Forbearance

Peter Wallison has a worthy OpEd in the WSJ, "Forbearance." Continuing my earlier thoughts on the financial response here and here, I don't think he goes far enough.

Let me tell a little story. Andy runs a restaurant. To run the restaurant, and live, he has a mortgage, he rents the restaurant space, and he borrowed money to buy to buy the equipment. Bob is retired. While he was working he lent Andy the money to buy the house and the restaurant equipment, and he owns the building. He lives off the income from these investments.

The virus comes and Andy has no income. He has enough savings to buy food for a while, and other current expenses. But he can't pay rent, mortgage, and debt payments. This is the central problem our government faces right now.

One answer: The federal government prints money and lends it to Andy so he can keep paying Bob. You can see a major problem here. Andy has no income. Eventually the restaurant may reopen, but then from the same profit stream Andy has to keep paying Bob and also pay back the loan that kept things going in the lockdown. Hmm.

Bailouts v Bankruptcy

Bailouts are back. It's all 2008 all over again.

Bankruptcy of a large corporation does not leave a crater behind. Bankruptcy is reorganization and protection, not liquidation. The point of bankruptcy is precisely to keep the business going. When a corporation files for bankruptcy, the stockholders are wiped out, bondholders lose a lot and become the new stockholders. The company rewrites a lot of contracts -- union contracts requiring a plane to fly even with empty seats, contracts to buy fuel at high prices, gate leases, and so forth.

Bailouts are bailouts to stockholders, bondholders, creditors, unions. The first three all basically signed up to write insurance, and got a fee for doing so. Bailouts are not bailouts to "the corporation" which isn't a thing.  Maybe maybe there was a case in 2008 that big banks were "systemic" and their creditors could not take the losses that they had signed up to take. Not so industrial companies.

Airlines and similar companies are in this mess because they took on way too much debt. If the government does bail out their stockholders and creditors, it makes a lot of sense not to let them take on  so much debt again. Repurchases per se are not the villain, as companies can borrow and pay big dividends. We might also start by finally, finally, removing the huge subsidies to debt.

If you're not persuaded, Veronique de Rugy and Gary Leff have an excellent and exhaustive article on this The Case Against Bailing out the Airline Industry. 

New Virus Podcast

A grumpy economist podcast on virus economics so far.

Low bond yields

Why are interest rates so low?

Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward trend since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the extra volatility that past inflation induces. But you can also see that real yields have fallen with the same pattern.

There is lots of discussion. A falling marginal product of capital, due to falling innovation, less need for new capital, a "savings glut," and so forth are common ideas. The use of government bonds in finance, the money-like nature of government debt among other institutional investors and liquidity stories are strong too. And most of the press is consumed with QE and central bank purchases holding down long term rates. I hope the steadiness of the trend cures that promptly.

Along the way in another project, though, I made the following graph:

The blue line is 10 times the growth rate of nondurable + services per capita (quarterly data, growth from a year ago). The red line is the negative of an approximate measure of the real return on 10 year government bonds. I took 10 x (yield - yield a year ago), and subtracted off the CPI.

Look at the last recession. Consumption fell like a rock, while the real return on long-term bonds was great. That real return came from a double whammy: long term bonds had great nominal returns as interest rates fell, and there was a big decline in inflation.  No shock, there is a "flight to quality" in recessions, along with a sharp decline in nominal rates. From a foreign perspective, the rise in the dollar added to the return of long-term bonds. The graph suggests this is a regular pattern going back to the almost-recession of 1987. In every recession, consumption falls, interest rates fall, inflation falls, so the real ex post return on government bonds rises.

Government bonds are negative beta securities. At least measured by consumption or recession betas.  Negative beta securities should have low expected returns. They should be less even than real risk free rates. I haven't seen that simple thought anywhere in the discussion of low long-term interest rates.  

Making the graph, I noticed it was not always thus. 1975, 1980, and 1982 have precisely the opposite sign. These were stagflations, times when bad economic times coincided with higher inflation and higher interest rates. Likewise, countries such as Argentina which go through periodic currency crises, devaluations, and inflations, flights to the dollar, all associated with bad economic times, should have the opposite sign. There is a hint that 1970 was of the current variety.

One could easily make a story for the sign flip, involving recessions caused by monetary policy and attempts to control inflation, vs. recessions involving financial problems in which people run to, rather than from, money in the recession.

In any case, the period of high yields was associated with government bonds that do worse in recessions, and the period of low yields is associated with government bonds that do better in recessions and have a negative beta. I haven't really seen that point made, though I am not fully up on the literature on time-varying betas in bond markets.

In any case, if we want to understand risk premiums in bond markets, this sort of simple macro story might be a good starting point before layering on institutional complexities.

Why stop at 100? The case for perpetuities

Issue 100-year Treasurys, advocates the Wall Street Journal.  It mentions a short note deep on the Treasury website that

Treasury’s Office of Debt Management is conducting broad outreach to refresh its understanding of market appetite for a potential Treasury ultra-long bond (50- or 100-year bonds). 

My 2 cents: Why stop at 100? Issue perpetuities! 

(I wrote a whole paper on this a while ago, if you want lots of detail and answers to practical questions. Unfortunately the Treasury website does not say how to send in suggestions, and nobody outreached to me, so this blog post is it.)

Perpetuities are bonds with no principal payment. Each perpetuity pays $1 forever.  If interest rates are 3%, to borrow $100, the government would sell three perpetuities, and then pay investors $3 each year. When the government wants to pay back the debt, it simply buys back the perpetuities on the open market.

A 100 year bond is almost a perpetuity. If the government issues a $100 100 year bond at 3%, only 100/(1.03)^100 = $5.20 of that value comes from the $100 principal payment. 95% of the value of a 100 year bond is already in the stream of coupons. For the investor, they are practically the same security. In particular they have nearly the same sensitivity to interest rate changes.

