Mulligan and the demand for opioids

This is another post from an Economic Policy Working Group meeting at Hoover, in which simple undergraduate supply and demand analysis, creatively applied, leads to a surprising result.  

Casey Mulligan presented "Prices and Policies in Opioid Markets." Paper, slides and video of the presentation.  (Updated link now works) 

Once prescription opioids became an evident crisis, the government took steps to restrict the supply, raising the price. Yet opioid consumption and overdoses went up. Explain that Mr. Chicago economist! 

Here's the clever answer: 

There are two ways to buy opioids, 1) legally or semi-legally; i.e. get opioids that come from pharmaceutical companies and are prescribed to someone by a doctor or 2) illegally. 

There is a fixed cost of entering the illegal market. .".Avoiding theft, acquiring self-dosing skills, or overcoming fear of needles. ...establishing a trusting relationship with a drug dealer...." But the cost per dose of illegal drugs is typically less than for legal drugs. 

So, imagine a drug user starting at B. At that price for legal (red) and illegal (black) drugs, the user chooses legal drugs at point B. Now raise the price of legal drugs, as shown by the arrow. If the user stayed with legal drugs, he or she would use less. But now there is an option, incur the fixed cost and buy illegal drugs on the black line. At the higher price for legal drugs that makes sense. But since the marginal cost of illegal drugs is lower, once the user has overcome the fixed cost, he or she uses more. 

Raise the price, and they consume more (of a substitute). 

Short and long run minimum wage

On Wednesday, Erik Hurst presented a lovely paper, "The Distributional Impact of the Minimum Wage in the Short and Long Run," written with Elena Pastorino, Patrick Kehoe, and Thomas Winberry, at the Hoover Economic Policy Working Group seminar. Video (a great presentation) and slides here. 

This is a beautiful and detailed model, which won't try to summarize here. I write to pass on one central graph and insight. 

Suppose there is some "monopsony power," at the individual firm level. Don't argue about that yet. Erik and coauthors  put it in, so that there is a hope that minimum wages can do some good, and it is the central argument made by minimum wage proponents. In the paper it comes because people are uniquely suited to a particular job for personal reasons. Professors don't like to move, they've figured out the ropes at their current university, so the dean can get away with paying less than they could get elsewhere. Why this applies to MacDonalds relative to the Taco Bell next door is a good question, but again, the point is to analyze it not to argue about it. 

"Labor demand" here is the marginal product of labor. (\(f'(N)\) It's what labor demand would be in a competitive market. The monopsnists' demand is lower). Monopsony means that the "marginal cost of labor" rises with the number of employees. There is a core of people that really love the job that you can hire at low cost. As you expand, though, you have to hire people who aren't that attached to this particular job, so you have to pay more. And you have to pay everyone else more too, (by reasonable assumption -- no individually negotiated wages), so the average cost of labor rises. 

Thus, the monopsonies firm chooses to hire fewer people \(N_m\),  produce less, and pay them a wage \(W_n\) below their marginal product.  ("Average cost of labor" is really the labor supply curve, call it \(w=L(N)\). Then \(\max (f(N)-wN\) s.t. \(w=L(N)\) yields \(f'(N)=w+NL'(N)\). The "marginal cost of labor" in the graph is this latter quantity: the wage you pay the last worker, plus all workers times the extra wage you must pay them all. Disclaimer: the equations are me reverse-engineering the graph.) 

Now, add a minimum wage. As the minimum wage rises above \(W_m\), we initially see a rise in the number of workers, and their incomes. The firm moves along the arrow as shown. (\(\max f(N)-wN\) s.t. \( w \ge L(N)\), \( w \ge w^\ast\) gives \(w^\ast = L(N)\) .) 

Keep raising the minimum wage, though. Once we get past the point that labor supply ("average cost of labor") requires a wage greater than the marginal product of labor, the firm turns around and hires fewer people: 

Trust Fund

The Social Security Trust fund is set to run out in a few years. Who cares? Is the total US Federal debt $31,456,554,630,496.28, including Treasury debt held by the Social Security trust fund and other agencies?  or is it "only" $24,629,050,125,670.81 held by the public? (Source.)

