Supply

The Revenge of Supply, at Project Syndicate

Surging inflation, skyrocketing energy prices, production bottlenecks, shortages, plumbers who won’t return your calls – economic orthodoxy has just run smack into a wall of reality called “supply.” 

Demand matters too, of course. If people wanted to buy half as much as they do, today’s bottlenecks and shortages would not be happening. But the US Federal Reserve and Treasury have printed trillions of new dollars and sent checks to just about every American. Inflation should not have been terribly hard to foresee; and yet it has caught the Fed completely by surprise. 

The Fed’s excuse is that the supply shocks are transient symptoms of pent-up demand. But the Fed’s job is – or at least should be – to calibrate how much supply the economy can offer, and then adjust demand to that level and no more. Being surprised by a supply issue is like the Army being surprised by an invasion. 

The current crunch should change ideas. Renewed respect may come to the real-business-cycle school, which focuses precisely on supply constraints and warns against death by a thousand cuts from supply inefficiencies. Arthur Laffer, whose eponymous curve announced that lower marginal tax rates stimulate growth, ought to be chuckling at the record-breaking revenues that corporate taxes are bringing in this year. 

Equally, one hopes that we will hear no more from Modern Monetary Theory, whose proponents advocate that the government print money and send it to people. They proclaimed that inflation would not follow, because, as Stephanie Kelton puts it in The Deficit Myth, “there is always slack” in our economy. It is hard to ask for a clearer test. 

But the US shouldn’t be in a supply crunch. Real (inflation-adjusted) per capita US GDP just barely passed its pre-pandemic level this last quarter, and overall employment is still five million below its previous peak. Why is the supply capacity of the US economy so low? Evidently, there is a lot of sand in the gears. Consequently, the economic-policy task has been upended – or, rather, reoriented to where it should have been all along: focused on reducing supply-side inefficiencies. 

One underlying problem today is the intersection of labor shortages and Americans who are not even looking for jobs. Although there are more than ten million listed job openings – three million more than the pre-pandemic peak – only six million people are looking for work. All told, the number of people working or looking for work has fallen by three million, from a steady 63% of the working-age population to just 61.6%. 

We know two things about human behavior: First, if people have more money, they work less. Lottery winners tend to quit their jobs. Second, if the rewards of working are greater, people work more. Our current policies offer a double whammy: more money, but much of it will be taken away if one works. Last summer, it became clear to everyone that people receiving more benefits while unemployed than they would earn from working would not return to the labor market. That problem remains with us and is getting worse. 

Remember when commentators warned a few years ago that we would need to send basic-income checks to truck drivers whose jobs would soon be eliminated by artificial intelligence? Well, we started sending people checks, and now we are surprised to find that there is a truck driver shortage. 

Practically every policy on the current agenda compounds this disincentive, adding to the supply constraints. Consider childcare as one tiny example among thousands. Childcare costs have been proclaimed the latest “crisis,” and the “Build Back Better” bill proposes a new open-ended entitlement. Yes, entitlement: “every family who applies for assistance … shall be offered child care assistance” no matter the cost. 

The bill explodes costs and disincentives. It stipulates that childcare workers must be paid at least as much as elementary school teachers ($63,930), rather than the current average ($25,510). Providers must be licensed. Families pay a fixed and rising fraction of family income. If families earn more money, benefits are reduced. If a couple marries, they pay a higher rate, based on combined income. With payments proclaimed as a fraction of income and the government picking up the rest, either prices will explode or price controls must swiftly follow. Adding to the absurdity, the proposed legislation requires states to implement a “tiered system” of “quality,” but grants everyone the right to a top-tier placement. And this is just one tiny element of a huge bill. 

Or consider climate policy, which is heading for a rude awakening this winter. This, too, was foreseeable. The current policy focus is on killing off fossil-fuel supply before reliable alternatives are ready at scale. Quiz: If you reduce supply, do prices go up or go down? Europeans facing surging energy prices this fall have just found out. 

In the United States, policymakers have devised a “whole-of-government” approach to strangle fossil fuels, while repeating the mantra that “climate risk” is threatening fossil-fuel companies with bankruptcy due to low prices. We shall see if the facts shame anyone here. Pleading for OPEC and Russia to open the spigots that we have closed will only go so far. 

Last week, the International Energy Agency declared that current climate pledges will “create” 13 million new jobs, and that this figure would double in a “Net-Zero Scenario.” But we’re in a labor shortage. If you can’t hire truckers to unload ships, where are these 13 million new workers going to come from, and who is going to do the jobs that they were previously doing? Sooner or later, we have to realize it’s not 1933 anymore, and using more workers to provide the same energy is a cost, not a benefit. 

It is time to unlock the supply shackles that our governments have created. Government policy prevents people from building more housing. Occupational licenses reduce supply. Labor legislation reduces supply and opportunity, for example, laws requiring that Uber drivers be categorized as employees rather than independent contractors. The infrastructure problem is not money, it is that law and regulation have made infrastructure absurdly expensive, if it can be built at all. Subways now cost more than a billion dollars per mile. Contracting rules, mandates to pay union wages, “buy American” provisions, and suits filed under environmental pretexts gum up the works and reduce supply. We bemoan a labor shortage, yet thousands of would-be immigrants are desperate to come to our shores to work, pay taxes, and get our economy going. 

A supply crunch with inflation is a great wake-up call. Supply, and efficiency, must now top our economic-policy priorities.

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Update: I am vaguely aware of many regulations causing port bottlenecks, including union work rules, rules against trucks parking and idling, overtime rules, and so on. But it turns out a crucial bottleneck in the port of LA is... Zoning laws! By zoning law you're not allowed to stack empty containers more than two high, so there is nowhere to leave them but on the truck, which then can't take a full container. The tweet thread is really interesting for suggesting the ports are at a standstill, bottled up FUBARed and SNAFUed, not running full steam but just can't handle the goods. 

Disclaimer: To my economist friends, yes, using the word "supply" here is not really accurate. "Aggregate supply" is different from the supply of an individual good. Supply of one good increases when its price rises relative to other prices. "Aggregate supply" is the supply of all goods when prices and wages rise together, a much trickier and different concept. What I mean, of course, is something like "the amount produced by the general equilibrium functioning of the economy, supply and demand, in the absence of whatever frictions we call low 'aggregate demand', but as reduced by taxes, regulations, and other market distortions." That being too much of a mouthful, and popular writing using the word "supply" and "supply-side" for this concept, I did not try to bend language towards something more accurate. 

What's in the reconciliation bill? A conversation with Casey Mulligan.

 A podcast discussion with Casey Mulligan. What's in the reconciliation bill? How will it work? 

Link to the podcast page, with lots of other formats. 

Yesterday Casey tweeted that he had read the entire 2,400 page bill. Casey does this sort of thing, as explained in his book "Your'e hired." I have been trying to figure out what's in it for a while. The media coverage is basically absent. (See this great Marginal Revolution post and Bloomberg column (gated, sadly) by Tyler Cowen.) I tried downloading the actual bill too, but promptly fell asleep. (Casey has some good hints on how to read it.) 

But here we are, about to embark on a huge set of new federal programs, really larger than anything since the Johnson Administration, and there is essentially no description of what they are, no debate on how they will work, and especially (my hobby horse) what incentives and disincentives they provide. Many of the previous welfare-state programs were disastrous for the supposed beneficiaries. How are we going to avoid that again? At most we talk about top line numbers. I'm a debt hawk, but if we could heal the planet, end all inequity, bring full social racial and gender justice, wipe out poverty, give every American a life of dignity, prosperity, and opportunity for a mere $3.5 trillion, I'm in. Double it. The real question is whether any of this will happen. 