But perpetuities are better. Most of all: Perpetuities would be much more liquid -- easy to buy, sell, and use as collateral.  The reason is simple. Once 100 year bonds get going, there would be 100 separate and distinct issues outstanding. The 2123 2.6% 100 year bond is a different bond from the 2124 2.7% 100 year bond. If a dealer has an order for the first and an offer for the second, he or she cannot make the trade. If you borrow and sell short the first, you cannot deliver the second in return. This segmentation would make the markets for each bond thinner, and the bid ask spread larger. It would keep a lot of dealers and traders and market makers needlessly in business, which may  be one good reason the financial industry seems largely against the idea.

Perpetuities, by contrast, are a single security. When the government borrows more next year, it is borrowing more of the same security.  There is one, thick, transparent, low-spread market.

A more liquid market would pay lower rates.  Much of the point is for the government to borrow at low rates. Much of the reason government debt has such low interest rates is that it is very liquid -- easy to buy and sell, the "safe haven" in bad  times and so forth. Government debt is somewhat like money, and like money pays less interest in return for its liquidity. Well, then, the more liquid the better!

A 100 year bond would make sense if there were a group of investors sitting around who really wanted to have $3 coupons for 100 years, and then $100 exactly in 100 years, not 101 years, and they were not planning to buy or sell in the meantime. That is not remotely the case. Long term bonds are actively traded. Perpetuities match the varied investment horizons of ultimate investors, and by being more liquid are more flexible.

There is plenty of historical precedent. Perpetuities actually came before long-term bonds. They were the cornerstone of UK finance for the entire 19th century.

One can raise a bunch of practical objections, and if you have them go check out the paper.

Lower costs? The WSJ only advocates 100 year debt on the notion it would give the Treasury a lower borrowing cost when yield curves are inverted. This is a good argument, but more difficult and subtle than the WSJ lets on. The current yield is not the lifetime cost.  The 100 year cost of borrowing with short term bonds depends on what short term interest rates do in the future. If rates go up, it costs eventually more to borrow short. If rates go down it costs less, even if the current yield curve is inverted. In the benchmark "expectations model" yields have already adjusted so the expected cost is the same. The issue is the same to a household deciding between an ARM and a fixed rate mortgage. Even if the current ARM rate is higher than the fixed, if ARM rates go down in the future, the ARM could end up being better.

My paper was part of a conference at Treasury, published by Brookings.  I had a good debate with Robin Greenwood, Sam Hanson, Joshua Rudolph, and Larry Summers who wrote The Optimal Maturity of Government Debt (available here). They argued for borrowing short, not long. A the time the yield curve was steeply upward sloping, and in their simulations they opined that the chance of short rates rising and long rates declining to the point that the cost advantage would invert was small. The current reality has changed that conclusion as now it is the short rates that are higher.

Still, I think this is the wrong way to look at it. The Treasury is not in a great position to play bond trader and figure out where small variations in the yield curve reflect profitable opportunities.

Risk management. Like all investors, though, the Treasury's first question should be risk management, not profit. And there is a great risk facing the US Treasury. We are clearly going to run up a lot more debt before sanity sets in. Go look at the just released CBO Long Term Debt Outlook.

Net interest is already large. What happens if interest rates go up? Yes, they are unbelievably low now. But nobody really knows why. Between "secular stagnation" and "r* has declined" and "savings glut" you can see economists making things up right and left. So, you should not have huge confidence that we will not  return to historically normal interest rates of the last few centuries, or moreover that we will never suffer the kinds of interest rate spikes that happen to highly indebted countries trying to roll over 100% of  GDP  or so debt in a recession,  financial crisis, or war. If interest rates rise sharply, the US Treasury, having borrowed  short, is screwed.  We bought the ARM at a teaser rate.

This,  to me, is the real argument that  the  government should issue lots more long-term debt; 100 years if needed (but please, only every 10 years or so!) or, much better, perpetuities. Buy the fixed rate mortgage, and you keep the house no matter what happens to rates. Let's keep the house. In this discussion with Greenwood et al, they argued that the chance of such an interest rate spike is low. Perhaps, but the insurance is cheap -- and with a flat or inverted yield  curve it's even cheaper.

Borrow long to buy insurance, not just for a good deal.

Update:

In response to a few comments. In the paper I proposed that the Treasury issue 1)  fixed-rate perpetuities -- a security that pays one  dollar forever -- 2) floating-rate perpetuities -- just like Fed reserves, the interest rate adjusts  daily  and the price is always exactly $1.00 3) indexed perpetuities  -- it pays one dollar adjusted for  the CPI (or one of its improved versions) forever. The first eventually replaces all long  term debt, the second eventually replaces all short term debt, and the third replaces TIPS.

The second is really more  important, and I'll do a separate post eventually. If the treasury offered a fixed-value floating-rate instantly transferrable security just like reserves, it would do wonders for the  financial system.

Lend the shutdown?

The Federal Government seems to be obeying with rather remarkable accuracy the constitutional mandate that the government may not spend money that has not been appropriated by Congress.

I would be curious to hear from legal experts, however, what stops the government from lending money to federal employees, or just guaranteeing loans.

After all the government lends money all over the place, and credit guarantees are even larger. Is the Treasury no longer operating small business loan programs? (Honest question.) Is the Fed no longer lending money to banks, if they want it? Are Fannie and Freddy refusing to buy home mortgages because the funds to guarantee home mortgages (which it does) are not appropriated? No. As far as I can tell, Federal lending and loan guarantee programs are up and running.

If so, what stops the Treasury, from either lending money directly to Federal employees, or guaranteeing private lending. After all, the Treasury will write their back paychecks when the time comes, so these are potentially risk free loans. What stops the Treasury from just writing on a federal employees' paycheck "this is a loan against your back pay?"

Or... Social security and Medicare are still running. Can they write advances against social security payments that will be deducted from future federal paychecks?

