New Paper -- the fiscal roots of inflation

I recently finished drafts of a few academic papers that blog readers might find interesting. Today, "The Fiscal Roots of Inflation."

The government debt valuation equation says that the real value of nominal debt equals the present value of surpluses. So, when there is inflation, the real value of nominal debt declines. Does that decline come about by lower future surpluses, or by a higher discount rate? You can guess the answer -- a higher discount rate.

Though to me this is interesting for how to construct fiscal theory models in which changes in the present value of government debt cause inflation, the valuation equation is every bit as much a part of  standard new-Keynesian models. So the paper does not take a stand on causality.

Here is an example of the sort of puzzle the paper addresses. Think about 2008. There was a big recession. Deficits zoomed, through bailout, stabilizers, and deliberate stimulus. Yet inflation.. declined. So how does the government debt valuation equation work? Well, maybe today's deficits are bad, but they came with news of better future surpluses. That's hard to stomach. And it isn't true in the data. Well, real interest rates declined and sharply. The discount rate for government debt declined, which raises the value of government debt, even if expected future surpluses are unchanged or declined. With a lower discount rate, government debt is more valuable. If the price level does not change, people want to buy less stuff and more government debt. That's lower aggregate demand, which pushes the price level down. Does this story bear out, quantitatively, in the data? Yes.

If you don't like discount rates and forward looking behavior, you can put the same observation in ex-post terms. When there is a big deficit, the value of debt rises. How, on average, does the debt-GDP ratio come back down on average? Well, the government could run big surpluses -- raise taxes, cut spending to pay off the debt. That turns out not to be the case. There could be a surge of economic growth. Maybe the stimuluses and infrastructure spending all pay off. That turns out not to be the case. Or, the real rate of return on government bonds could go down, so that debt grows at a lower rate. That turns out to be, on average and therefore predictably, the answer.

Identities

OK, to work. The paper starts by developing a Cambpell-Shiller type identity for government debt. This works also for arbitrary maturity structures of the debt. Corresponding to the Campbell-Shiller return linearization, $$ \rho v_{t+1}=v_{t}+r_{t+1}^{n}-\pi_{t+1}-g_{t+1}-s_{t+1}. $$ The log debt to GDP ratio at the end of period \(t+1\), \(v_{t+1}\), is equal to its value at the end of period \(t\), \(v_{t}\), increased by the log nominal return on the portfolio of government bonds \(r_{t+1}^{n}\) less inflation \(\pi_{t+1}\), less log GDP growth \(g_{t+1}\), and less the real primary surplus to GDP ratio \(s_{t+1}\). Surpluses, unlike dividends, can be negative, so I don't take the log here. This surplus is scaled to have units of surplus to value, so a 1% change in "surplus" changes the log value of debt by 1%. I use this equation to measure the surplus.

Iterating forward, and imposing the transversality condition, we have a Campbell-Shiller style present value identity, $$ v_{t}=\sum_{j=1}^{\infty}\rho^{j-1}s_{t+j}+\sum_{j=1}^{\infty}\rho^{j-1}g_{t+j} -\sum_{j=1}^{\infty}\rho^{j-1}\left( r_{t+j}^{n}-\pi _{t+j}\right). $$ Take innovations \( \Delta E_{t+1} \equiv E_{t+1}-E_t \) and we have $$ \Delta E_{t+1}\pi_{t+1}-\Delta E_{t+1} r_{t+1}^{n}= -\sum_{j=0}^{\infty} \rho^{j} \Delta E_{t+1}s_{t+1+j} -\sum_{j=0}^{\infty} \rho^{j} \Delta E_{t+1} g_{t+1+j}+\sum_{j=1}^{\infty} \rho^{j} \Delta E_{t+1}\left( r_{t+1+j}^{n}-\pi_{t+1+j}\right) $$ Unexpected inflation devalues bonds. So it must come with a decline in surpluses, a rise in the discount rate, or a decline in bond prices. Notice the value of debt disappeared, which is handy.

The bond return comes from future expected returns or inflation, so it's nice to get rid of that too. With a geometric maturity structure in which the face value of bonds of \(j\) maturity is \(\omega^j\), a high bond return today must come from lower bond returns in the future. $$ \Delta E_{t+1}r_{t+1}^{n} = -\sum_{j=1}^{\infty}\omega^{j}\Delta E_{t+1} r_{t+1+j}^{n} =-\sum_{j=1}^{\infty}\omega^{j}\Delta E_{t+1}\left[ (r_{t+1+j}^{n}-\pi_{t+1+j})+\pi_{t+1+j}\right] $$ Substitute and we have the last and best identity $$ \sum_{j=0}^{\infty}\omega^{j} \Delta E_{t+1}\pi_{t+1+j} = -\sum_{j=0}^{\infty} \rho^{j} \Delta E_{t+1}s_{t+1+j} -\sum_{j=0}^{\infty} \rho^{j} \Delta E_{t+1}g_{t+1+j} +\sum_{j=1}^{\infty} (\rho^{j} -\omega^{j})\Delta E_{t+1}\left( r_{t+1+j}^{n}-\pi_{t+1+j}\right) . $$ With long-term debt a weighted sum of current and future inflation corresponds to changes in expected surpluses and discount rates. A fiscal shock can result in future inflation, thereby falling on today's long term bonds. Equivalently, a surprise deficit today \(s_{t+1}\) must be met by future surpluses, by lower returns, or by devaluing outstanding bonds, so that the debt/GDP ratio is reestablished.

Results

I ran a VAR and computed the responses to various shocks.

Here is the response to an inflation shock - -an unexpected movement \(\Delta E_1 \pi_1\). All other variables may move at the same time as the inflation shock.

Inflation is persistent, so a 1% inflation shock is about a 1.5% cumulative inflation shock, weighted
by the maturity of outstanding debt.

So, where is the 1.5% decline in present value of surpluses? Which terms of the identity matter?
Inflation does come with persistent deficits here. The sample is 1947-2018, so a lot of the inflation shocks come in the 1970s. You might raise three cheers for the fiscal theory, but not so fast. The deficits turn around and become surpluses. The sum of all surpluses term in the identity is a trivial -0.06, effectively zero. These deficits are essentially all paid back by subsequent surpluses.

Growth declines by half a percentage point cumulatively, accounting for 2/3 of the inflation. And the discount rate rises persistently. Two thirds of the devaluation of debt that inflation represents comes from higher real expected returns on government bonds, which in turn means higher interest rates that don't match inflation. (More graphs in the paper.)

Growth here is negatively correlated with inflation, which is true of the overall sample, but not of the story I started out with. What happens in a normal recession, that features lower inflation and lower output? Let's call it an aggregate demand shock. To measure such an event, I simply defined a shock that moves both output and inflation down by 1%. Here are the responses to this "recession shock."

 Inflation and output go down now, by 1%, and by construction. That's how I defined the shock. This is a recession with low growth, low inflation, and deficits. Not shown, interest rates all decline too.

So where does the low inflation come from in the above decomposition. Do today's deficits signal future surpluses? Yes, a bit. But not enough -- the cumulative sum of surpluses is -1.15% On its own, deficits should cause 1% inflation, the fiscal theory puzzle that started me out in this whole business. Growth quickly recovers, but is not positive for a sustained period. Like 2008, we see a basically downward shift in the level of GDP. That contributes another 1% inflationary force. The discount rate falls however,  so strongly as to raise the real value debt by almost 5 percentage points! That overcomes the inflationary forces and accounts for the deflation.

