thanking people, they had us write out a separate thanks. That seems not to be up yet, but I include mine below. I am very thankful, humbled to be included in such august company, and not so boorish that I would not have spent my whole talk without mentioning that, absent the separate opportunity to say so. 

Bradley prize remarks (i.e. condense three decades of policy writing into 10 minutes): 

Creeping stagnation ought to be recognized as the central economic issue of our time. Economic growth since 2000 has fallen almost by half compared with the last half of the 20th Century. The average American’s income is already a quarter less than under the previous trend. If this trend continues, lost growth in fifty years will total three times today’s economy. No economic issue — inflation, recession, trade, climate, income diversity — comes close to such numbers.

Growth is not just more stuff, it’s vastly better goods and services; it’s health, environment, education, and culture; it’s defense, social programs, and repaying government debt.

Why are we stagnating? In my view, the answer is simple: America has the people, the ideas, and the investment capital to grow. We just can’t get the permits. We are a great Gulliver, tied down by miles of Lilliputian red tape.  

Walter Russell Mead and Grapes of Wrath Episode II

Walter Russell Mead has a nice essay in Tablet on California. This excerpt struck me. You too were probably dragged through "Grapes of Wrath" at some point in school, or you've seen the movie. But what happens next? Mead's insight hadn't occurred to me. Spoiler: 

Ma Joad might have ended up as the “Little Old Lady From Pasadena,” leaving her garden of white gardenias to become the terror of Colorado Boulevard in her ruby-red Dodge. Rose of Sharon would be a Phyllis Schlafly-loving Reagan activist reunited with her husband, now owner of a small chain of franchise fast-food outlets. 

A longer excerpt:   

 John Steinbeck’s The Grapes of Wrath chronicled the suffering of a group of bankrupt former farmers fleeing the Dust Bowl in Oklahoma to arrive, desperate and penniless, in an unwelcoming California.

Wednesday, May 17, 2023

Bob Lucas and his papers

My first post described a few anecdotes about what a warm person Bob Lucas was, and such a great colleague. Here I describe a little bit of his intellectual influence, in a form that is I hope accessible to average people.

The “rational expectations” revolution that brought down Keynesianism in the 1970s was really much larger than that. It was really the “general equilibrium” revolution. 

Macroeconomics until 1970 was sharply different from regular microeconomics. Economics is all about “models,” complete toy economies that we construct via equations and in computer programs. You can’t keep track of everything in even the most beautiful prose. Microeconomic models, and “general equilibrium” as that term was used at the time, wrote down how people behave — how they decide what to buy, how hard to work, whether to save, etc.. Then it similarly described how companies behave and how government behaves. Set this in motion and see where it all settles down; what prices and quantities result. 

Tuesday, May 16, 2023

Hoover Monetary Policy Conference

Friday May 12 we had the annual Hoover monetary policy conference. Hoover twitter stream here.  Conference webpage and schedule here (update 5/24 now contains videos.) As before, the talks, panels, and comments will eventually be written and published. 

The Fed has experienced two dramatic institutional failures: Inflation peaking at 8%, and a rash of bank failures. There were panels focused on each, and much surrounding discussion.  

Monday, May 15, 2023

Bob Lucas

I just got the sad news that Bob Lucas has passed away. He was truly a giant among economists, and a wonderful warm person. 

I will only pass on three remembrances that others will not likely mention. 

Bob was incredibly welcoming to me, a young brash and fairly untutored young economist from Berkeley.  

In the fall of 1985 I gave what was no doubt the most disastrous first seminar by a new assistant professor in the Department's history. It was something about random walks and real business cycles, and was going nowhere. Bob stopped by my office, and expressed doubt about this random walk stuff. He said, if you look at longer and longer horizons, GNP volatility goes down. At least I had the wit to recognize what had just been handed to me on a silver platter, dropped everything and wrote the "Random walk in GNP," my first big paper. Without that, I doubt I would be where I am today. Thank you Bob.  He and Nancy were kind to us socially as well. 

The first Lucas paper that I recall reading, while I was still at Berkeley, was his review of a report to the OECD.  I don't think anyone else writing about Bob will mention this masterpiece. If you get annoyed by policy blather, read this article. Reading it as a grad student, I loved the way he sliced through loose prose like warm butter. No BS with Bob. Only clear thinking please. I mentioned it later, and he laughed saying he wrote it in a bad mood because he was getting divorced. Like "After Keynesian Macroeconomics," Bob could wield a pen. 

Much later,  I attended a revelatory money workshop. Bob presented an early version of, I think, "Ideas and growth."  In the model, people have ideas, and bump into each other randomly and share ideas. Questioner after questioner complained that there wasn't any economics in the model. Why not put in some incentive for people to bump in to each other, or something non mechanical. Time after time, Bob answered each suggestion that he had tried it, but it didn't make much difference to the outcome, so he stripped it out of the model. Clearly, he had been playing with this model over a year, working to eliminate  needless ingredients, not to add more generality. It's great to see the production function at work. 

Bob is known as a theorist, but he had a great handle on empirical work as well. His Carnegie Rochester money demand paper basically reinvented cointegration, and saw clearly what dozens of others missed. "Mechanics of economic development" starts by putting together facts. "International evidence on inflation-output tradeoffs" 1973 makes one stunning graph. And more. 

There is so much to say about Bob the great economist, superb colleague and tremendous human being, but I will stop here for now. RIP Bob. And thank you. 


Ben Moll has a lovely twitter thread about Bob as a thesis adviser. Bob covered Ben's thesis draft with useful comments. Bob read my early papers and did the same thing. This encouraged a culture of comments. Though a young assistant professor, I took it as a duty to write comments on Bob's papers! And some of them actually helped. This was the culture of the economics department in the 1980s, not common. Bob helped quite a few people and JPE authors to see what their papers were really about, making dramatic improvements.  

The outpouring on twitter is remarkable. More remarkable, here is a man for whom we could celebrate every single paper as pathbreaking. Yet the outpouring is all about his wonderful personal qualities. 

A correspondent reminds me of one last story. Bob's divorce agreement specified half of his Nobel prize, which he paid. Asked  by a reporter if he had regrets, he answered "A deal's a deal." 

Next post, focused on intellectual contributions. 

FTPL 50% off sale

Princeton University Press has a 50% off sale on all books, including the (overpriced, sorry) Fiscal Theory of the Price Level.  The splash page also offers 30% off if you give them your email, but I'm not sure if they add. 

Saturday, May 13, 2023

Missing mortgage contract innovation

From WSJ 

"Many Americans who want to move are trapped in their homes—locked in by low interest rates they can’t afford to give up. 