I've been mulling these questions over, prodded by conversations with some colleagues. 

The "trust fund" exists because for a while, Social Security taxes were larger than Social Security payments. Social Security used the extras to buy Treasury debt. Now there are fewer workers, more retirees and more generous benefits, so Social Security taxes are smaller than payments. Social Security sells off its "trust fund." And it seems we're in trouble when the "trust fund" runs out.  

But that's not how it works at all. Treasury debt is not an asset like a stock or bond, or Uncle Scrooge's pool of gold coins. Treasury debt is a claim against future income taxes. Cashing in Treasury debt just  means paying for benefits with income taxes. 

The ups and downs of the trust fund just reflect a change in how we finance spending. While payroll taxes > social security spending, which was the case until 2007, then payroll taxes are financing other spending. When payroll taxes < social security spending, then income taxes or increases in debt are financing social security spending, which (graph below) was the case after 2008.* The trust fund just adds up this change over time. But exhausting the trust fund is, in this view, really irrelevant. 

source: CBO

That doesn't mean we can all go to sleep, for two reasons. First, when payroll taxes < Social Security outlays, and the trust fund is winding down, then income taxes or additional public debt must finance the shortfall. The government has to spend less on other things, raise income tax receipts, or borrow which means raising future taxes. And, per the graph, the numbers are not small. 1% of GDP is $230 billion. The extra strain on income taxes, other spending, or debt, happens right now, when the trust fund is positive but decreasing. 

Zero matters only because by law,  when the trust fund goes to zero, Social Security payments must be automatically cut to match Social Security taxes. That's the sudden drop in the graph. The program was set up as if  the trust fund were buying stocks and bonds, real assets, and would not lay claim on income tax revenues. But it was not; social security taxes were used to cover other spending, and now income taxes must start to pay social security benefits. 

What happens when the trust fund runs out, then?  Congress has a choice: automatically cut benefits, as shown, or change the law so that the government can pay Social Security benefits from income taxes, or, more realistically, by issuing ever more debt, until the bond vigilantes come. (Or raise payroll taxes, or reform the whole mess.) I bet on change the law. 

So what's the right measure of debt? It's conventional to look only at debt in public hands. But there is a case to look at the total debt, i.e. including the trust funds. Those are the total claims against the income  tax. Looking at it this way, however, one could also go on and count unfunded future social security benefits as a debt -- the present value of the difference between the two lines above, which leads to immense numbers, per Larry Kotlikoff. 

I have usually not considered the present value of unfunded promises as "debt," because Congress can change the payments at any time. Changing debt repayment to the public is a default, with financial and legal consequences; changing social security benefits is legislation. You can't sell your future social security benefits as you can sell your treasury debt. The trust fund is half way on this scale. What would be the consequence of a haircut or rescheduling of trust fund debt? Would that trigger something like cross-default clauses in corporate debt? I don't know. The event is unlikely anyway. The left pocket defaulting on the right pocket doesn't help pay the bills. The trust fund is certainly unlikely to run, and its debt is not used as collateral in financial transactions. As a somewhat meaningless accounting identity, it's a lot less "debt" than the debt in public hands. 

I think this all goes to remind us that paying off the existing debt is not the US central fiscal problem. The central problem is vast unfunded future promises. Defaulting or inflating away current debt does nothing to fund those promises. 

I look forward to comments on this one, especialy if there are standard views on these apparently simple questions that I'm not aware of. 

*In the end,  

payroll taxes + income & other taxes + increase in public debt = Social Security spending + other spending. 

The trust fund nets out. 

Fair/consumption tax adjustment

The main (vocal) comment on my consumption/fair tax post and oped  has been to complain about retirees who have earned income, paid taxes, saved, and now must pay consumption taxes on what they buy with the proceeds. 

When writing an oped, one tries to anticipate a few objections, but not to overdo it. I left this one out because it surely seemed an easy exercise for the reader. This is a problem easily solved with money. If the consumption tax is 30%, then the government can top up retirement savings by 30%. Done. 