Here is a plot of the interest rates in response to the same shock. i is the three month rate, y is the 10 year rate, and rn is the return on the government bond portfolio. Yes, interest rates at all maturities jump down in this recession. Sharply lower rates mean a one-period windfall for the owners of long term bonds, then expected bond returns fall too.

The point 

Discount rates matter. If you want to understand the fiscal foundations of inflation, you have to understand the government debt valuation equation. Inflation and deflation over the cycle is not driven by changing expected surpluses. If you want to view it "passively," inflation and deflation over the cycle does not result in passive policy accommodation through taxes, as most footnotes presume. The fiscal roots (or consequences) of inflation over the cycle are the strong variation in discount rates -- expected returns.

The fiscal process

Notice that the response of primary surpluses in all these graphs is s-shaped. Primary surpluses do not follow an AR(1) type process. In response to today's deficits, there is eventually a shift to a long string of surpluses that partially repay much though not all of that debt. This seems completely normal, except that so many models specify AR(1) style processes for fiscal surpluses. Surely that is a huge mistake. Stay tuned. The next paper shows how to put an s-shaped surplus process in a model and why it is so important to do so.

Comments on the paper are most welcome.

Dudley on reserves

Bill Dudley, ex President of the New York Fed, has an excellent Bloomberg editorial on reserves.

Reserves are accounts that banks hold at the Fed. The Fed used to pay no interest on these accounts. Accordingly, banks held very small quantities, as little as $10 billion in all, and they managed that quantity very carefully against legal reserve requirements, and having just enough around to make payments. To control interest rates, the Fed used to change the supply of reserves, and then watch the Federal Funds rate, the rate banks charge each other to borrow reserves.

"Each day, the Federal Reserve Bank of New York would assess whether to add or drain bank reserves from the financial system to balance the supply and demand to achieve the desired short-term interest rate. While straightforward in theory, the process was extremely complex to carry out. "

Since 2008, the Fed has started paying interest on reserves. The interest the Fed pays on reserves largely determines interest rates elsewhere, and the Fed doesn't have to go through a hoopla every morning to figure out just how many reserves to offer. The banking system is awash in trillions of dollars of reserves. And there has been no hyperinflation, nor indication that the Fed cannot control interest rates if it wishes to.

There has been a lot of controversy within the Fed about keeping the new system vs. the old.

Conference announcement

If you're working on fiscal issues, especially fiscal theory of the price level, here is a good conference you should submit to or attend. Don't wait, the deadline is today. Yes, this is self-interested -- I'm going and giving a talk so it's entirely in my interest that the other papers are interesting! The conference website is here

Economics and cognitive dissonance

What is the value of economics? "Have you economists ever proved anything that isn't obvious?" is a common complaint.

Tyler Cowen has an insightful post on Marginal Revolution, that provides a lovely insight into the power of economic thinking.

Often, multiple policy questions come down to a single issue. We may not know the answers to any of the questions, but we can at least say that the single issue drives the answer to all of them. So once you decide one issue goes one way, you can't (rationally) believe another issue goes another way, no matter how politically convenient that might be.

The issue here is the "elasticity of labor demand." If wages go down 10%, how many more workers will employers hire? If wages go up 10%, how many fewer will they hire? Already, note, that's one number, and it makes little sense to believe a higher number in one direction than another except for some likely quite transitory adjustment costs.

Tyler

There is a longer history of minimum wage assumptions not really being consistent with other economic views. 

Have you ever heard someone argue for wage subsidies and minimum wage hikes?  No go!  The demand for labor is either elastic or it is not. 

Have you ever heard someone argue for minimum wage hikes and inelastic labor demand, yet claim that immigrants do not lower wages?  Well, the latter claim about immigration implies elastic labor demand. 

Have you ever heard someone argue that “sticky wages” reduce employment in hard times but government-imposed sticky minimum wages do not?  Uh-oh. [The link is good too - JC]  

It would seem we can now add to that list.  Maybe we will see a new view come along:
“Labor demand is elastic when licensing restrictions are imposed, but labor demand is inelastic when minimum wages are imposed.”

This is a bit of economic-ese, so let me translate just a bit. The argument for a minimum wage is that labor demand is inelastic -- employers will hire the same number of workers. They will just absorb the higher wages or pass along the costs to customers. Workers get all the benefit. If labor demand is elastic, employers cut back on the number of employees. Most people lose their jobs and only a lucky (or productive, or willing to tolerate harsher working conditions) few get the higher wage.

The argument for wage subsidies requires the opposite assumption. If we subsidize wages, do employers respond by just paying people less? (Or, of we pay the subsidy to the worker, are the same number now willing to work for lower wages from employers? An often forgotten core result of economics is, it doesn't matter who pays the tax or gets the subsidy.) That is the case if labor demand is inelastic. Or do employers respond by paying the same amount, and expanding the workforce? That is the result if labor demand is elastic. You need elastic labor demand for wage subsidies to work as intended.

Thus, you can't simultaneously be for higher minimum wages and for wage subsidies. That is cognitive dissonance. Or, inconsistency. Or wishful thinking. And very common.

Likewise, just about 99% of macroeconomics is centered on the proposition that wages are "sticky." (1%, consisting of basically me, still has doubts.) If deflation breaks out, wages do not fall. Wages are too high. Employers cut back on workers, and people are unemployed. For this argument to work, (among other things) labor demand must be elastic. And then inducing exactly the same situation by minimum wages must have exactly the same result -- fewer jobs.

The point on immigration is good. The labor demand curve unites a price and a quantity. Thus, if pushing on a price has little effect on quantity, we know that pushing on a quantity has a large effect on price. Or, you have a hard time believing one thing about pushing on a price, and another thing about pushing on a quantity.

If you don't like minimum wage hikes, you can't believe that immigrants are pushing down wages. If you like higher minimum wages, you must believe that immigrants are terrible for labor markets. This proposition should be equally uncomfortable on the left and the right.

(Supply demand graphs are great here. I leave them as an exercise for the reader. If you know how to read them, this was all obvious already.)

Yes, one can complicate the analysis in each case to get a desired result -- add adjustment costs, asymmetries, or whatever. But it is striking that most discussions don't do that -- they don't reconcile that what is good for the goose ought to be good for the gander, and defend why not in a specific case.

Tyler:

Third addendum: Of course there are numerous other ways this analysis could run.  What is striking to me is that people don’t seem to undertake it at all.

It is interesting in policy debates how people debating each issue seem not to connect with other issues. Clear thinking is hard. "Wait, this comes down to the elasticity of labor demand, and we made the opposite assumption last Tuesday discussing immigration" is not the sort of thought that occurs naturally.  It is also a sign that policy-oriented economics is all too often searching for justification of pre-determined answers.

Update: Casey Mulligan complains that Tyler and I both left out the many margins of adjustment that happen in response to minimum wages, such as making hours less convenient, reducing benefits, making work less pleasant, and so forth. Casey's right, but Casey needs to relax! This isn't an extensive minimum wage post. I've blogged about those effects many times before. They're real and important. And the other side may want to complicate things as well. Before we come up for excuses why (say) minimum wages and immigration are different, let us at least acknowledge the simple model in which they are the same, and that to the extent labor demand elasticity bears in the analysis of each, one should use a consistent assumption on that ingredient.

More on low long-term interest rates

In an environment with stable inflation, the yield curve should typically be inverted.

