Interest-paying money is not inflationary

(With credible fiscal policy, of course.)  Another interesting case, from JP Koning's Blog "Moneyness"

RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below. 

(Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)

Koning describes the lack of inflation as a result of the perceived "permanence" of the increased reserves. I think it comes from the fact that reserves pay interest -- as they do in New Zealand. Either way, the point is that banks and people are happy to sit on interest-paying money, in enormous quantities, just as they are on bonds.

More Cash and Zero Bound

In my last post I started thinking about how options other than currency enforce a zero bound. Imagine there is no more currency, and the Fed tries to impose -5% interest rates. You put in a dollar, you get out 95 cents. What other ways are there to guarantee that if you put in a dollar you get back a dollar? (In my last post, I also pointed out that in each case rules or laws could be changed, but that the magintude of the required changes was pretty big.)

 From Kenneth Garbade and Jamie McAndrews in a nice Liberty Street Economics blog post

• Certified check. Go to the bank, tell the bank to write you a $10,000 certified check. Put it in your sock drawer. (More: "Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees.")

Or, inspired by that: 

• Don't cash checks. Every 90 days, call up, say you lost the check, ask them to reissue it. 

Clumsy. But as Ken and Jamie point out, it's very easy for a company to get started that does this, and offer fixed-value accounts to clients, beating the -5% at banks. Or, even in today's super-regulated environment, maybe banks could figure out to do this. After all, the Medici figured out in the 1400s to write offsetting bills of exchange to synthesize interest.

So, the project will mean changing the rules and laws governing checks, going back hundreds of years.

An earlier post by Todd Keister:

• Money market mutual funds.

Currently money market funds promise fixed value, and pay positive interest.  They are not set up to charge negative interest, or to allow capital losses. Maybe they should -- I've argued for floating NAV -- but they don't. The Fed kept the 0.25% rate on reserves precisely so banks and money market funds didn't have to reinvent themselves in ways that allow capital losses or negative rates. 

Miles Kimball has also been writing in favor of negative nominal rates and thinking about the zero bound. One post is here. 

Cancel currency?

Ken Rogoff has  an interesting NBER Working paper "Costs and Benefits to Phasing Out Paper Currency."

Ken would like to get rid of paper currency in favor of all electronic transactions. I'm a big fan of low-cost electronic transactions using interest-paying electronic money. But I'm not ready to give up cash. 

Ken has two basic points: The zero bound, and tax evasion / illegal economy. 

Ruble Trouble

On Russia, the fall of the Ruble.

This is an interesting event on which to test out our various frameworks for thinking about macroeconomics and monetary economics.

Theories

There are three basic perspectives on exchange rates.

1. Multiple equilibria. Lots of words are used here, "speculative attacks," "sudden stops," "hot money," "self-confirming equilibria" "self-fulfilling prophecies" "contagion" and so on. Basically, the exchange rate can go up or down on the whims of traders. There is often some news sparking or coordinating the bust.  Some of the mechanism is like bank runs, pointing to "illiquidity" rather than "insolvency" as the basic problem.

This has been a dominant paradigm since the early 1990s. I've been a bit suspicious both on the nebulousness of the economics (lots of buzzwords are always a bad sign), and since the analysis seems a bit reverse engineered to justify capital controls, currency controls, (i.e. expropriation of middle-class savers and poor currency-holders), IMF rescues, and lots of nannying by self-important institutions and their advisers who will monitor "imbalances," "control" who can buy or sell what, and so forth. But models are models and facts are facts.

2. Monetary. Exchange rates come from monetary events, and primarily the actions of central banks. For example, much of the analysis of the dollar strengthening relative to euro and yen attributes it to the idea that the US Fed has stopped QE and will soon raise rates, while the ECB and Japan seem about to start QE and keep rates low.

3. Fiscal theory. Exchange rates come fundamentally from expectations of future fiscal balance of governments; whether the governments will be able and willing to pay off their debts. If people see inflation or default coming, they bail out of the currency, which sends the price of the currency down. Inflation follows; immediately in the price of traded goods, more slowly in others.