Well, Casey read the bill and knows what's in it! Tune in to find out.. 

PS, I hope to get the podcast going more regularly this fall,

Update: 

A summary and review from David Henderson. 

Casey writes a detailed blog post on BBB disincentives. 

Inequality/opportunity survey

I was interested by a simple survey run by the Archbridge Institute on attitudes regarding inequality vs. opportunity, and  equality vs. equity issues. 

Reducing inequality, "there should be no Billionaires" is only the top issue for a quarter of people. Equality of opportunity, and help for those on the bottom garner about 60%. The demographic consistency is interesting. Yes, the young and the credentialed skew more left -- our education system is passing on its values. But not nearly as much as you'd think. Minorities are not much different than the rest. Redistributionist opinions are a bit of a luxury belief, but again not as much as you'd think. 

The meaning of "equality," the founding concept of our nation (Jefferson) is even more stark. Equity -- end up in the same place -- scores dismally. Even starting in the same place scores dismally. Extra help for the disadvantaged, something I would choose as #2 goal, scores dismally. "Equality before the law and people have a fair chance to pursue opportunity regardless of where they started" is the overwhelming winner. Again, the demographic consistency is surprising relative to the Standard Narrative. And heart-warming.

What is the best way to get ahead economically? Employment, college degree, and family and social support completely drown out even the fable of "well-designed" government assistance programs. 

The report goes on like this, with a nice executive summary. 

Even around Hoover, I hear passed along a conventional wisdom: Income inequality is a Huge Problem. It will lead to social and political unrest. "We" must do something about it or our country will fall apart. 

Not, apparently, according to vast quantities of survey respondents. Opportunity remains a problem in the US, and if I were to design something to appeal to these survey respondents, that's the word I would be using. 

Debt ceiling modest proposal -- perpetuities

The debt ceiling dance has started again. Read Treasury Secretary Janet Yellen in the Wall Street Journal. 

A modest proposal: Issue perpetuities.  

The Treasury computes the total amount of debt by its face or principal value, not its market value*. If the Treasury issues a bond that pays $1 coupons each year for 10 years and then pays $100 at maturity, the treasury counts this as $100 additional debt. The Treasury ignores the coupon payments, and how much the bond actually sells for, i.e. how much the Treasury actually borrows, when the bond is auctioned.  

Now you see my answer: Perpetuities have coupons, but no principal. A perpetuity pays $1 forever. In reality, it pays $1 until the Treasury buys it back. 

The Treasury could also issue coupon-only debt, just the $2 coupons for 10 years. Or it could issue debt with huge coupons and small principal payments, $2 a year for 10 years and then an additional dollar in year 10, and say debt increases by $1. But perpetuities are great for all sorts of other reasons, so why not use this opportunity? 

Perpetuities can have fixed coupon payments or variable coupons. The Treasury could sell a perpetual bond whose interest rate equals SOFR (the new Libor), whatever the Fed is paying on excess reserves, etc. If the Treasury wants to borrow short to harvest temporarily low short-term interest rates, then floating-rate perpetuities do the trick. Of course I would rather also take this moment to start borrowing long, locking in absurdly low interest costs. 

The Treasury could lower debt outstanding now, by rolling debt into perpetuities, issuing new perpetuities, and buying debt on the open market, issuing perpetuities in return. Goodbye debt limit. 

Too clever? Maybe. OK, undoubtedly yes. But if economics lunchroom talk can consider trillion-dollar coins, we can talk about perpetuities. Or maybe a serious attempt to do this would bring US treasury accounting into the 1960s, with cutting-edge concepts like market values not face values,  duration not average principal maturity, and interest cost concept that goes beyond coupons, so that the debt limit and treasury accounting is more economically meaningful.  

Disclaimers: 

*I spent some time on google and the Treasury website trying to figure out just how debt subject to limit is calculated, and this is my best guess. If I'm wrong, please write and I'll issue a classic "never mind." 

Yes, I am guilty here of having the same answer in response to different questions. See here on why I like perpetuities for other reasons.  

What about Japan?

What about Japan? It's a question I often hear from advocates of fiscal expansion. Japan has huge debts and no crisis or inflation (so far). Doesn't that prove the US can borrow a ton more money painlessly? 

I offer two new points today: 1) Not every high debt country is so happy. 2) Just what did Japan get for all its fiscal stimulus? Indeed, I will start asking "What about Japan?" Japan seems a tough case for those who advocate that fiscal stimulus will save us from secular stagnation, or that huge spending programs bring prosperity in other dimensions.   

1. Picking and choosing

Here, fresh from the April IMF Fiscal Monitor  is the list of top 30 countries sorted by debt to GDP ratios. I boldfaced larger countries. 

Yes, Japan is up there at 256% of GDP. The champion is Venezuela however. Sudan and Eritrea are not particularly known for economic prosperity. Greece and Italy are not held up as examples to follow either. Serial defaulter Argentina is behind the US already. 

If Japan is sustainable, that doesn't mean all large debts are sustainable. It means there's something different about Japan than the other countries on the list -- or ones now lower down on the list because they already defaulted or had crises. 

2. So what did Japan get for all that debt anyway? 

It was not always thus. Japan started borrowing heavily in the 1990s from a debt/GDP ratio of 63%. (For some reason the IMF does not have US data before 2002.) 

Those debts come from deficits, of 5-10% of GDP every year. Since 2006, the US has been behaving a lot like Japan, or more so. We only have less debt because the US ran surpluses through the 1990s. 

Japan has had perpetually low GDP growth, low inflation and zero interest rates since the 1990s. I view it as low "supply" growth, but it ought to be the poster child for "secular stagnation" fans. 

So I turn the question around: If massive deficits, including lots of "infrastructure"  are going to boost the US economy, why did they not do so for Japan? 

Update

In response to tweets about why is Japan different from the US,  

I did not want to repeat old points. Japan's debt is long-term, held by domestic people, pensions and central bank. US debt is short-term, held by foreign central banks and financial institutions. Our debt is much more prone to run, and a rise in interest rates will feed quickly into the budget. Japan also has accumulated assets from trade surpluses; we have the opposite. Japan's debt is held by old people and subject to estate tax. A lot of Japanese hold bank accounts, as mutual funds and similar investment vehicles familiar in the US are less prevalent. Bank accounts flow in to reserves, backed by Treasury debt. 

More importantly, Japan  does not have looming unfunded Social Security and Medicare, underfunded pensions, contingent liabilities (Fannie and Freddy guarantee most home mortgages, who is going to pay student loans?) bailout guarantees and more.

 Sustainability is about debt vs. ability to repay; about future deficits;  not debt alone.

Japan's slow growth for three decades comes from microeconomics, taxes, regulations, demographics, slow productivity, not money, stimulus, "aggregate demand." 

The price of indulgences, 2021

 

Source. My correspondent provides the answer: 

5bps: IVV (column #3) (iShares Core S&P 500 ETF)

15bps: ESGU (column #1)  (iShares ESG Aware MSCI USA ETF) 

30bps: LCTU (column #2) (BlackRock U.S. Carbon Transition Readiness ETF) “Sea change” quote from BlackRock here 

I have not independently checked, though the answer hardly matters. The fees and portfolios tell the story. Obviously any claim that this ESG portfolio will outperform after fees is ... strained. 

