A Kind Word for the Fed

 This is my first post over at Substack. Follow me here and let me know if it isn't working. 

The post is in praise of interest on reserves and abundant reserves, with (of course) some suggestions for improvements. 

Bond risk premiums -- certainty found and lost again

This is a second post from a set of comments I gave at the NBER Asset Pricing conference in early November at Stanford.  Conference agenda here. My full slides here. First post here, on new-Keynesian models

I  commented on "Downward Nominal Rigidities and Bond Premia" by François Gourio  and Phuong Ngo. The paper was about bond premiums. Commenting made me realize that I thought I understood the issue, and now I realize I don't at all. Understanding term premiums still seems a fruitful area of research after all these years.  

I thought I understood risk premiums

The term premium question is, do you earn more money on average holding long term bonds or short-term bonds? Related, is the yield curve on average upward or downward sloping? Should an investor hold long or short term bonds? 

New-Keynesian models, a puzzle of scientific sociology

This post is from a set of comments I gave at the NBER Asset Pricing conference in early November at Stanford.  Conference agenda here. My full slides here. There was video, but sadly I took too long to write this post and the NBER took down the conference video. 

I was asked to comment on "Downward Nominal Rigidities and Bond Premia" by François Gourio  and Phuong Ngo. It's a very nice clean paper, so all I could think to do as discussant is praise it, then move on to bigger issues. These are really comments about whole literatures, not about one paper. One can admire the play but complain about the game. 

The paper implements a version of Bob Lucas' 1973 "International evidence" observation. Prices are less sticky in high inflation countries. The Phillips curve more vertical. Output is less affected by inflation. The Calvo fairy visits every night in Argentina. To Lucas, high inflation comes with variable inflation, so people understand that price changes are mostly aggregate not relative prices, and ignore them. Gourio and Ngo use a new-Keynesian model with downwardly sticky prices and wages to express the idea.  When inflation is low, we're more often in the more-sticky regime. They use this idea in a model of bond risk premia. Times of low inflation lead to more correlation of inflation and output, and so a different correlation of nominal bond returns with the discount factor, and a different term premium. 

I made two points, first about bond premiums and second about new-Keynesian models. Only the latter for this post. 

This paper, like hundreds before it, adds a few ingredients on top of a standard textbook new-Keynesian model. But that textbook model has deep structural problems. There are known ways to fix the problems. Yet we continually build on the standard model, rather than incorporate known ways or find new ways to fix its underlying problems. 

Problem 1: The sign is "wrong" or at least unconventional.

FTPL news: discount and Economist list

 

Just in time for the holidays, the perfect stocking stuffer -- if you have really big stockings. 30% discount on Fiscal Theory of the Price Level until June 30 2024. 

And Fiscal Theory makes the Economist's list of best books for 2023. 

Prices vs. inflation and a mortgage puzzle

Mickey Levy's excellent WSJ oped leaves some thoughts. 

Inflation has fallen, though I still suspect it may get stuck around 3-4%. But prices "are 18.9% higher than its [their] pre-pandemic level." And some important prices have risen even more. "Rental costs continue to rise in lagged response to the 46.1% surge in home prices."  Those who are taking a victory lap about the end of inflation (the rate of change of prices) are befuddled by continuing consumer (and voter) anger. 

Well, prices are not the same thing as inflation.

Heterogeneous Agent Fiscal Theory

Today, I'll add an entry to my occasional reviews of interesting academic papers. The paper: "Price Level and Inflation Dynamics in Heterogeneous Agent Economies," by Greg Kaplan, Georgios Nikolakoudis and Gianluca Violante. 

One of the many reasons I am excited about this paper is that it unites fiscal theory of the price level with heterogeneous agent economics. And it shows how heterogeneity matters. There has been a lot of work on "heterogeneous agent new-Keynesian" models (HANK). This paper inaugurates heterogeneous agent fiscal theory models. Let's call them HAFT. 

Interest rates and inflation part 2: Losing faith in VARs

(This post continues part 1 which just looked at the data. Part 3 on theory is here) 

When the Fed raises interest rates, how does inflation respond? Are there "long and variable lags" to inflation and output?  

There is a standard story: The Fed raises interest rates; inflation is sticky so real interest rates (interest rate - inflation) rise; higher real interest rates lower output and employment; the softer economy pushes inflation down. Each of these is a lagged effect. But despite 40 years of effort, theory struggles to substantiate that story (next post), it's had to see in the data (last post), and the empirical work is ephemeral -- this post.  

The vector autoregression and related local projection are today the standard empirical tools to address how monetary policy affects the economy, and have been since Chris Sims' great work in the 1970s. (See Larry Christiano's review.) 