These “golden handcuffs” are keeping the supply of homes for sale unusually low and making the market more competitive and pricey than some forecasters expected.   

The reluctance of homeowners to sell differentiates the current housing market from past downturns and could keep home prices from falling significantly on a national basis, economists say."

What's going on? US 15 or 30 year fixed-rate mortgages have a catch -- you can't take it with you. If interest rates go up, and you want to move, you can't take the old mortgage with you. You have to refinance at the higher interest rate. It's curiously asymmetric, as if interest rates go down you have the right to refinance at a lower rate. 

As a result, yes, people stay in houses they would rather sell in order to keep the low interest rate on their fixed rate mortgage. They then don't free up houses that someone else would really rather buy. (In California, the right to keep paying low property taxes, which reset if you buy a new house also keeps some people where they are. And everywhere, transfer taxes add a small disincentive to move.) 

This is a curious contract structure. Why can't you take a mortgage with you, and use it to pay for a new house? Sure, mortgages with that right would cost more; the rate would be a bit higher initially. But fixed rate mortgages already cost more than variable rate mortgages, and people seem willing to pay for insurance against rising rates. I can imagine that plenty of people might want to buy that insurance to make sure they can live in a house of given cost, though not necessarily this house.  Conversely, fixed-rate mortgages that did not give the right to refinance, where you have to pay a penalty to get out of the contract if rates go down, would also be cheaper up front, yet people aren't screaming for those. 

Thursday, April 20, 2023

How do interest rates lower inflation?


A few days ago I gave a short talk on the subject. I was partly inspired by a little comment made at a seminar, roughly "of course we all know that if prices are sticky, higher nominal rates raise higher real rates, that lowers aggregate demand and lowers inflation." Maybe we "know" that, but it's not as readily present in our models as we think. This also crystallizes some work in the ongoing "Expectations and the neutrality of interest rates" project. 

The equations are the utterly standard new-Keynesian model. The last equation tracks the evolution of the real value of the debt, which is usually in the footnotes of that model. 

OK, top right, the standard result. There is a positive but temporary shock to the monetary policy rule, u. Interest rates go up and then slowly revert. Inflation goes down. Hooray. (Output also goes down, as the Phillips Curve insists.) 

The next graph should give you pause on just how you interpreted the first one. What if the interest rate goes up persistently? Inflation rises, suddenly and completely matching the rise in interest rate! Yet prices are quite sticky -- k = 0.1 here. Here I drove the persistence all the way to 1, but that's not crucial. With any persistence above 0.75, higher interest rates give rise to higher inflation. 

What's going on? Prices are sticky, but inflation is not sticky. In the Calvo model only a few firms can change price in any instant, but they change by a large amount, so the rate of inflation can jump up instantly just as it does. I think a lot of intuition wants inflation to be sticky, so that inflation can slowly pick up after a shock. That's how it seems to work in the world, but sticky prices do not deliver that result. Hence, the real interest rate doesn't change at all in response to this persistent rise in nominal interest rates.  Now maybe inflation is sticky, costs apply to the derivative not the level, but absolutely none of the immense literature on price stickiness considers that possibility or how in the world it might be true, at least as far as I know. Let me know if I'm wrong. At a minimum, I hope I have started to undermine your faith that we all have easy textbook models in which higher interest rates reliably lower inflation. 

(Yes, the shock is negative. Look at the Taylor rule. This happens a lot in these models, another reason you might worry. The shock can go in a different direction from observed interest rates.) 

Panel 3 lowers the persistence of the shock to a cleverly chosen 0.75. Now (with sigma=1, kappa=0.1, phi= 1.2), inflation now moves with no change in interest rate at all.  The Fed merely announces the shock and inflation jumps all on its own. I call this "equilibrium selection policy" or "open mouth policy." You can regard this as a feature or a bug. If you believe this model, the Fed can move inflation just by making speeches! You can regard this as powerful "forward guidance." Or you can regard it as nuts. In any case, if you thought that the Fed's mechanism for lowering inflation is to raise nominal interest rates, inflation is sticky, real rates rise, output falls and inflation falls, well here is another case in which the standard model says something else entirely. 

Panel 4 is of course my main hobby horse these days. I tee up the question in Panel 1 with the red line. In that panel, the nominal interest are is higher than the expected inflation rate. The real interest rate is positive. The costs of servicing the debt have risen. That's a serious effect nowadays. With 100% debt/GDP each 1% higher real rate is 1% of GDP more deficit, $250 billion dollars per year. Somebody has to pay that sooner or later. This "monetary policy" comes with a fiscal tightening. You'll see that in the footnotes of good new-Keynesian models: lump sum taxes come along to pay higher interest costs on the debt. 

Now imagine Jay Powell comes knocking to Congress in the middle of a knock-down drag-out fight over spending and the debt limit, and says "oh, we're going to raise rates 4 percentage points. We need you to raise taxes or cut spending by $1 trillion to pay those extra interest costs on the debt." A laugh might be the polite answer. 

So, in the last graph, I ask, what happens if the Fed raises interest rates and fiscal policy refuses to raise taxes or cut spending? In the new-Keynesian model there is not a 1-1 mapping between the shock (u) process and interest rates. Many different u produce the same i. So, I ask the model, "choose a u process that produces exactly the same interest rate as in the top left panel,  but needs no additional fiscal surpluses." Declines in interest costs of the debt (inflation above interest rates) and devaluation of debt by period 1 inflation must match rises in interest costs on the debt (inflation below interest rates). The bottom right panel gives the answer to this question. 

Review: Same interest rate, no fiscal help? Inflation rises. In this very standard new-Keynesian model,  higher interest rates without a concurrent fiscal tightening raise inflation, immediately and persistently. 

Fans will know of the long-term debt extension that solves this problem, and I've plugged that solution before (see the "Expectations" paper above).

The point today: The statement that we have easy simple well understood textbook models, that capture the standard intuition -- higher nominal rates with sticky prices mean higher real rates, those lower output and lower inflation -- is simply not true. The standard model behaves very differently than you think it does. It's amazing how after 30 years of playing with these simple equations, verbal intuition and the equations remain so far apart. 

The last two bullet points emphasize two other aspects of the intuition vs model separation. Notice that even in the top left graph, higher interest rates (and lower output) come with rising inflation. At best the higher rate causes a sudden jump down in inflation -- prices, not inflation, are sticky even in the top left graph -- but then inflation steadily rises. Not even in the top left graph do higher rates send future inflation lower than current inflation. Widespread intuition goes the other way. 