When I did my Senate testimony on financial regulation and climate change, someone (I forget who)  suggested that financial regulators need to really crack down on ESG, carbon, diversity, and other virtue claims by investment managers and large corporations. I heartily agree. Of course, we have different motivations.  I got the sense that the person suggesting it wanted to make sure companies really did keep all their virtuous promises. I think that being forced to document their virtue, with criminal penalties for securities fraud hanging in the balance, would show just how empty this whole exercise is. 

Update: To be clear, I'm all for the free market. If people want to pay 30 bps for glossy feel-good marketing materials (click the above link) attached to their S&P500 fund, more power to them and the producers of such materials. Of course, central banks who have spent 30 years bemoaning "bubbles," "overpricing" "speculative enthusiasms" might not want to be piling on to such efforts. Again. 

Cruz on crony capitalism

Senator Ted Cruz wrote a blistering Wall Street Journal Op-Ed decrying CEOs who pander to Democrats by making profoundly uninformed public statements. He announced that he will no longer take money from their corporate political action committees. And, he states

This time, we won’t look the other way on Coca-Cola’s $12 billion in back taxes owed. This time, when Major League Baseball lobbies to preserve its multibillion-dollar antitrust exception, we’ll say no thank you. This time, when Boeing asks for billions in corporate welfare, we’ll simply let the Export-Import Bank expire.

Cruz' statement is unintentionally devastating. So what about last time? 

So there it is in front of us, in writing, from a major politician. Political support, and campaign cash bought $12 billion tax breaks, antitrust exemptions, and Ex-Im subsidies. From Republicans. So much for any public policy pretense. And if those CEOs just figured out who has the power to hand out goodies now, and the Democrat's demands for public obeisance as well as cash, well, it's a lot harder to object that the CEOs fall in line.  

Inequality mirage?

David Splinter and Gerald Auten gave last week's Hoover Economic Policy Working Group seminar, summarizing their past and some work in progress on the distribution of income.  Link in case the above embed does not work. A recent paper. Splinter's web page. 

Splinter and Auten are very even handed, just-the-facts, economists. I'll pass on their facts. Grumpy interpretations are my own. 

It is a fact generally accepted that income inequality has grown a lot recently, and this is a "problem" to be "solved." So what if the great inequality crisis simply isn't true? Let's leave aside whether income is a good measure (it isn't), let's just look at the fact, has income inequality substantially increased? 

No. Here is the headline result. In their careful redoing of the numbers, the top 1% share of income has barely budged since the 1970s. (And, by the way, if you think the mid 1970s economy was the great happy prosperity we should try to reestablish, you're too young to remember the 1970s.)

Now we get in to a deep under the hood exercise about costing up income, and where did Piketty and Saez go wrong. The video has some of that. The papers have more, and a long list of back and forth, including comparisons with many other studies. I'll name just a few.

Omitted income.   Piketty Saez leave out many kinds of income. Auten Splinter attribute all national income to somebody.  Before 1986 many wealthy people were incorporated.  Leaving out corporate income biases the early shares down. Auten Splinter fix that. Pre-tax and transfer income! Who cares about pre-tax income! Auten Splinter calculate income after taxes at the top -- lower -- and including transfers at the bottom -- higher. Demographics. Marriage rates have fallen, so Auten Splinter calculate income by individuals. Benefits! They include benefits like employer-provided health insurance.

One can quibble, but one can quibble. At least this cornerstone "fact" of political debate is a lot less sure than it looks. 

If the rich aren't getting richer, the poor aren't getting poorer:

Defining inequality so it can't be fixed

In one of their series of excellent WSJ essays, Phil Gramm and John Early notice that conventional income inequality numbers report the distribution of income before taxes and transfers. After taxes and transfers, income inequality is flat or decreasing, depending on your starting point. 

Source: Phil Gramm and John Early in the Wall Street Journal

If your game is to argue for more taxes and transfers to fix income inequality, that is a dandy subterfuge as no amount of taxing and transferring can ever improve the measured problem! 

The puzzle of Europe

Here are two unsettling slides I made for a talk. Here is GDP per capita in US, UK, France and Italy and China (2020 dollars, source world bank) 

To make the comparison easier, here is each country not including China, divided by the US: 

Here are the 2019 numbers (in 2019 dollars, again World Bank) US: $65,297. UK $42,330. That's 35% less than the US. Or, the US is  54% better off than the UK.. France: $40,494. Italy: $33,228 That's 50% less than US. Or the US is 96% better off than Italy.  China: $20,261.

And it's been getting steadily worse. France got almost to the US level in 1980. And then slowly slipped behind. The UK seems to be doing ok, but in fact has lost 5 percentage points since the early 2000s peak. And Italy... Once noticeably better off than the UK, and contending with France, Italy's GDP per capita is now lower than it was in 2000. 

GDP per capita is income per capita. The average European is about a third or more worse off than the average American, and it's getting worse. 

What the heck happened? It could happen here too. Maybe it already has, just not as bad. 

This should be profoundly unsettling for economists.  Everyone thinks free trade is a good thing. The European union, one big integrated market, was supposed to ignite growth. It did not. The grand failure of the world's biggest free trade zone really is a striking fact to gnaw on. 

Sure, other things are not held constant. Perhaps what should have been the world's biggest free trade zone became the world's biggest regulatory-stagnation, high-tax, welfare-state disincentive zone. Still, "it would have been even worse" is a hard argument to make. 

Economists haven't been talking about Eurosclerosis for a while but I think we should. 

These are huge numbers. The worst estimates of climate change are 7% of GDP in 2100. And those are surely overstated (see the excellent new paper by José Luis Cruz and Estban Rossi-Hansberg) You may admire the NHS for saving money, but even if the 20% of GDP we spend on health care is totally wasted, we're still ahead.  Lots of people admire the European model. Just how far Europe is behind the US is remarkable -- and getting worse. 

(Follow up post on productivity) 

Techsodus/Techsit politics.

The tech industry is fed up and leaving San Francisco in particular, the valley and California in general. Covid, like a war, speeds things up. If you're a young economist you could do worse than study this latest chapter in the (likely) decline of great cities (SF, NY, LA? Chicago?) and the movement of people and industries to friendlier, safer, and more welcoming climates. If you're a young political economist, whether they bring with them the politics that destroyed the places they left behind -- slash and burn progressivism -- will be equally interesting to watch. 

I ran across a great essay on this saga by Mike Solana. 

The latest fashion is to claim it's immoral for tech founders and companies to leave, after they have "extracted" so much wealth here. Mike skewers this new fashion, pointing out that tech companies and their founders created wealth here.  Microcode is not mined like gold. 

I take extreme issue with the notion that industry leaders have taken something from the “community,” ...This is precisely the opposite of reality. ... They are the network. Technology workers do not “extract” value from the region, they are what makes the region valuable.

...the Bay Area’s nativist, anti-immigration political climate has certainly not created the tech community, which is populated largely by immigrants, be they from out of the state or out of the country 

But he really digs in on the culture and politics that is going to send this golden goose packing to Austin: 

 the technology industry has brought tremendous tax revenue to the Bay Area. The budget of San Francisco literally doubled this decade, from around six billion to over twelve billion dollars. With our government’s incredible, historic abundance of wealth, the Board of Supervisors has presided over: a dramatic increase in homelessness, drug abuse, crime — now including home invasion — and a crippling cost of living that can be directly ascribed to the local landed gentry’s obsession with blocking new construction. ...

"Landed gentry." That's really good.  