I am losing faith in the method and results. We need to find new ways to learn about the effects of monetary policy. This post expands on some thoughts on this topic in "Expectations and the Neutrality of Interest Rates," several of my papers from the 1990s* and excellent recent reviews from Valerie Ramey and  Emi Nakamura and Jón Steinsson, who  eloquently summarize the hard identification and computation troubles of contemporary empirical work.

Maybe popular wisdom is right, and economics just has to catch up. Perhaps we will. But a popular belief that does not have solid scientific theory and empirical backing, despite a 40 year effort for models and data that will provide the desired answer, must be a bit less trustworthy than one that does have such foundations. Practical people should consider that the Fed may be less powerful than traditionally thought, and that its interest rate policy has different effects than commonly thought. Whether and under what conditions high interest rates lower inflation, whether they do so with long and variable but nonetheless predictable and exploitable lags, is much less certain than you think. 

Rangvid on housing inflation

(This post is an interlude between history and VARs) 

Jesper Rangvid has a great blog post today on different inflation measures. 

CPI and PCE core inflation (orange and gray) are how the US calculates inflation less food and energy, but including housing. We do an economically sophisticated measure that tries to measure the "cost of housing" by rents for those who rent, plus how much a homeowner pays by "renting" the house to him or herself. You can quickly come up with the plus and minus of that approach, especially for looking at month to month trends in inflation. Europe in the "HICP core" line doesn't even try and leaves owner occupied housing out altogether. 

Jesper's point: if you measure inflation Europe's way, US inflation is already back to 2%. The Fed can hang out a "mission accomplished" banner. (Or, in my view, a "it went away before we really had to do anything serious about it" banner.) And, since he writes to a European audience, Europe has a long way to go. 

A few deeper (and slightly grumpier) points: 

Papers: Dew-Becker on Networks

I've been reading a lot of macro lately. In part, I'm just catching up from a few years of book writing. In part,  I want to understand inflation dynamics, the quest set forth in "expectations and the neutrality of interest rates," and an  obvious next step in the fiscal theory program. Perhaps blog readers might find interesting some summaries of recent papers, when there is a great idea that can be summarized without a huge amount of math. So, I start a series on cool papers I'm reading. 

Today: "Tail risk in production networks" by Ian Dew-Becker, a beautiful paper. A "production network" approach recognizes that each firm buys from others, and models this interconnection. It's a hot topic for lots of reasons, below.  I'm interested because prices cascading through production networks might induce a better model of inflation dynamics. 

(This post uses Mathjax equations. If you're seeing garbage like [\alpha = \beta] then come back to the source  here.) 

To Ian's paper: Each firm uses other firms' outputs as inputs. Now, hit the economy with a vector of productivity shocks. Some firms get more productive, some get less productive. The more productive ones will expand and lower prices, but that changes everyone's input prices too. Where does it all settle down? This is the fun question of network economics. 

Ian's central idea: The problem simplifies a lot for large shocks. Usually when problems are complicated we look at first or second order approximations, i.e. for small shocks, obtaining linear or quadratic ("simple") approximations. 

On the x axis, take a vector of productivity shocks for each firm, and scale it up or down. The x axis represents this overall scale. The y axis is GDP. The right hand graph is Ian's point: for large shocks, log GDP becomes linear in log productivity -- really simple. 

Why? Because for large enough shocks, all the networky stuff disappears. Each firm's output moves up or down depending only on one critical input. 

Apartment inflation

 

This beautiful graph comes from calculatedriskblog.com. (Courtesy Andy Atkeson who used it in a nice discussion of a great paper by Ivan Werning at the Minneapolis Fed Foundations of Monetary Policy conference.) 

The central lines that don't move so much are the average rent. This is the quantity used by the Bureau of Labor Statistics to compute the consumer price index. The blue and yellow lines are the rent of new leases. 

The first thing this informs is the economic theory of "sticky prices." Apartment rents are a classic "sticky price;" the rent is fixed in dollar terms for a year. So, landlords deciding how much rent to charge, and people deciding how much they're willing to pay,  balance rents now vs. higher rents in the future. If everyone believes that inflation will be 10% over the next year, then it makes sense to raise the rent 5% now, and to pay the 5% higher rent, because  the savings at the end of the year balance the cost in the beginning. (Obviously, the economics are much more subtle than this, but you get the idea.) And Voila', you see it. 

The graph also says there is some predictability and nomentum to inflation. Inflation should not be a surprise to forecasters. If you see rents on new leases much above average rents, it's a pretty good bet that average rents will be rising in the future! This kind of phenomenon may be under exploited in formal inflation forecasting. 

And, on the continuing speculation whether inflation will go away with interest rates still substantially below current inflation, the graph does seem a leading indicator that the rational expectations model is winning.  