In all this theorizing, the Phillips Curve strikes me as the weak link. The Fed and common intuition make the Phillips Curve causal: higher rates cause lower output cause lower inflation. The original Phillips Curve was just a correlation, and Lucas 1972 thought of causality the other way: higher inflation fools people temporarily to producing more. 


Here is the Phillips curve (unemployment x axis, inflation y axis) from 2012 through last month. The dots on the lower branch are the pre-covid curve, "flat" as common wisdom proclaimed. Inflation was still 2% with unemployment 3.5% on the eve of the pandemic. The upper branch is the more recent experience. 

I think this plot makes some sense of the Fed's colossal failure to see inflation coming, or to perceive it once the dragon was inside the outer wall and breathing fire at the inner gate. If you believe in a Phillips Curve, causal from unemployment (or "labor market conditions") to inflation, and you last saw 3.5% unemployment with 2% inflation in February 2021, the 6% unemployment of March 2021 is going to make you totally ignore any inflation blips that come along. Surely, until we get well past 3.5% unemployment again, there's nothing to worry about. Well, that was wrong. The curve "shifted" if there is a curve at all. 

But what to put in its place? Good question. 


Lots of commenters and correspondents want other Phillips Curves. I've been influenced by a number of papers, especially "New Pricing Models, Same Old Phillips Curves?" by Adrien Auclert, Rodolfo Rigato, Matthew Rognlie, and Ludwig Straub, and "Price Rigidity: Microeconomic Evidence and Macroeconomic Implications" by Emi Nakamura and  Jón Steinsson, that lots of different micro foundations all end up looking about the same. Both are great papers. Adding lags seems easy, but it's not that simple unless you overturn the forward looking eigenvalues of the system; "Expectations and the neutrality of interest rates" goes on in that way. Adding a lag without changing the system eigenvalue doesn't work. 

Wednesday, March 15, 2023

On marking to market and risk management

Two more thoughts:

1) In the SBV debacle, many of my colleagues and friends jump to the conclusion, we should just mark all assets to market and forget about this "hold to maturity" business.

Not so fast. Like all imperfect patches, there is some logic to it. Suppose you have a $100 payment that you have to make in 10 years. To cover that payment, you buy a $100 face value Treasury zero coupon bond. Done, zero risk. 

Now interest rates rise. The value of your asset has fallen in value! It's only worth, say, $90! Are you underwater? No, because when the time comes, you still will have exactly $100 to make the needed payment. 

You will quickly answer, well, mark both assets and liabilities to market. The $100 payment is now also worth $90, so marking both sides to market would reveal no change. But there is a lot of unneeded volatility here. And in most cases, the $100 payment is not tradeable on a market, while the $100 asset is. So now, you're going to be balancing marking to market vs. marking to model. Add the regulator's and many participant's distrust of market prices, which are always seemingly "illiquid," "distressed," in a state of "fire sale," "dysfunctional," and so forth. Add the pointlessness of it all. In this situation we all know that you can make the payment in 10 years. Lock it up and ignore it. Call the asset "hold to maturity." 

Of course, suppose the point of that asset is to make sure that depositors with $100 accounts can always get their money back by selling the asset. Well, now we have Silicon Valley Bank. 

Hence the imperfect fudge of current accounting and regulation rules. "Hold to maturity" assets don't get marked to market, and indeed there are penalties for selling them to meet current needs. Lots of "liquidity" and other rules are supposed to make sure there are adequate short run liabilities to stop a run. Those were of course completely absent in SBV's case -- a truly spectacular failure of elementary regulation. 

In short, mark to market makes sense to assess if a bank can make its payments and avoid failure tomorrow. Hold to maturity makes a bit of sense to assess if a bank can make its payments and avoid failure years from now, when both long term assets and long term liabilities come due. That is, if it survives that long. 

2) There is a lot of criticism of SBV bank management and board for being underinvested in risk management and over invested in lobbying, political connections, donations to politically popular causes, and so forth. Ex post, their choice of managerial investments looks brilliant! What brought in the millions to stem a run, I ask you? In today's highly political banking system, they made optimal choices. To an economist, many puzzling actions are just an optimal answer to a different question. 

Update: Ok, I went too far with that one. Management are out, shareholders wiped out. I'll stick with the idea that uninsured depositors did a great job of monitoring -- they monitored that the bank had the political chops to demand and get a bailout of uninsured depositors! 

From a correspondent: 

"It seems to me now that SVB was really a money market fund with the addition of a bit of equity and breaking all the SEC asset and liquidity rules that MMFs are subject to. " 

Or, it was really a mutual fund (money market funds with $1 values can't invest in long term bonds, long term bond funds must have floating NAV) that was violating rules on floating NAV! 

Small bank thoughts

 Three small thoughts. 

1) There is much commentary that bank troubles will interfere with the Fed's plan to lower inflation by raising rates. Actually, this is a feature not a bug. The main mechanism by which, in the Fed's view, raising interest rates slows the economy and lowers inflation is by "constricting credit," "tightening financial conditions," lowering borrowing that finances investment and consumer durables purchases.  The Fed didn't want runs, no, but it wants the result. If you don't like that, well, we need to think of other ways to contain inflation, like taking the fiscal gasoline off the fire. 

2) On uninsured deposits. A correspondent suggests that the Fed simply mandate that all large depositors participate in the sorts of services, there for the asking, that split large accounts into multiple $249k accounts spread over multiple banks, or sweeps into money market funds. 

I don't think that mandating this system is a good idea. If you're going to do that, of course, you might as well just insure all deposits and keep it simple. 

But the suggestion prompts doubt over the oft repeated notion that we want large sophisticated depositors to monitor banks. Anyone who was large and sophisticated enough to monitor banks had already gamed the system to make sure their accounts were insured, at some nontrivial cost in fees and trouble. The only people left with millions in checking accounts were, sort of by definition, financially unsophisticated or too busy running actual companies to bother with this sort of thing. Sort of like taxes. 

We might as well give in, that all deposits are here forth insured. If so, of course, then banks are totally gambling with the house's money. But we also have to give in that if they can't spot this elephant in the room, asset risk regulation is hopeless. The only workable answer (of course) is narrow deposit taking -- all runnable deposits invested in reserves and short term treasuries; fund portfolios of long term debt with long-term borrowing (CDs for example) and lots of equity.

3) Liquidity and fixed value are no longer necessarily tied together. I still don't quite get why better payment services are not attached to floating value funds. Then we wouldn't need run-prone bank accounts at all. 


Tuesday, March 14, 2023

How many banks are in danger?

With amazing speed and impeccable timing, Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru analyze how exposed the rest of the banking system is to an interest rate rise.