I presume there is something stopping this -- that it is a step too clever, like the trillion dollar coin solution to the debt limit. But I would be curious to hear what the limitation is.

(HT Marginal Revolution on federal employees' other sources of financing, at pretty high interest rates.)

Volatility

An essay at The Hill on what to make of market volatility:

What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year?

The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come? 

Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility.  Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come. 

Still, is this at last the time? A few guideposts are handy. 

There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level.

Twenty percent volatility is normal. Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop. 

Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason.

...

They asked me to hold off a few weeks before posting the whole thing. So either wait two weeks or head over to The Hill. I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility. 

Kotlikoff on the Big Con

In preparing some talks on the financial crisis, 10 years later, I ran across a very nice article, The Big Con -- Reassessing the "Great" Recession and its "Fix" by Larry Kotlikoff. (Here, if the first link doesn't work.) 

Larry is also the author of Jimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati and Martin Hellwig's The Bankers' New Clothes is one of the central works outlining the possibility of equity-financed banking and narrow deposit-taking, and how it could end financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have promised people they can have their money back in full, at any time, but they have invested that money in illiquid and risky assets. When people all do that at the same time, the system fails. Such a run is inherently unpredictable. If you know it's happening tomorrow, you run to get your money out and it happens today.

This is a common view echoed by many others, including Ben Bernanke. What's distinctive about Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to as causes of the crisis are not really central.  Short-term debt, run-prone liabilities are gas in the basement. Just what causes the spark, how big the firehouse is, are not central, as without gas in the basement the spark would not cause a fire.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "

Larry then takes apart each of these non-culprits, as below.

Lira Crash

No, a currency board won't save the Lira, contra Steve Hanke's oped in the Wall Street Journal. Steve:

Turkey should adopt a currency board. A currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. It is required to hold anchor-currency reserves equal to 100% of its monetary liabilities,...

Well, that sounds reasonable no? If 100% of the country's currency and bank reserves are backed by US dollars, and the currency is pegged to the dollar, what could go wrong? Don't want Lira? The central bank promises to exchange 1 Lira for 1 dollar and always has enough dollars to make good on the promise. It sounds like an ironclad peg.

Government debt is the problem. Turkey may still have the resources to back its currency 100% with dollar assets. But what about the looming debt? Turkey does not have the resources to back all its government debt with dollar assets! If it did, it would not have borrowed in the first place.

So what happens when the debt comes due? If the government cannot raise enough in taxes to pay it off, or convince investors it can raise future taxes enough to borrow new money to roll it over, it must either default on the debt or print unbacked Lira.

I.e. a currency board run by an insolvent government will fail. The government will eventually grab the foreign reserves.

The Argentinian currency board did fail, and this is basically why.

Nobel Symposium on Money and Banking Day 2

Day 2 of the Nobel Symposium on Money and Banking focused on monetary policy. (My last post covered Day 1 on banking.)

Bernanke

Sadly Ben Bernanke's video and slides are not up on the website. Ben showed some very interesting evidence that the crisis was an unpredictable run, rather than the usual story about predictable defaults resulting from too much credit. Things really did get suddenly a lot worse in September and October 2008. Yes, it's easy to say this is defense against the charge that he should have done more ahead of time. But evidence is evidence, and I find it quite plausible that the relatively small losses in subprime need not have caused such a massive crisis and recession absent a run. Ben says the material is part of a paper he will release soon, so look for it. One can understand that Bernanke is careful about releasing less than perfect drafts of papers and videos.

History

Barry Eichengreen gave a scholarly account of why history matters, especially the great depression, and we should pay more attention to it. (Paper, video.) He aimed squarely at typical economists whose knowledge stopped at Friedman and Schwartz, or perhaps Ben Bernanke's famous non-monetary channels paper, in which bank failures propagated the depression. He emphasized the role of the gold standard and international cooperation or non-cooperation, and warned against facile comparisons of the gold standard experience to today's events and the euro in particular.

Randy Kroszner has a great set of slides and an engaging presentation. He also started on parallels with the great depression, and told well the story of the US default on gold clauses. He closed with a warning about fighting the last war -- particularly apt given the exclusive focus of most of this conference on the events of 2008 -- and on how to start a crisis. In his view when Bank of England Gov Mervyn King said: “We will support Northern Rock." People hear "Northern Rock's in trouble? Run!" Likewise, in my view, speeches by President Bush and Treasury Secretary Paulson did a lot to spark the run in the US.

DSGE

A highlight for me, was the session on DSGE models.

Marty Eichenbaum (video, slides, subsequent paper) gave a nice review of the current status of new Keynesian DSGE models, and how they are developing in reaction to the financial crisis and recession, and the zero bound episode.

Harald Uhlig

Critiques, or more precisely lists of outstanding puzzles and challenges, are often more memorable and novel than positive summaries, and Harald Uhlig delivered a clear and memorable one. (Video, Slides)

Asset prices are a longstanding problem in DSGE models. In typical linearized form, the quantity dynamics are governed by intertemporal substitution, and the asset prices by risk aversion, and neither has much influence on the other. (I learned this from Tom Tallarini.) Rather obviously, our recent recession was all about risk aversion -- people stopped consuming and investing, and tried to move from private to government bonds because they were scared to death, not a sudden attack of thriftiness. There is a lot of current work going on to try to repair this deficiency, but it still lives in the land of extensions of the model rather than the mainstream. Harald also points out a frequently ignored implication of Epstein-Zin utility, the utility index reflects all consumption and anything that enters utility

Financial frictions are blossoming in DSGE models, in two forms: First, HANK or "heterogenous agent" models, which add things like borrowing constraints and uninsurable risks so that the distribution of income matters, and in an eternal quest to make the models work more like static ISLM. Second, in response to the financial crisis (see first day!) stylized models of banking and intermediary finance are showing up. I'm still a little puzzled that the more standard time-varying risk aversion part of macro-finance got ignored, (a plea here) but that is indeed what's going on.