It obviously need not be that generous. First, old savers will benefit by not having to pay capital gains tax and estate tax on their savings. That almost adds up to the consumption tax right there! So at best they need a subsidy only equal to the difference between the new consumption taxes and what they will save from the absence of all other taxes. Second, the market is likely to boom. So, subsidy only to the value of investments on the day before the tax is announced. Third, this only applies to old savers. Fans of wealth taxation should be lining up for the consumption tax as it hits high wealth accumulators most! (There is an interesting question whether the CPI will include the consumption tax or not. If so, social security is immediately indexed and rises to pay the tax, thereby greatly benefiting seniors who no longer pay income taxes on social security.) 

But more importantly, in the big government intergenerational transfer scheme, current old people who have saved money came out pretty well. They get a lot more out of social security and medicare than they put in, and a lot more than young people will ever see. Whatever the benefits of 100% debt to GDP are, they got them and their grandchildren will pay them. If one is arguing on distributive justice, leaving the poker game just after you scored a big hand, and then crying about taxes is a bit unseemly.

And I'm sure that's only the beginning. Every reform has winners and losers. Tax lawyers and accountants are going to do terribly!  I assume some muddy mess will emerge to compensate old savers and other politically organized losers.  Government and politics are about transfers. Economics is about incentives. If every change must be completely Pareto optimal, we might as well go back to subsistence farming. 

Fair tax oped

An Oped in the Wall Street Journal on the "fair tax" proposal. As usual, I have to wait 30 days to post the full version 

The bill eliminates the personal and corporate income tax, estate and gift tax, payroll (Social Security and Medicare) tax and the Internal Revenue Service. It replaces them with a single national sales tax. Business investment is exempt, so it is effectively a consumption tax.

I've been writing about consumption taxes for a while. Some previous posts on these points,  VAT (WSJ), A progressive VAT, Consumption tax, Tax reform, Taxes, Alternative Minimum Tax, also  Wealth and Taxes Convexification and complication Tax graph Economists and Taxes Corporate tax burden Tax Reform Tax reform again (WSJ) Corporate tax reading list Corporate tax (zero) Trump taxes 2 Those address a lot of the what ifs and whatabouts. 

But it's not progressive! (Meaning, better off people pay the same rate, not the same amount, not "politically progressive"). 

Already the "fair tax" proposal adds 

Each household would get a check each month, so that purchases up to the poverty line are effectively not taxed.

Yes, effectively universal basic income from Republicans! One could do more. And as in the above forest of links there are plenty of ways to make a consumption tax as progressive as you'd like. 

But the most important point, with added emphasis: 

the progressivity of a whole tax and transfer system matters, not of a particular tax in isolation. If a flat consumption tax finances greater benefits to people of lesser means, the overall system could be more progressive than what we have now. A consumption tax would still finance food stamps, housing, Medicaid, and so forth. And it would be particularly efficient at raising revenue, meaning there would potentially be more to distribute—a point that has led some conservatives to object to a consumption tax.

RIP Indexed Bonds in Canada

(An oped at Globe and Mail with Jon Hartley) 

Finance Minister Chrystia Freeland recently announced that the government of Canada  will no longer issue inflation-protected “real return” bonds. A kerfuffle erupted.

The government may wish to avoid inflation-protected bonds, because it thinks inflation will get a lot worse than markets do. But betting in markets is not a responsible strategy.

If the government won’t do it, corporations, banks and financial institutions should issue these bonds themselves rather than just complain. Not every asset must be provided by the government.

Real return bonds adjust both principal and interest for inflation. If inflation goes up, you get more money back. Nice. But when everyone expects inflation, you pay a commensurately higher price ahead of time.

The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 

Updates:

Chris Russo wrote in Barrons Sept 2021 reporting on internal Fed strategizing for this event. 

The Fed will treat defaulted Treasury obligations the same as non defaulted obligations. Their regulatory treatment will remain the same including capital requirements and risk weights. Moreover these securities "will not be adversely classified or criticized by examiners." 