Clarification: Of course, the graph says nothing about causality; did new leases rise sharply because people expected inflation in average leases, or did new leases rise for other reasons, and we're just seeing the old theorem that marginal  > average when average is rising. But it is consistent with the expectations story, and illuminates that story nicely. 

The Fiscal Theory of Inflation

We often summarize that the fiscal theory is a theory of the price level: The price level adjusts so that the real value of government debt equals the present value of surpluses. That characterization seems to leave it to a secondary role. But with any even tiny price stickiness, fiscal theory is really a fiscal theory of inflation. The following two parables should make the point, and are a good starting point for understanding what fiscal theory is really all about. This point is somewhat buried in Chapter 5.7 of Fiscal Theory of the Price Level. 

Start with the response of the economy to a one-time fiscal shock, a 1% unexpected decline in the sum of current and expected future surpluses, with no change in interest rate, at time 0. The model is below, but today's point is intuition, not staring at equations. This is the continuous-time version of the model, which clarifies the intuitive points. 

Response to 1% fiscal shock at time 0 with no change in interest rates

The one-time fiscal shock produces a protracted inflation. The price level does not move at all on the date of the shock. Bondholders lose value from an extended period of negative real interest rates -- nominal interest rates below inflation. 

 What's going on? The government debt valuation equation with instantaneous debt and with perfect foresight is \[V_{t}=\frac{B_{t}}{P_{t}}=\int_{\tau=t}^{\infty}e^{-\int_{w=t}^{\tau}\left(  i_{w}-\pi_{w}\right)  dw}s_{\tau}d\tau\] where \(B\) is the nominal amount of debt, \(P\) is the price level, \(i\) is the interest rate \(\pi\) is inflation and \(s\) are real primary surpluses. We discount at the real interest rate \(i-\pi\). We can use this valuation equation to understand variables before and after a one-time probability zero "MIT shock." 

With flexible prices, we have a constant real interest rate, so \(i_w-\pi_w\). Thus if there is a downward jump in  \(\int_{\tau=t}^{\infty}e^{-r \tau}s_{\tau}d\tau\), as I assumed to make the plot, then there must be an upward jump in the price level \(P_t\), to devalue outstanding debt. (Similarly, a diffusion component to surpluses must be matched by a diffusion component in the price level.) The initial price level adjusts so that the real value of debt equals the present value of surpluses. This is the standard understanding of the fiscal theory of the price level. Short-term debt holders cannot be made to lose from expected future inflation. 

But that's not how the simulation in the figure works, with sticky prices. Since now both \(B_t\) and \(P_t\) on the left hand side of the government debt valuation equation cannot jump, the left-hand side itself cannot jump. Instead, the government debt valuation equation determines which path of inflation \(\{\pi_w\}\) which, with the fixed nominal interest rate \(i_w\), generates just enough lower real interest rates \(\{i_w-\pi_w\}\) so that the lower discount rate just offsets the lower surplus.  Short-term bondholders lose value as their debt is slowly inflated away during the period of low real interest rates, not in an instantanoues price level jump. 

In this sticky-price model, the price level cannot jump or diffuse because only an infinitesimal fraction of firms can change their price at any instant in time. The price level is continuous and differentiable. The inflation rate can jump or diffuse, and it does so here; the price level starts rising. As we reduce price stickiness, the price level rise happens faster, and smoothly approaches the limit of a price-level jump for flexible prices. 

In short, fiscal theory does not operate by changing the initial price level. Fiscal theory determines the path of the inflation rate. It really is a fiscal theory of inflation, of real interest rate determination.  

The frictionless model remains a guide to how the sticky price model behaves in the long run. In the frictionless model, monetary policy sets expected inflation via \(i_t = r+E_t \pi_{t+1}\) or \(i_t = r+\pi_t\), while fiscal policy sets unexpected inflation \(\pi_{t+1}-E_t\pi_{t+1}\) or \(dp_t/p_t-E_t dp_t/p_t\).  In the long run of my simulation, the price level does inexorably rise to devalue debt, and the interest rate determines the long-run expected inflation. But this long-run characterization does not provide useful intuition for the higher frequency path, which is what we typically want to  interpret and analyze. 

It is a better characterization of these dynamics that monetary policy---the nominal interest rate---determines a set of equilibrium inflation paths, and fiscal policy determines which one of these paths is the overall equilibrium, inflating away just enough initial debt to match the decline in surpluses. 