The conundrum, here as elsewhere in DSGE, is that the more people play with the models, the further they get from their founding philosophy: macro models that do talk about monetary policy, (now) financial crises, but that obey the Lucas rules: Optimization, budget constraints, markets, or, more deeply, structures that have some hope of being policy invariant and therefore predictions that will survive the Lucas critique. Already, many ingredients such as Calvo pricing are convenient parables, but questionably realistic as policy-invariant.

Harald points out that since most of the frictions are imposed in a rather ad-hoc manner, neither will they be policy-invariant. This is a deeper and more realistic point than commonly realized. Every time market participants hit a "friction," they tend to innovate a way around that friction so it doesn't hurt them next time. Regulation Q on interest rates was once a "friction," and then the money market fund was invented. The result is too often "chicken papers:"

The understandable trouble is, if you try to microfound every single friction from Deep Theory -- just why it is that credit card companies put a limit on how much you can borrow, in terms of asymmetric information, moral hazard, and so forth -- the audience will be asleep long before you get to the data. Also, as we saw in day 1, there is (to put it charitably) a lot of uncertainty in just how contract or banking theory maps to actual frictions. I think we're stuck with ad-hoc frictions, if you want to go that route.

Harald's next point is, I think, his most devastating, as it describes a huge hole in current models that is not (unlike the last two) a point of immense current research effort. The Phillips curve and inflation are the central point of the New Keynesian DSGE model -- and a disaster. 

The Phillips curve is central. The point of the model is for monetary policy to have output effects. Money itself has (rightly) disappeared in the model, so the only channel for monetary policy to work is via the Phillips curve. Interest rates change inflation, and inflation causes output changes. No surprise, it is very hard for that model to produce anything like the last recession out of small changes in inflation. (I have to agree here with the premise of the financial frictions view -- if you want your model to produce the last recession, other than by one huge shock, the model needs something like a financial crisis.)

The Phillips curve in the data is well known

Less well known, but worth lots of attention, is how the now standard DSGE models completely fail to capture inflation. Harald's slide:

The point of the slide, in simpler form: The standard Phillips curve is

inflation today = beta x expected inflation next year + kappa x output gap  + shock

Essentially all inflation is accounted for by the shock. The model is basically silent about the source of inflation. Looking at the model as a whole, not just one equation, Neither monetary policy shocks nor changes in rules accounts for any significant amount of inflation. 

I made a similar graph recently. Use the standard three equation model

Now, use actual data on output y, inflation pi, and interest rate i, to back out the shocks v. Turn off the monetary policy shock vi = 0. Solve the model and plot the data -- what would have happened if the Fed had exactly followed the Taylor rule? 

Answer: Inflation and output would have been virtually the same. The inflation of the 1970s and its conquest in the 1980s had nothing to do with monetary policy mistakes. It is entirely the fault, and then fortunate consequence, of "marginal cost" shocks that come from out of the model. This is a pretty uncomfortable prediction of a model designed to be about monetary policy! Or, as Harald put it

• Data: no Phillips-Curve tradeoff.
• QDSGE: don’t account for inflation with monetary policy shocks.
• The NK / Phillips-Curve-based NK QDSGE models may thus provide a poor guide for monetary policy.

Wait, you ask, what about Marty Eichenbaum's pretty graphs, such as this one, showing the effects of a monetary policy shock?

The answer: After a lot of work, the effects of a monetary policy shock look (at last) about like what Milton Friedman said they should look like in 1968. But monetary policy shocks don't account for any but a tiny part of output and inflation variation, quite contra Friedman (and Taylor, and many others') view.

Last, standard new Keyensian DSGE models have strong "Fisherian" properties. In response to long lasting or expected interest rate rises, inflation goes up. More on this later.

Ellen McGrattan

Ellen stole the show. (Slides.) Take a break, and watch the video. She manages to be hilarious and incisive. And unlike the rest of us, she didn't try to sheohorn a two hour lecture into her 15 minutes.

Her central points. First, like Harald, she points out that the models are driven by large shocks with less and less plausible structural interpretation, and thus further from the Lucas critique solution than once appeared to be the case. The shocks are really "wedges," deviations from equilibrium conditions of the model with unknown sources

What to do? Focus on rules and institutions. This is a deep point. Even DSGE modelers, in the desire to speak to policy makers, often adopt the static ISLM presumption that policy is about actions, about decisions, whether to raise or lower the funds rate. The other big Lucas point is that we should think about policy in terms of rules and institutions, not just actions.

Monetary policy and ELB

Stephanie Schmitt-Grohé (slides, video)  talked about the Fisherian possibility -- that raising interest rates raises inflation. New-Keynesian DSGE models, with rational expectations, have this property, especially for permanent or preannounced interest rate increases, and when at zero interest rates or otherwise in a passive regime where interest rates do not react more than one for one with inflation. She and Martin Uribe have been advocating this possibility as a serious proposal for Europe and Japan that want to raise inflation.

She presented some nice evidence that permanent increases in interest rates do increase inflation -- and right away, not just in the long run.

Mike Woodford. (slides, video)  gave a dense talk (37 slides, 20 minutes) on policy at the lower bound. During the ELB, central banks moved from interest rates to asset purchases and forward guidance. Mike asks,

To what extent does this mean that the entire conceptual framework of monetary stabilization policy needs to be reconsidered, for a world in which ELB might well continue periodically to bind? 

In classic form, Mike sets the question up as a Ramsey problem. Given a DSGE model, what is the optimal policy, given that interest rates are occasionally constrained? He derives from that problem a price level target. The price level target works, intuitively, by committing the central bank to a period of extra inflation after the zero bound ends. It is a popular form of forward guidance. The innovation here is to derive that formally as an optimal policy problem.