Recap: SVB failed, basically, because it funded a portfolio of long-term bonds and loans with run-prone uninsured deposits. Interest rates rose, the market value of the assets fell below the value of the deposits. When people wanted their money back, the bank would have to sell at low prices, and there would not be enough for everyone. Depositors ran to be the first to get their money out. In my previous post, I expressed astonishment that the immense bank regulatory apparatus did not notice this huge and elementary risk. It takes putting 2+2 together: lots of uninsured deposits, big interest rate risk exposure. But 2+2=4 is not advanced math. 

How widespread is this issue? And how widespread is the regulatory failure? One would think, as you put on the parachute before jumping out of a plane,  that the Fed would have checked that raising interest rates to combat inflation would not tank lots of banks. 

Banks are allowed to report the "hold to maturity" "book value" or face value of long term assets. If a bank bought a bond for $100 (book value) or if a bond promises $100 in 10 years (hold to maturity value), basically, the bank may say it's worth $100, even though the bank might only be able to sell the bond for $75 if they need to stop a run. So one way to put the issue is, how much lower are mark to market values than book values? 

The paper (abstract):  

The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. 

... 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks have lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. 

... Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. ... these calculations suggests that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

Saturday, March 11, 2023

Silicon Valley Bank Blinders

The Silicon Valley Bank failure strikes me as a colossal failure of bank regulation, and instructive on how rotten the whole edifice is. I write this post in an inquisitive spirit. I don't know the details of how SVB was regulated, and I hope some readers do and can chime in. 

As reported so far by media, the collapse was breathtakingly simple. SVB paid a bit higher interest rates than the measly 0.01% (yes) that Chase offers. It attracted large deposits from venture capital backed firms in the valley. Crucially, only the first $250,000 are insured, so most of those deposits are uninsured. The deposits are financially savvy customers who know they have to get in line first should anything go wrong. SVB put much of that money into long-maturity bonds, hoping to reap the difference between slightly higher long-term interest rates and what it pays on deposits.  But as we've known for hundreds of years, if interest rates rise, then the market value of those long-term bonds fall. Now if everyone comes asking for their money back, the assets are not worth enough to pay everyone back.  

In sum, you have "duration mismatch" plus run-prone uninsured depositors. We teach this in the first week of an MBA or undergraduate banking class. This isn't crypto or derivatives or special purpose vehicles or anything fancy. 

Where were the regulators? The Dodd Frank act added hundreds of thousands of pages of regulations, and an army of hundreds of regulators. The Fed enacts "stress tests" in case regular regulation fails. How can this massive architecture fail to spot basic duration mismatch and a massive run-prone deposit base? It's not hard to fix, either. Banks can quickly enter swap contracts to cheaply alter their exposure to interest rate risk without selling the whole asset portfolio. 

Saturday, March 4, 2023

Economic Journal Home Bias

Home Bias in Economics Journals is an interesting new paper by Dirk Bethmann, Felix Bransch, Michael Kvasnicka, and Abdolkarim Sadrieh (via Marginal Revolution).

...Researchers from Harvard, but also nearby Massachusetts Institute of Technology (MIT), and from Chicago (co-)author a disproportionate share of articles in their respective home journal.... We study this question in a difference-in-differences framework, using data on both current and past author affiliations and cumulative citation counts for articles published between 1995 and 2015 in the QJE, JPE, and American Economic Review (AER), which serves as a benchmark. We find that median article quality is lower in the QJE if authors have ties to Harvard and/or MIT than if authors are from other top-10 universities, but higher in the JPE if authors have ties to Chicago. We also find that home ties matter for the odds of journals to publish highly influential and low impact papers. Again, the JPE appears to benefit, if anything, from its home ties, while the QJE does not. 

On the bottom end as well, 

articles with a Chicago aliation in the JPE are less likely to be amongst the group of relatively low impact articles (i.e., to rank among the 25% or 10% of least cited articles published in the three journals in a year) than articles in the JPE authored by researchers from other top-10 institutions. 

Those are the what, but not the why. These findings naturally provoke some thought from my time at Chicago, and as JPE editor. 

Thursday, March 2, 2023

Fair tax full text

From the Wall Street Journal Feb 2. After 30 days I can post full text. 

A Consumption Tax Is the Shock Our Broken System Needs

Something remarkable happened last month. On Jan. 9, Georgia Rep. Buddy Carter introduced the “Fair Tax” bill to the House of Representatives, and secured a promise of a floor vote. The bill eliminates the personal and corporate income tax, estate and gift tax, payroll (Social Security and Medicare) tax and the Internal Revenue Service. It replaces them with a single national sales tax. Business investment is exempt, so it is effectively a consumption tax. Each household would get a check each month, so that purchases up to the poverty line are effectively not taxed.

Lessons from Sargent and Leeper

At the AEI fiscal theory event last Tuesday Tom Sargent and Eric Leeper made some key points about the current situation, with reference to lessons of history. 

Tom's comments updated his excellent paper with George Hall "Three World Wars" (at pnas,  summary essay in the Hoover Conference volume). Tom and George liken covid to a war: a large emergency requiring immense expenditure. We can quibble about "require" but not the expenditure. 

(2008 was a little war in this sense as well.) Since outlays are well ahead of receipts, these huge temporary expenditures are financed by issuing debt and printing money, as optimal tax theory says they should be. 

In all three cases, you see a ratcheting up of outlays after the war. That's happening now, and in 2008, just as in WWI and WWII. 

After WWI and WWII, there is a period of primary surpluses -- tax receipts greater than spending -- which helps to pay back the debt. This time is notable for the absence of that effect. 

We see that most clearly by plotting the primary deficits directly. The data update since Tom and George's original paper (dots) makes that clear. To a fiscal theorist, this is a worrisome difference. We are not following historical tradition of regular, full employment, peacetime surpluses. 

The two world wars were also financed by a considerable inflation. The important consequence of inflation is that it inflates away government debt. Essentially, we pay for part of the war by a default on debt, engineered via inflation. 

Tuesday, February 28, 2023

FTPL Videos

 Two great videos just dropped related to fiscal theory. 

The first is an "Uncommon Knowledge" interview with Peter Robinson. We start with fiscal theory and move on far and wide. Peter is a great interviewer, and the Uncommon Knowledge production team put together a great video of it. Pick your link: Video at Hoover (best, in my view); Hoover event page with podcast, links and more info, Youtube, Twitter, Facebook

Second, Michael Strain at AEI moderated a great panel discussion on fiscal theory with me, Robert Barro, Tom Sargent and Eric Leeper. Three of the founding fathers of fiscal theory offer thoughtful comments, and Michael had provocative questions. I start with a 20 minute presentation, with slides, so this is the most compact "what is the fiscal theory" video to date. It's at the AEI event page or Youtube 

Friday, February 24, 2023

Mulligan and the demand for opioids

This is another post from an Economic Policy Working Group meeting at Hoover, in which simple undergraduate supply and demand analysis, creatively applied, leads to a surprising result.  

