Nobel Symposium on Money and Banking Day 1

I attended the Nobel Symposium on Money and Banking in May, hosted by the Swedish House of Finance and Stockholm School of Economics.   It was a very interesting event. Follow the link for all the presentations and videos. (Click on "program." )

This review is  idiosyncratic, focusing on presentations that blog readers might find interesting. My apologies to authors I leave out or treat briefly -- all the presentations were action-packed and even my verbose blogging style can't cover everything.

"Nobel" in the title has a great convening power! The list of famous economists attending is impressive. And each presenter put great effort into explaining what they were doing, in part on wise invitation from the organizers to keep it accessible.  As a result I  understood far more than I do from usual 20 minute conference presentations and 15 minute discussions.

The first day was really "banking day," giving a whirlwind tour of the financial economics of banking.

Trading liquidity

Darrell Duffie gave (as always) a super presentation on the effects regulation is having on arbitrage in markets. (Slides, video)

ACA dropouts

Half of the people who sign up for Obamacare (ACA) get a flurry of medical care, then drop out before a year is over. They can always sign up again if they need to. People who stay on insurance tend to be those who have ongoing chronic and expensive conditions that need continual care. The implications for the viability of such insurance are not good.

This is the interesting conclusion of a new paper, "Take-Up, Drop-Out, and Spending in ACA Marketplaces" by Rebecca Diamond, Michael Dickstein, Tim McQuade, and Petra Persson. One good summary graph:

Lessons of the ELB

I gave a short presentation on monetary policy at the Nobel Symposium run by the Swedish House of Finance. It was an amazing conference, and I'll post a blog review as soon as they get the slides up of the other talks. Offered 15 minutes to summarize what I know about the zero bound, as well as to comment on presentations by Mike Woodford and Stephanie Schmitt-Grohé, here is what I had to say. There is a pdf version here and slides here. Novelty disclaimer: Obviously, this involves a lot of recycling and digesting older material. But simplifying and digesting is a lot of what we do.

Update: video of the presentation here. Or hopefully the following embed works:

Lessons of the long quiet ELB
(effective lower bound) 

We just observed a dramatic monetary experiment. In the US, the short-term interest rate rate was stuck at zero for 8 years. Reserves rose from 10 billion to 3,000 billion. Yet inflation behaved in this recession and expansion almost exactly as it did in the previous one. The 10 year bond rate continued its gentle downward trend unperturbed by QE or much of anything else.

Europe's bound is ongoing with the same result.

Conference on the cross section of returns.

The Fama-Miller Center at Chicago Booth jointly with EDHEC and the Review of Financial Studies will host a conference on September 27–28, 2018 in Chicago, on the theme “New Methods for the Cross Section of Returns.” Conference announcement here and call for papers here.

Papers are invited for submission on this broad theme, including:

• Which characteristics provide incremental information for expected returns?
• How can we tame the factor zoo?
• What are the key factors explaining cross-sectional variation in expected returns?
• How many factors do we need to explain the cross section?
• How can we distinguish between competing factor models?
• Do anomaly returns correspond to new factors?  

Why a blog post for this among the hundreds of interesting conferences? Naked self-interest. I agreed to give the keynote talk, so the better the conference papers, the more fun I have! 

This is, I think, a hot topic, and lots of people are making good progress on it. It's a great time for a conference, and I look forward to catching up and trying to integrate what has been done and were we have to go. 

My sense of the topic and the challenge: (Some of this reprises points in "Discount rates," but not all) 

Both expected returns and covariances seem to be stable functions of characteristics, like size and book/market ratio. The expected return and covariance of an individual stock seems to vary a lot over time. So we need to build ER(characteristics) and then see if it lines up with covariance(R, factors | characteristics), where factors are also portfolios formed on the basis of characteristics. 

Q is better than you think

This lovely graph comes from "Learning and the Improving Relationship Between Investment and q" by Daniel Andrei, William Mann, and Nathalie Moyen. The careful investment and q measurement make it much better than similar figures I've made for example Figure 4 here. Their paper explores the puzzle, just why did q theory work worse before 1995?