Debt denial

Our national debt denial is a new essay on debt. Yes, it repackages many themes from previous essays, but debt is important, and I'm refining things through many efforts. This one is better, I think, than previous efforts. 

This appears in a new biweekly column in National Review Online, "Supply and Demand," which I'll be doing with Casey Mulligan. 

In French here

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Does debt matter? As the Biden administration and its economic cheerleaders prepare ambitious spending plans, a radical new idea is spreading: Maybe debt doesn’t matter. Maybe the U.S. can keep borrowing even after the COVID-19 recession is over, to fund “investments” in renewable energy, electric cars, trains and subways, unionized public schools, housing, health care, child care, “community development” schemes, universal incomes, bailouts of student debt, state and local governments, pensions, and many, many more checks to voters.

The argument is straightforward. Bond investors are willing to lend money to the U.S. at extremely low interest rates. Suppose Washington borrows and spends, say, $10 trillion, raising the debt-to-GDP ratio from the current 100 percent to 150 percent. Suppose Washington just leaves the debt there, borrowing new money to pay interest on the old money. At 1 percent interest rates, the debt then grows by 1 percent per year. But if GDP grows at 2 percent, then the ratio of debt to GDP slowly falls 1 percent per year, and in a few decades it’s back to where it was before the debt binge started.

What could go wrong? This scenario requires that interest rates stay low, for decades to come, and remain low even as the U.S. ramps up borrowing. The scenario requires that growth continues to outpace interest rates. Most of all, this scenario requires that big deficits stop. For at best, this is an argument for a one-time borrowing binge or small perpetual deficits, on the order of 1 percent of GDP, or only $200 billion today.

Yet an end to big borrowing is not in the cards. The federal government borrowed nearly $1 trillion in 2019, before the pandemic hit. It borrowed nearly $4 trillion through the third quarter of 2020, with more to come. If we add additional and sustained multi-trillion-dollar borrowing, and $5 trillion or more in each crisis, the debt-to-GDP ratio will balloon even with zero interest rates. And then in about ten years, the unfunded Social Security, Medicare, and pension promises kick in to really blow up the deficit. The possibility of growing out of a one-time increase in debt simply is irrelevant to the U.S. fiscal position.

Everyone recognizes that the debt-to-GDP ratio cannot grow forever, and that such a fiscal path must end badly.

Rhetoric of economic policy -- Biden plan analysis

Last week saw four interesting statements by economists regarding the economic effects of Biden economic plans. 

My focus will be "An Analysis of Vice President Biden’s Economic Agenda: The Long Run Impacts of Its Regulation, Taxes, and Spending" by  Timothy Fitzgerald, Kevin Hassett, Cody Kallen and Casey Mulligan, a 50 page report. (Yes, hosted by the Hoover Institution, my employer). The Wall Street Journal gave it major coverage in its editorial page, offering a thoughtful summary.   

I  contrast that piece with  a letter  signed by 13 Nobel-Prize winning economists  endorsing Biden's economic policies. A separate open letter  signed by 1072 regular economists wrote, and a similar Economists for Trump letter.   

I am a bit late to the game, as it took me a while to read the weighty Hoover report. However, unlike letter writers, I have no illusions that my opinions will sway the election. 

And, if the polls are right and Biden wins, the question of just what Biden's policies will be, and their economic effects, will have perhaps greater resonance after the election than in the Biden vs. Trump choice of the election.  As they formalize, debate, and institutionalize the plans, surely quantitative analysis of the likely outcomes will matter.  

I highlight this report not because of its contribution to the issue of the day. This report marks a dramatic innovation in rhetoric, how economists analyze political plans. The authors really have started a revolution in policy analysis. This was evident in their previous work at the CEA, but the report highlights it. 

*****

The report. 

The deep innovation: This is entirely, and appropriately, a neoclassical analysis. This report shows you how to do serious, quantitive, applied, large-scale detailed and transparent incentive-based analysis. 

(I use "incentive-based" as a clearer and less charged word than "neoclassical" these days. It gets to the central point.) 

This report puts the neoclassical growth model at the center of policy analysis, rather than the simple Keynesian ISLM model. And that's exactly appropriate for permanent long-run policies, not short-run get out of a depression policies. 

More on debt

Following my last post on debt I've thought a bit more, and received some very useful emails from colleagues. 

A central clarifying thought emerges. 

The main worry I have about US debt is the possibility of a debt crisis. I outlined that in my last post, and (thanks again to correspondents) I'll try to draw out the scenario later. The event combines difficulty in rolling over debt, the lack of fiscal space to borrow massively in the next crisis. The bedrock and firehouse of the financial system evaporates when it's needed most. 

To the issue of a debt crisis, the whole debate about r<g, dynamic inefficiency, sustainability, transversality conditions and so forth is largely irrelevant. 

We agree that there is some upper limit on the debt to GDP ratio, and that a rollover crisis becomes more likely the larger the debt to GDP ratio.  Given that fact, over the next 20-30 years and more, the size of debt to GDP and the likelihood of a debt crisis is going to be far more influenced by fiscal policy than by r-g dynamics. 

In equations with D = debt, Y = GDP, r = rate of return on government debt, s = primary surplus, we have* \[\frac{d}{dt}\frac{D}{Y} = (r-g)\frac{D}{Y} - \frac{s}{Y}.\] In words, growth in the debt to GDP ratio equals the difference between rate of return and GDP growth rate, less the ratio of primary surplus (or deficit) to GDP. 

Now suppose, the standard number, r>g, say r-g = 1% or so. That means to keep long run average 100% debt/GDP ratio, the government must run a long run average primary surplus of 1% of GDP, or $200 billion dollars. The controversial promise r<g, say r-g = -1%, offers a delicious possibility: the government can keep the debt/GPD ratio at 100% forever, while still running a $200 billion a year primary deficit! 

But this is couch change! Here are current deficits from the CBO September 2 budget update

We were running $1 trillion deficits before the pandemic. Each crisis seems to bring greater stimulus.  

I especially like this view because it doesn't make sense that an interest rate 0.1% above the growth rate vs. an interest rate 0.1% below the growth rate should make a dramatic difference to the economy. Once you recognize some limit on the debt/GDP ratio, and desirability of some long-run stable debt/GDP, there is no big difference between these two values. The surplus required to stabilize debt to GDP smoothly runs from negative couch change to positive couch change. 

I find this a liberating proposition. I find the whole sustainability, long run limits, dynamic inefficiency, transversality condition and so forth a big headache. For the question at hand it doesn't matter! (There are other questions for which it does matter, of course.) 

As we look forward,  debt/GDP dynamics for the next 20 years are going to be dominated by the primary surplus/deficit, not plausible variation in r-g. The CBO's 10 years of 6-8% of GDP overwhelm 1-2% of r-g. If each crisis continues to ratchet up 10% of GDP deficits per year, more so. The Green New Deal, and large federal assumption of student debts, state and local debts, pension obligations, and so forth would add far more to debt/GDP than decades of r vs. g.  

**********

Now that this is clear, I realize I did not emphasize enough that Olivier Blanchard's AEA Presidential Address  acknowledges well the possibility of a debt crisis: 

Fourth, I discuss a number of arguments against high public debt, and in particular the existence of multiple equilibria where investors believe debt to be risky and, by requiring a risk premium, increase the fiscal burden and make debt effectively more risky. This is a very relevant argument, but it does not have straightforward implications for the appropriate level of debt.