Long term investors care about money when they retire, not next month. Most investors are long-term.

If inflation is steady, long-term bonds are a safer way to save money for the long run. If you roll over short-term bonds, then you do better when interest rates rise, and do worse when interest rates fall, adding risk to your eventual wealth. The long-term bond has more mark-to-market gains and losses, but you don't care about that. You care about the long term payout, which is less risky. (Throw out the statements and stop worrying.) So, in an environment with varying real rates and steady inflation, we expect long rates to be less than short rates, because short rates have to compensate investors for extra risk.

If, by contrast, inflation is volatile and real rates are steady, then long-term bonds are riskier. When inflation goes up, the short term rate will go up too, and preserve the real value of the investment, and vice versa. The long-term bond just suffers the cumulative inflation uncertainty. In that environment we expect a rising yield curve, to compensate long bond holders for the risk of inflation.

So, another possible reason for the emergence of a downward sloping yield curve is that the 1970s and early 1980s were a period of large inflation volatility. Now we are in a period of much less inflation volatility, so most interest rate variation is variation in real rates. Markets are figuring that out.

Most of the late 19th century had an inverted yield curve. UK perpetuities were the "safe asset," and short term lending was risky. It also lived under the gold standard which gave very long-run price stability.

(Yes, this argument is about portfolio variance, not beta, and assumes that the bond portfolio is a substantial part of the investor's wealth, or that inflation happens in bad times, at least over the investor's long horizon.)

***

This is a follow-up to low bond yields. That post has several good comments with links to the literature.

On that point, Uri Carl and Anthony Dierks send along this lovely graph from their note which makes the same point as my earlier blog post. The plot is different measures of the time-varying "covariance between Real Activity and Nominal Measures." The covariance changes sign, as I suspected.

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.

Summers tweet stream on secular stagnation

Larry Summers has an interesting tweet stream (HT Marginal Revolution) on the state of monetary policy. Much I agree with and find insightful:

Can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade?...There is little room for interest rate cuts..QE and forward guidance have been tried on a substantial scale....It is hard to believe that changing adverbs here and there or altering the timing of press conferences or the mode of presenting projections is consequential...interest rates stuck at zero with no real prospect of escape - is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation....The one thing that was taught as axiomatic to economics students around the world was that monetary authorities could over the long term create as much inflation as they wanted through monetary policy. This proposition is now very much in doubt.

Agreed so far, and well put. "Monetary policy" here means buying government bonds and issuing reserves in return, or lowering short-term interest rates. I am still intrigued by the possibility that a commitment to permanently higher rates might raise inflation, but that's quite speculative.

and later

Limited nominal GDP growth in the face of very low interest rates has been interpreted as evidence simply that the neutral rate has fallen substantially....We believe it is at least equally plausible that the impact of interest rates on aggregate demand has declined sharply, and that the marginal impact falls off as rates fall.  It is even plausible that in some cases interest rate cuts may reduce aggregate demand: because of target saving behavior, reversal rate effects on fin. intermediaries, option effects on irreversible investment, and the arithmetic effect of lower rates on gov’t deficits

Central banks are a lot less powerful than everyone seems to think, and potentially for deep reasons. File this as speculative but very interesting. Larry has many thoughts on why lowering interest rates may be ineffective or unwise.

The question is just how bad this is? The economy is growing, unemployment is at an all time low, inflation is nonexistent, the dollar is strong. Larry and I grew up in the 1970s, and monetary affairs can be a lot worse.

Yes, the worry is how much the Fed can "stimulate" in the next recession. But it is not obvious to me that recessions come from somewhere else and are much mitigated by lowering short term rates as "stimulus." Many postwar recessions were induced by the Fed, and the Great Depression was made much worse by the Fed. Perhaps it is enough for the Fed simply not to screw up -- do its supervisory job of enforcing capital standards in booms (please, at last!) do its lender of last resort job in financial crises, and don't make matters worse.

But how bad is it now? Here Larry and I part company. Larry is, surprisingly to me, still pushing "secular stagnation"

Call it the black hole problem, secular stagnation, or Japanification, this set of issues should be what central banks are worrying about...We have come to agree w/ the point long stressed by Post Keynesian economists & recently emphasized by Palley that the role of specific frictions in economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand. 

The right issue for macroeconomists to be focused on is assuring adequate aggregate demand.  

My jaw drops.

The unemployment rate is 3.9%, lower than it has ever been in a half century. It fell faster after about 2014 than in the last two recessions.

Labor force participation is trending back up.

Wages are rising faster and faster, especially for less skilled and education educated workers.

 There are 8 million job openings in the US.

Why in the world are we talking about "lack of demand?

Inflation, and history

Phil Gramm and John Early have an excellent WSJ oped on inflation measurement.

Many conventional inflation measures are  overstated by around 1% per year, because they don't capture quality change well. When the iPhone 22 comes out, and costs (say) the same as the iPhone 21, that looks like there is no inflation. But the iPhone 22 has dozens of new features, so you're really getting "more phone," and there is deflation. Think of all the things like mapping that are now free. It's not just tech. Houses are bigger and better, cars are much better and safer, and lots of services are now free

No price index takes account of the fact that each month more than twice as many people get medical advice from WebMD as visit the doctor’s office in America. 

The people who make price indices try hard to account for quality, but the result is still biased.

Now for many uses we don't get too upset about this, just as a clock that's always 5 minutes fast is still useful. In particular, for spotting trends in inflation, is it rising or falling, a steady 1% bias doesn't make much difference.

Where it does make a big difference is when you cumulate inflation over a long period of time. We  do that in the politically charged question, is the average American better off now than his or her parents were in 1975, and if so how much? Now whether 1% per year times 44 years is more inflation or better stuff matters a lot.

When corrected for documented price overstatements, real average hourly earnings from 1975 to 2017 are shown to have risen some 52%, not 6%—an additional $6.77 an hour. Real median household income increased 68%, not 21%—$17,060 more annually. 

And published poverty incidence fell by almost half. Combined with the 67% drop in poverty that comes from accounting for all government transfers, poverty incidence sank from 12.3% to about 2%. 

In the political debate over the fate of the "middle class" these are huge differences. The mantra-repeated narrative that the "middle class" hasn't advanced at  all  since the 1970s is simply not true. (Quotes because I reject the idea that we are a class society,  and hence the use of this word.)

Gold Oped

Now that 30  days have passed, I can post the whole July 18 gold oped in the Wall Street Journal.

Some of President Trump’s potential nominees to the Federal Reserve Board have expressed sympathy for a return to the gold standard. Conventional monetary-policy experts deride the idea—and not wholly without reason. The gold standard won’t work for a 21st-century monetary and financial system. It is possible, however, to emulate its best features without actually restoring the gold standard.

The idea behind the gold standard is simple: The government promises that if you bring in, say, $1,000 in cash, you can trade it for one ounce of gold, and vice versa. By pegging the dollar to something of independent value, it promises to solve the problem of inflation or deflation. And we don’t need central-bank wizards to run things anymore.

Yet the aim of monetary policy isn’t to stabilize the dollar price of gold; it is, rather, to stabilize the prices of all goods and services. The price of gold has varied from $1,000 to $1,800 an ounce in the past 10 years. Had the Fed fixed that price, critics say the price of everything else would have had to vary this much.