Craig Burnside, Marty Eichenbaum and Sergio Rebelo's sequence of papers on currency crises, starting with  JPE "Prospecitve Deficits and the Asian Currency Crisis" (ungated drafts here) was big in my thinking on these issues. They showed how each crisis involved a big claim on future government deficits.  Prices fall, banks get in trouble, governments will bail out banks, so governments will be in trouble.  Inflation lowers real salaries of government workers. And so on.

The "future" part is important. Earlier work on crises noticed that current debts or deficits were seldom large, governments in crises often had surprisingly large foreign currency reserves, and there were no signs of sudden monetary loosening.  This earlier absence of a cause problem had led to much of the multiple-equilibrium literature. But money is like stock, and its value today depends on future "fundamentals."

Monetary and fiscal views are related. The question really is whether the central bank can stop an inflation and currency collapse by force of will, or whether it will have to cave in to fiscal pressures.

Most basically, a currency, like any asset, has a "fundamental" value, like a present value of dividends; it may have a "liquidity" value, like money; and it may have a "sunspot" or "multiple equilibrium value." The question is, which component is really at work in an event like this one -- or, realistically, how much of each? The money and fiscal views also much more clearly bring the currency into the picture.

So, as I read the stories of Russia's troubles, I'm thinking about which broad category of ideas best helps me to digest it. You can guess which one I think fits best. Yes, everyone likes to read the paper and see how it proves they were right all along. But at least being able to do that is the first step.

Inequality at WSJ -- the oped

This is a Wall Street Journal oped on inequality. With 30 days passed, I can post it here. It's a much edited version of my evolving "Why and How we Care About Inequality" essay.


What the ‘Inequality’ Warriors Really Want

Progressives decry inequality as the world’s most pressing economic problem. In its name, they urge much greater income and wealth taxation, especially of the reviled top 1% of earners, along with more government spending and controls—higher minimum wages, “living” wages, comparable worth directives, CEO pay caps, etc.

Inequality may be a symptom of economic problems. But why is inequality itself an economic problem? If some get rich and others get richer, who cares? If we all become poor equally, is that not a problem? Why not fix policies and problems that make it harder to earn more?

Autopsy

Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas.  As usual, the whole thing will be here in a month.

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

Read more at WSJ...

Update: Hoover has an ungated version here;  Cato has an ungated version here.

Deflation links

Commenter Zack sent the following Paul Krugman links and quotes, which deserve promotion from the comments section.

"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster."
http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk/

"So we're really heading into Japanese-style deflation territory"
 http://krugman.blogs.nytimes.com/2009/07/02/smells-like-deflation/

 "So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend." http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/

 "But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
http://www.nytimes.com/2009/05/04/opinion/04krugman.html

"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
http://krugman.blogs.nytimes.com/2010/07/11/trending-toward-deflation/

"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."
http://www.nytimes.com/2009/02/06/opinion/06krugman.html?partner=permalink&exprod=permalink&_r=0

As we know, it didn't turn out that way. We have had positive inflation for 6 years.

Why does this matter? Normally, it doesn't and it shouldn't.

Real or risk-neutral wolf?

Today's Torsten Slok chart. In yesterday's chart, we saw that the market forward curve keeps forecasting a recovery that never comes. Here, we see the same pattern, over much longer time period, in the survey of professional forecasters. They're always forecasting that interest rates will rise.

I think there are deep lessons from this chart. And not the simple "economists are always wrong," or even "economic forecasts are biased." The chart offers a nice warning about how we interpret surveys.

Expectations matter a lot to modern macroeconomics. But you can't directly see expectations. So many researchers have turned to surveys to measure what people say they "expect." And they find all sorts of weird things. People "expect" stock returns to be implausibly high in booms, and low in busts. Professional forecasters "expect" interest rates always to go up.

The trouble here, I think, is that we have forgotten what "expect" means to the average person.

1994?

Torsten Slok at Deutsche Bank sends the graph, along with some musings on the eternal question: When (if?) interest rates rise, will it look like 1994, or like 2004? Will rates rise quickly, leading to a bath in long-term bonds? Or will rates rise slowly and predictability?

The graph shows you actual short term rates (red) and forward curves. As this lovely graph points out, the forward curve has been predicting rises in rates for years now. And it's been wrong over and over again. Economists all over have been forecasting a robust recovery too, and that hasn't happened either.