Mike's price level target is stochastic, changing optimally over time to respond to shocks. I'm a little skeptical that the central bank can observe and understand such shocks, especially given the above Uhlig-McGrattan discussion about the nature of shocks. Also, as I emphasize in comments, I'm dubious about the great power of promises of what the central bank will do in the far future to stimulate output today. I'm a fan of price level targets, but on both sides, not just as stimulus, but for utterly different reasons.

Mike takes on rather skeptically the common alternative -- quantitative easing, asset purchases during the time of the bound. He points out that to work, people have to believe that the increase in money is permanent, and won't be quickly withdrawn when the zero bound is over. As evidence, he points to Japan:

Similarly, he likes the price level target over forward guidance -- speeches in place of action -- as it is a more credible commitment to do things ex-post that the bank may not wish to do ex-post.

Finally, he addresses the puzzles of new Keynesian models at the zero bound -- forward guidance has stronger effects the further in the future is the promise; effects get larger as prices get less sticky, and so on. He argues that models should replace rational expectations with a complex k-step iterated expectations rule.

Me.

Video, slides from Sweden, slides from my webpage, written version. I covered this in a previous blog post, so won't repeat it all. I put a lot of effort in to it, and it summarizes a lot of what I've been doing in 15 minutes flat, so I recommend it (of course). It also offers more perspective on above points by Mike and Stephanie. My favorite line, referring to Mike's push for irrational expectations is something close to

"I never thought we would come to Sweden, that I would be defending the basic new-Keynesian program, and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest." 

Emi Nakamura

Poor Emi had to go last in an exhausting conference of jet-lagged participants. She did a great job (video, slides) covering a century of monetary history and monetary ideas clearly and transparently. These are great slides to use for an undergraduate or MBA class on monetary policy, as well. An abbreviated list:

• Gold standard
• Seasonal variation in interest rates under the gold standard; money demand shocks
• Money demand shocks in the 1980s -- how the supposedly "stable" V in MV=PY fell apart when the Fed pushed on M.
  
  
  
• Theoretical instability / indeterminacy of interest rate targets
• The switch to interest rate targets and corridors in operating procedures
• The (near-miraculous) success of inflation targets
  
• Taylor rules and other theory of determinate inflation under interest rate targets
• How is it "monetary economics" without money?
• Why did immense QE not cause inflation? 

The overarching theme is the grand story of a move, intellectual and practical, from money supply targets (of which gold is one) to interest rate targets.

Postlude

Monday featured two panels, Macroeconomic research and the financial crisis: A critical assessment, with Annette Vissing-Jørgensen, Luigi Zingales, Nancy Stokey, and  Robert Barro ; and Banking and finance research and the financial crisis: A critical assessment with Kristin Forbes, Ricardo Reis, Amir Sufi, and Antoinette Schoar.

Perhaps it's in the nature of panels, but I found these a disappointment, especially compared to the stellar presentations in the main conference. Also I think it would have been better to allow more (any, really) audience questions; the whole conference was a bit disappointing for lack of general discussion, especially with such a stellar group.

In particular, Luigi led by excoriating the profession for not paying attention to housing problems and financial crises. I thought this a bit unfair and simultaneously short-sighted. He singled out monetary economics textbooks, including Mike Woodford's, for omitting financial crises. Well, Mike omitted asteroid impacts too. It isn't a book about financial crises. And, after lamabasting all of us, he said not one word about events since 2009. What are we missing now? I had to stand up and ask that rude question, again suggesting that perhaps we are all not listening to Ken Rogoff this time. Annette went on to ask something like "don't you Chicago people believe in any regulation at all," and the respondents were too polite to say what an unproductive question that is and just move on.

Again, I offer apologies to authors and discussants I didn't get to. The whole thing was memorable, but there is only so much I can blog! Do go to the site and look at the other sessions, according to your interests.

Argentina update and IMF

From Alejandro Rodriguez, my correspondent from the last post

We are ***! People are withdrawing funds from fixed income mututal funds (which hold ARS 300 billion of CB short term debt). Yestedary alone people withdrew 4% from those funds and ran to the dollar today. Peso falls 5% to $24.00 ARS/USD. Next step is a ran against term deposits in banks. Next tuesday the CB has to roll over ARS 680 billion of short term debt. A conservative estimate is that ARS 150 billion will not be rolled over and will ran immediatelly to the dollar. No IMF bailout will stop the crisis but it will definitively help us in the aftermath.

PS: If you want to know what interest rates are now (like if anyone cares about them anmore)

maturity APR 5 days 81% 41 days 45%

PS2: CB trying to control the FX as I write email. Down to $23.00 ARS/USD.

Coincidentally, as Argentina started this spiral, I was at the Hoover conference on "Currencies, Capital, and Central Bank Balances," and thinking about it especially during the session on "Capital Flows, the IMF’s Institutional View and Alternatives" featuring Jonathan Ostry, who bravely came to defend the IMF's Institutional View, Sebastian Edwards, and John Taylor, moderated by George Shultz.

Briefly, in the good old days, the IMF was solidly for the Postwar Order that viewed capital restricitons -- laws stopping people from investing in a country or taking their investments out -- were bad things and to be avoided at all times.

That changed, and the new view, as summarized compactly by John Taylor, is much more friendly toward "capital flow management":

what is new about the Institutional View is that “capital flows require active policy management,” which includes “controlling their volume and composition directly using capital account restrictions.” (p. 8) The Institutional View document (IMF 2012) defines key terms and gives examples. For example,.. CFMs thus include “capital controls” that “discriminate on the basis of residency” and macro-prudential policies that differentiate on the basis of currency (p. 40). ..[The quotes and page numbers in the next two paragraphs are from Ghosh, Ostry, and Qureshi (2017).]

As Ostry explained, the new view also includes a stronger reliant on fiscal stimulus tools to counter domestic difficulties.