Letter 2 from Argentina

Alejandro Rodrigues writes again from Argentina (previous post)

"This  graph shows the evolution of peso denominated fixed income mutual funds. On Monday (after the elections) this funds suffered withdrawals of 6% of the total shares. Net assets fell by more as prices plummeted (-5%). On Tuesday, shares fell by 6% again but prices remained constant. On Monday, Money Market funds suffered withdrawals (drop in shares) of 16% although they didn't break the buck (on average). "

I gather from other discussions that Argentinians are trying to move assets fast to dollars. That is consistent with this drop in Peso denominated fund assets. (Though of course for every seller there is a buyer -- I wonder who the private parties (non funds) are that are buying Peso fixed income assets!)

There is an interesting dynamic here. The chance of a new regime with terrible economic policies rises. It causes a rush to dollars. People suspect that the new regime will impose capital controls.  The  government has trouble rolling over its own currency debt, as interest rates rise. That makes the fiscal situation worse.

In short, the chance of a bad government taking over can provoke a crisis that makes the chance of a bad government taking over larger. Or perhaps Argentines will break the usual electoral patterns.

The Reader's Guide to Optimal Monetary Policy

The Reader's Guide to Optimal Monetary Policy is a snazzy new website created by Anthony Diercks and Cole Langlois at the Federal Reserve Board.  Screenshot: 

Who said 2% inflation is a good idea? The graph shows publication date on the horizontal axis, the optimal inflation rate on the y axis, and the size of the circle is the number of citations. 

The sizeable number of dots around -4% reflect the "Friedman rule" idea. (Sadly, the graph doesn't include Friedman. It only goes back to 1990.) The idea here is that the nominal interest rate should be zero, so you earn the same on money as on bonds. Then there is no reason to economize on holding cash. Most of these were written when real rates were thought to be around 4%, so you need 4% deflation to get a nominal interest rate of zero. Ah, the good old days. 

More dots show up around zero. These are mostly "sticky price" models. Now there are costs to changing prices. So the economy works best when people don't have to change prices at all, 0% inflation.   

Note the paucity of papers at 2%, the Fed's inflation target. This is a nice testament to the honesty of  the Fed and its researchers.

The website allows you to graph many other issues, search for papers and so on. If you hover over a paper you get a great little two-sentence summary of the paper's main idea. If you click, you get the abstract and link to the paper. Have fun. Trigger warning: you may end up wasting a good deal of time. 

Whither the Fed?

Steve Williamson has an excellent long essay, "Is the Fed Doing Anything Right?" on the current state of monetary policy.

Why is the Fed lowering rates?

(If you're impatient, skip to the ** of the most interesting and provocative points)

Steve starts with an Ode to Rules. It would be nice if the Fed acted more stably and predictably, leaving less room for the interpretation that they're just changing their minds, or panicking, or giving in to Trump tweets.

So Steve phrases the question nicely: what has changed since last September, when the Fed seemed fully on a "normalization" path? What is the "data" in a "data-dependent" policy?

They decided (with a couple of dissents) to reduce the target range for the fed funds rate by 0.25% to 2.00-2.25%. That seems to represent a change of plan, since in September 2018, the median FOMC member was thinking that the fed funds rate by the end of 2019 would be 3%. So, something important must have changed since last September. What was it?

From the FOMC statement and Powell's presser after the meeting, it seems there were 5 things bothering the committee: 

1. Weak global growth.
2. Trade policy uncertainty.
3. Muted inflation.
4. The neutral rate of interest is down.
5. The natural rate of unemployment is down.

Go see Steve's graphs. There really is not much case that the US economy is slowing down.

Typically central banks lower interest rates in the face of observed decreases in aggregate economic activity - somewhere. But we haven't seen any such thing. Must be some very weird policy rule at work here.

That's a bit overstated. Central banks do react too forecasts. But most central banks, including ours, react cautiously knowing just how unreliable forecasts are.

 I can certainly understand that there's "trade policy uncertainty." More like "Trump uncertainty," I think. But that's been with us since January 2017. And for North America, which we could argue is more relevant for the US, the trade uncertainty is actually lower than it was in September. The USMCA was signed by Mexico, Canada, and the US on November 30, 2018, though it is as yet not ratified. Brexit anxiety is with us of course, but again that's nothing new. So, I think you have to be more specific if you want to make a general case about policy uncertainty. And what's the hurry? You can't wait for resolution?

The uncertainty work is interesting (a great recent example). But if uncertainty really is an economic problem, it should be reflected in today's investment, investment plans (a great measure) hiring, durables purchases stock prices, and other forward-looking measures. Moreover, it's not clear that the Fed should offset uncertainty as trade. They are "supply" shocks. (Previous post)

The one thing that has changed a bit is inflation.

.."muted" is as a good a word as any for that, relative to the 2% inflation target. The Fed's chosen measure - headline PCE - is at 1.4%, and stripping out food and energy gives us 1.6%. Not low, certainly, and well within what you might think is reasonable tolerance, but definitely below target.

But, putting Steve's point in stronger voice, , 0.4% variation in inflation over nearly a year is tiny in historical context, certainly not the sort of things that usually reverse a steady tightening project.

**

Here though, Steve's most interesting and provocative points start.

"But, suppose we thought that the only problem here is a slightly-below-target inflation rate. What would the corrective action be?"

...
The traditional answer, of course, is, lower interest rates.

and assuming there is a stable Phillips curve, everyone knows that lower nominal interest rates imply lower real interest rates in the short run. And lower real interest rates, as everyone knows, makes "aggregate demand" go up. Further, as everyone knows, output is demand-determined, so output therefore goes up. Then, by Phillips curve logic, inflation goes up.

But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as we can see in this exchange. 

The exchange  is really good on both sides. Don't underestimate AOC. She rather brilliantly and knowledgeably led Powell down the road to admit the Phillips curve has died, so unemployment doesn't cause inflation any more. Then she smoothly went right to the (false) implication that any policy previously criticized as being inflationary will not cause inflation. She mentioned minimum wages, but green new deal, free college, medicare for all and a  fiscal blowout cannot be far behind. Powell didn't take the bait, but it's wiggling on the hook.

What about the Phillips curve? Inflation seems to have nothing to do with unemployment (or is it vice versa??) Japan and Europe, as well as our own 10 years of slow growth, seem testament to the falsity of the proposition that lower interest rates spark inflation.

Powell seems to be telling AOC what his staff told him, which is that the Phillips curve is currently very flat. The Phillips curve is still there though, or so Powell seems to think, though he seems a little confused about how the whole thing works. ... 

you can see that in the presser with Powell. The reporters are trying hard to understand what the Fed is up to, Powell is struggling to explain it, and everything is coming out muddled. For example, this exchange: [JC: I edited for clarity] 

MICHAEL MCKEE. ...How does cutting interest rates lower, or how does cutting interest rates keep that going since the cost of capital doesn’t seem to the issue here.= 

CHAIR POWELL. You know, I really think it does, and I think the evidence of my eyes tells me that our policy ... supports confidence, it supports economic activity, household and business confidence, and through channels that we understand. So, it will lower borrowing costs. ... since we noted our vigilance about the situation in June, you saw financial conditions move up...You see confidence, which had troughed in June....You see economic activity on a healthy basis. It just, it seems to work through confidence channels as well as the mechanical channels that you are talking about.