(To non-finance people: The forward rate is the rate you can lock in today to borrow in the future. So the forward curve ought to reflect where the market expects interest rates to go. If people expect rates to rise more than the forward curve, they rush to lock in now, which drives up the forward curve. Also, the forward curve is a cutoff between making and losing on long-term bonds. If interest rates rise following the forward curve, then long bonds and short bonds give the same return. If rates rise slower, long-term bondholders make more money. If rates rise faster, long bonds make less than short or even lose money. So, should you buy long term bonds? Compare your interest rate forecast to the last dashed line and decide.)

Torsten:

The chart .. makes you humble when it comes to the timing of the first rate hike.

Indeed.

But once the Fed starts hiking, they will likely raise rates faster than the market currently is anticipating. Think about it: The Fed has basically decided that they will only start hiking rates once there are signs of inflation.. If the economy is overheating, then raising the fed funds rate to 0.5% is not going to slow the economy down....To cool the economy down, the fed funds rate needs to be above the neutral fed funds rate, which we estimate to be 3.5%...to get inflation under control, the Fed will likely have to raise rates well above the neutral level, potentially above 5%...

So his scenario is, interest rates low and more good times for long term bonds until (if) inflation substantially exceeds 2%, then a big rout, as small rises will not do much quickly to dampen inflation. More like 1994.

An interesting view into the brains of bond traders:

Who is afraid of a little deflation? Op-Ed

This was a Wall Street Journal Op-Ed from a month ago. Now I can post the whole thing in case you missed it then.

Who is Afraid of a Little Deflation?

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Loggerheads

Government Debt Management at the Zero Lower Bound is a very nice and interesting paper by Robin Greenwood, Sam Hanson, Josh Rudolph, and Larry Summers.

Figure 1. Comparing Quantitative Easing and Treasury Maturity Extension, 2007–2014 ...the cumulative change in 10-year equivalents (scaled as a percentage of GDP) associated with the respective balance sheet policies undertaken by the Federal Reserve and the Treasury. Positive values increase the interest rate risk placed in public hands (Treasury policies), while negative values decrease it (typically Fed QE, but also Treasury maturity shortening in 2008–2009).

First point, what the Fed taketh away, the Treasury giveth. (Hence the title of this post). The Fed bought lots of long-term debt, with the idea that this would raise the price, lower the interest rate on the long-term debt, and thus stimulate the economy.

At the same time, however, the Treasury was selling lots of long-term debt. Interest rates are very low, and debts are high, so it's a great time to lock in low-rate financing. Homeowners and businesses are doing the same thing.

Level, Slope and Curve for Stocks

"The Level, Slope and Curve Factor Model for Stocks" is an interesting and important empirical finance paper by Charles Clarke at the  University of Connecticut.

Charles uses the Fama-French (2008) variables to forecast stock returns, i. e.,  size, book to market, momentum, net issues, accruals, investment, and profitability. \[ Ret_{i,t+1} = \beta_0 + \beta_1 Size_{i,t} + \beta_2 BtM_{i,t} + \beta_3 Mom_{i,t} + \beta_4 zeroNS_{i,t} + \beta_5 NS_{i,t} + \beta_6 negACC_{i,t} + \] \[ + \beta_7 posACC_{i,t} + \beta_8 dAtA_{i,t} + \beta_9 posROE_{i,t} + \beta_{10} negROE_{i,t} + e_{i,t+1} \] He forms 25 portfolios based on the predicted average return from this regression, from high to low expected returns.  Then, he finds the principal components of these 25 portfolio returns.

Source: Charles Clarke

And the result is... hold your breath... Level, Slope and Curvature! The picture on the left plots the weights and loadings of the first three factors. The x axis are the 25 portfolios, ranked from the one with low average returns to 25 with high average return. The graph represents the weights -- how you combine each portfolio to form each factor in turn -- and also the loadings -- how much each portfolio return moves when the corresponding factor moves by one.

No surprise, the 3 factors explain almost all the variance of the 25 portfolios returns, and the three factors provide a factor pricing model with very low alphas; the APT works.

Now, why am I so excited about this paper?

Policy penance

The last few posts haven't worked out so well, that's for sure. After a too-grumpy reaction to Alan Blinder's review,  I wanted to say something nice and find common ground with the "what's wrong with macro" articles and even Krugman's posts. In doing so I was much too quick and superficial in characterizing what's going on at high levels of our policy institutions. The only result was that  I managed to annoy all my friends and colleagues at the Fed, IMF, and so on.