Policy makers would "presumably want to avoid the impression that the Federal Reserve was effectively financing government spending." 

The Fed will 

transact with defaulted securities at market prices

Eventually 

The Fed could move the defaulted securities on to its balance sheet [English translation: buy] ...this set of options is the most contentious. Powell described them as "loathsome"... the institutional risk would be huge. The economics of it are right but you'd be stepping in to his difficult political world and looking like you are making the problem go away. Lacker called it "beyond the pale." John Williams... supported keeping those options on the table. ...no Fed governor categorically rejected the third option. 

As I read it, this is considerably less than what I described. The Fed worries here about not inadvertently forcing individual banks to treat treasury assets as defaulted securities, which is good. But the main issue is whether financial markets, many not banks, will accept treasury collateral for lending, or whether we have as in 2008 a grand unwinding of the chain of short-term financing due to lack of collateral. Only the "loathsome" option addresses that issue as far as I can see. And if you want to stem a collateral run, it's best to clarify ahead of time. 

Casey Mulligan inquired

I am confused about your proposal.  Fed is part of the government. With currency in circulation not (?) counting against the debt limit aren't you suggesting the Treasury debt be (contingently) replaced with currency? Or would the Fed be defaulting on whatever asset it lends out?

Boy, if I didn't explain it well enough for Casey, I must really need a remedial writing course. Answer/clarification: 

Sorry if not clear. Fed can buy / lend against existing treasury debt, in default, and offer cash/reserves in exchange. This solves the financial crisis issue. It does not allow the treasury to borrow more, or the Fed to finance deficits. 

A fiscal theory fest at AEI, launch podcast, and official release.

Mark your calendars! February 28th 3:00 PM eastern the AEI's Michael Strain will host a zoom event on Fiscal Theory of the Price Level. Info and registration here. 

This event will be particularly good because Michael convinced Robert Barro, Tom Sargent, and Eric Leeper to come and discuss. These are the giants on whose shoulders I meekly stand. 

Robert Barro did the modern version of "Ricardian Equivalence." If people look at government debt and understand that there will be taxes to pay it off, they save and the deficit (with lump sum taxes) has no effect. He also did the modern version of tax smoothing. It is good government policy to borrow in bad times, and repay in good times, with steady low taxes, rather than raise distorting tax rates a lot in bad times. Both underlie fiscal theory,  

Tom Sargent, with Neil Wallace wrote “Unpleasant Monetarist Arithmetic,” the cornerstone of the modern fiscal theory. They pointed out that if fiscal policy is stuck in deficits, monetary policy can only choose to inflate now or inflate later. Tom went on to write many fantastic papers on the theory of fiscal-monetary interactions, and on their place in economic history. His "ends of four big inflations" showed that the great post WWI hyperinflations ended when the fiscal problem was solved, involving no monetary stringency. A good lesson, now mostly forgotten in the widespread view that ending inflation must come with misery. His Nobel speech “United States Then, Europe Now” is a great example of historical work. In my view, the Nobel Committee should have given him a prize for monetary-fiscal interactions, which is even better than the econometric work they cited. Maybe he'll be the first economist to get two.    

Eric Leeper is the original innovator of the modern fiscal theory in his paper "Equilibria under ‘active’ and ‘passive’ monetary and fiscal policies. " Eric put fiscal theory in the context of interest rate targets, r rather than money supply, which is how all our central bankers operate, and includes nominal rather than real debt. Thus, he integrates fiscal theory with how our monetary policy actually works, creates the essential model of inflation under interest rate targets, and integrates fiscal theory with modern new-Keynesian or general equilibrium models that are 99% of all applied work. 

I'm going to try to be as brief as possible so we can hear from these amazing economists, plus Michael, no slouch himself. This much talent can't possibly sit still and not say things that are a bit critical, and thought provoking. 

****

Vince Ginn of the "Let People Prosper" Podcast did a very nice interview on FTPL.  Like many economists, Vince has a good monetarist heart, and explaining the difference between FTPL and monetarism was useful for me. 