Casey Mulligan presented "Prices and Policies in Opioid Markets." Paper, slides and video of the presentation.  (Updated link now works) 

Once prescription opioids became an evident crisis, the government took steps to restrict the supply, raising the price. Yet opioid consumption and overdoses went up. Explain that Mr. Chicago economist! 

Here's the clever answer: 

There are two ways to buy opioids, 1) legally or semi-legally; i.e. get opioids that come from pharmaceutical companies and are prescribed to someone by a doctor or 2) illegally. 

There is a fixed cost of entering the illegal market. .".Avoiding theft, acquiring self-dosing skills, or overcoming fear of needles. ...establishing a trusting relationship with a drug dealer...." But the cost per dose of illegal drugs is typically less than for legal drugs. 

So, imagine a drug user starting at B. At that price for legal (red) and illegal (black) drugs, the user chooses legal drugs at point B. Now raise the price of legal drugs, as shown by the arrow. If the user stayed with legal drugs, he or she would use less. But now there is an option, incur the fixed cost and buy illegal drugs on the black line. At the higher price for legal drugs that makes sense. But since the marginal cost of illegal drugs is lower, once the user has overcome the fixed cost, he or she uses more. 

Raise the price, and they consume more (of a substitute). 

Short and long run minimum wage

On Wednesday, Erik Hurst presented a lovely paper, "The Distributional Impact of the Minimum Wage in the Short and Long Run," written with Elena Pastorino, Patrick Kehoe, and Thomas Winberry, at the Hoover Economic Policy Working Group seminar. Video (a great presentation) and slides here

This is a beautiful and detailed model, which won't try to summarize here. I write to pass on one central graph and insight. 

Suppose there is some "monopsony power," at the individual firm level. Don't argue about that yet. Erik and coauthors  put it in, so that there is a hope that minimum wages can do some good, and it is the central argument made by minimum wage proponents. In the paper it comes because people are uniquely suited to a particular job for personal reasons. Professors don't like to move, they've figured out the ropes at their current university, so the dean can get away with paying less than they could get elsewhere. Why this applies to MacDonalds relative to the Taco Bell next door is a good question, but again, the point is to analyze it not to argue about it. 

"Labor demand" here is the marginal product of labor. (\(f'(N)\) It's what labor demand would be in a competitive market. The monopsnists' demand is lower). Monopsony means that the "marginal cost of labor" rises with the number of employees. There is a core of people that really love the job that you can hire at low cost. As you expand, though, you have to hire people who aren't that attached to this particular job, so you have to pay more. And you have to pay everyone else more too, (by reasonable assumption -- no individually negotiated wages), so the average cost of labor rises. 

Thus, the monopsonies firm chooses to hire fewer people \(N_m\),  produce less, and pay them a wage \(W_n\) below their marginal product.  ("Average cost of labor" is really the labor supply curve, call it \(w=L(N)\). Then \(\max (f(N)-wN\) s.t. \(w=L(N)\) yields \(f'(N)=w+NL'(N)\). The "marginal cost of labor" in the graph is this latter quantity: the wage you pay the last worker, plus all workers times the extra wage you must pay them all. Disclaimer: the equations are me reverse-engineering the graph.) 

Now, add a minimum wage. As the minimum wage rises above \(W_m\), we initially see a rise in the number of workers, and their incomes. The firm moves along the arrow as shown. (\(\max f(N)-wN\) s.t. \( w \ge L(N)\), \( w \ge w^\ast\) gives \(w^\ast = L(N)\) .) 

Keep raising the minimum wage, though. Once we get past the point that labor supply ("average cost of labor") requires a wage greater than the marginal product of labor, the firm turns around and hires fewer people: 

Saturday, February 18, 2023

Trust Fund

The Social Security Trust fund is set to run out in a few years. Who cares? Is the total US Federal debt $31,456,554,630,496.28, including Treasury debt held by the Social Security trust fund and other agencies?  or is it "only" $24,629,050,125,670.81 held by the public? (Source.)

I've been mulling these questions over, prodded by conversations with some colleagues. 

The "trust fund" exists because for a while, Social Security taxes were larger than Social Security payments. Social Security used the extras to buy Treasury debt. Now there are fewer workers, more retirees and more generous benefits, so Social Security taxes are smaller than payments. Social Security sells off its "trust fund." And it seems we're in trouble when the "trust fund" runs out.  

But that's not how it works at all. Treasury debt is not an asset like a stock or bond, or Uncle Scrooge's pool of gold coins. Treasury debt is a claim against future income taxes. Cashing in Treasury debt just  means paying for benefits with income taxes. 

The ups and downs of the trust fund just reflect a change in how we finance spending. While payroll taxes > social security spending, which was the case until 2007, then payroll taxes are financing other spending. When payroll taxes < social security spending, then income taxes or increases in debt are financing social security spending, which (graph below) was the case after 2008.* The trust fund just adds up this change over time. But exhausting the trust fund is, in this view, really irrelevant. 

source: CBO

That doesn't mean we can all go to sleep, for two reasons. First, when payroll taxes < Social Security outlays, and the trust fund is winding down, then income taxes or additional public debt must finance the shortfall. The government has to spend less on other things, raise income tax receipts, or borrow which means raising future taxes. And, per the graph, the numbers are not small. 1% of GDP is $230 billion. The extra strain on income taxes, other spending, or debt, happens right now, when the trust fund is positive but decreasing. 

Zero matters only because by law,  when the trust fund goes to zero, Social Security payments must be automatically cut to match Social Security taxes. That's the sudden drop in the graph. The program was set up as if  the trust fund were buying stocks and bonds, real assets, and would not lay claim on income tax revenues. But it was not; social security taxes were used to cover other spending, and now income taxes must start to pay social security benefits. 

What happens when the trust fund runs out, then?  Congress has a choice: automatically cut benefits, as shown, or change the law so that the government can pay Social Security benefits from income taxes, or, more realistically, by issuing ever more debt, until the bond vigilantes come. (Or raise payroll taxes, or reform the whole mess.) I bet on change the law. 

So what's the right measure of debt? It's conventional to look only at debt in public hands. But there is a case to look at the total debt, i.e. including the trust funds. Those are the total claims against the income  tax. Looking at it this way, however, one could also go on and count unfunded future social security benefits as a debt -- the present value of the difference between the two lines above, which leads to immense numbers, per Larry Kotlikoff. 