As penance, I'll try a blog post that more accurately characterizes the interaction of research and policy, "Keynesian" and modern economics, and so on, as I see it.

If we look one step below the political level, for example at the FOMC minutes and what research staff are up to at institutions like Fed and IMF, you see a very sophisticated interaction between the ideas of modern economic research and policy. The FOMC minutes and speeches by board members (all easy to find on the Fed's website) are a great source. The FOMC seems, to an outsider,  like the world's highest-level debating club on modern macroeconomics.

On many of the dividing lines between traditional Keynesian and modern economics, the policy discussion is decidedly modern.

Uber stars vs. taxi regulators

Uber.gov is a great story about Uber, taxi scams, captured regulation, and so on.  Have fun.

 ...

How The “Sin City Shuffle” Works There are two main routes to get from the Vegas airport to the Strip. One of them is illegal. To figure out which one you’re on, apply this test: Look outside. If you can’t find outside, you’re in a tunnel—which means you’re being ripped off.

The I-215 tunnel adds about $10 to your fare, but one in three cabbies “longhauled” undercover cops through it anyway. The country hasn’t seen this kind of brazenness since Bankerty Robberson opened a Skimask Hut outside Wells Fargo in 1979.

What can possibly be done about such a confounding crime? I had plenty of time to research this on a recent trip to Vegas, while my own cabbie, Mickey, drove me to the Bellagio by way of Montpelier, Vermont.

Uber’s absurd answer to longhauling is straight from your childhood: When a driver behaves badly, he only gets one star. Within hours, Uber adjusts your fare. Their systems can do this automatically because they have everything they need to calculate an “ideal” fare—start point, end point, traffic conditions, and past fares. If the driver keeps scamming others, he automatically gets fired.

But Nevada officials found fault in Uber’s stars. In fact, they kicked the company out of town for not protecting tourists.

Read the rest here

What's wrong with macro?

Reflecting on my overly grumpy last post, as well as many recent Krugman columns, I think there is really a fundamental consensus here.

There is, in fact, a sharp divide between macroeconomics used in the top levels of policy circles, and that used in academia.

Blinders

Alan Blinder has what looked like an interesting-looking essay in the New York Review of Books, "What's the matter with economics?" Alan has usually been thoughtful, the WSJ house liberal columnist, so I approached it hoping for well-reasoned argument I might disagree with, but be interested by and learn something from. And it started well, pointing out the many things on which economists all agree and policy does not.

Alas, then we get to macro. Something about stimulus sends people off the deep end.  One little quote pretty much summarizes the tone and (lack of) usefulness of the whole thing:

The great Milton Friedman of the University of Chicago, a favorite target of Madrick, may have been right or wrong; but he was certainly far to the right. Much the same can be said of several other economists cited by Madrick as representing the mainstream. For example, he quotes John Cochrane, also of the University of Chicago, as saying in 2009 that Keynesian economics is “not part of what anybody has taught graduate students since the 1960s. [Keynesian ideas] are fairy tales that have been proved false.” The first statement is demonstrably false; the second is absurd. People can and do argue over the macroeconomic views associated with the so-called Chicago School, but it’s clear that the views of that school are far from the mainstream.

"Demonstrably false" and "absurd" are pretty strong.

Am I wrong that graduate programs do not teach any Keynesian economics? I went to look at the Princeton University Economics Department graduate course offerings. Following up on the ones titled "macro," I found

McCloskey on Piketty and Friends

Deirdre McCloskey has written an  excellent essay reviewing Thomas Piketty’s Capital in the Twenty-First Century.

As an economic historian and historian of economic ideas, McCloskey can place the arguments into the framework of centuries-old ideas (and fallacies) as few others can. She has read philosophy and "social ethics." She can even knowledgeably review the literary references.

Her central point: "trade-based betterment," (she wisely avoids "capitalism" to emphasize that  the focus on "capital" is about a hundred years out of date) has raised living standards by factors of 30 or more -- much more if you think about health, freedom, lifespan, tavel, etc. unavailable at any price in 1800;  it has led to much greater equality in many things that count, such as consumption, health and so on; and stands to do so again if we do not kill the goose that laid these golden eggs.  From late in the review,

Redistribution, although assuaging bourgeois guilt, has not been the chief sustenance of the poor....If all profits in the American economy were forthwith handed over to the workers, the workers ... would be 20 percent or so better off, right now....