Steve comments scathingly:

Well, there's no confidence channel running from Powell to me, that's for sure.... Powell started off well when he was appointed. He opted for press conferences after every FOMC meeting, reduced the wordiness of FOMC statements, and generally seemed to be communicating well. But this decision makes clear what his limitations are. Powell is an attorney whose experience with monetary policy comes from sitting on the FOMC since 2011. You may think that puts you at the center of things. Sorry, it doesn't. There's a lot Powell doesn't know, and it shows.

True, a "confidence channel'' is something of a new idea, though quite common in central banking circles. We just need to give more and better speeches. All we have to fear is fear itself. But if one accepts an "uncertainty channel" certainly "confidence" can be interpreted as "belief in the Fed put," or other beliefs about future Fed policy.

I think Steve's personal attack on Powell is unwarranted.  Here and in other speeches I see someone who does a darn good job  of digesting fancy macroeconomics, and distinguishing the nuggets of wisdom from the craziness. Many (most) trained PhD economists are no better at steering the ship. You don't necessarily want a PhD hydrodynamicist at the wheel in a storm.

Most of all "There is a lot Powell doesn't know, and it shows" seems to me totally unwarranted. Just what is there to "know" about the Phillips curve? I would much rather have Powell's healthily acknowledged uncertainty than a PhD economist who thinks he or she "knows" how the Phillips curve really works.

(As a reminder, the Phillips curve is not standard economics. It is an empirical correlation that gained causal status by its repetition. Tight labor markets should coincide with higher real wages, wages higher than prices. But there is no natural logic that tight labor markets should coincide with higher wages and prices overall.)

Steve himself goes on to prove just how little anyone "knows" about the Phillips curve and the proper direction of policy right now:

So what's going on here? The Fed announced a normalization plan.. What's that mean? Normal means that short-term nominal interest rates are high enough to be consistent with 2% inflation over the long term. ... That's just the logic of Irving Fisher, which we all learned as undergrads. But, if the nominal interest rate is too low on average, then inflation will be too low, on average. That's abundantly obvious given the post-1995 Japanese experiment. Late last year, the FOMC was thinking that a normal fed funds rate is about 2.5-3.0%. I think that's about right. Basically, they aborted normalization. And, if the FOMC thinks an important goal is hitting 2% inflation, it should have kept its target fed funds rate range constant, or moved it up. [My emphasis]

Steve acknowledges here participation in the great neo-Fisherian heresy, which I flirt with as well. The equations of our best models scream it. Japan and Europe scream it, and their comparison with the US.

Maybe yes, maybe no. But Neo-Fisherians have no business criticizing the Fed chair for uncertainty and a bit of muddiness about how the Phillips curve works, or how interest rates affect inflation!

Steve goes on to discuss the end of QE and IOER, with interesting facts. The "floor system" does seem to be falling apart. I think the answer is simple: if you want to peg rates, peg rates: offer anyone to deposit at 2.00%, and offer anyone to borrow (with treasury collateral) at 2.25%. The Fed wants only the former, to limit quantities, and to offer different rates to different institutions according to their favor with the Fed. All a topic for another day.

Trade and the Fed

Nina Karnaukh of Ohio State sent along this lovely graph of the 6 month Fed Funds futures around the beginning of August. Read this as the market's guess about what is happening to the Federal Funds rate over the next 6 months.

The first drop in price occurs with the FOMC announcement 2 PM July 31. The price drop is equivalent to a a rise in expected future interest rates of about 5 basis points or 0.05%. This has been read as market disappointment that the Fed did not signal more future rate cuts.

The subsequent price spike is this,

That statement caused a 10 bps rise in price, i.e. decline in expected interest rate.  The natural interpretation: The markets expect the  Fed to lower rates in a trade war, either directly or in response to the economic damage the trade war will cause.

I had read the Fed's recent actions as just a case of late expansion jitters, perhaps with a mild response  to slightly lowered inflation. But this is clear evidence that the market sees the Fed reacting to trade news.

************

Should central banks offset trade wars? I think this is a question nobody is asking but it needs to be asked. Central banks including the US Fed and ECB seem to take for granted that any reduction in economic activity demands "stimulus" to offset it. But stimulus can only provide "aggregate demand." What if the problem is "aggregate supply" -- an economy humming along at full demand, and then someone throws a wrench in the works, be it a trade war, a bad tax code, or a regulatory onslaught? (I'll stop using quotes, to signal my dislike for these terms.)

Conventional wisdom ways that central banks should not offset reductions in aggregate supply. You can fight a lack of aggregate demand, but monetary policy cannot fight a decline in aggregate supply. The first job of a central bank should be to distinguish demand from supply shocks, so it can react to the former, but not to the latter.  This standard wisdom emanates from the 1970s, where central banks kept rates low to offset the effects of oil price shocks -- supply shocks -- and ended up producing worse recessions and inflation.

Yet expressing this view at central banks these days, people stare at me with blank expressions. Distinguish... supply... from... demand... shocks....why would we do that? The view from about 1960s Keynesianism that all fluctuations in output, employment and prices come from demand, seems to have flowered again.

Now, in this conventional (i.e. 1980 Keynesianism vs 1965 Keynesianism) view the problem with offsetting a "supply" shock is that the monetary stimulus causes inflation. And now we have inflation once again drifting slightly lower. So perhaps the trade war is a "demand" shock? It's hard to see how though.

More plausibly, perhaps the policy uncertainty about the trade war is causing a decline in "demand." Why build a factory if any day now another tweet  could render it unprofitable? The prospect of a trade war -- or the kind of serious political and trade turmoil that would follow Tianamen II in Hong Kong -- is a "confidence" shock. But the uncertainty is genuine. A rise in risk premium in an uncertain environment is genuine. People should hold off building factories that depend on a Chinese supply chain until we know if there is going to be a trade war. Unless the Fed is stepping more and more into the role of psychologist in chief, to decree that such fears are irrational, it's not obvious that the Fed should try to goose investment by artificially lowering the short term rate in response to a  rise in trade fears.

A second possibility arises from more 1980s economics. A "supply" or productivity shock also lowers the expected return on investment. So the real  interest rate should decline in response to such a shock. That is another reason perhaps for some interest rate decline in response to a negative supply shock. But how much? This still does not justify the same response to all sources of output decline, or (in our case) fear of output decline that has not happened yet.

The other possibility is that the Fed is now watching the exchange rate, as most other central banks do. The one thing that still does seem to work is that raising interest rates raises the value of the currency. The trade war raises the value of the dollar, and the US clearly wants to manipulate the dollar back down again.

Every era’s monetary and financial institutions are unimaginable until they’re real

Every era’s monetary and financial institutions are unimaginable until they’re real, writes Tyler Cowen in an excellent Bloomberg.com essay on the anniversary of Bretton Woods. (MR link)

Our ancestors' experience with paper money leading quickly to massive inflation would leave them agape at our completely unbacked fiat money and floating exchange rates which has led only to mild inflation.

...fast forward [from the gold standard] to the current day. Currencies are fiat, the ties to gold are gone, and most exchange rates for the major currencies are freely floating, with periodic central bank intervention to manipulate exchange rates. For all the criticism it receives, this arrangement has also proved to be a viable global monetary order, and it has been accompanied by an excellent overall record for global growth. 

Yet this fiat monetary order might also have seemed, to previous generations of economists, unlikely to succeed. Fiat currencies were associated with the assignat hyperinflations of the French Revolution, the floating exchange rates and competitive devaluations of the 1920s were not a success, and it was hardly obvious that most of the world’s major central banks would pursue inflation targets of below 2%. Until recent times, the record of floating fiat currencies was mostly disastrous.