I have usually not considered the present value of unfunded promises as "debt," because Congress can change the payments at any time. Changing debt repayment to the public is a default, with financial and legal consequences; changing social security benefits is legislation. You can't sell your future social security benefits as you can sell your treasury debt. The trust fund is half way on this scale. What would be the consequence of a haircut or rescheduling of trust fund debt? Would that trigger something like cross-default clauses in corporate debt? I don't know. The event is unlikely anyway. The left pocket defaulting on the right pocket doesn't help pay the bills. The trust fund is certainly unlikely to run, and its debt is not used as collateral in financial transactions. As a somewhat meaningless accounting identity, it's a lot less "debt" than the debt in public hands. 

I think this all goes to remind us that paying off the existing debt is not the US central fiscal problem. The central problem is vast unfunded future promises. Defaulting or inflating away current debt does nothing to fund those promises. 

I look forward to comments on this one, especialy if there are standard views on these apparently simple questions that I'm not aware of. 

*In the end,  

payroll taxes + income & other taxes + increase in public debt = Social Security spending + other spending. 

The trust fund nets out. 

Sunday, February 12, 2023

Fair/consumption tax adjustment

The main (vocal) comment on my consumption/fair tax post and oped  has been to complain about retirees who have earned income, paid taxes, saved, and now must pay consumption taxes on what they buy with the proceeds. 

When writing an oped, one tries to anticipate a few objections, but not to overdo it. I left this one out because it surely seemed an easy exercise for the reader. This is a problem easily solved with money. If the consumption tax is 30%, then the government can top up retirement savings by 30%. Done. 

It obviously need not be that generous. First, old savers will benefit by not having to pay capital gains tax and estate tax on their savings. That almost adds up to the consumption tax right there! So at best they need a subsidy only equal to the difference between the new consumption taxes and what they will save from the absence of all other taxes. Second, the market is likely to boom. So, subsidy only to the value of investments on the day before the tax is announced. Third, this only applies to old savers. Fans of wealth taxation should be lining up for the consumption tax as it hits high wealth accumulators most! (There is an interesting question whether the CPI will include the consumption tax or not. If so, social security is immediately indexed and rises to pay the tax, thereby greatly benefiting seniors who no longer pay income taxes on social security.) 

But more importantly, in the big government intergenerational transfer scheme, current old people who have saved money came out pretty well. They get a lot more out of social security and medicare than they put in, and a lot more than young people will ever see. Whatever the benefits of 100% debt to GDP are, they got them and their grandchildren will pay them. If one is arguing on distributive justice, leaving the poker game just after you scored a big hand, and then crying about taxes is a bit unseemly.

And I'm sure that's only the beginning. Every reform has winners and losers. Tax lawyers and accountants are going to do terribly!  I assume some muddy mess will emerge to compensate old savers and other politically organized losers.  Government and politics are about transfers. Economics is about incentives. If every change must be completely Pareto optimal, we might as well go back to subsistence farming. 

Friday, February 3, 2023

Fair tax oped

An Oped in the Wall Street Journal on the "fair tax" proposal. As usual, I have to wait 30 days to post the full version 

The bill eliminates the personal and corporate income tax, estate and gift tax, payroll (Social Security and Medicare) tax and the Internal Revenue Service. It replaces them with a single national sales tax. Business investment is exempt, so it is effectively a consumption tax.

I've been writing about consumption taxes for a while. Some previous posts on these points,  VAT (WSJ)A progressive VATConsumption taxTax reformTaxesAlternative Minimum Tax, also  Wealth and Taxes Convexification and complication Tax graph Economists and Taxes Corporate tax burden Tax Reform Tax reform again (WSJ) Corporate tax reading list Corporate tax (zero) Trump taxes 2 Those address a lot of the what ifs and whatabouts. 

But it's not progressive! (Meaning, better off people pay the same rate, not the same amount, not "politically progressive"). 

Already the "fair tax" proposal adds 

Each household would get a check each month, so that purchases up to the poverty line are effectively not taxed.

Yes, effectively universal basic income from Republicans! One could do more. And as in the above forest of links there are plenty of ways to make a consumption tax as progressive as you'd like. 

But the most important point, with added emphasis: 

the progressivity of a whole tax and transfer system matters, not of a particular tax in isolation. If a flat consumption tax finances greater benefits to people of lesser means, the overall system could be more progressive than what we have now. A consumption tax would still finance food stamps, housing, Medicaid, and so forth. And it would be particularly efficient at raising revenue, meaning there would potentially be more to distribute—a point that has led some conservatives to object to a consumption tax.

Wednesday, February 1, 2023

RIP Indexed Bonds in Canada

(An oped at Globe and Mail with Jon Hartley) 

Finance Minister Chrystia Freeland recently announced that the government of Canada  will no longer issue inflation-protected “real return” bonds. A kerfuffle erupted.

The government may wish to avoid inflation-protected bonds, because it thinks inflation will get a lot worse than markets do. But betting in markets is not a responsible strategy.

If the government won’t do it, corporations, banks and financial institutions should issue these bonds themselves rather than just complain. Not every asset must be provided by the government.

Real return bonds adjust both principal and interest for inflation. If inflation goes up, you get more money back. Nice. But when everyone expects inflation, you pay a commensurately higher price ahead of time.

Tuesday, January 31, 2023

The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 


Chris Russo wrote in Barrons Sept 2021 reporting on internal Fed strategizing for this event. 

The Fed will treat defaulted Treasury obligations the same as non defaulted obligations. Their regulatory treatment will remain the same including capital requirements and risk weights. Moreover these securities "will not be adversely classified or criticized by examiners." 

Policy makers would "presumably want to avoid the impression that the Federal Reserve was effectively financing government spending." 

The Fed will 

transact with defaulted securities at market prices


The Fed could move the defaulted securities on to its balance sheet [English translation: buy] ...this set of options is the most contentious. Powell described them as "loathsome"... the institutional risk would be huge. The economics of it are right but you'd be stepping in to his difficult political world and looking like you are making the problem go away. Lacker called it "beyond the pale." John Williams... supported keeping those options on the table. Fed governor categorically rejected the third option. 

As I read it, this is considerably less than what I described. The Fed worries here about not inadvertently forcing individual banks to treat treasury assets as defaulted securities, which is good. But the main issue is whether financial markets, many not banks, will accept treasury collateral for lending, or whether we have as in 2008 a grand unwinding of the chain of short-term financing due to lack of collateral. Only the "loathsome" option addresses that issue as far as I can see. And if you want to stem a collateral run, it's best to clarify ahead of time. 