The graph also bears on the "monopoly" debate. Corporations are making huge profits, stocks are high, yet we don't see investment, the story goes -- marginal q must be much less than average q, indicating some sort of fixed factor or rent. Not in the graph.

Fiscal theory of monetary policy

Teaching a PhD class and preparing a few talks led me to a very simple example of an idea, which I'm calling the "fiscal theory of monetary policy." The project is to marry new-Keynesian models, i.e. DSGE models with price stickiness, with the fiscal theory of the price level. The example is simpler than the full analysis with price stickiness in the paper by that title.

It turns out that the FTPL can neatly solve the problems of standard new Keynesian models, and often make very little difference to the actual predictions for time series. This is great news. A new-Keynesian modeler wanting to match some impulse response functions, nervous at the less and less credible underpinnings of new-Keynesian models, can, it appears, just change footnotes about equilibrium selection and get back to work. He or she does not have to throw out a lifetime of work, and start afresh to look at inflation armed with debts and deficits. The interpretation of the model may, however, change a lot.

This is also an extremely conservative (in the non-political sense) approach to curing new-Keynesian model problems. You can keep the entire model, just change some parameter values and solution method, and problems vanish (forward guidance puzzle, frictionless limit puzzle, multiple equilibria at the zero bound, unbelievable off-equilibrium threats etc.) The current NK literature is instead embarked on deep surgery to cure these problems: removing rational expectations, adding constrained or heterogeneous agents, etc. I did not think I would find myself in the strange position trying to save the standard new-Keynesian model, while its developers are eviscerating it! But here we are.

The FTMP model

(From here on in, the post uses Mathjax. It looks great under Chrome, but Safari is iffy. I think I hacked it to work, but if it's mangled, try a different browser. If anyone knows why Safari mangles mathjax and how to fix it let me know.)

Here is the example. The model consists of the usual Fisher equation, \[ i_{t} = r+E_{t}\pi_{t+1} \] and a Taylor-type interest rate rule \[ i_{t} = r + \phi \pi_{t}+v_{t} \]

\[ v_{t} =\rho v_{t-1}+\varepsilon_{t}^{i} \]

Now we add the government debt valuation equation \[ \frac{B_{t-1}}{P_{t-1}}\left( E_{t}-E_{t-1}\right) \left( \frac{P_{t-1}% }{P_{t}}\right) =\left( E_{t}-E_{t-1}\right) \sum_{j=0}^{\infty}\frac {1}{R^{j}}s_{t+j} \]

Linearizing \begin{equation} \pi_{t+1}-E_{t}\pi_{t+1}=-\left( E_{t}-E_{t+1}\right) \sum_{j=0}^{\infty }\frac{1}{R^{j}}\frac{s_{t+j}}{b_{t}}=-\varepsilon_{t+1}^{s} \label{unexpi} \end{equation} with \(b=B/P\). Eliminating the interest rate \(i_{t}\), the equilibrium of this model is now \begin{equation} E_{t}\pi_{t+1} =\phi\pi_{t}+v_{t} \label{epi} \end{equation}

\[ \pi_{t+1}-E_{t}\pi_{t+1} =-\varepsilon_{t+1}^{s} \]

or, most simply, just \begin{equation} \pi_{t+1}=\phi\pi_{t}+v_{t}-\varepsilon_{t+1}^{s}. \label{equil_ftmp} \end{equation}

Here is a plot of the impulse response function:

Friedman 1968 at 50

This month marks the 50th anniversary of Milton Friedman's The Role of Monetary Policy, one of the most influential essays in economics ever.  To this day, economics students are well advised to go read this classic article, and carefully. The Journal of Economic Perspectives hosted three excellent articles, by Greg Mankiw and Ricardo Reis, by Olivier Blanchard, and by Bob Hall and Tom Sargent.

Friedman might have subtitled it "neutrality and non-neutrality."  Monetary policy is neutral in the long run -- inflation becomes disconnected from anything real including output, employment, interest rates, and relative prices. But monetary policy is not neutral in the short run.