Response to 1% deficit shock at time 0 with no change in interest rate 

This second graph gives a bit more detail of the fiscal-shock simulation, plotting the primary surplus \(s\), the value of debt \(v\), and the price level \(p\). The surplus follows an AR(1). The persistence of that AR(1) is irrelevant to the inflation path. All that matters is the initial shock to the discounted stream of surpluses. (I make a big fuss in FTPL that you should not use AR(1) surplus process to match fiscal data, since most fiscal shocks have an s-shaped response, in which deficits correspond to larger surpluses. However, it is still useful to use an AR(1) to study how the economy responds to that component of the fiscal shock that is not repaid.) 

To see how initial bondholders end up financing the deficits, track the value of those bondholders' investment, not the overall value of debt. The latter includes debt sales that finance deficits. The real value of a bond investment held at time 0, \(\hat{v}\), follows \[d \hat{v}_t = (r \hat{v}_t + i_t - \pi_t)dt. \] I plot the time-zero value of this portfolio, \[e^{-rt} \hat{v}_t.\] As you can see this value smoothly declines to -1%. This is the quantity that matches the 1% by which surpluses decline. (I picked the initial surplus shock \(d\varepsilon_{s,t}=1/(r+\eta_s)\) so that \(\int_{\tau=0}^\infty e^{-r\tau}\tilde{s}_t d\tau =-1.\) )

Response to interest rate shock at time 0 with no change in surpluses 

The third graph presents the response to an unexpected permanent rise in interest rate. With long-term debt, inflation initially declines. The Fed can use this temporary decline to offset some fiscal inflation. Inflation eventually rises to meet the interest rates. Most interest rate rises are not permanent, so we do not often see this long-run stability or neutrality property. The initial decline in interest rates comes in this model from long-term debt. As the dashed line shows, with shorter-maturity debt inflation  rises right away. With instantaneous debt, inflation follows the interest rate exactly. 

Again, in this continuous-time model the price level does not move instantly. The higher interest rate sets off a period of lower inflation, not a price-level drop. 

With long-term debt the perfect-foresight valuation equation is \[V_{t}=\frac{Q_tB_{t}}{P_{t}}=\int_{\tau=t}^{\infty}e^{-\int_{w=t}^{\tau}\left(  i_{w}-\pi_{w}\right)  dw}s_{\tau}d\tau. \] where \(Q_t\) is the nominal price of long-term government debt. Now, with flexible prices, the real rate is fixed \(i_w=\pi_w\). With no change in surplus \(\{s_\tau\}\), the right hand side cannot change. Inflation \(\{\pi_w\}\) then simply follows the AR(1) pattern of the interest rate. However, the higher nominal interest rates induce a downward jump or diffusion in the bond price \(Q_t\). With \(B_t\) predetermined, there must be a downward jump or diffusion in the price level \(P_t\). In this way, even with flexible prices, with long-term debt we can see an instant in which higher interest rates lower inflation before ``long run'' neutrality kicks in. 

How does the price level not jump or diffuse with sticky prices? Now \(B_t\) and \(P_t\) are predetermined on the left hand side of the valuation equation. Higher nominal interest rates \(\{i_w\}\) still drive a downward jump or diffusion in the bond price \(Q_t\). With no change in \(s_\tau\), a spread \(i_w-\pi_w\) must open up to match the downward jump in bond price \(Q_t\), which is what we see in the simulation. Rather than an instant downward jump in price level, there is instead a long period of low inflation, of slow price level decline, followed by a gradual increase in inflation. 

Again, the frictionless model does provide intuition for the long-run behavior of the simulation. The three year decline in price level is reminiscent of the downward jump; the eventual rise of inflation to match the interest rate is reminiscent of the immediate rise in inflation. But again, in the actual dynamics we really have a theory of \emph{inflation}, not a theory of the \emph{price level}, as on impact the price level does not jump at all. Again, the valuation equation generates a path of inflation, of the real interest rate, not a change in the value of the initial price level. 

The general lessons of these two simple exercises remain: 

Both monetary and fiscal policy drive inflation. Inflation is not always and everywhere a monetary phenomenon, but neither is it always and everywhere fiscal. 

In the long run, monetary policy completely determines the expected price level. As the inflation rate ends up matching the interest rate, inflation will go wherever the Fed sends it. If the interest rate went below zero (these are deviations from steady state, so that is possible), it would drag inflation down with it, and the price level would decline in the long run. 

One can view the current situation as the lasting effect of a fiscal shock, as in the first graph. One can view the Fed's option to restrain inflation as the ability to add the dynamics of the second graph. 

Don't be too put off by the simple AR(1) dynamics. First, these are responses to a single, one-time shock. Historical episodes usually have multiple shocks. Especially when we pick an episode ex-post based on high inflation, it is likely that inflation came from several shocks in a row, not a one-time shock. Second, it is relatively easy to add hump-shaped dynamics to these sorts of responses, by standard devices such as habit persistence preferences or capital accumulation with adjustment costs. Also, full models have additional structural shocks, to the IS or Phillips curves here for example. We analyze history with responses to those shocks as well, with policy rules that react to inflation, output, debt, etc. 