See more on p. 1226. Blanchard's concise summary

there can be multiple equilibria: a good equilibrium where investors believe that debt is safe and the interest rate is low and a bad equilibrium where investors believe that debt is risky and the spread they require on debt increases interest payments to the point that debt becomes effectively risky, leading the worries of investors to become self-fulfilling.

Let me put this observation in simpler terms. Let's grow the debt / GDP ratio to 200%, $40 trillion relative to today's GDP. If interest rates are 1%, then debt service is $400 billion. But if investors get worried about the US commitment to repaying its debt without inflation, they might charge 5% interest as a risk premium. That's $2 trillion in debt service, 2/3 of all federal revenue. Borrowing even more to pay the interest on the outstanding debt may not work. So, 1% interest is sustainable, but fear of a crisis produces 5% interest that produces the crisis. 

Brian Riedi at the Manhattan Institute has an excellent exposition of debt fears. On this point, 

... there are reasons rates could rise. ...

market psychology is always a factor. A sudden, Greece-like debt spike—resulting from the normal budget baseline growth combined with a deep recession—could cause investors to see U.S. debt as a less stable asset, leading to a sell-off and an interest-rate spike. Additionally, rising interest rates would cause the national debt to further increase (due to higher interest costs), which could, in turn, push rates even higher.

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So how far can we go? When does the crisis come?  There is no firm debt/GDP limit. 

Countries can borrow a huge amount when they have a decent plan for paying it back. Countries have had debt crises at quite low debt/GDP ratios when they did not have a decent plan for paying it back. Debt crises come when bond holders want to get out before the other bond holders get out. If they see default, haircuts, default via taxation, or inflation on the horizon, they get out. r<g contributes a bit, but the size of perpetual surplus/deficit is, for the US, the larger issue. Again, r<g of 1% will not help if s/Y is 6%. Sound long-term financial strategy matters. 

From the CBO's 2019 long term budget outlook (latest available) the outlook is not good. And that's before we add the new habit of massive spending. 

Here though, I admit to a big hole in my understanding, echoed in Blanchard and other's writing on the issue. Just how does a crisis happen? "Multiple equilibria" is not very encouraging. Historical analysis suggests that debt crises are sparked by economic and political crises in the shadow of large debts, not just sunspots.  We all need to understand this better.  

******

Policy. 

As Blanchard points out, small changes do not make much of a difference.  

 a limited decrease in debt—say, from 100 to 90 percent of GDP, a decrease that requires a strong and sustained fiscal consolidation—does not eliminate the bad equilibrium. ...

Now I disagree a bit. Borrowing 10% of GDP wasn't that hard! And the key to this comment is that a temporary consolidation does not help much. Lowering the permanent structural deficit 2% of GDP would make a big difference! But the general point is right. The debt/GDP ratio is only a poor indicator of the fiscal danger. 5% interest rate times 90% debt/GDP ratio is not much less debt service than 5% interest rate times 100% debt/GDP ratio. Confidence in the country's fiscal institutions going forward much more important. 

At this point the discussion usually devolves to "Reform entitlements" "No, you heartless stooge, raise taxes on the rich." I emphasize tax reform, more revenue at lower marginal rates. But let's move on to unusual policy answers. 

Borrow long. Debt crises typically involve trouble rolling over short-term debt. When, in addition to crisis borrowing, the government has to find $10 trillion new dollars just to pay off $10 trillion of maturing debt, the crisis comes to its head faster. 

As blog readers know, I've been pushing the idea for a long time that especially at today's absurdly low rates, the US government should lock in long-term financing. Then if rates go up either for economic reasons or a "risk premium" in a crisis, government finances are much less affected. I'm delighted to see that Blanchard agrees: 

to the extent that the US government can finance itself through inflation-indexed bonds, it can actually lock in a real rate of 1.1 percent over the next 30 years, a rate below even pessimistic forecasts of growth over the same period

It's not a total guarantee. A debt crisis can break out when the country needs to borrow new money, even absent a roll over problem. But avoiding the roll-over aspect would help a lot! Greece got in trouble because it could not roll over debts, not because it could not borrow for one year's spending. 

Contingent plans? Blanchard's concise summary adds another interesting option 

 contingent increases in primary surpluses when interest rates increase. 

I'm not quite sure how that works. Interest rates would increase in a crisis precisely because the government is out of its ability or willingness to tax people to pay off bondholders. Does this mean an explicit contingent spending rule? Social security benefits are cut if interest rates exceed 5%? That's an interesting concept. 

Or it could mean interest rate derivatives. The government can say to Wall Street (and via Wall Street to wealthy investors) "if interest rates exceed 5%, you send us a trillion dollars." That's a whole lot more pleasant than an ex-post wealth tax or default, though it accomplishes the same thing. Alas, Wall Street and wealthy bondholders have lately been bailed out by the Fed at the slightest sign of trouble so it's hard to say if such options would be paid. 

Growth. Really, the best option in my view is to work on the g part of r-g. Policies that raise economic growth over the next decades raise the Y in D/Y, lowering the debt to GDP ratio; they raise tax revenue at the same tax rates; and they lower expenditures. It's a trifecta. In my view, long-term growth comes from the supply side, deregulation, tax reform, etc. Why don't we do it? Because it's painful and upsets entrenched interests. For today's tour of logical possibilities if you think demand side stimulus raises long term growth, or if you think that infrastructure can be constructed without wasting it all on boondoggles, logically, those help to raise g as well. 

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*Start with \(\frac{dD}{dt} = rD - s.\) Then \( \frac{d}{dt}\frac{D}{Y} =  \frac{1}{Y}\frac{dD}{dt}-\frac{D}{Y^2}\frac{dY}{dt}.\)

*** 

Update: David Andolfatto writes, among other things, 

"Should we be worried about hyperinflation? Evidently not, as John does not mention it"

For these purposes, hyperinflation is equivalent to default. In fact, a large inflation is my main worry, as I think the US will likely choose default via inflation to explicit default. This series of posts is all about inflation. Sorry if that was not clear. 

also 

Is there a danger of "bond vigilantes" sending the yields on USTs skyward? Not if the Fed stands ready to keep yields low.

All the Fed can do is offer overnight interest-paying government debt in exchange for longer-term government debt. If treasury markets don't want to roll over 1 year bonds at less, than, say, 10%, why would they want to hold Fed reserves at less than 10%? If the Fed buys all the treasurys in exchange for reserves that do not pay interest, that is exactly how we get inflation. And mind the size. The US rolls over close to $10 trillion of debt a year. Is the Fed going to buy $10 trillion of debt? Who is going to hold $10 trillion of reserves, who did not want to hold $10 trillion of debt. 

In a crisis, even the Fed loses control of interest rates. 

 

Debt Matters

Debt Matters

(This is a draft of an oped. I got done and saw it's 1500 words, so I'm posting it for your enjoyment rather than go through a painful 600 word diet. Diet later. Maybe. ) 

Last week, the U.S. passed a milestone — US federal debt in private hands exceeded 100% of GDP. But does all this debt matter, or is worrying about debt passé?

This debate has been going on among economists for a while. One does not need to go to the incoherence of "modern monetary theory" to find support for the view that debt has few consequences. Olivier Blanchard, of MIT and the IMF, in his Presidential Address to the American Economic Association, (excellent summary here) declared that “there may be no fiscal costs” of additional debt. The core of his argument is that the interest rate on government debt may be lower than the growth rate of the economy so the US can roll over debt forever. 