There are three big ingredients of the macroeconomic revolution of the 1960s and 1970s.  1) The remarkable neutrality theorems including the Modigliani Miller theorem (debt vs. equity does not alter the value of the firm), Ricardian equivalence (Barro, debt vs. taxes doesn't change stimulus), and the neutrality of money. 2) The economy operates intertemporally, not each moment in time on its own.  3) Basing macroeconomics in decisions by people, not abstract relationships among aggregates, such as the "consumption function" relating consumption to income. Efficient markets, rational expectations, real business cycles, etc. integrate these ingredients. You can see all three underlying this article.

As money is not neutral in the short run, the neutrality theorems are not true of the world in their raw form, but they form the supply and demand framework on which we must add frictions. Friedman's permanent income hypothesis really kicked off the latter, and The Role of Monetary Policy is a central part of the first.

I.  The Phillips curve

Friedman's view on the Phillips curve is the most durable and justly famous contribution. William Phillips had observed that inflation and unemployment were negatively correlated. (The observation is often stated in terms of wage inflation, or in terms of the gap between actual and potential output.)

For fun, I plotted the relationship between inflation and unemployment in data up until 1968, with emphasis in red on the then most recent data, 1960-1968.  This was the evidence available at the time.

The Keynesians of Friedman's day had integrated this idea into their thinking, and advocated that the US exploit the tradeoff to obtain lower unemployment by adopting slightly higher inflation.

Friedman said no. And, interestingly for an economist whose reputation is as a dedicated empiricist, his argument was largely theoretical. But it was brilliant, and simple.

Fama Portfolio

The Fama Portfolio, is a new book from the University of Chicago Press. This is a collection of Gene Fama's papers, edited by Toby Moskowitz and me. It includes introductory essays by a group of Gene's distinguished colleagues, Ken French, Bill Schwert, René Stulz, Cliff Asness, John Liew, Campbell Harvey, Jan Liu, Amit Seru, and Amir Sufi.

The essays explain the ideas in modern terms, tell you why the papers are important, explain how the papers influenced subsequent thinking, update you on where our understanding on each point is today, and speculate about where new ideas may go. The continuing vitality of this work, even parts decades old, is impressive.

The task was hard. Which Fama papers should one read? Well, all of them! but we nonetheless had to pick. We typically chose a famous one from early in one of Gene's many research programs, and then a less known later one that really sums it up clearly. Gene's ideas get clearer over time, just like the rest of ours do.

The press lets us post our essays.  Here are mine (most joint with Toby):

1. Preface;
2. Efficient Markets and Empirical Finance; 
3. Luck vs. Skill;
4. Risk and Return; 
5. Return Forecasts and Time Varying Risk Premiums; 
6. Our Colleague.

Other authors may post their essays on their webpages. Otherwise, you'll just have to buy the book!

The contents:

A great EFG

On Friday, I went to the NBER EFG (Economic Fluctuations and Growth) meeting at the SF Fed. Program and papers here.  The papers were great, the discussions were great, the comments were great, even the food was good. (You know you're in California when the conference snack is avocado toast.)

The papers:

Slok on QE, and a great paper

DB's Torsten Sløk writes in his regular email analysis:

Yesterday I participated in the annual US Monetary Policy Forum here in Manhattan, and the 96-page paper presented concluded that we don’t really know if QE has worked. This was also the conclusion of the discussion, where several of the FOMC members present actively participated. Nobody in academia or at the Fed is able to show if QE, forward guidance, and negative interest rates are helpful or harmful policies. 

Despite this, everyone agreed yesterday that next time we have a recession, we will just do the same again. Eh, what? If we can’t show that a policy has worked and whether it is helpful or harmful how can we conclude that we will just do more next time? And if it did work, then removing it will have no consequences? There is a big intellectual inconsistency here.