****

As of January 17, The Fiscal Theory of the Price Level is formally released! Along with this good news, I have some bad news -- I have to take down the free version on my website. However, keep that in mind for the (sadly) evolving typo list, sample chapters, online appendix, follow on essays, and revisions as they come. I already have a revised Chapter 5 posted, which does a better job of introducing fiscal theory in standard new-Keynesian models. 

Two points on the debt limit, 1 serious 1 fun

Everyone keeps repeating that hitting the debt limit would necessitate a default on principal and interest. The Treasury itself says 

Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.   

The first statement is correct. The second is not. The government is still hauling in tax revenues. The Treasury could easily say "given the catastrophe that a default would produce, we will always pay interest and principal on treasury debt before any other payment." Congress could pass a law stating that fact. There is no economic reason  that a debt limit should force a default. 

There is a legal argument, and a claim that the Treasury cannot prioritize debt payments over other legally mandated payments. In the research I've been able to do however, this is a very uncertain claim. And it makes no sense. The Treasury is legally obligated to make debt payments, as it is obligated to pay Social Security checks, and also legally obligated not to borrow. Law prescribes the impossible. It has to prioritize. Indeed, unpaid bills are a form of debt, so if you want  to be a stickler, the government will violate the debt limit no matter what it does. 

The second statement is false. The US has defaulted on  gold clauses in the 1930s. It has defaulted on other "legal obligations."

The third is correct, and appropriate. If we are to tussle over paying Wall Street fat cats vs. grandma's social security, keep in mind just what a catastrophe default would be. Grandma will be way worse off if that happens. Treasury debt is now the golden collateral, supporting most of the financial system. (We should have a financial system much less dependent on short term collateralized borrowing, but that's another story.) If in default it would not be. Worse, and most important here, if financial markets suspect a default will really happen, they will start refusing to accept treasury collateral in the first place. This is basically what happened in 2008 with mortgage backed securities. They didn't fall to pieces,  they just weren't acceptable as collateral any more. 

A flight from treasury collateral under a debt limit would be far worse. And the government's magic tonic, borrow a ton and bail everyone out, would be unavailable. 

Perhaps Treasury thinks that by threatening default, they can get Congress to wake up and raise the debt limit promptly. But this risks Wall Street also believing the threat and causing the panic you're trying to prevent. 

Treasury secretary Janet Yellen should say out loud, right now "we pay principal and interest on treasury debt first, before anything else." President Biden should back her up. Drastic delays in social security, medicine, government shutdown and more are plenty enough threat to get Congress to move, without risking a run. 

States with balanced budget rules are interesting legal precedent. The State of Illinois, while I was watching, simply delayed payments, often by years. It paid its bonds on time. That isn't a good outcome of course, but it represents the State's choice of how to handle the legal requirement to pay vendors and to pay interest and principal on bonds. Other states have defaulted as have cities and counties. And countries. 

*****

Now for fun. Just print money, some say. Fortunately, our legal system is full of mechanisms to prevent the government from printing money instead of borrowing it. The treasury has to issue debt; the Fed has to buy it,  and thereby give the Treasury new money to spend.  That violates the debt limit. But Treasury can create coins. So, last time, the fun suggestion of $1 trillion dollar coins came up. 

Here is a novel proposal in the same sprit. The debt limit is calculated based on face value, not market value of debt. A bond promising $100 in 10 years and $3 coupons from now to then counts as $100 of debt. So issue perpetuities. Or, more realistically, issue coupon only debt.  The government could issue a bond that pays a $3 coupon for 30 years and no principal payment. As things are now calculated, that bond adds zero to the debt! 

Like the trillion dollar coin, this proposal so clearly violates the spirit of the debt limit that I doubt serious people would do it. It does point to a serious shortcoming in how the Treasury calculates debt however. Most of the time Treasury issues debt at par, borrowing $100 and promising to repay $100 in 10 years. Then the distinction does not matter. But the formulas should be fixed. 

Disclaimer: I'm not an expert on the law of the debt limit. If these points are in error, let me know and I'll issue a "never mind." 