The model  I use for these simple simulations is a simplified version of the model presented in FTPL 5.7.  

$$\begin{aligned}E_t dx_{t}  &  =\sigma(i_{t}-\pi_{t})dt \\E_t d\pi_{t}  &  =\left(  \rho\pi_{t}-\kappa x_{t}\right)  dt\  \\ dp_{t}  &  =\pi_{t}dt \\ E_t dq_{t}  &  =\left[  \left(  r+\omega\right)  q_{t}+i_{t}\right] dt \\ dv_{t}  &  =\left(  rv_{t}+i_{t}-\pi_{t}-\tilde{s}_{t}\right)  dt+(dq_t - E_t dq_t) \\ d \tilde{s}_{t}  &  = -\eta_{s}\tilde{s}_{t}+d\varepsilon_{s,t} \\ di_{t}  &  = -\eta_{i}i_t+d\varepsilon_{i,t}. \end{aligned}$$

I use parameters \(\kappa = 1\), \(\sigma = 0.25\), \(r = 0.05\), \(\rho = 0.05\), \(\omega=0.05\), picked to make the graphs look pretty. \(x\) is output gap, \(i\) is nominal interest rate, \(\pi\) is inflation, \(p\) is price level, \(q\) is the price of the government bond portfolio, \(\omega\) captures a geometric structure of government debt, with face value at maturity \(j\) declining at \(e^{-\omega j}\), \(v\) is the real value of government debt, \(\tilde{s}\) is the real primary surplus scaled by the steady state value of debt, and the remaining symbols are parameters. 

Thanks much to Tim Taylor and Eric Leeper for conversations that prompted this distillation, along with evolving talks. 

Fiscal theory update

Whew. The penultimate draft of The Fiscal Theory of the Price Level is now done, and in the hands of the copy-editors at Princeton. There is still time to send me typos, thinkos, wrong equations, excessive repetition and more! 

FTPL article

I wrote a short-ish article for the Journal of Economic Perspectives on Fiscal Theory of the Price Level. It tries to summarize the 700 page book in a readable article with no equations. Let me know how I'm doing -- comments most welcome. 

Portfolio podcast

I did a Rational Reminder podcast and video, focusing on portfolio theory, but also a tour through asset pricing. My hosts Benjamin Felix and Cameron Passmore were unusually well prepared and asked great questions! Video below, or go here for video, podcast, and transcript for people (like me) who read more than listen.

Weisbach advice

I got a chance to see the page proofs of Michael Weisbach's upcoming book, "The Economists' Craft."  This leapt out at me from the preface: 

A second observation I have made over the years is that, perhaps because of a lack of good advice, many scholars, both doctoral students and faculty members, constantly make the same mistakes. Far too many publicly circulated papers contain incredibly long, mind-numbingly dull literature surveys; introductions that go on and on before they tell the reader what the point of the paper is and why the reader should bother to waste her time on it; data descriptions containing insufficient detail for a third party to replicate the results; tables that are unnecessary, badly labeled, or hard to understand; or overly dry prose written in the passive voice and apparently designed to put the reader to sleep. In addition, many scholars manage their time so badly when giving presentations that they do not get to the main results of their paper until the last five minutes of the talk. Their presentations are often poorly designed, with slides that are incomprehensible or even unreadable owing to their use of fonts so small that participants sitting more than a few rows back cannot read them. Young faculty routinely mismanage their career by not having a coherent research agenda, not getting their papers to journals, or not making connections with people in their field who teach at other universities. Sometimes they do not even bother to show up for seminars in their field at their own university.

 So true. This book's contrary advice will be very useful. 

Virtual finance theory seminar

I'm giving "A fiscal theory of monetary policy with partially-repaid long-term debt" at the virtual finance theory seminar, Wed Oct 28 at 1 PM EDT. Brett Green leads off with "Due Diligence" at 12 PM EDT. If interested, come join. Warning: this is an academic theory paper whose whole point is to look at equations. 

The link has an email address which I don't want to post here, email for a zoom invitation. 

This is an excellent seminar series and one of the first of the new international zooms, which are an exciting development. Thanks to Linda Schilling for organizing.

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.

***********

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. 

********

*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. 

 

Strategies for Monetary Policy

Strategies for Monetary Policy is a new book from the Hoover Press based on the conference by that name John Taylor and I ran last May. (John Taylor gets most of the credit.) This year's conference is sadly postponed due to Covid-19. We'll have lots to talk about May 2021.

At that link, you can see the table of contents and read Chapter pdfs for free. You can buy the book for $14.95 or get a free ebook.

The conference program and videos are still up.