As Tyler points out, even 20 years ago the standard opinion was that the euro would not work.

Another surprising monetary innovation would be the euro. Both Milton Friedman and Paul Krugman warned that the euro was unlikely to succeed and persist. Yet it has proven more durable than many people expected, and there does not seem to be an end in sight. This kind of a common fiat currency, spread across so many nations, is without precedent in world history.

(I quibble with that one: Gold coins were an international currency, and throughout history coins have been shared among countries. Our own "dollar" comes from the common colonial use of a Spanish coin.)

The sovereign default issue remains, but that less-than-desired  inflation remains the euros' problem would have been a big surprise. That countries like Greece and Italy would, so far, choose the hard path of staying on the euro rather than take the sugar high of another devaluation is indeed a political if not an economic surprise.

Bretton Woods' system, including fixed exchange rates, the IMF, a dollar sort of pegged to gold but you can't have gold, dollar reserves, and extensive capital controls is as archaic to us as it was radical to pre WWII thinking.

Tyler only hints at the main message:

 Looking forward, don’t assume the status quo will hold forever, but rather prepare to be shocked....

So as you consider the legacy of Bretton Woods this week, remember that core lesson: There will be major changes in monetary and institutional arrangements that no one can even imagine right now. Assume the permanency of the status quo at your peril.

My main point is to underline that hint.

We forget how recent our own monetary certainties are,. Well into the 1970s, mainstream Keynesian economists thought that inflation came from "wage price spirals" and administered prices, and that central banks were pretty irrelevant. Milton Friedman was a radical upstart. He won, dramatically, on the importance of central banks. Yet too his focus on money growth rates died out with the 1980s. The current consensus view that central banks have the power to control inflation, and the power, ability, and duty to stabilize the economy, all by setting short term rates, is an idea that only took shape in the late 1980s and 1990s.

And that is falling to pieces all around us. That no "deflation spiral" breaks out at the zero bound undermines that view entirely. The death of the Phillips curve, the antithesis of the 1970s -- strong output and employment with puzzlingly low inflation -- the endless inflation below central bank targets, all stand witness. (And be careful what you wish for! Strong growth with low inflation is pretty darn nice!)

Intellectually, we grope to maintain the illusion of an all-powerful central bank, whose asset purchases and Delphic pronouncements about its future actions powerfully steer the economy. But the feeling that perhaps Friedman won too much, and that central banks are not nearly as powerful as they seem (other the power to screw things up, which they retain!)  is getting stronger and stronger.

The only thing that is sure is that our current doctrines will look as archaic 20 years from now as Bretton Woods, and the 1950s-60s Keynesian consensus, do today. That humility -- and the hard and and critical thinking it ought to provoke -- are indeed great lessons of this anniversary.

Every era’s monetary and financial institutions are unimaginable until they’re real. And so will be the next era's institutions.

New Papers

I've been remiss about blogging lately while I finished two new papers, "The Fiscal Roots of Inflation," and "The Value of Government Debt." I'm posting here for those who might  be interested, and I appreciate  comments.

Both papers apply asset pricing variance decompositions to questions of government finance and inflation. The inflation paper is  part of the long-running fiscal theory of the price level project. (Note: this post uses MathJax which may not show properly on all devices.)

I start by deriving an analogue to the Campbell-Shiller linearization of the return identity:
\[ \beta v_{t+1}=v_{t}+r_{t+1}^{n}-\pi_{t+1}-g_{t+1}-s_{t+1}. \] The log debt to GDP ratio at the end of period \(t+1\), \(v_{t+1}\), is equal to its value at the end of period t, \(v_{t}\), increased by the log nominal return on the portfolio of government bonds \(r_{t+1}^{n}\) less inflation \(\pi_{t+1}\), less log GDP growth \(g_{t+1}\), and less the primary surplus \(s_{t+1}\). The "surplus" in this linearization is the surplus to GDP ratio, divided by the steady state debt to GDP ratio. It's not a log, so it can be negative. \(\beta = e^{-(r-g)}\) is a discount rate corresponding to the steady state real rate \(r\) less GDP growth rate \(g\).

Iterating forward, the present value identity is \begin{equation} v_{t}=\sum_{j=1}^{\infty}\beta^{j-1}\left[ s_{t+j}-\left( r_{t+j}^{n}-\pi_{t+j}+g_{t+j}\right) \right] .\label{pvsy}% \end{equation} I simplify by using \(\beta=1\) as the point of linearization. 1 vs. 0.99 doesn't make any significant difference for empirical purposes.

Now apply standard asset pricing ideas. To focus on inflation, in "Fiscal Roots" I take the time \(t+1\) innovation of the present value identity, \(\Delta E_{t+1}\equiv E_{t+1}-E_{t}\). Rearranging, we have the unexpected inflation identity, \begin{align} & \Delta E_{t+1}\pi_{t+1}-\Delta E_{t+1}\left( r_{t+1}^{n}-g_{t+1}\right) \label{Epiintro}\\ & =-\sum_{j=0}^{\infty}\Delta E_{t+1}s_{t+1+j}+\sum_{j=1}^{\infty}\Delta E_{t+1}\left( r_{t+1+j}^{n}-\pi_{t+1+j}-g_{t+1+j}\right) .\nonumber \end{align} A decline in the present value of surpluses, coming either from a change in expected surpluses or a rise in their discount rates, must result in a lower real value of the debt. This reduction can come about by unexpected inflation, or by a decline in nominal long-term bond prices. The value of debt drops out, which is handy and simplifies matters.

All that glitters is not gold

I wrote a Wall Street  Journal Oped on the gold standard, partly in response to last week's Oped by James Grant (whose "PhD standard" is a great quip) and Greg Yp's excellent column on Judy Shelton and gold.

Pegging the dollar to gold won't  stop inflation or deflation.  Inflation was already quite volatile in the 19th  century, and it would be worse today:

What determines the value of gold relative to all goods and services? In the 19th century, gold coins were used for many transactions. People and businesses had to keep an inventory of gold coins in proportion to their expenditures. If the value of gold rose relative to everything else (deflation), people gained an incentive to spend them, and thereby drive up the prices of everything else. If the value of gold fell (inflation), people needed more of it, so they spent less and drove down other prices. This crucial mechanism linked the price of gold to all other prices. 

That link is now completely gone. Other than jewelry and some minor industrial uses, there is nothing special about gold, and little linking the price of gold to all other prices. If the Fed pegged the price of gold today, the price of everything else would just wander away. The Fed might just as effectively peg the price of chewing gum. A monetary anchor is a good thing, but the anchor must be tied to the ship. Gold no longer is. 

Broader commodity standards face the same problem. Traded commodities are such a small part of the economy that the relative price of commodities can swing widely with little effect on inflation.

In particular, if the value of gold goes up, you have deflation, which many people are  worried about today. The gold standard did nothing to stop the sharp  deflation  of the 1930s.

Gold is not really a monetary promise, it's a fiscal promise:

If people demanded more gold from the government than it had in reserve, the government had to raise taxes or cut spending to buy more gold. More often, the government would borrow to get gold, but governments must credibly promise to raise taxes or cut spending to borrow. This fiscal commitment ultimately gave money its value, not the sometimes-empty promise to exchange money for gold. Taxes ultimately back all government money. The gold standard made this fiscal commitment visible and testable. 