Larry Summers, ex treasury secretary, President of Harvard, and adviser to presidents, surely the preeminent policy economist of our generation, has advocated that additional debt-financed spending may have so strong a multiplier as to pay for itself. (Paper here) As a result “expansionary fiscal policies may well reduce long-run debt-financing burdens," a super-Keynesian version of the Laffer curve

(I don’t mean to pick on Blanchard and Summers — they are only superbly distinguished representatives of widely held views.) 

Unlike MMT, these are logically consistent possibilities. But are they right? 

The interest rate on government debt is indeed slightly lower than good guesses of the economy’s growth rate, as sadly low as the latter is, so that if we roll over debt with no additional deficits, the debt to GDP ratio will slowly decline and the US can indeed run this slow-rolling Ponzi scheme. 

But how long will this happy circumstance of ultra-low interest rates continue? More to the point, how scaleable is this opportunity? Bond market investors lend 100% of GDP to the US government at 1% interest. Will they lend 200% of GDP at the same low interest rate, or will they start to require higher interest rates? A government that finances itself only with money and no debt need not pay back the money -- but, obviously, cannot double the opportunity. 

What happens when, rather than grow out of a given debt, the US piles on larger and larger debt to GDP ratios each year? The analysis is about sustainability of a large, but steady debt to GDP ratio. It does not justify a debt to GDP ratio that grows 10 percentage points per year.  At what debt to GDP ratio must the party stop and the growing out of it begin? 

Blanchard recognizes these limits are out there somewhere, and that debt crowds out private investment. But just where the limits are is less clear. That finding the limits will be unpleasant is clear. 

Summers’ view is likewise limited to a period of “secular stagnation” with perennially deficient demand, sticky prices and wages, and the other requirements of extreme Keynesianism.  Are we in such a period, or is covid a supply shock? Was the economy really suffering lack of demand when unemployment hit 50 year lows last February? 

Washington knows no such sophistication, but our politicians have grasped the logical implications of the proposition that debt does not matter with more clarity than have economists. 

The notion that debt matters, that spending must be financed sooner or later by taxes on someone, and that those taxes will be economically destructive, has vanished from Washington discourse on both sides of the aisle. The covid response resembles a sequence of million-dollar bets by non-socially distanced drunks at a secretly reopened bar: I’ll spend a trillion dollars! No, I’ll spend two trillion dollars! That anyone has to pay for this is un-mentioned. Well, perhaps nobody does have to pay. 

And who is to blame them, really? Markets offer 1% long-term interest rates. Blowout spending  financed by the Fed printing money — which is no different from debt — has resulted in no inflation so far. Faced with the deep concerns of current voters, worry that our children and grandchildren might have to pay off debt is not particularly salient. They’re either in the basement playing video games or out protesting for the end of capitalism anyway.  Politicians will take the cheap money as long as markets are happy to provide it. 

The economists, even the modern monetary theorists, envision debt issued to finance worthy investments, or valuable spending, all undertaken with a careful green eyeshade approach. Washington has figured out the logical conclusion of the idea that Federal debt doesn’t matter, in a way these economists have not: If debt and money printing have no fiscal cost, why be careful about how you spend money? Send checks to voters. Why not? It’s costless. No boondoggle project is objectionable. Send billions to prop up dying businesses. Why not? It’s costless. Why bother fixing the post office? Send them another $25 billion. Or $100. 

Deeper: Why should citizens have to pay back debts if the Federal government does not have to do so? Bail out student loans. Bail out bankrupt states and locals and their pensions. Cancel the rent. Cancel the mortgage. Why should anyone have to pay any debt if the Federal government has access to a money machine? Why work? Why should the federal government not just keep printing money and sending it to us? Other countries are not so lucky as we are. Why should emerging markets pay back debt if the US does not have to? Bail them out. 

Why indeed should anyone pay taxes? Here Stephanie Kelton, MMT proponent, has followed the logic. The only reason to charge taxes at all, in her view, is to expropriate the wealthy to rob them of political power. 

These are inescapable logical conclusions of the view that federal debt has no fiscal cost. If you’re uncomfortable with the end of the trip, perhaps you should revisit the assumption from which it inexorably follows. At least, you recognize that the opportunity to borrow with little fiscal cost is limited, so should be preserved. 

Advocates point to WWII. It is true, that the US exited an even greater debt to GDP ratio. It was not painless. Growth higher than interest rates was part of it, but not all. Two bouts of inflation, in the late 1940s and in the 1970s devalued much debt. The US ran steady primary (excluding interest costs) surpluses from the 1940s through the mid 1970s. Spending was low in the pre-entitlement economy, and nobody was totting up hundreds of trillions in unfunded promises. The war, and its spending, was over. Statutory personal taxes and actual corporate taxes were high. Financial repression and closed international capital markets kept interest rates on government bonds low, and deprived Americans of better investment opportunities and our and the world’s economies much needed investment capital. And we had an international debt crisis in the early 1970s, prompting the abandonment of Bretton woods and depreciation of the dollar. 

In short, the US grew out of WWII debt by not borrowing any more, by decades of fiscal probity, and by strong supply-side growth in a deregulated economy. We have none of these reassurances going forward. And this, and the UK exit from Napoleonic War debt in the 1800s by starting the industrial revolution are about the only historical examples of a semi-successful repayment of this much debt. Otherwise, the history of large sovereign debts is one long sorry tale of default, inflation, devaluation, and consequent financial chaos. The UK did not exit WWII debt successfully, leading to crisis after crisis, and everyone else did worse. 

Still, what should we be afraid of? The vision of grandchildren saddled with taxes, or even just unable to borrow more while the economy sits at its limit, of, say, 200% debt to GDP, is indeed not a salient brake to spending. 

That is not the danger. The danger the US faces, the danger we should repeat and keep in mind, is a debt crisis. We print our own money, so the result may be a sharp inflation that wipes away the value of debt rather than an even more disruptive default, but the consequences will be almost as dire. 

Imagine that 5 or even 10 years from now we have another crisis, which we surely will. It might be another, worse, pandemic; a war involving china, Russia or the Middle East. Imagine the US follows its present trends of partisan government dysfunction, so an impeachment is going on, a contested election, and even militias roaming the streets of still boarded up cities. Add a huge economic recession, but unreformed spending promises. 

At this point, the US has, say, 150% debt to GDP.  It needs to borrow another $5 - $10 trillion, or get people to hold that much more newly-printed money, to bail out once again, and pay everyone’s bills for a while. It will need another $10 trillion or so to roll over maturity debt. At some point bond investors see the end coming, as they did for Greece, and refuse. Not only must the US then inflate or default, but the firehouse of debt relief, bailout and stimulus that everyone expects is absent, together with our capacity for military or public health spending to meet the shock that sparks the crisis. 

Yes, I've warned about this before, and no, it hasn't happened yet. Well, if you live in California you live on an earthquake fault. That the big one hasn't happened yet doesn't mean it never will.  

No, interest rates do not signal such problems. (Alan Blinder, covering such matters in the Wall Street Journal, "if the U.S. Treasury starts to supply more bonds than the world's investors demand, the markets will warn us with higher interest rates and a sagging dollar. No such yellow lights are flashing.) They never do. Greek interest rates were low right up until they weren’t. Interest rates did not signal the inflation of the 1970s, or the disinflation of the 1980s. Lehman borrowed at low rates until it didn’t. Nobody expects a debt crisis, or it would have already happened. 

We cannot tell when the conflagration will come. But we can remove the kindling and gasoline lying around. Reform long-term spending promises in line with long run revenues. Reform the tax code to raise money with less damage to the economy. And today, spend only as if someone has to pay it back. Because someone will have to pay it back. 