But such

one-time redistributions are two orders of magnitude smaller in helping the poor than the 2,900 percent Enrichment from greater productivity since 1800. Historically speaking 25 percent is to be compared with a rise in real wages 1800 to the present by a factor of 10 or 30, which is to say 900 or 2,900 percent. 

As a too-long post on a far-too-long review of a enormously-too-long book, I'll pass on some particularly good bits with comment.

On the long history of fashionable worrying:

Sequester and vortex redux.

I posted this last week, but I was unaware at the time of the Paul Krugman's "Keynes is slowly winning" post; Tyler Cowen's 15-point response, documenting not only Keynesian failures but more importantly how the policy world is in fact moving decidedly away from Keynesian ideas, right or wrong (that was Krugman's point); and Krugman's retort, predictably snarky and disconnected from anything Cowen said, changing the subject from Keynesian ideas are winning to the standard what a bunch of morons they're not Keynesians though I keep telling them to be. (I like Krugman's chart though. I see a glass half full -- look at all those nominal wage cuts, even in Spain! And look how many people got raises.)

In that context, I added two "Facts in front of our noses." Keynsesians, and Krugman especially, said the sequester would cause a new recession and even air traffic control snafus. Instead, the sequester, though sharply reducing government spending, along with the end of 99 week unemployment insurance, coincided with increased growth and a big surprise decline in unemployment. And ATC is no more or less chaotic than ever. Keynesians, and Krugman especially, kept warning of a "deflation vortex." We and Europe still don't have any deflation, and even Japan never had a "vortex."  These are not personal prognostications, but widely shared and robust predictions of a Keynesian worldview. Two strikes. Batter up. 

The original: (This is a re-post if you saw it the first time around, but easier to copy and paste than link.) 

 

Multiplier? What multiplier? 

Frameworks for Central Banking in the Next Century

The special issue of the JEDC containing papers from the conference "Frameworks for Central Banking in the Next Century" is available until Jan 18 online for free. My "monetary policy with interest on reserves" is here.  Alas, Elsevier doesn't allow me to post a pdf and only allows free access until Jan 18, so if you want pdfs grab them now. 

The lineup is pretty impressive. Of those I have read, I highly recommend Sargent, Prescott, Ohanian, Ferguson and Plosser to blog readers. In particular, if you thought Friedman was always and everywhere MV=PY and 4%, read Sargent.

The lineup:

Target the spread?

To send you off with some more Thanksgiving good cheer, here is another out of the box Neo-Fisherian idea.

Perhaps the Fed (or the Treasury) should target the spread between real and nominal interest rates.

Above, I plotted the real (TIPS) and nominal 5 year rates. By the usual relationship \[ i_t = r_t + E_t \left[ \pi_{t+1} \right] \] we typically interpret the difference between real (r) and nominal (i) rate as the expected inflation rate.

Now, the usual Neo-Fisherian idea says, peg the nominal rate (i), eventually the real rate (r) will settle down, and inflation will follow the nominal rate. It's contentious, among other reasons, because we're not quite sure how long it takes the real rate to settle down, and there is some fear that real rate movements induce a temporarily opposite move in inflation.

So why not target the spread? The Fed or Treasury could easily say that the yield difference between TIPS and Treasuries shall be 2%. (I prefer 0, but the level of the target is not the point.)  Bring us your Treasuries, say, and we will give you back 1.02 equivalent TIPS. Give us your TIPS, and we will give you back 0.98 Treasuries. (I'm simplifying, but you get the idea.) They could equivalently simply intervene in each market until market prices go where they want. Or offer nominal-for-indexed swaps at a fixed rate.

Now, I think, the Neo-Fisherian logic is even tighter. If the government targets the difference \( i_t - r_t  \), in a firmly committed way, \( E_t \left[ \pi_{t+1} \right] \) is going to have to adjust.  I plotted 5 years, because I'm attracted to the idea of nailing down 5 year inflation expectations, but the general idea works across the maturity spectrum.