Investors, on the other hand, have a different view. Almost all clients I discuss this topic with believe that QE lowered long rates, inflated stock prices, and narrowed credit spreads. Why? Because when the Fed and ECB buy government bonds, then the sellers of those government bonds take the cash they get and spend it on buying higher-yielding assets such as IG credit and dividend-paying equities. In other words, central bank policies lowered risk premia in financial markets, including in credit and equities. As QE, forward guidance, and negative interest rates come to an end, risk premia, including the term premium, should normalize and move back up again. And this process starts with the risk-free rate, i.e. Treasury yields moving higher, which is what we are observing at the moment.

These lovely paragraphs encapsulate well the academic and industry/policy view, and the tension in the former.

I'm interested by the latter tension: Industry and media commenters are deeply convinced that the zero interest rate and QE period had massive effects on financial markets, in particular lowering risk premiums and inflating price bubbles.

The Fiscal Theory of Monetary Policy

"Stepping on a Rake: the Fiscal Theory of Monetary Policy" is new paper, just published in the European Economic Review. This link gets you free access, but just for the next few days. After that, I can only post the last manuscript. (I held off sending this hoping the EER would fix the figure placement in the html version, but that didn't happen.)

The paper is about how the fiscal theory of the price level can describe monetary policy. Even without monetary, pricing, or financial frictions, the central bank can fix interest rates. In the presence of long-term debt higher interest rates lead to lower inflation for a while. Interest rate targets, forward guidance, and quantitative easing all work by the same mechanism. The paper also derives Chris Sims' "stepping on a rake" paper which makes that point, and integrates fiscal theory with a detailed new Keynesian model in continuous time.

Boot Camp

Hoover has just announced the 2018 Summer Boot Camp August 19-25 2018

The Hoover Institution’s Summer Policy Boot Camp (HISPBC) is an intensive, one week residential immersion program in the essentials of today’s national and international United States policy. The program is intended to instruct college students and recent graduates on the economic, political, and social aspects of United States public policy. The goal is to teach students how to think critically about public policy formulation and its results.

Using a highly interactive, tutorial-style model designed to foster fact-based critical thinking on the most important policy issues, students will have a unique chance to interact directly with the faculty of Stanford University’s Hoover Institution, comprised of world-renowned scholars in economics, government, political science, and related fields.  Each half-day will be dedicated to one topic, chosen because of its immediate relevance to today’s and tomorrow’s challenges. Participants will collaborate through class discussions, study groups, and team projects that encourage diverse perspectives. Enrollment is limited, in order to facilitate maximum interaction with the faculty and other participants.

This was a big success last year. I taught one section of the bootcamp, and I thought the students were a great cross section of really interesting smart people.

Oh, and it's free.

Journal graphics in a bygone era

To illustrate MV = PY. (It was MV=PT then.)  In  Irving Fisher, "The Equation of Exchange 1896-1910," The American Economic Review Vol. 1, No. 2 (June, 1911), pp. 296-305, via JSTOR.

A paper, and publishing

Even at my point in life, the moment of publishing an academic paper is a one to celebrate, and a moment to reflect.

The New-Keynesian Liquidity Trap is published in the Journal of Monetary Economics -- online, print will be in December. Elsevier (the publisher) allows free access and free pdf downloads at the above link until November 9, and encourages authors to send links to their social media contacts. You're my social media contacts, so enjoy the link and download freely while you can!

The paper is part of the 2012-2013 conversation on monetary and fiscal policies when interest rates are stuck at zero -- the "zero bound" or "liquidity trap." (Which reprised an earlier 2000-ish conversation about Japan.)

At the time, new-Keynesian models and modelers were turning up all sorts of fascinating results, and taking them seriously enough to recommend policy actions. The Fed can strongly stimulate the economy with promises to hold interest rates low in the future. Curiously, the further in the future the promise, the more stimulative.  Fiscal policy, even totally wasted spending, can have huge multipliers. Broken windows and hurricanes are good for the economy. And though price stickiness is the central problem in the economy, lowering price stickiness makes matters worse. (See the paper for citations.)