****

To clarify, this is just a fun way to get around the debt limit if one wants a fun way to do it. It's not obvious that getting around the debt limit is a good idea. What is the justification for running primary deficits right now? No, I'm not a balanced budget nut. In times of crisis, war, pandemic, and recession, the government should borrow, for standard tax-smoothing reasons. But then the government should repay the debt. When the economy is humming and there is no crisis on, we should be running small steady primary surpluses. That is now. One has to argue that yes, we should get there, and stop borrowing in good times,  but it's too hard to do all of a sudden. But just what are those adjustment costs? A crisis is a terrible thing to waste. Today is as good a day as any to clean up the US long term fiscal mess. It's not clear to me that Washington does anything better if it takes a long time to do it. 

 

Waning inflation, supply and demand.

 

Source here. 

Inflation seems to be waning. The conventional change from a year ago: 

The month to month changes now suddenly more popular on the way down than it was on the way up: 

I generally don't make predictions -- unconditional forecasting is a fraught game in economics. But I have been as far out on a limb this year as I ever have in thinking this is possible and even likely. 

Cheers for Powell

 Jay Powell's Stockholm speech lays it out with Gettysburg address clarity and brevity. Relative to usual central-bankerese it's soaring rhetoric too. 

...Decisions about policies to directly address climate change should be made by the elected branches of government and thus reflect the public's will as expressed through elections.

... without explicit congressional legislation, it would be inappropriate for us to use our monetary policy or supervisory tools to promote a greener economy or to achieve other climate-based goals. We are not, and will not be, a "climate policymaker."

Strassel insight, and cheers for a long speaker tussle

I'm a policy wonk, but I care very little about politics, who is up and who is down. The house speaker voting coverage has been largely the latter, with no more than the usual tropes about "normal Republicans" vs. "Radicals" suffused with Trump-loving election-denying fervor.  

The WSJ's Kim Strassel, whose fact-filled columns are always a delight, explains that there actually are important issues at stake here: 

Committees barely function. Members have no ability to debate or amend. Leaders disappear into back rooms to cook up mammoth bills that are dropped on the floor for last-minute take-it-or-leave it votes. Add Mrs. Pelosi’s Covid “proxy” voting rules, and most of the House didn’t even bother to clock in.

Under the proposed new rules package, committees are back in charge of legislation, with rules designed to ensure that bills address single subjects—rather than catch-all legislation. It similarly gives members new power to challenge amendments that aren’t related to the topic at hand. And it revives “Calendar Wednesday,” whereby any committee chairman can bring a bill straight to the floor.

It includes new provisions for accountability and transparency. Proxy voting is history, as are virtual committee meetings. It requires a 72-hour rule to give members time to read legislation. It ends Democrats’ wild experiment with staffer unionization, which threatened to tie the chamber up with crazy demands. 

Fun Fisherian Graph

In working on a revision to fiscal theory of the price level chapter 5 on sticky price models, and a revision of "Expectations and the neutrality of interest rates" I came up with this fun impulse-response function. It  has an important lesson about interpreting impulse response functions.

It's a response to the indicated interest rate path, with no change in fiscal policy, in a simple new-Keynesian model with short-term debt. 

Rational expectations new-Keynesian models have the implication that higher interest rates raise inflation in the long run. They also tend to raise inflation in the short run. I've been looking for better mechanisms by which higher interest rates might lower inflation in the short run in these models, without adding a contemporaneous fiscal austerity as standard new-Keynesian models do. Fiscal theory explores a model based on long-term debt that does the trick, but has a lot of shortcomings. So I'm looking for something better. 

This graph has only short term debt. I generate the pretty interest rate response by hand. It follows \(i_t=30e^{-1.2t}-29.5e^{-1.3t}-0.05.\) Then I compute inflation and output in response to that interest rate path. 

Wow! Higher interest rates lead to high real interest rates,  send inflation down, and create a little recession. Once inflation is really lowered, the central bank can lower interest rates. The price level (not shown) falls nearly linearly, as we often see in VARs.   

Doesn't this look a lot like the standard story for the 1980s? A big dose of high real rates lowers inflation, and then the Fed can follow inflation downward and get back to normal at a lower rate. 