It is possible, though, to answer gold standard advocates critiques of current affairs without a return to gold

..the U.S. could enact a policy today that emulates the good features of the gold standard. I call it the CPI standard. First, Congress and the Fed would agree that “price stability” in the Fed’s mandate means precisely that, not perpetual 2% inflation. The Fed’s mandate would be to keep the consumer-price index (or a suitably improved index) as close as possible to a stated value. 

Second, the CPI target would bind fiscal policy (Congress and the Treasury) as well as monetary policy (the Fed). Inflation would require automatic fiscal tightening and deflation would trigger loosening, just as a gold-standard government trying to defend its currency must tighten fiscally to raise its gold reserves. 

Third, the government would emulate the promise to trade gold for notes in modern financial markets. There are many ways to do this, but the simplest is to commit to trade regular debt for inflation-indexed debt at the same price. Under this system, inflation would cost the government money and force a fiscal tightening in the same way gold once did. And vice versa—the system would forestall deflation as well. 

 I conclude

Gold-standard advocates offer a cogent critique of current monetary policy, but a return to gold is unfeasible. A stable CPI, immune from both inflation and deflation, backed by the same fiscal commitments that underlay gold, is worth taking seriously.

As usual, I have to wait 30 days to post the whole thing.

The Phillips curve is still dead

Greg Mankiw posted a clever graph a month ago, which he titled "The Phillips Curve is Alive and Well."

No, Greg, the Phillips curve is still as dead as Generalissimo Franco.

The lines, in case you can't see them are the employment-population ratio 25-54, and the average hourly earnings of production and nonsupervisory employees. Wait a minute, the Phillips curve, as it appears in contemporary macroeconomics, is a relation between inflation, a coordinated rise in prices and wages,  not real wages or hourly earnings, and unemployment or the output gap, not the employment-population ratio. How does the traditional Phillips curve look? Here is unemployment vs. CPI inflation

and here is inflation vs. the GDP gap:



Here is "core" (less food and energy) inflation vs. unemployment:

Except for one little blip in the depths of the 2009 recession. The Phillips curve is dead. (Long live the Phillips curve, the crowd sings nonetheless.) Inflation trundles along, ignoring unemployment or the output gap.

What's going on? Primarily, I think Greg goes deeply wrong in looking at average hourly earnings, or wages for short. The whole art and magic of the Phillips curve is about inflation, the rise in both prices and wages.  Greg's graph is perfectly sensible microeconomics. The labor market is tight, demand for labor is high, you have to pay people more to get them to work. The rise in wages is a rise in real wages, a rise in wages relative to prices.

Similarly, one might imagine tight product markets, with strong demand, as a time that output prices and measured inflation would rise relative to wages.

The puzzle and promise of the Phillips curve is the idea that tighter labor markets, traditionally measured by the unemployment rate, correlate with higher wages and prices. That takes more doing. Typically, you have to think that workers are fooled into working for what they think are higher real wages, and only later discover that prices have gone up too. And you have to think that firms rather mechanically raise prices passing on higher labor costs, and keep selling things when they do. Despite the intuitive appeal of tight markets leading to rising prices and wages, that simple intuition is wrong to describe a correlation between tight markets and both prices and wages, which is what the Phillips curve is and was.

The employment-population ratio is a little bit curious but less so. Much modern labor economics doesn't focus on unemployment.

What is happening should be cause for celebration by the way -- real wages are rising. From growth to inequality to the hand-wringing about declining labor share, it's hard to find anything bad to say about that!

Greg's "Phillips curve" also does not extend backwards. Here's what happens if. you push the data slider to the left on Greg's graph, going back to the 1960s rather than start in 1990:




Greg's correlation is absent in the heyday of the Phillips curve. Greg's alive Phillips curve was born in 1990.  (What you're seeing is, of course, the rise in labor force participation, particularly among women, until 1990.) That's why the traditional (ex ante!) Phillips curve really was about gap measures

The conventional inflation-unemployment Phillips curve also died just about contemporaneously with the Generalissimo:

The negative correlation which Phillips noted around 1960 turned to a positive, or stagflationary correlation in the 1970s. One nice negatively correlated data point in the disinflation of 1982 is it.

The policy world, including the Fed, ECB, and related institutions, continues to believe in the Phillips Curve, and as causation not just correlation: tight labor markets cause inflation. But its evident death is causing some unsettled feelings for sure.

*****

Catching up on Greg's blog, I also found a lovely and sage quip:

Washington Post columnist Robert Samuelson argues "It’s time we tear up our economics textbooks and start over." He uses my book as a prime example. Perhaps not surprisingly, I disagree. My summary of Samuelson's article: Economics textbooks should be more like economics journalism, says an economics journalist.

There is so much "starting over" in the air -- modern monetary magic on the left, neo-mercantilism on the right -- that understanding long settled questions is indeed what education should be about. (And not just the sharing of untutored opinions.)

Textbook writers, on the other hand, emphasize those things that are true, important, and unknown to the typical reader (an 18 year old college freshman). Newness has little relevance. The lessons of Adam Smith do not apply only to the 18th century, the lessons of David Ricardo do not apply only to the 19th century, and the lessons of John Maynard Keynes do not apply only to the 20th century. They are timeless ideas that may not make good news stories but should be central to introductory economics. Just as Newtonian mechanics should remain central to introductory physics.

Well, I think Keynes will go the way of phlogiston, but I agree with the point, and anyway a good 19th century scientist should know what phlogiston is.


****

Update:

Or maybe we should call it the Phillips Cloud. Here is the traditional inflation vs. unemployment graph, for the 1990-today sample and then the whole postwar period

Some economists run a regression line here, and proclaim the Phillips curve to be flat. They conclude, unemployment is incredibly sensitive to inflation -- just a bit more inflation would make a lot of jobs. I conclude it's just mush.

Financial Inflation?

Torsten Slok sends this lovely picture of the S&P500 and the price index for portfolio management and investment advice services. Torsten explains that "50% of the decline in core PCE inflation since the peak in July has been driven by financial services, and with the stock market rebounding, we should expect to see the financial services component move higher again."

What's going on? I think it's this: Most portfolio management payments are a percent of value -- you pay a fee, say 1%, of the total value of the portfolio. When the stock market goes down 10%, you pay 10% less in fees. Now, the BEA's job is to figure out, did you get 10% less quantity -- did you get 10% less "valuable advice" for that fee? You're not an idiot, so you're paying 1% off the top of your wealth annually, a third of Senator Warren's dreaded wealth tax, for something of value, the BEA figures. Or did the "price" of financial services go down 10%? Evidently, the BEA assumes the price, not the quantity changed, so the "price" of financial services tracks the stock market.

This is of course nonsense. On the other hand, I have no better idea how to separate 1% management fees into a "price" or a "quantity" (or, heaven forbid, a "quality improvement"). The number of people working to provide you financial advice didn't change 10%. Though, in the long run, it will if the market stays down. How should, or does, the PCE handle rents, or dividend payments? I don't know.

I went back to the documentation for how the PCE is constructed to try to understand these questions and see if my hunch is correct, but I failed to understand anything in there. (I got lost in the "commodity flow method," see p. 5-27.) I would value comments from people who understand this stuff.

Overall, I think the lesson is that our measures of inflation are pretty noisy. First we throw out food and energy. Now it looks to me that "core" should throw out management-fee based financial services, or at least assume that the price is fixed (1% sounds like a fixed price) rather than the quantity. Do real estate and other commissions do the same thing and the price index rises and falls with the price of housing? What's next?