Casey Mulligan inquired

I am confused about your proposal.  Fed is part of the government. With currency in circulation not (?) counting against the debt limit aren't you suggesting the Treasury debt be (contingently) replaced with currency? Or would the Fed be defaulting on whatever asset it lends out?

Boy, if I didn't explain it well enough for Casey, I must really need a remedial writing course. Answer/clarification: 

Sorry if not clear. Fed can buy / lend against existing treasury debt, in default, and offer cash/reserves in exchange. This solves the financial crisis issue. It does not allow the treasury to borrow more, or the Fed to finance deficits. 

Saturday, January 21, 2023

A fiscal theory fest at AEI, launch podcast, and official release.

Mark your calendars! February 28th 3:00 PM eastern the AEI's Michael Strain will host a zoom event on Fiscal Theory of the Price Level. Info and registration here. 

This event will be particularly good because Michael convinced Robert Barro, Tom Sargent, and Eric Leeper to come and discuss. These are the giants on whose shoulders I meekly stand. 

Robert Barro did the modern version of "Ricardian Equivalence." If people look at government debt and understand that there will be taxes to pay it off, they save and the deficit (with lump sum taxes) has no effect. He also did the modern version of tax smoothing. It is good government policy to borrow in bad times, and repay in good times, with steady low taxes, rather than raise distorting tax rates a lot in bad times. Both underlie fiscal theory,  

Tom Sargent, with Neil Wallace wrote “Unpleasant Monetarist Arithmetic,” the cornerstone of the modern fiscal theory. They pointed out that if fiscal policy is stuck in deficits, monetary policy can only choose to inflate now or inflate later. Tom went on to write many fantastic papers on the theory of fiscal-monetary interactions, and on their place in economic history. His "ends of four big inflations" showed that the great post WWI hyperinflations ended when the fiscal problem was solved, involving no monetary stringency. A good lesson, now mostly forgotten in the widespread view that ending inflation must come with misery. His Nobel speech “United States Then, Europe Now” is a great example of historical work. In my view, the Nobel Committee should have given him a prize for monetary-fiscal interactions, which is even better than the econometric work they cited. Maybe he'll be the first economist to get two.    

Eric Leeper is the original innovator of the modern fiscal theory in his paper "Equilibria under ‘active’ and ‘passive’ monetary and fiscal policies. " Eric put fiscal theory in the context of interest rate targets, r rather than money supply, which is how all our central bankers operate, and includes nominal rather than real debt. Thus, he integrates fiscal theory with how our monetary policy actually works, creates the essential model of inflation under interest rate targets, and integrates fiscal theory with modern new-Keynesian or general equilibrium models that are 99% of all applied work. 

I'm going to try to be as brief as possible so we can hear from these amazing economists, plus Michael, no slouch himself. This much talent can't possibly sit still and not say things that are a bit critical, and thought provoking. 


Vince Ginn of the "Let People Prosper" Podcast did a very nice interview on FTPL.  Like many economists, Vince has a good monetarist heart, and explaining the difference between FTPL and monetarism was useful for me. 


As of January 17, The Fiscal Theory of the Price Level is formally released! Along with this good news, I have some bad news -- I have to take down the free version on my website. However, keep that in mind for the (sadly) evolving typo list, sample chapters, online appendix, follow on essays, and revisions as they come. I already have a revised Chapter 5 posted, which does a better job of introducing fiscal theory in standard new-Keynesian models. 

Wednesday, January 18, 2023

Two points on the debt limit, 1 serious 1 fun

Everyone keeps repeating that hitting the debt limit would necessitate a default on principal and interest. The Treasury itself says 

Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.   

The first statement is correct. The second is not. The government is still hauling in tax revenues. The Treasury could easily say "given the catastrophe that a default would produce, we will always pay interest and principal on treasury debt before any other payment." Congress could pass a law stating that fact. There is no economic reason  that a debt limit should force a default. 

There is a legal argument, and a claim that the Treasury cannot prioritize debt payments over other legally mandated payments. In the research I've been able to do however, this is a very uncertain claim. And it makes no sense. The Treasury is legally obligated to make debt payments, as it is obligated to pay Social Security checks, and also legally obligated not to borrow. Law prescribes the impossible. It has to prioritize. Indeed, unpaid bills are a form of debt, so if you want  to be a stickler, the government will violate the debt limit no matter what it does. 

The second statement is false. The US has defaulted on  gold clauses in the 1930s. It has defaulted on other "legal obligations."

The third is correct, and appropriate. If we are to tussle over paying Wall Street fat cats vs. grandma's social security, keep in mind just what a catastrophe default would be. Grandma will be way worse off if that happens. Treasury debt is now the golden collateral, supporting most of the financial system. (We should have a financial system much less dependent on short term collateralized borrowing, but that's another story.) If in default it would not be. Worse, and most important here, if financial markets suspect a default will really happen, they will start refusing to accept treasury collateral in the first place. This is basically what happened in 2008 with mortgage backed securities. They didn't fall to pieces,  they just weren't acceptable as collateral any more. 

A flight from treasury collateral under a debt limit would be far worse. And the government's magic tonic, borrow a ton and bail everyone out, would be unavailable. 

Perhaps Treasury thinks that by threatening default, they can get Congress to wake up and raise the debt limit promptly. But this risks Wall Street also believing the threat and causing the panic you're trying to prevent. 

Treasury secretary Janet Yellen should say out loud, right now "we pay principal and interest on treasury debt first, before anything else." President Biden should back her up. Drastic delays in social security, medicine, government shutdown and more are plenty enough threat to get Congress to move, without risking a run. 

States with balanced budget rules are interesting legal precedent. The State of Illinois, while I was watching, simply delayed payments, often by years. It paid its bonds on time. That isn't a good outcome of course, but it represents the State's choice of how to handle the legal requirement to pay vendors and to pay interest and principal on bonds. Other states have defaulted as have cities and counties. And countries. 


Now for fun. Just print money, some say. Fortunately, our legal system is full of mechanisms to prevent the government from printing money instead of borrowing it. The treasury has to issue debt; the Fed has to buy it,  and thereby give the Treasury new money to spend.  That violates the debt limit. But Treasury can create coins. So, last time, the fun suggestion of $1 trillion dollar coins came up. 

Here is a novel proposal in the same sprit. The debt limit is calculated based on face value, not market value of debt. A bond promising $100 in 10 years and $3 coupons from now to then counts as $100 of debt. So issue perpetuities. Or, more realistically, issue coupon only debt.  The government could issue a bond that pays a $3 coupon for 30 years and no principal payment. As things are now calculated, that bond adds zero to the debt! 