The paper shows how tenuous all these predictions are. The models have multiple solutions, and the answer they give comes down to an almost arbitrary choice of which solution to pick. The standard choice implies a downward jump in the price level when the recession starts, which requires the government to raise taxes to pay off a windfall to government bondholders. Picking equilibria that don't have this price level jump, and don't require a jump to large fiscal surpluses (which we don't see) I overturn all the predictions. Sorry, no magic. If you want a better economy, you have to work on supply, not demand.

Today's thoughts, though, are about the state of academic publication.

I wrote the paper in the spring and summer of 2013, posted it to the internet, and started giving talks. Here's the story of its publication:

More non-voting shares

Tim Kroencke at the University of Basel wrote a nice follow up on non-voting shares (previous posts here and here) , which I share with permission. Some of the controversy was whether companies would issue shares and whether investors would by them. It turns out, yes, and he sends a gorgeous example in which control rights and cash flow rights are priced differently and react to different events:

....

In Germany, it is quite common for large companies to issue voting shares (Stammaktien) and non-voting shares (Vorzugsaktien) and one can make nice case studies. Here is one I did a while ago,  that I have updated today, and I want to share with you:

In 2005, Porsche started to buy Volkswagen shares. In 2008, it became obvious that Porsche tried to overtake Volkswagen and the price of voting shares, and only the voting shares, skyrocked. Volkswagen became the world’s biggest company…  well, for a couple of days.

Some figures to give perspective: first, the share price of non-voting vs voting Volkswagen shares traded in Frankfurt:

The optimal inflation rate

Anthony Diercks has a very useful review of the the academic literature on the question, what is the optimal inflation rate? He includes 150 papers, ordered from low to high inflation.

Broadly speaking, we start with the Friedman result that the optimal nominal interest rate is zero, so the optimal inflation rate is the negative of the real rate of interest. The optimal nominal interest rate is zero, so people feel no incentive to economize on money holdings, or devote effort to cash management, paying bills late and collecting early. Many sticky price models suggest an optimal inflation rate of zero, so you don't have to change sticky prices. Then,

Most all of the studies that have found a positive optimal inflation rate have been written in the last ten years. The increase in the number of studies with a positive optimal inflation rate can be explained predominantly by the rise of two modelling features: (1) inclusion of the zero lower bound and (2) financial frictions.  

The zero bound means the Fed may want some headroom, a higher nominal rate in normal times. (More on that issue in an earlier post here).

Then, economists get creative. Anthony provides a nice list of additional ingredients that have appeared in the literature:

Reis on the state of macro

Ricardo Reis has an excellent essay on the state of macroeconomics. "Is something really wrong with macroeconomics?"

In substantive debates about actual economic policies, it is frustrating to have good economic thinking on macro topics being dismissed with a four-letter insult: it is a DSGE. It is worrying to see the practice of rigorously stating logic in precise mathematical terms described as a flaw instead of a virtue. It is perplexing to read arguments being boxed into macroeconomic theory (bad) as opposed to microeconomic empirical work (good), as if there was such a strong distinction. It is dangerous to see public grant awards become strictly tied to some methodological directions to deal with the crisis in macroeconomics.

There have been lots of essays lately bemoaning the state of macroeconomics. Most of these essays are written by people not actively involved in research, or by older members of the profession who seem tired when faced with the difficulty of understanding what the young whippersnappers are up to, or by economic journalists who don't really understand the models they are criticizing. I am old enough to feel this temptation and have to fight it.

Many bemoan the simplifications of economic models, not recognizing that good economic models are quantiative parables. Models are best when they isolate a specific mechanism in a transparent way.

Critics usually conclude that we need to add the author's favorite ingredients -- psychology, sociology, autonomous agent models, heterogeneity, learning behavior, irrational expectations, and on and on -- stir the big pot, and somehow great insights will surely come. This is the standard third-year PhD student approach to writing a thesis, and explains why it takes five years to get a PhD.

A Revised Radical

A revised draft of "Michelson-Morley, Fisher, and Occam" is now on my webpage (Yes, new title.)