Much of the conference was about the question, what will the Fed do during the next downturn? Here we are, and I think it is a valuable snapshot. Of course I have some self interest in that view.

As long as I'm shamelessly promoting, I'll put in another plug for my related Homer Jones Lecture at the St. Louis Fed, video here and the article Strategic Review and Beyond: Rethinking Monetary Policy and Independence here. That was written and delivered in early March, about 5 minutes before the lookouts said "Iceberg ahead." John and I don't put a lot of our own work into the conference books, but it sparked a lot of thoughts.  I am grateful to Jim Bullard and the St. Louis Fed for the chance to put those together.

Monetary policy is back to "forget about moral hazard, rules, strategies and the rest, the world is ending." This is a philosophy that happens quite regularly and now has become the rule and strategy. So strategic thinking about monetary policy is more important than ever.  This is a philosophy very much due to John Taylor.

The last part of my Homer Jones paper delves into just what risks the big thinkers of central banking were worried about on the eve of the pandemic. Pandemic was not in any stress test.  BIS, BoE, FSB and IMF  wanted everyone to start stress testing ... climate change and inequality. This is a story that needs more telling.    

Bailout redux

The greatest financial bailout of all time is underway. It’s 2008 on steroids. Yet where is the outrage? The silence is deafening. Remember the Tea Party and occupy Wall Street? “Never again” they said in 2008. Now everyone just wants the Fed to print more money, faster. (Well, there are some free market economists left. But we're a small voice!)

Maybe the Fed is right that if any bondholder loses money, if bond prices fall, if companies reorganize in bankruptcy, the financial system and the economy will implode. I am not here today to criticize that judgement. But if so, we must ask ourselves how we got to this situation, again, so soon. Once is an expedient. Twice is a habit.  It is clear that going forward any serious shock will be met by bailouts, and the Fed printing reserves to buy vast quantities of any fixed-income asset whose price starts to fall.

Why does the Fed feel the need to jump in? Because once again America is loaded up with debt, because bankruptcy is messy, and because the Fed fears that debt holders losing money will stop the financial system from providing, well, more debt.

This crisis is a huge wealth shock. The income lost during shutdown is simply gone. The question is, who is going to take that loss? Borrowing to keep paying bills, the current solution, posits  that future profits will soak up today's losses. We'll see about that. The CARES act puts future taxpayers squarely on the hook to pay today's bills. But where do those bills go? To creditors -- property owners, bond holders, and so forth. If we're looking around for pots of wealth to absorb today's losses, why are bondholders not chipping in? The biggest wealth transfer in history is underway, from tomorrow's taxpayers to today's bondholders, on the theory that if they lose money the economy falls apart?

OK, but why did America load up with debt again, apparently all "systemically important?" Could the expectation of a bailout any time there is an economy wide shock happens have had something to do with it? Will we do anything when this is over to stop companies from once again loading up with debt -- especially short term debt -- and forcing the Fed's hand again?

Meantime, anyone who hoarded some savings in the hope of profiting from fire sales, in the hope of providing liquidity to "distressed markets" has once again been revealed as a chump. Will we do anything to encourage them? Will lots of debt, private gain, taxpayers take the losses,  be the perpetual character of our financial system.

"You can't worry about moral hazard in a crisis," they said, and they didn't. At least last time there was some recognition of moral hazard, and a promise to clean up the moral hazard with reform. Will there be any such effort this time? Is anyone even thinking about the enormous moral hazard we are creating with these precedents? Will  the financial system perpetually a four-year-old on a bicycle, a parent running closely behind with one hand on the seat? Will the "Powell put" on fixed income grow ever larger? Or will we, this time, finally cure the financial system so it can survive the next shock?

A bailout 

Small but symbolic: The federal government just bailed out the airlines -- or more precisely airline stockholders, bondholders, unions, airplane leaseholders and other creditors who would lose in bankruptcy.

 "big airlines will receive 70% of the money as grants—which won’t be paid back—and 30% as loans. The cash comes with strings attached: Airlines must give the government warrants amounting to 10% of a given loan’s value that can be swapped for stocks; they cannot lay off staff until September; and they face restrictions on dividends, buybacks and executive compensation."

Oh, and as the article makes clear, this only gets us maybe through the summer. Anyone want to take a bet that planes are full again by September?

The big banks got bailed out in 2008 — or more precisely, the stockholders, bondholders and creditors of the big banks got bailed out.  Never again, they said. Again.

Now, one can make a case that big banks are “systemic,” that if their bondholders lose money the financial system collapses. Just how are airline bondholders “systemic?” What calamity falls if airline bondholders don’t get paid in full?  Just why is a swift pre-packaged bankruptcy not the right answer for airlines? This seems like a great time to renegotiate airplane and gate leases, union contracts (some require the airlines to keep flying empty planes!) fixed-price fuel contracts and more.