My obvious thought, is just how much would Argentina's problems be solved by more capital flow management, currency restrictions, investment restrictions, fiscal stimulus and so forth. And whether the IMF, if it rides to the rescue, will suggest more such dirigisme for its bailout money. The old IMF view -- commit to openness, fix your budget problems, and a somewhat jaundiced view of the ability of even well intentioned central bankers to execute masterstrokes of technocratic "management"  -- might have something to go for it still.

(It's worth remembering that capital cannot flow in aggregate. The only way capital can leave a country is on boats.  You can sell a factory to a local at a low price, and you can sell the foreign currency for dollars at a low price, but you cannot move a factory once built and someone else has to buy the foreign currency and give you dollars. Capital and trade accounts must balance. Capital cannot flow in the short run. Prices can change.

"Flow management" is one of those soothing NGO acronyms for what is in fact property seizure. You can tell I'm not favorably predisposed)

Why not taxes?

Reaction to the Washington Post oped (blog post, pdf) on debt  has been sure and swift. We suspected we might get criticized by Republicans for complaining about deficits are a problem.  Instead, the attack came from the left.  Justin Fox hit first, followed by a joint oped by Martin  Baily, Jason Furman, Alan Krueger, Laura Tyson and Janet Yellen. It's almost an official response from the Democratic economic establishment.

Their bottom line, really, is that entitlements and deficits are not a problem. They put the blame pretty much entirely on the recently enacted corporate tax cut.   (I'm simplifying a bit. As did they, a lot.)

By contrast, we focused on entitlement spending -- Social Security, Medicare, Medicaid, VA, pensions, and social programs -- as the central budget problem, and entitlement reform (not "cut") together with a strong focus on economic growth as the best answer. Our warning was that interest costs could rise sharply and unexpectedly and really bring down the party.

Well, deficit equals spending minus tax revenue, so why not just raise taxes to solve the budget problem?

First, let's get a handle on the size and source of the problem. 

I. Roughly speaking the long term deficit gap is 5 rising to 10 percentage points of GDP. And the big change is entitlements -- social security, medicare, medicaid, pensions. 

For example, even Fox's graph shows social security spending rising from 11% of payroll in 2006 and asymptoting at 18%.

The most recent 2017 CBO long-term budget outlook is quite clear. Long before the tax cut that so upsets our critics was even a glimmer in the President's eye, they were warning of budget problems ahead:

If current laws generally remained unchanged, the Congressional Budget Office projects, ..debt...would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation....

Why Are Projected Deficits Rising?

In CBO’s projections, deficits rise over the next three decades—from 2.9 percent of GDP in 2017 to 9.8 percent in 2047—because spending growth is projected to outpace growth in revenues (see figure below). In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt.

The CBO gives us this nice graphs to make the point:

Another CBO's graph follows. Top graph -- where is the spending increase? Social security, health, and interest. Not "other noninterest spending."

(In the bottom graph you see a rosy forecast that individual income taxes will rise a few percent of GDP to help pay for this. Don't be so sure. This comes from inflation pushing us into higher tax brackets and assuming congress won't do anything about it. Notice also how small corporate taxes are in the first place.)

The more recent CBO budget and economic outlook is equally clear: The near term problem is 5 percentage points of GDP:

CBO estimates that the 2018 deficit will total $804 billion....[GDP is $20 Trillion, so that's 4% of GDP]  ... In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022... Deficits remain at 5.1 percent between 2022 and 2025 ... Over the 2021–2028 period, projected deficits average 4.9 percent of GDP..

Then, things get worse,

In CBO’s projections, outlays for the next three years remain near 21 percent of GDP, which is higher than their average of 20.3 percent over the past 50 years. After that, outlays grow more quickly than the economy does, reaching 23.3 percent of GDP ... by 2028. 

That increase reflects significant growth in mandatory spending—mainly because the aging of the population and rising health care costs per beneficiary are projected to increase spending for Social Security and Medicare, among other programs. It also reflects significant growth in interest costs, which are projected to grow more quickly than any other major component of the budget, the result of rising interest rates and mounting debt. ... 

And that's only 2028.

You see the problem in our critic's complaint:

"The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending. This year, revenue is expected to fall below 17 percent of gross domestic product." 

Let us take the estimate that the recent tax cut cost $1.5 trillion over 10 years, i.e. $150 billion per year or 0.75% of GDP.  Compared to the $800 billion current deficit it's small potatoes. Compared to the 5 percent to 10 percent of GDP we need to find in the sock drawer, it's peanuts.   (Compared to the $10 trillion or more racked up in the last 10 years it's not huge either!)

[Update: Thanks to commenters, I now notice the "had been expected." OK, we expected 4% of GDP deficits, and then they passed a tax cut and now it's 5% of GDP. Sure. On the day that the tax cut was passed, the entire increase in the deficit was due to the tax cut. But our article, and the economy, is about the overall level of the deficit. The problem is what had been expected, not the recent minor change!]

Here is what the CBO has to say about it: 

For the next few years, revenues hover near their 2018 level of 16.6 percent of GDP in CBO’s projections. Then they rise steadily, reaching 17.5 percent of GDP by 2025. At the end of that year, many provisions of the 2017 tax act expire, causing receipts to rise sharply—to 18.1 percent of GDP in 2026 and 18.5 percent in 2027 and 2028. They have averaged 17.4 percent of GDP over the past 50 years.

17, maybe 18. We're waddling around in the 1% range, when the problem is in the 10 percent range. The long run budget problem has essentially nothing to do with the Trump tax cut. It has been brewing under Bush, Obama, and Trump. It fundamentally comes from growth in entitlements an order of magnitude larger. 

It is simply not true that "The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending."

To call us "dishonest" -- to call George Shultz "dishonest," in the printed pages of the Washington Post -- for merely repeating what's been in every CBO long term budget forecast for the last two decades really is a new low for economists of this stature. Is Krugmanism infectious?