Blanchard concludes with “public debt.. can be used but it should be used right.” I agree. We are in a crisis, and thoughtful spending with borrowed or printed money is necessary. (How about a test a week for every American?) But keep constantly in mind, it will be paid back, steadily or chaotically. There really is no argument. Most of these points are in Blachard's Presidential Address. 

Whether a steady debt/GDP ratio can life with small steady primary deficits, rather than small steady primary surpluses is not the interesting question. There is a limit, a debt/GDP beyond which markets will not lend. On  this, I think, we all agree. There is a finite fiscal capacity. Even though in theory the r<g argument would allow a 1,000% debt to GDP ratio, or 10,000%, at some point the party stops. The closer we are to that limit, the closer we are to a real crisis when we need that fiscal capacity and it is no longer there. 

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And now, dear fellow Americans, enjoy your Labor Day. Please listen to Dr. Fauci and don't run out to party like you did on Memorial Day. Let's be sensible and get this thing over with. 

Update: A new and better post More on Debt follows. 

The Surplus Process

How should we model surpluses and deficits? In finishing up a recent article and chapter 5 and 6 of a Fiscal Theory of the Price Level update, a bunch of observations coalesced that are worth passing on in blog post form.

Background: The real value of nominal government debt equals the present value of real primary surpluses, \[ \frac{B_{t-1}}{P_{t}}=b_{t}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}. \] I 'm going to use one-period nominal debt and a constant discount rate for simplicity. In the fiscal theory of the price level, the \(B\) and \(s\) decisions cause inflation \(P\). In other theories, the Fed is in charge of \(P\), and \(s\) adjusts passively. This distinction does not matter for this discussion. This equation and all the issues in this blog post hold in both fiscal and standard theories.

The question is, what is a reasonable time-series process for \(\left\{s_{t}\right\} \) consistent with the debt valuation formula? Here are surpluses

The blue line is the NIPA surplus/GDP ratio. The red line is my preferred measure of primary surplus/GDP, and the green line is the NIPA primary surplus/GDP.

The surplus process is persistent and strongly procyclical, strongly correlated with the unemployment rate.  (The picture is debt to GDP and surplus to GDP ratios, but the same present value identity holds with small modifications so for a blog post I won't add extra notation.)

Something like an AR(1) quickly springs to mind, \[ s_{t+1}=\rho_{s}s_{t}+\varepsilon_{t+1}. \] The main point of this blog post is that this is a terrible, though common, specification.

Write a general MA process, \[ s_{t}=a(L)\varepsilon_{t}. \] The question is, what's a reasonable \(a(L)?\) To that end, look at the innovation version of the present value equation, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}=\sum_{j=0}^{\infty}\beta ^{j}a_{j}\varepsilon_{t}=a(\beta)\varepsilon_{t}% \] where \[ \Delta E_{t}=E_{t}-E_{t-1}. \] The weighted some of moving average coefficients \(a(\beta)\) controls the relationship between unexpected inflation and surplus shocks. If \(a(\beta)\) is large, then small surplus shocks correspond to a lot of inflation and vice versa. For the AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx 2.\) Unexpected inflation is twice as volatile as unexpected surplus/deficits.

\(a(\beta)\) captures how much of a deficit is repaid. Consider \(a(\beta)=0\). Since \(a_{0}=1\), this means that the moving average is s-shaped. For any \(a(\beta)\lt 1\), the moving average coefficients must eventually change sign. \(a(\beta)=0\) is the case that all debts are repaid. If \(\varepsilon_{t}=-1\), then eventually surpluses rise to pay off the initial debt, and there is no change to the discounted sum of surpluses. Your debt obeys \(a(\beta)=0\) if you do not default. If you borrow money to buy a house, you have deficits today, but then a string of positive surpluses which pay off the debt with interest.

The MA(1) is a good simple example, \[ s_{t}=\varepsilon_{t}+\theta\varepsilon_{t-1}% \] Here \(a(\beta)=1+\theta\beta\). For \(a(\beta)=0\), you need \(\theta=-\beta ^{-1}=-R\). The debt -\(\varepsilon_{t}\) is repaid with interest \(R\).

Let's look at an estimate. I ran a VAR of surplus and value of debt \(v\), and I also ran an AR(1).

Here are the response functions to a deficit shock:

The blue solid line with \(s=-0.31\) comes from a larger VAR, not shown here. The dashed line comes from the two variable VAR, and the line with triangles comes from the AR(1).

The VAR (dashed line) shows a slight s shape. The moving average coefficients gently turn positive. But when you add it up, those overshootings bring us back to \(a(\beta)=0.26\) despite 5 years of negative responses. (I use \(\beta=1\)). The AR(1) version without debt has \(a(\beta)=2.21\), a factor of 10 larger!

Clearly, whether you include debt in a VAR and find a slightly overshooting moving average, or leave debt out of the VAR and find something like an AR(1) makes a major difference. Which is right? Just as obviously, looking at \(R^2\)   and t-statistics of the one-step ahead regressions is not going to sort this out.

I now get to the point.

Here are 7 related observations that I think collectively push us to the view that \(a(\beta)\) should be a quite small number. The observations use this very simple model with one period debt and a constant discount rate, but the size and magnitude of the puzzles are so strong that even I don't think time-varying discount rates can overturn them. If so, well, all the more power to the time-varying discount rate! Again, these observations hold equally for active or passive fiscal policy. This is not about FTPL, at least directly.

1) The correlation of deficits and inflation. Reminder, \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =a(\beta)\varepsilon_{t}. \] If we have an AR(1), \(a(\beta)=1/(1-\rho_{s}\beta)\approx2\), and with \(\sigma(\varepsilon)\approx5\%\) in my little VAR, the AR(1) produces 10% inflation in response to a 1 standard deviation deficit shock. We should see 10% unanticipated inflation in recessions! We see if anything slightly less inflation in recessions, and little correlation of inflation with deficits overall. \(a(\beta)\) near zero solves that puzzle.

2) Inflation volatility. The AR(1) likewise predicts that unexpected inflation has about 10% volatility. Unexpected inflation has about 1% volatility. This observation on its own suggests \(a(\beta)\) no larger than 0.2.

3) Bond return volatility and cyclical correlation. The one-year treasury bill is (so far) completely safe in nominal terms. Thus the volatility and cyclical correlation of unexpected inflation is also the volatility and cyclical correlation of real treasury bill returns. The AR(1) predicts that one-year bonds have a standard deviation of returns around 10%, and they lose in recessions, when the AR(1) predicts a big inflation. In fact one-year treasury bills have no more than 1% standard deviation, and do better in recessions.

4) Mean bond returns. In the AR(1) model, bonds have a stock-like volatility and move procyclically. They should have a stock-like mean return and risk premium. In fact, bonds have low volatility and have if anything a negative cyclical beta so yield if anything less than the risk free rate. A small  (a(\beta)\) generates low bond mean returns as well.