If taxpayers have to give airlines cash grants don't we get some reassurance this doesn't have to happen again? Even I would say, no more debt financing. You can see the instinct in "restrictions on dividends, buybacks and executive compensation." Democrats in Congress wanted "stakeholder" board seats, carbon reporting, and more. Why not go full Dodd-Frank on them? Detailed regulation of their financial affairs, stress tests to make sure they can survive the next time? Like banks, the existing airlines might not end up minding so much a return to the 1970s status as regulated utilities. Or, more likely, like GM, we just forget about it, let them load up on debt again, and pretend there won't be a 2030 bailout?

The Fed's big artillery

The real action is at the Fed. The Fed is buying commercial paper, corporate bonds, municipal bonds. The Fed is explicitly propping up asset prices. The Fed is also lending directly to companies. The current guesstimate is $4 trillion, with $2 trillion already accomplished. More is coming.

It started "small" On March 17, the Fed bailed out money market fund investors, buying the “illiquid” assets of those funds so that the funds could continue to pay out dollar for dollar.  Recall that in 2008, the Fed and Treasury bailed out money market fund investors, buying assets to stop a run on money-market funds' promise that you can always cash out at $1. Never again, they said. Fixed dollar promises must be backed by Treasuries, other funds must let asset values float. Again.

On March 17 the Fed also announced it will buy commercial paper.  “Directly from eligible companies.” Yes, the Fed prints reserves to lend directly to companies that can issue A1/P1 commercial paper.

"By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. " 

Why are companies borrowing long term by rolling over commercial paper? Didn't we learn anything about rolling over short term debt in 2008? Are we going to follow up by putting a stop to that? Why don't companies have more equity financing, on which they can just stop paying dividends?

"Investors" you say, it's not all the Fed. Read carefully. "By eliminating much of the risk..." The Fed props up prices, and removes risk. Then private investors will come in. The markets won't ride that bike without the Fed's hand on the saddle, apparently. Why do we bother to have private markets?

On March 17 the Fed started to lend again to primary dealers. These are the traders, much maligned by the Volcker rule.

The PDCF will offer overnight and term funding with maturities up to 90 days...Credit extended to primary dealers under this facility may be collateralized by a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities. 

Let's translate. You're the trading desk at, say Goldman Sachs. You want to buy stocks, as you think people are dumping in a hurry. Great, that's what traders are supposed to do: "provide liquidity." But, sadly, you're in the habit of of funding trading activity by borrowing money, short term. And you can't do that right now. So the Fed will now lend you the money to buy stocks, and will take the stocks as collateral! It's almost as if the Fed is buying stocks -- except you get the gains, and if you go under, the Fed gets the stocks! (A friend in the securities industry say nobody is bothering to investigate and price high grade corporates. The Fed is setting the prices.)

Again, the Fed is between a rock and hard place. Yes "balance sheets are constrained." Trading firms don't have enough equity to take on additional risk. The natural buyers at asset fire sales are constrained out of the market. Bail the Fed feels it must. But this is exactly what happened when the Fed first lent to broker/dealers in 2008! Why in the world are we in this position, 12 years after that crisis?

On March 20, the Fed expanded into state and municipal markets. The mechanism is the same: Fed lends to a financial institution, which buys the assets, and then gives the Fed the assets as collateral for the loan. Once again the point is  "enhance the liquidity and functioning of crucial state and municipal money markets."

On March 23, the Fed rolled out real artillery. Ominously, Treasury markets appeared "illiquid," so the Fed has stepped in buying $1.3 trillion in the first month -- more than the Treasury issued.  The Fed is funding Treasury borrowing with newly printed reserves.  The Fed now buys mortgage backed securities.

And now.. corporate bonds. This is well past 2008.

the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.

Translation: The Fed will buy new corporate bonds, thus directly lending to corporations. And it will buy  outstanding bonds.

Why would it do that? Well, to "provide liquidity." This is a word that ought to set off BS detectors. Yes, there is such a thing as an "illiquid" market. There is also such a thing as a market whose prices are dropping like a stone. Sell all you want but at 50 cents on the dollar. "I wish I had sold at yesterday's prices" is not illiquidity. You have to pay people a lot to take risk right now. Which is it? Hard to tell. There are ways to tell, of course. For example, illiquid markets have negative price autocorrelation -- a low price today bounces back. I am not aware of the Fed having applied this or any other test. (Research topic suggestion.)

Again, I don't want to criticize, but there sure is a danger of propping up prices under the guise of "illiquidity." The Fed's view that if the Fed takes all risk off the table "liquidity" will reappear is also pretty close to taking risk off the table so prices will rise.