Like the trillion dollar coin, this proposal so clearly violates the spirit of the debt limit that I doubt serious people would do it. It does point to a serious shortcoming in how the Treasury calculates debt however. Most of the time Treasury issues debt at par, borrowing $100 and promising to repay $100 in 10 years. Then the distinction does not matter. But the formulas should be fixed. 

Disclaimer: I'm not an expert on the law of the debt limit. If these points are in error, let me know and I'll issue a "never mind." 


To clarify, this is just a fun way to get around the debt limit if one wants a fun way to do it. It's not obvious that getting around the debt limit is a good idea. What is the justification for running primary deficits right now? No, I'm not a balanced budget nut. In times of crisis, war, pandemic, and recession, the government should borrow, for standard tax-smoothing reasons. But then the government should repay the debt. When the economy is humming and there is no crisis on, we should be running small steady primary surpluses. That is now. One has to argue that yes, we should get there, and stop borrowing in good times,  but it's too hard to do all of a sudden. But just what are those adjustment costs? A crisis is a terrible thing to waste. Today is as good a day as any to clean up the US long term fiscal mess. It's not clear to me that Washington does anything better if it takes a long time to do it. 


Saturday, January 14, 2023

Waning inflation, supply and demand.


Source here

Inflation seems to be waning. The conventional change from a year ago: 

The month to month changes now suddenly more popular on the way down than it was on the way up: 

I generally don't make predictions -- unconditional forecasting is a fraught game in economics. But I have been as far out on a limb this year as I ever have in thinking this is possible and even likely. 

Tuesday, January 10, 2023

Cheers for Powell

 Jay Powell's Stockholm speech lays it out with Gettysburg address clarity and brevity. Relative to usual central-bankerese it's soaring rhetoric too. 

...Decisions about policies to directly address climate change should be made by the elected branches of government and thus reflect the public's will as expressed through elections.

... without explicit congressional legislation, it would be inappropriate for us to use our monetary policy or supervisory tools to promote a greener economy or to achieve other climate-based goals. We are not, and will not be, a "climate policymaker."

Friday, January 6, 2023

Strassel insight, and cheers for a long speaker tussle

I'm a policy wonk, but I care very little about politics, who is up and who is down. The house speaker voting coverage has been largely the latter, with no more than the usual tropes about "normal Republicans" vs. "Radicals" suffused with Trump-loving election-denying fervor.  

The WSJ's Kim Strassel, whose fact-filled columns are always a delight, explains that there actually are important issues at stake here: 

Committees barely function. Members have no ability to debate or amend. Leaders disappear into back rooms to cook up mammoth bills that are dropped on the floor for last-minute take-it-or-leave it votes. Add Mrs. Pelosi’s Covid “proxy” voting rules, and most of the House didn’t even bother to clock in.

Under the proposed new rules package, committees are back in charge of legislation, with rules designed to ensure that bills address single subjects—rather than catch-all legislation. It similarly gives members new power to challenge amendments that aren’t related to the topic at hand. And it revives “Calendar Wednesday,” whereby any committee chairman can bring a bill straight to the floor.

It includes new provisions for accountability and transparency. Proxy voting is history, as are virtual committee meetings. It requires a 72-hour rule to give members time to read legislation. It ends Democrats’ wild experiment with staffer unionization, which threatened to tie the chamber up with crazy demands. 

Wednesday, January 4, 2023

Fun Fisherian Graph

In working on a revision to fiscal theory of the price level chapter 5 on sticky price models, and a revision of "Expectations and the neutrality of interest rates" I came up with this fun impulse-response function. It  has an important lesson about interpreting impulse response functions.

It's a response to the indicated interest rate path, with no change in fiscal policy, in a simple new-Keynesian model with short-term debt. 

Rational expectations new-Keynesian models have the implication that higher interest rates raise inflation in the long run. They also tend to raise inflation in the short run. I've been looking for better mechanisms by which higher interest rates might lower inflation in the short run in these models, without adding a contemporaneous fiscal austerity as standard new-Keynesian models do. Fiscal theory explores a model based on long-term debt that does the trick, but has a lot of shortcomings. So I'm looking for something better. 

This graph has only short term debt. I generate the pretty interest rate response by hand. It follows \(i_t=30e^{-1.2t}-29.5e^{-1.3t}-0.05.\) Then I compute inflation and output in response to that interest rate path. 

Wow! Higher interest rates lead to high real interest rates,  send inflation down, and create a little recession. Once inflation is really lowered, the central bank can lower interest rates. The price level (not shown) falls nearly linearly, as we often see in VARs.   

Doesn't this look a lot like the standard story for the 1980s? A big dose of high real rates lowers inflation, and then the Fed can follow inflation downward and get back to normal at a lower rate. 

That analysis is totally wrong!  In this model, a higher interest rate always leads to higher inflation in both the short and the long run.  Inflation is a two-sided moving average of interest rates with positive coefficients. Inflation declines here in advance of the protracted interest rate decline starting in year 2. Lower future interest rates drag inflation down, despite, not because of the rise in interest rate from year 0 to year 2, and despite, not because of the high real interest rates of that period. Those high real rates add interest costs on the debt and are an inflationary force here.  If the central bank wants a disinflation in this model, it will achieve that sooner by simply lowering interest rates immediately. The Fisherian effect will kick in faster, and it will not be fighting the fiscal consequences of higher interest costs on the debt. 

Beware facile interpretations of impulse-response functions! It would be easy to read this one as saying high interest rates bring down inflation and cause a recession, and then the central bank can normalize. But that intuition is exactly wrong of the model that produces this graph.  

The model is \[ \begin{align*} E_t dx_{t} & =\sigma(i_{t}-\pi_{t})dt\\ E_t d\pi_{t} & =\left( \rho\pi_{t}-\kappa x_{t}\right) dt \\ dv_{t} & =( rv_{t}+i_t-\pi_{t}-\tilde{s}_{t}) dt  \end{align*}\] Parameters are \(\kappa = 0.1, \  \sigma = 0.25,\   \rho = 0.1,\ r = 0.01.\) I used a lot of price stickiness and an unrealistically high \(\rho\) to make the graph prettier.  

Update: For Old Eagle Eye. I'm plotting an impulse response function. Variables start at zero, there is one shock, then we solve the deterministic version of the model. The system has two variables with expectations, and two unstable eigenvalues. So we solve forward to determine the initial conditions uniquely. All explained in FTPL, see especially the new Chapter 5 and pointer to the Online Appendix with formulas.