Put another way, US government debt is about $20 trillion. Various estimates of the entitlement "debt," how much the government has promised more than its revenues, start at $70 trillion and go up in to the hundreds.

To be clear, I agree with the critic's complaint about the tax cut.

"The right way to do reform was to follow the model of the bipartisan tax reform of 1986, when rates were lowered while deductions were eliminated."

Yes! As in many previous blog posts, I am very sad that the chance to do a big 1986 seems to have passed. A large, revenue neutral, distribution neutral, savage cleaning and simplification of the tax code would have been great. There are some elements in the current one -- the lower marginal corporate rate is nice, and there is some capping of deductions, which is why it was a "good first step." But it fell short of my dreams too in many ways.

If only these immensely influential authors had been clamoring for their friends in the Resistance to join forces and pass such a law, rather than (Larry and Jason in particular) spend the whole time arguing that corporate tax cuts just help the rich, perhaps it might have happened. Having to do the whole thing under reconciliation put a lot of limits on what the Republicans could accomplish.

All that aside though, we're still talking about 0.75% of GDP cut compared to a 5%-10% of GDP problem. The long run deficit problem does not come from this tax cut.

II OK, so why not just tax the rich to pay for entitlements? 

I hope I have sufficiently dismissed the main line of this particular criticism -- that deficits are all due to the Trump tax cut and all we have to do is put corporate rates back to 35% and all will be well.

On to the larger question, echoed by many commenters on our piece. OK, social security and health are expensive. Let's just tax the rich to pay for it. Like Europe does, so many say.

I do think that roughly speaking we could pay for American social programs with European taxes. That is, 40% payroll taxes rather than our less than 20%; 50% income taxes, starting at very low levels; 20% VAT; various additional taxes like 100% vehicle taxes and gas that costs 3 times ours.

I don't think we can pay for European social programs with European taxes, because Europe can't do it. Their debt/GDP ratios are similar to ours. And their lower growth rates both are the result of this system and compound the problem. Many European countries are responding exactly as we suggest, with deep reforms to their social programs -- less state-paid health insurance, more stringent eligibility requirements and so on.

But that's the option: heavy middle class taxes for middle class benefits, at the cost of substantially lower growth, which itself then drives the needed tax rates up further.

America in fact already has a more progressive tax system than pretty much any other country. Making it more progressive would increase economic distortions dramatically.

A key principle here is that the overall marginal tax rate matters.  There is a tendency, especially on the left, to quote only the top Federal marginal rate of about 40%, and to say therefore that high income Americans pays less taxes than most of Europe. But that argument forgets we also pay state and sometimes local taxes.

The top federal rate is about 40%. In California, we add 13% state income tax, and with no deductibility we're up to 53% right there. But what matters is every wedge between what you produce for your employer and the value of what you get to consume. So we have to add the 7.5% sales tax, so we're up to 60.5% already.

But we're not done.  The Federal corporate tax is now 21%, and California adds 8.84%, so roughly 29% combined. Someone is paying that. If, like sales tax it comes out of higher prices, then add it to the sales tax. Those on the left say no, corporate taxes are all paid by rich people, which is why they were against lowering them. OK, then they contribute fully to the high-income marginal rate.

What about property tax? The main thing people do with a raise in California is to buy a bigger house. Then they pay 1% property tax. As a rough idea, suppose you pay 30% of your income on housing and the price is 20 times the annual cost (typical price/rent ratio). Then you are paying 6% of your income in property taxes. Add 6 percentage points.

I'm not done. All distortions matter. In much of  Europe they charge taxes and then provide people health insurance. We have a cross subsidy scheme, in which you overpay to subsidize others. It's the same as a tax, except much less efficient.  In terms of economic damage, and the overall marginal rate, it should be included. If you live in a condo, whose developer was forced to provide "affordable housing" units, you overpaid just like a tax and a transfer. And so on. I won't try to add these in, but all distortions count.

In sum, we're at a pretty high marginal tax rate already. The notion that we can just blithely raise another 10% of GDP from "the rich" alone without large economic damage does not work.  This isn't a new observation. Just about every study of how to pay for entitlements comes to the same conclusion.

Again, my argument is not about sympathy for the rich. It is a simple cause and effect argument. Marginal tax rates a lot above 70% are going to really damage the economy and not bring in the huge revenue we need.

Bottom line: Paying for the current entitlements entirely by taxes would involve a big tax hike on middle income Americans. 

III Answers

The most important answer is economic growth. 30 years of 3% growth rather than 2% growth gives you 35% more GDP, and thus 35% more tax revenue. If federal revenues are 20% of GDP, that's 7%
of the previous GDP right there.  Deregulation and tax reform -- get on with the lower marginal rates and simplification that we agree on -- are important.

(The CBO also writes,

In CBO’s projections, the effects of the 2017 tax act on incentives to work, save, and invest raise real potential GDP throughout the 2018–2028 period....

The largest effects on GDP over the decade stem from the tax act. In CBO’s projections, it boosts the level of real GDP by an average of 0.7 percent and nonfarm payroll employment by an average of 1.1 million jobs over the 2018–2028 period. During those years, the act also raises the level of real gross national product (GNP) by an annual average of about $470 per person in 2018 dollars.

This is not a terrible result!)

Our oped was clear to say social program "reform" not just "cut." Little things like changing indexing and retirement ages make a big difference over 30 years. We argue for reducing the growth and expansion of entitlements, not "cut."  Removing some of the very high work disincentives would help people get off some programs. Europe is facing this too, and many countries are a good deal more stringent about qualification than we are.

Our critics say that to point out America cannot pay for the entitlements we have currently promised "dehumanizes the value of these programs to millions of Americans." No. Failing to reform entitlements now and gently will lead to chaotic cuts in the future, on programs that people depend on. If we're going to throw around accusations of heartlessness, denying the problem is the heartless approach.