The Fed is already buying new bonds from companies to finance their new expenditures. Propping up prices of existing bonds is a way to let old bondholders cash out at high prices, now before the deluge. Just why can't old bondholders even take mark-to-market losses?

And, if corporate bondholders need to be bailed out in this way, are we going to do anything about it going forward? Do you get to buy junk bonds, high interest municipal debt, and the Fed will let you out if anything bad happens?

Wrap up

OK, I haven't even gotten through March and the Fed is just getting going. Let's wrap up.

The Fed has felt the need to take over essentially all new lending in the economy. The Fed is also propping up most fixed-income prices. The Fed is deliberately removing risk from holding these assets.

Once again, I will be told, "this isn't the time to think about moral hazard." But having done this twice, the first time with huge protest, the second time as if it is perfectly normal, this is the pattern, and the moral hazard is there. The economy will load up on debt, especially short term debt. People will not keep stashes of savings around to provide liquidity or jump on buying opportunities. And the need for bailouts will be larger in the next crisis.

"But the Fed made money in 2008" you may retort. And it has a half chance of making money again. If the recession wraps up in September and these "loans" get paid back, it will do nicely. If the recession goes on a year and all these "loans" go sour, it will not look so pretty.

Yes, in 2008 the Fed and treasury successfully operated the world's largest hedge fund, printing money to buy low-price assets. But is this really the function of the Federal Reserve? Do we want it driving private hedge funds out of the liquidity provision business, by its ability to print rather than borrow money, and by the off-balance-sheet put that the US taxpayer will in the end take losses if this massively leveraged portfolio doesn't work out?

Where is the outrage? Where are the financial economists? Where is the reform plan so we don't do this again? At a minimum, can we say tha  the government could stop subsidizing debt, via tax deduction and regulatory preference for "safe" (ha!) debt as an asset?

Hello out there? In 2008, everyone was writing financial crisis papers. Now everyone is playing amateur epidemiologist.

Finance colleagues, you have a bigger crisis and intervention to study, and a deeper set of regulatory conundrums. Is everyone just too scared of sounding critical of the Fed? Get to work!

The Fed and Treasury's actions are telling us we are on the verge of financial apocalypse. Let's wake up and look at what's coming, especially if it doesn't all get better by September.

Some links 

This post continues from Financial Pandemic.

I had planned a longer post on the details of many of these programs, but this is long enough.


A great explanation by Robert McCauley in FT. Section heads include  1) Acting as a lender of last resort to securities firms, 2) acting as a lender of last resort to investment funds, 3) acting as a securities dealer of last resort, 4) acting as a securities underwriter of last resort and finally 5) acting as a securities buyer of last resort.

A simple tweet storm by Victoria Guida

Via the indefatigable Torsten Slok,

Financial Policy During the COVID-19 Crisis MIT opeds on financial affairs

A great list of policy trackers.

Financing Firms in Hibernation During the COVID-19 Pandemic

The Yale Financial Stability Tracker and especially the Finance Response Tracker are very useful list of what's going on.

Fed Intervention in the To-Be-Announced Market for Mortgage-Backed Securities
by Bruce Mizrach and Christopher J. Neely is a very nice description of what's going on there

The United States as a Global Financial Intermediary and Insurer by Alexander Monge-Naranjo. More contingent liabilities waiting for Uncle Sam bailouts.

A data set of international fiscal responses

New paper: fiscal theory of monetary policy

A second new paper: "A fiscal theory of monetary policy with partially repaid long-term debt."

By "fiscal theory of monetary policy" I mean a model with standard DSGE ingredients, including inertemporal optimization and market clearing, monetary policy described by interest rate targets, price or other frictions, but closed by fiscal theory, "active" fiscal policy rather than "active" monetary policy.

I aim to build a standard simple but somewhat realistic model of this sort, a parallel to the three equation textbook model that has been part of the new-Keynesian tool kit since the 1990s. I keep the model as simple and standard as possible, so the effect of the innovations one the fiscal side are clearer.

Two parts of the specification are central. First, long-term debt allows the model to produce a negative response of inflation to interest rates. Long-term debt also allows a fiscal shock to result in a protracted inflation, which slowly devalues long term bonds, rather than a price level jump.

Second, and most important, the paper writes down a process for fiscal surpluses in which today's deficits are partially repaid by tomorrow's surpluses. Look quickly at the surplus response functions in my last post. When the government runs a deficit, it reliably runs subsequent surpluses that partially repay some of the accumulated debt. The surplus is not an AR(1)! It has an s-shaped response function.

So if you want a realistic fiscal theory model, you need a surplus with an s-shaped response function, but you need to keep "active" fiscal policy. This combination is the central innovation of the paper.