This paper argues that the long quiet zero bound is an important experiment. The zero bound or an interest rate peg can be stable, and determinate. Longstanding contrary doctrines are simply wrong -- the doctrine that interest rate pegs must be unstable, starting with Milton Friedman, or the new-Keynesian view that the zero bound will lead to sunspot volatility.

I struggle hard with the implication that raising interest rates will eventually raise inflation. I've posted the paper before, but if any of you are following it this is a big revision.

What happens to inflation at the zero bound, and with a huge expansion of reserves? The big surprise: Nothing. This dog did not bark.

YIMBY papers

Two new papers on housing restrictions are noteworthy, Housing Constraints and Spatial Misallocation by Chang-Tai Hsieh and Enrico Moretti, and  The Economic Implications of Housing Supply by Ed Glaeser and Joe Gyourko.

Readers of this blog will not be surprised at the idea that zoning and other restrictions drive up the cost of housing, and that this has many bad consequences on economic growth and inequality. The papers are especially noteworthy for much deeper implications.

Hsieh and Moretti:

...high productivity cities like New York and the San Francisco Bay Area have adopted stringent re- strictions to new housing supply, effectively limiting the number of workers who have access to such high productivity. Using a spatial equilibrium model and data from 220 metropolitan areas we find that these constraints lowered aggregate US growth by more than 50% from 1964 to 2009.

1) The costs of regulation. The biggest problem in economics right now (yes, I mean that) is, How do we measure the growth consequences of regulation? Looking at the Western world's sclerotically slow growth rate, and listening to many anecdotes, it seems at least plausible that productive innovation is being strangled by byzantine bureacracy, captured by rent-seeking and anti-competitive forces. (Your other choices are, we just ran out of ideas, or some sort of endless "lack of demand.")

But how do we move past anecdote? How to we come up with "regulation is costing the economy x percentage points of growth?" Our statistical measurement system, GDP, unemployment, inflation, and so on, was beautifully designed in the 1940s to measure very Keynesian demand concepts. It isn't designed to answer the question of our time, how much growth is regulation costing us? We are flying in the dark. And Europe, perpetually in an Augustinian moment -- Lord,  grant me structural reform, just not yet--is also.

Well, Hsieh and Moretti are doing it, and by doing so showing one path to answering the larger question.

Half of all US growth for a half century is an astounding amount. 1964: $3,734 trillion;   2009: $14,419 Trillion. Growth = 3.05% per year. At 6.1% per year, $3734 x (1.061)^(2009-1964)=$53.6 trillion dollars!

OK, maybe that's too huge. Well, read the paper and see how they came up with the number. If you don't like their assumptions make different ones. More important than this number is how they are coming up with answers to this, the most important question of economics.

2) Models and micro vs. macro

So how do they make the calculation? Roughly, they measure productivity in cities. They assume that people get higher wages in San Francisco because there are some very high productivity activities that have to be done here. They assume that business could expand and form here, and workers could move here and join in those high productivity activities, both earning higher wages and making more and better stuff for the rest of us. But those workers can't move, and businesses can't expand and form, because housing supply is restricted.

You can see grounds for objection.

Fintech and Shadow Banks

"Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks" is an interesting new paper by  Greg Buchak, Gregor Matvos, Tomasz Piskorski, and Amit Seru

1. Shadow banks and fintech have grown a lot.

the market share of shadow banks in the mortgage market has nearly tripled from 14% to 38% from 2007-2015. In the Federal Housing Administration (FHA) mortgage market, which serves less creditworthy borrowers, the market share of shadow banks increased...from 20% to 75% of the market. In the mortgage market, “fintech” lenders, have increased their market share from about 5% to 15% in conforming mortgages and to 20% in FHA mortgages during the same period

2. Where are they expanding? They seem to be doing particularly well in serving lower income borrowers -- FHA loans.  They also can charge higher rates than conventional lenders, apparently a premium for convenience of not having to sit in the bank for hours and fill out forms,