Jiang, Lustig, Van Nieuwerburgh and Xiaolan recently raised this puzzle, using a VAR estimate of the surplus process that generates a high \(a(\beta)\). Looking at the valuation formula \[ \frac{B_{t-1}}{P_{t}}=E_{t}\sum_{j=0}^{\infty}\beta^{j}s_{t+j}, \] since surpluses are procyclical, volatile, and serially correlated like dividends, shouldn't surpluses generate a stock-like mean return? But surpluses are crucially different from dividends because debt is not equity. A low surplus \(s_{t}\) raises  our estimate of subsequent surpluses \(s_{t+j}\). If we separate out
 \[b_{t}=s_{t}+E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=s_{t}+\beta E_{t}b_{t+1}  \] a decline in the "cashflow" \(s_{t}\) raises the "price" term \(b_{t+1}\), so the overall return is risk free. Bad cashflow news lowers stock pries, so both cashflow and price terms move in the same direction. In sum a small \(a(\beta)\lt 1\) resolves the Jiang et. al. puzzle. (Disclosure, I wrote them about this months ago, so this view is not a surprise. They disagree.)

5) Surpluses and debt. Looking at that last equation, with a positively correlated surplus process \(a(\beta)>1\), as in the AR(1), a surplus today leads to  larger value of the debt tomorrow. A deficit today leads to lower value of the debt tomorrow. The data scream the opposite pattern. Higher deficits raise the value of debt, higher surpluses pay down that debt. Cumby_Canzoneri_Diba (AER 2001) pointed this out 20 years ago and how it indicates an s-shaped surplus process.  An \(a(\beta)\lt 1\) solves their puzzle as well. (They viewed \(a(\beta)\lt 1\) as inconsistent with fiscal theory which is not the case.)

6) Financing deficits. With \(a(\beta)\geq1\), the government finances all of each deficit by inflating away outstanding debt, and more. With \(a(\beta)=0\), the government finances deficits by selling debt. This statement just adds up what's missing from the last one. If a deficit leads to lower value of the subsequent debt, how did the government finance the deficit? It has to be by inflating away outstanding debt. To see this, look again at inflation, which I write \[ \frac{B_{t-1}}{P_{t-1}}\Delta E_{t}\left( \frac{P_{t-1}}{P_{t}}\right) =\Delta E_{t}s_{t}+\Delta E_{t}\sum_{j=1}^{\infty}\beta^{j}s_{t+j}=\Delta E_{t}s_{t}+\Delta E_{t}\beta b_{t+1}=1+\left[ a(\beta)-1\right] \varepsilon_{t}. \] If \(\Delta E_{t}s_{t}=\varepsilon_{t}\) is negative -- a deficit -- where does that come from? With \(a(\beta)>1\), the second term is also negative. So the deficit, and more, comes from a big inflation on the left hand side, inflating away outstanding debt. If \(a(\beta)=0\), there is no inflation, and the second term on the right side is positive -- the deficit is financed by selling additional debt. The data scream this pattern as well.

7) And, perhaps most of all, when the government sells debt, it raises revenue by so doing. How is that possible? Only if investors think that higher surpluses will eventually pay off that debt. Investors think the surplus process is s-shaped.

All of these phenomena are tied together.  You can't fix one without the others. If you want to fix the mean government bond return by, say, alluding to a liquidity premium for government bonds, you still have a model that predicts tremendously volatile and procyclical bond returns, volatile and countercyclical inflation, deficits financed by inflating away debt, and deficits that lead to lower values of subsequent debt.

So, I think the VAR gives the right sort of estimate. You can quibble with any estimate, but the overall view of the world required for any estimate that produces a large \(a(\beta)\) seems so thoroughly counterfactual it's beyond rescue. The US has persuaded investors, so far, that when it issues debt it will mostly repay that debt and not inflate it all away.

Yes, a moving average that overshoots is a little unusual. But that's what we should expect from debt. Borrow today, pay back tomorrow. Finding the opposite, something like the AR(1), would be truly amazing. And in retrospect, amazing that so many papers (including my own) write this down. Well, clarity only comes in hindsight after a lot of hard work and puzzles.

In more general settings \(a(\beta)\) above zero gives a little bit of inflation from fiscal shocks, but there are also time-varying discount rates and long term debt in the present value formula. I leave all that to the book and papers.

(Jiang et al say they tried it with debt in the VAR and claim it doesn't make much difference.  But their response functions with debt in the VAR, at left,  show even more overshooting than in my example, so I don't see how they avoid all the predictions of a small \(a(\beta)\), including a low bond premium.)

A lot of literature on fiscal theory and fiscal sustainability, including my own past papers, used AR(1) or similar surplus processes that don't allow \(a(\beta)\) near zero. I think a lot of the puzzles that literature encountered comes out of this auxiliary specification. Nothing in fiscal theory prohibits a surplus process with \(a(\beta)=0\) and certainly not \(0 \lt a(\beta)\lt 1\).

Update

Jiang et al. also claim that it is impossible for any government with a unit root in GDP to issue risk free debt. The hidden assumption is easy to root out. Consider the permanent income model, \[ c_t = rk_t + r \beta \sum \beta^j y_{t+j}\] Consumption is cointegrated with income and the value of debt. Similarly, we would normally write the surplus process \[ s_t = \alpha b_t + \gamma y_t. \] responding to both debt and GDP. If surplus is only cointegrated with GDP, one imposes \( \alpha = 0\), which amounts to assuming that governments do not repay debts. The surplus should be cointegrated with GDP and with the value of debt.  Governments with unit roots in GDP can indeed promise to repay their debts.

New Virus Podcast

A grumpy economist podcast on virus economics so far.

Rajan on Piketty

People often ask what I think of Piketty. I have to admit: I haven't read his books (or pretended to). Life is short, and it's 1,000 pages.

But Raghu Rajan has, and writes a splendid and well written review at the FT.  Bottom line, the choir is singing:

as a call for nations to enact massive redistribution programmes to reduce inequality, this latest work will persuade few outside his devoted following.

What's wrong?

Piketty describes social systems through the ages — such as slavery, feudalism, colonialism and caste — collectively as “inequality regimes”. No surprises, then, about what he thinks is their key attribute. In each case, he uses historical sources to map the distribution of incomes and wealth and show how the situation today parallels those earlier abhorrent episodes. The obvious implication: if we are not disturbed by what is going on around us, we should be.

 If our level of inequality is the same as slavery, feudalism, colonialism, and caste, then we are no better or different. That's an astonishing statement, though common on the left.

A Better Wealth and Taxes

CATO has put out a much-improved version of my "Wealth and Taxes" series on wealth inequality and the wealth tax. Html here and pdf here. Many thanks to Chris Edwards and the CATO staff for editing and formatting it, and getting it out in this nice format. 

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Alan Reynolds wrote with interesting comments. Among others,

the $18+ trillion now invested in retirement, education and health savings accounts has gradually made middle-income investment income more and more invisible in tax returns as time moved on.   Exemption of $500,000 of capital gains on home sales further reduced the IRS-reported capital income of all but the top 1%.

...the Saez-Zucman methodology is sure to show the rich having a larger and larger share of taxable income from capital, and therefore of wealth based on that taxable income, because income from the savings of middle-income taxpayers has become increasingly unreported. 

Bottom line:

Because tax laws exempted a rising share of investment income (and residential capital gains) of the bottom 95%, the visible portion left showing for the top 1% must appear as a rising share (of a meaningless total). 

I still like my 2006 WSJ title: "The Top 1% of WHAT?"  Pre-tax, pre-transfer income reported on individual income tax returns was never meaningful, and capital income on those tax returns is incomparable over time. 

Grumpy Podcast

We're trying a Grumpy Economist Podcast. The first one talks about my series on wealth inequality and wealth tax. I can't stand listening to myself, as think I always sound dumb and regret all the things I could have said better, so I haven't listened. But I hope it sounds better to the rest of you and provides a useful new grumpy outlet. Thanks to Scott Immergut and Troy Senik who do all the work.