That analysis is totally wrong!  In this model, a higher interest rate always leads to higher inflation in both the short and the long run.  Inflation is a two-sided moving average of interest rates with positive coefficients. Inflation declines here in advance of the protracted interest rate decline starting in year 2. Lower future interest rates drag inflation down, despite, not because of the rise in interest rate from year 0 to year 2, and despite, not because of the high real interest rates of that period. Those high real rates add interest costs on the debt and are an inflationary force here.  If the central bank wants a disinflation in this model, it will achieve that sooner by simply lowering interest rates immediately. The Fisherian effect will kick in faster, and it will not be fighting the fiscal consequences of higher interest costs on the debt. 

Beware facile interpretations of impulse-response functions! It would be easy to read this one as saying high interest rates bring down inflation and cause a recession, and then the central bank can normalize. But that intuition is exactly wrong of the model that produces this graph.  

The model is \[ \begin{align*} E_t dx_{t} & =\sigma(i_{t}-\pi_{t})dt\\ E_t d\pi_{t} & =\left( \rho\pi_{t}-\kappa x_{t}\right) dt \\ dv_{t} & =( rv_{t}+i_t-\pi_{t}-\tilde{s}_{t}) dt  \end{align*}\] Parameters are \(\kappa = 0.1, \  \sigma = 0.25,\   \rho = 0.1,\ r = 0.01.\) I used a lot of price stickiness and an unrealistically high \(\rho\) to make the graph prettier.  

Update: For Old Eagle Eye. I'm plotting an impulse response function. Variables start at zero, there is one shock, then we solve the deterministic version of the model. The system has two variables with expectations, and two unstable eigenvalues. So we solve forward to determine the initial conditions uniquely. All explained in FTPL, see especially the new Chapter 5 and pointer to the Online Appendix with formulas. 

Fiscal-monetary interaction

An email correspondent sent the above graph. The title is [Federal Reserve] Liabilities and Capital: Liabilities: Earnings Remittances Due to the U.S. Treasury.

The Treasury pays the Fed interest on the Fed's asset holdings. The Fed pays interest on reserves to banks and to other financial institutions that have, effectively, deposits at the Fed. As long as Treasury interest is greater than interest the Fed pays, the Fed makes money. It spends some, and returns the interest to the Treasury. The Fed also issues cash, which pays no interest, so the Fed makes steady money on the difference between interest bearing assets and the zero return of cash. 

But when short-term rates the Fed pays rise sufficiently above the Fed's interest earnings, the Fed loses money. It stops sending interest earnings to the Treasury. The graph is in essence the amount the Fed owes the Treasury in this scheme. Usually the Fed makes some money -- the graph goes up -- then the Fed pays out to the Treasury and the graph goes back to near zero. When the Fed loses money, the Treasury doesn't send a check. Instead, the Fed accumulates its losses, $16 billion so far. The Fed then will wait to make this amount back again before it starts sending money back to the Treasury. 

Calomiris on Gramm Ekelund and Early on Income Distribution.

Charles Calomiris has a splendid WSJ review of a great book, "The Myth of American Inequality" by by Phil Gramm, Robert Ekelund and John Early.

It is a "'a truth universally acknowledged,' according to the Economist magazine in 2020" that 

little progress has been made in raising average American living standards since the 1960s; that poverty has not been substantially reduced over the period; that the median household’s standard of living has not increased in recent years and inequality is currently high and rising 

Most of all the last one. 

All of this is false. Most of all the last one. 

1) Income. The central jaw-dropping, astonishing fact: The statistics you read about income and income inequality ignore taxes and transfers. By doing so, of course, they create a problem that is immune to its purported solution! 

FTPL revised Ch. 5 draft

The book isn't out yet, but I can't help myself... A revised draft of Chapter 5, fiscal theory in sticky price models is up on my website here. Giving talks over the last year and writing some subsequent essays, I see clearer ways to present the sticky price models.  Bottom line, these three graphs provide a nice capsule summary of what fiscal theory is all about: 

Response of inflation, output and price level to a 1% deficit shock, with no change in interest rates. Bondholders lose from a long period of inflation above the nominal interest rate. Inflation goes away eventually on its own. 