Tremors

A debt crisis does not come slowly and predictably. This year's short term bond holders, a very risk averse lot, are mostly interested in whether next year, new bondholders will show up, to lend the government money to pay this year's bondholders back. Bondholders can run on small jitters over that expectation.

When bondholders get nervous, they demand higher interest rates. More than higher interest rates, they diversify their portfolios, or just refuse. Debt gets "hard to sell" at any price. A different class of bondholders, willing to take risks for better rates, must come in to replace the safety-oriented clientele that currently holds short-term government debt.

As interest rates rise, interest costs on the debt rise. At $20 trillion of debt, when interest rates rise to 5%, interest costs rise to $1 trillion dollars, essentially doubling the deficit. That makes markets more nervous, they demand even higher interest rates, and when that spiral continues, you have a full blown debt crisis on your hands.

Short term debt compounds the problem. Since the US has borrowed very short term, interest increases make their way to the budget more quickly. If the US had borrowed everything in 30 year bonds, the spiral mechanism from higher rates to higher deficits would be cut off.

The crisis typically comes in bad times -- when in a war, recession, or financial crisis, the government suddenly needs to borrow a lot more and markets doubt its ability to repay.

But there is a case for a crisis to happen in good times as well. We have known for decades that the fundamental US problem is promised entitlement spending far beyond what our current tax system can fund. Markets have, sensibly I think, presumed that the US would fix this problem sooner or later. It's not that hard as a matter of economics. Well, say markets in 2005, OK for now, you have a war on terror and a war in Iraq on your hands, we'll trust you to fix entitlements later. Well, say markets in 2012, OK for now, you're recovering from a massive financial panic and great recession. We'll trust you to fix entitlements later, and we'll even lend you another $10 trillion dollars. But what's our excuse now? At 4% unemployment, after 8 years of uninterrupted growth, if we can't sit down now and solve the problem, when will we? Markets have a right to think perhaps America is so fractured we won't be able to fix this in time. Or, more accurately, markets have a right to worry that next year's markets will have that worry, and get out now.

All this is well known, and most commenters including me think that day is in the future. But the future comes often quicker than we think.

With that prelude, two pieces of news strike me as distant early warning signs. Here, from Torsten Sløk's excellent email distribution are two graphs of the bid-to-cover ratio in Treasury auctions.

Torsten's interpretation:

The first chart below shows that the bid-to-cover ratio at 4-week T-bill auctions is currently at the lowest level in almost ten years.... demand is also structurally weaker when you look at 10-year auctions, see the second chart. The main risk with issuing a lot of short-dated paper such as 4-week T-bills is that in 4 weeks it all needs to be rolled over and added to new issuance in the pipeline. In other words, the more short-dated paper is issued, the bigger the snowball in front of the US Treasury gets. 

Things are so far looking ok, but the risks are rising that the US could have a full-blown EM-style fiscal crisis with insufficient demand for US government debt, and such a loss of confidence in US Treasury markets would obviously be very negative for the US dollar and US stocks and US credit. The fact that this is happening with a backdrop of rising inflation is not helpful. Investors in all asset classes need to watch very carefully how US Treasury auctions go for any signs of weaker demand.

The last part is the mechanism I described above. As an ivory tower economist, I tend to overlook such technical issues. If the bid to cover ratio is low, well, then that just means we need higher rates. But higher rates aren't a panacea as above, since higher rates make paying it back harder still. As I look at debt crises, also, it isn't just a matter of higher rates. There comes a point that the usual people aren't buying at all.

Again, we're not there yet, and I think we have a long way to go. But this is a little rumble.

The second tremor is Why International Investors Aren’t Buying U.S. Debt in the Wall Street Journal.  The overall message is also that international investors are getting nervous.

US 10 year yields are 2.9% already. German yields are 0.68%. Why aren't people buying our debt? Well, number one, they are worrying a further slide in the dollar. Which comes when next year's international bond holders really don't want to hold US debt.

Most of the article is.. well, difficult for this former finance professor to follow. The article claims that one used to be able to lock in the difference, "Last year, buying Treasurys and swapping the proceeds back into euros provided European investors with a higher return than buying German sovereign bonds."[my emphasis] This sounds like arbitrage, "covered interest parity violations." That arbitrage is not perfect, but my impression is that it's not whole percentage points either. And you really can't lock in 10 years of funding. Besides which, someone else is on the risk-taking side of the swap. So the interviewed traders must be only partially hedging the difference. Perhaps it's really "uncovered interest parity," where you borrow Europe 0.68% invest in the US 2.9% and pray or only partially hedge the exchange rate risk. (On that, "The New Fama Puzzle by Matthieu Bussiere, Menzie D. Chinn, Laurent Ferrara, Jonas Heipertz, blog post at econbrowser documents that uncovered interest parity, where you invest in the high yield currency and take the risk, is losing its profitability. Interest spreads seem to correspond to future exchange rate changes after all.)

All to follow up on for another day. Mostly, it rang a bell as a little tremor that people who answer WSJ reporter's phone calls are expressing nervousness about US debt.

Again, these are little rumbles. I still think that a full blown crisis will come only amid a large international crisis, featuring some big country defaults (Italy?), big financial trouble in China, perhaps a war, state and local pension failures, and the US comes to markets with unresolved entitlements and asks for another $10 trillion. But I could be wrong. We live on an earthquake fault of debt, and the one thing I know from my own past forecasting ability (I have lived through 1987, the dot com boom and bust, 2008, the recent boom, and more, and saw none of them coming in real time) that I will not see it coming either.

Update:  Reply to Benjamin Cole, below. The US has never spent less on defense, as a fraction of GDP or of the federal budget, than it is doing today, since the 1930s. Here is defense / GDP. Defense / federal budget is even less, as the budget has expanded as a share of GDP.