(The point of throwing out food and fuel is not that they don't matter but a feeling that the core CPI today is a better guide of where the overall CPI will be in the future. A more thorough analysis of which components are better forecasters of overall CPI would be welcome.)

Maybe an inflation measure that is less comprehensive but better measured isn't such a terrible idea. Maybe the Fed worrying about 1.8% vs. 2% inflation is not such a good idea.

Smith, MMT, and science in economics

Many blog readers have asked for my opinions of "Modern Monetary Theory." I haven't written yet, because I try to read about things in some detail, ideally from original sources, before reviewing them, which I have not done. Life is short.

From the summaries I have read, some of the central propositions of MMT draw a false conclusion from two sensible premises. 1) Countries that print their own currencies do not have to default on excessive debts. They can always print money to pay off debts. True. 2) Inflation in the end can and must be controlled by raising taxes or cutting spending, sufficiently to soak up such printed (non-interest-bearing) money. True. The latter proposition is the heart of the fiscal theory of the price level, so I would have an especially tough time objecting.

It does not follow that the US need not worry about deficits, and may happily borrow tens of trillions to finance all sorts of spending. Borrow $50 trillion or so. When bondholders revolt, print money to pay off the bonds. When this results in inflation, raise taxes to soak up the money. OK, but this latter step is exactly raising taxes to pay off the bonds. Moreover, if bondholders see that the plan is to pay off bonds with printed money, they refuse to buy or roll over bonds in the first place and the inflation can happen right away.

This may reflect a common confusion between today's money with the new money that pays off debt. It would only take $1.5 trillion in extra taxes or lower spending to retire current currency (non-interest bearing government debt) outstanding. But  that's not the task after the great bond bailout. Then we have to raise taxes or cut spending by, in my example,  the $50 trillion printed to pay off the bonds. Large debts are either paid or defaulted, and inflation is the same thing economically as default. Period. (Currency boards run in to some of the same problem. Backing today's currency is not enough to avoid devaluation, if one does not back all the debt which promises to pay currency.)

I must admit some amusement that Keynesian commentators, having urged fiscal stimulus and decried evil "Austerians" for years, are apoplectic to be passed on the left. But that does not make the ideas of those passing on the left any more right.  There is also a different and interesting strain of thought, exemplified by recent writings by Larry Summers and Olivier Blanchard, that the current low interest rate environment might allow for somewhat, but not unlimited, extra borrowing. Those ideas are completely different analytically. I hope to cover them in a later blog post.

Noah Smith and guru-based theory

But, as I said, I have not studied MMT, so perhaps I'm missing something. Enter Noah Smith, who has delved in to figure out just what MMT is and whether or how it hangs together.

Noah interestingly characterizes MMT as  "Guru-based theory." Noah:

Dollarize Argentina

Argentina should dollarize, says Mary Anastasia O'Grady in the Wall Street Journal -- not a peg, not a currency board, not an IMF plan, just give up and use dollars.

Another currency crisis is roiling Argentina... The peso has lost half its value against the U.S. dollar since January. Inflation expectations are soaring. 

The central bank has boosted its overnight lending rate to an annual 60% to try to stop capital flight. But Argentines are bracing for spiraling prices and recession. 

...the troubles have been brewing for some time. On a trip to Buenos Aires in February, I got an earful from worried economists who said Mr. Macri was moving too slowly to reconcile fiscal accounts. 

In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall. That put pressure on the central bank to print money so as not to starve the economy of low-priced credit ahead of midterm elections in 2017.... 

A sharp selloff of the peso in May was followed by a new $50 billion standby loan from the International Monetary Fund in June. With a monetary base that is up over 30% since last year, in a nation that knows something about IMF intervention, that was like waving a red cape in front of a bull. 

The peso was thus vulnerable when currency speculators launched an attack on the Turkish lira last month and the flight to the dollar spilled over into other emerging markets, including Argentina. After decades of repeated currency crises, Argentines can smell monetary mischief. A peso rout ensued.

Conventional Wisdom these days -- the standard view around the Fed, IMF, OECD, BIS, ECB, and at NBER conferences -- says that countries need their own currencies, so they can quickly devalue to address negative "shocks." For example, conventional wisdom says that Greece would have been far better off with its own currency to devalue rather than as part of the euro. I have long been skeptical.

It's not working out so great for Argentina. As Mary points out, short term financing means there can be "speculative attacks" on the currencies of highly indebted countries that run their own currencies, just as there can be runs on banks. And Conventional Wisdom, silent on this issue advocating a Greek return to Drachma, was full in that the Asian crises of the late 1990s were due to "sudden stops," and such speculative machinations of international "hot money."

Well, says CW, including the IMF's "institutional view," that means countries need "capital flow management," i.e. governments need to control who can buy and sell their currency and and who can buy or sell assets internationally.  Yet Venezuela and Iran are crashing too, and not for lack of capital flow "management." My understanding is Argentina does not allow free capital either. Moreover, if there is a chance you can't take your money out, you don't put it in in the first place. There is a reason the post Bretton Woods international consensus drove out capital restrictions.

So I agree with Mary -- dollarize. Just get it over with. What possible benefit is Argentina getting from clever central bank currency manipulation, if you want a dark word, or management, if you want a good one? Use the meter and the kilogram too.

There is a catch, however, not fully explicit in Mary's article. The underlying problem is fiscal, not monetary. To repeat,

"Mr. Macri was moving too slowly to reconcile fiscal accounts. ...In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall." 

So, I think it's a bit unfair for Mary to complain that Argentina's problem is that it "has a central bank." I don't know what any central banker could do, given the fiscal problems, to stop the currency from crashing.

If the government dollarizes, it can no longer inflate or devalue to get out of fiscal trouble. Argentina has pretty much already lost that option anyway. If the government borrows Pesos, inflating or devaluing eliminates that debt. But if the government borrows in dollars, a devaluation or inflation taxes a much smaller base of peso holders to try to pay back the dollar debt.

Still, a dollarized government must either pay back its bills or default. That's how the Euro was supposed to work too, until Europe's leaders, seeing how much Greek debt was stuffed into French and German banks, burned the rule book.

So the underlying problem is fiscal. With abundant fiscal resources, the government could have borrowed abroad to stop a run on the Peso. And without those resources, dollarization will not solve its debt and deficit problem. Dollarization will force the government to shape up fast, which may be Mary's point.

Dollarization will insulate the private economy from government fiscal troubles. This is a great, perhaps the greatest, point in its favor. Even if the government defaults, companies in a fully dollarized, free capital flow economy, can shrug it off and go about their business. Forced to use pesos, subject to sharp inflation, devaluation, capital and trade restrictions, the government's problems infect the rest of the economy.

Last, CW likes devaluation and inflation because it supposedly "stimulates" the economy through its troubles surrounding a crisis. That strikes me as giving a cancer patient an espresso. Argentina is getting both inflation and recession, not a stimulative boom out of its inflation.

Dollarization is not a currency board, which Argentina also tried and failed. A currency board is a promise to keep the peso equal to the dollar, and to keep enough dollars around to back the pesos. Alas, it does not keep dollars around to back all the governments' debts, so the government soon enough will see the kitty of dollars and grab them, abrogating the currency board. Dollarization means the economy uses dollars, period, and there is no pool of assets sitting there to be grabbed.