Stanford hates fun

Source: Stanford Daily

Stanford hates fun is the title of the second Stanford article in the Wall Street Journal this week. (On the first, Stanford's guide to acceptable words, enough said already.) 

This has been bubbling up for a while. Last June, Ginevra Davis wrote a powerful article in Palladium, "Stanford's war on social life." She recounted how the slightly transgressive Stanford atmosphere in the 90s, which seeded the slightly transgressive get it done attitude of tech in the early 2000s, is being smothered by the Administration. For example, back in the early 90s, 

...The brothers were winding down from Kappa Alpha’s annual Cabo-themed party on the house lawn.... a day-to-night extravaganza that would start sometime in the morning and continue long after midnight. The girls wore bikini tops and plastic flower leis, and the boys wore their best Hawaiian shirts.

Uh-oh, I can already smell trouble if you tried that today. But the point,  

That year, the brothers had filled the entire main level of Kappa Alpha’s house with a layer of sand six inches deep. The night was almost over; the guests were leaving and the local surf rock band had been paid their customary hundred dollars in beer. The only question was what to do with all the sand.

No one remembers who had the idea to build the island. A group of five or six brothers managed the project. One rented a bulldozer...

Later that year, the brothers installed a zipline from the roof of their house to the center of the island. They also built a barge, which they would paddle around the lake on weekends and between classes.

More generally 

Through the late 1990s, Stanford ... featured a wacky campus culture that combined collegiate prep with West Coast laissez-faire. Stanford was home to a rich patchwork of wild and experimental campus life. Communal living houses (“co-ops”) encouraged casual nudity, while fraternities threw a raucous annual “Greek Week” and lit their houses on fire. Until 2013, Stanford hosted a fully student-run anarchist house, where residents covered the walls with eccentric murals. 

Today, 

The Kappa Alpha boys have been kicked out of their old house. Lake Lagunita was closed to student activities in 2001,...

...In less than a decade, Stanford’s administration eviscerated a hundred years of undergraduate culture and social groups. They ended decades-old traditions. They drove student groups out of their houses. They scraped names off buildings. They went after long-established hubs of student life, like fraternities and cultural theme houses...

Expectations and the neutrality of interest rates video

I revised "Expectations and the neutrality of interest rates" and presented at the Hoover Economic Policy workshop. Thanks to the great Hoover team, here it is by video. If the embed doesn't work, here's the Hoover webpage with the video. The updated paper and slides are here. 

CDC, more on politicized agencies

Continuing a series on rot and politicization in administrative agencies... "Sure" comments on Marginal Revolution are fascinating. My excerpts:

The reasons you cannot change the CDC have little to do with remote work.  The major issues are:

2. It is overrun with academics....Many look at the CDC as complementary to an academic career and even the lifers have CVs at least compatible with going academic. This means a lot of the work product and setup is geared more toward publication, conference presentation, and deliberative work rather than rapid response.

A similar culture pervades the Fed. Fed researchers primarily regard the Fed as a home to write publications that will advance an academic career, with "policy work" culturally degraded. Both Board and regional Feds have developed into quite good centers for academic economic research, which seems overall a good thing, but one wonders just why the central bank should funnel what is in the end taxpayer money to this endeavor. However it also means that when inflation surges to 8%, nobody saw it coming, and we wonder why.  

3. The place has gone monocultural. ...Since 2015, their political donations have been 99.94% to Democrats. This means that they get bogged down in the latest vanguard concerns of the Democratic base and that they are increasingly ignorant about and isolated from the bulk of the populace. Things that make some sense in dense urban corridors where few people get dirty at work make little sense in sparsely populated areas with significant morbidity burdens from work.

Second great experiment second update

The November CPI is in, and inflation continues to moderate despite interest rates that, while rising, are still below current inflation. The great experiment seems to be working out, at least for now. (Previous post, with links to earlier writing.)