An essay. It's an overview of what a growth-oriented policy program might look like. Regulation, finance, health, energy and environment, taxes, debt social security and medicare, social programs, labor law, immigration, education, and more. There is a more permanent version here and pdf version here. This version shows on blogger, but if your reader mangles it, the version on my blog or one of the above will work better.

I wrote it the Focusing the presidential debates initiative. The freedom of authors in that initiative to disagree is clear.

Economic Growth

Growth is central

Sclerotic growth is the overriding economic issue of our time. From 1950 to 2000 the US economy grew at an average rate of 3.5% per year. Since 2000, it has grown at half that rate, 1.7%. From the bottom of the great recession in 2009, usually a time of super-fast catch-up growth, it has only grown at two percent per year.² Two percent, or less, is starting to look like the new normal.

Small percentages hide a large reality. The average American is more than three times better off than his or her counterpart in 1950. Real GDP per person has risen from $16,000 in 1952 to over $50,000 today, both measured in 2009 dollars. Many pundits seem to remember the 1950s fondly, but $16,000 per person is a lot less than $50,000!

If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000 not $50,000. That’s a huge difference. Nowhere in economic policy are we even talking about events that will double, or halve, the average American’s living standards in the next generation.

Even these large numbers understate reality.

Open-Mouth Operations

(Note: This post uses mathjax and has embedded pictures. When posts are reposted elsewhere these often get mangled. If it's not displaying well, come to the original at johnhcochrane.blogspot.com)

Our central banks have done nothing but talk for several years now. Interest rates are stuck at zero, and even QE has stopped in its tracks. Yet, people still ascribe big powers to these statements. Ms. Yellen sneezes, someone thinks they hear "December" and markets move.

Buried deep in the paper I posted earlier this week is a potential model of "open mouth" operations, that might of interest to blog readers.

Use the standard "new-Keynesian" model \[ x_{t} = E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1}) \] \[ \pi_{t} = \beta E_{t}\pi_{t+1}+\kappa x_{t} \] Add a Taylor rule, and suppose the Fed follows an inflation-target shock with no interest rate change \[ i_t = i^\ast_t + \phi_\pi ( \pi_t - \pi^\ast_t). \] \[ i^\ast_t = 0 \] \[ \pi^\ast_t = \delta_0 \lambda_1^{-t} \] Equivalently express the Taylor rule with a ``Wicksellian'' shock, \[ i_t = \hat{i}_t + \phi_\pi \pi_t \] \[ \hat{i}_t = - \delta_0 \phi_\pi \lambda_1^{-t}. \] In both cases, \[ \lambda_{1} =\frac{\left( 1+\beta+\kappa\sigma\right) +\sqrt{\left( 1+\beta+\kappa\sigma\right) ^{2}-4\beta}}{2} \gt 1 \] Yes, this is a special case. The persistence of the shocks is just equal to one of the roots of the model. Here \(\delta_0\) is just a parameter describing how big the monetary policy shock is.

Now, solve the model by any standard method for the unique locally bounded solution. The answer is \[ \pi_{t} = \delta_0 \lambda_1^{-t}, \] \[ \kappa x_{t} = \delta_0 (1-\beta \lambda_1^{-1}) \lambda_1^{-t} \] \[ i_t = 0 \]

Here is the equilibrium path of inflation and interest rates (flat red line at zero).

Swiss Deflation

The Wall Street Journal Monday Oct 19 offers a reflection on deflation in Switzerland.

"It’s as close to an economic consensus as you can get: Deflation is bad for an economy, and central bankers should avoid it at all costs."

I differ, as does Milton Friedman's "Optimum quantity of money." And my "who's afraid of a little deflation" in... The Wall Street Journal.

"Then there’s Switzerland, whose steady growth and rock-bottom unemployment is chipping away at that wisdom."

"At a time of lively global debate about low inflation and its ill effects, tiny Switzerland—with an economy 4% the size of the U.S.—offers a fascinating counterpoint, with some even pointing to what they call 'good deflation.' ”

Indeed. The 1970s had stagflation. Now we have the opposite, "good deflation."  The Phillips curve lives on in "consensus."

Switzerland also is a good case for just how powerless central banks are to do much about it.

Do higher interest rates raise or lower inflation?

A new working paper by that title (pdf).  Some of the main ideas are in a longish post from last August.

The fact that inflation is so stable when interest rates are stuck at zero has profound implications. If inflation is stable at a zero peg, it must be stable at a higher peg as well, which means raising interest rates must sooner or later raise inflation. The open question, which this paper goes after, is whether inflation can temporarily decline when interest rates rise. (Graphs from an earlier blog post here.)

Classical "Keynesian" or "Monetarist" models say that inflation is unstable in a peg. They must be wrong. "New-Keynesian" models say that inflation is stable in a peg, a good point in their favor. The important difference is rational expectations. If people drive a car looking in the rear view mirror, cars are unstable and veer off the road. If people look forward, then cars are stable and get back on the road on their own.

But the standard new-Keynesian model also predicts that inflation goes up if interest rates rise, as shown in the graph.  Interest rates are blue, inflation is red, output is black. The dashed line is when people know the rise is coming, the solid line for when it's a surprise.  Raising rates does lower output, just as you thought.

The paper tries everything to revive the idea that higher interest rates lower inflation, without luck.

Abstract:

The standard new-Keynesian model accounts well for the fact that inflation has been stable at a zero interest rate peg. However, If the Fed raises nominal interest rates, the same model model predicts that inflation will smoothly rise, both in the short run and long run. This paper presents a series of failed attempts to escape this prediction. Sticky prices, money, backward-looking Phillips curves, alternative equilibrium selection rules, and active Taylor rules do not convincingly overturn the result. The evidence for lower inflation is weak. Perhaps both theory and data are trying to tell us that, when conditions including adequate fiscal-monetary coordination operate, pegs can be stable and inflation responds positively to nominal interest rate increases.

Open Borders

Alex Tabarrok has a very nice and very short piece at the Atlantic, The Case for Getting Rid of Borders—Completely. (HT Marginal Revolution)

In the Soviet era, there were walls and guards with guns, and we deplored that people were not allowed to cross the border. Is it that different that the guards with guns are on the other side of the walls?

If you're a liberal, you should cheer the policy with the greatest chance of elevating the world's poor and reducing global inequality. If you're a conservative, believe in the rights of individuals and freedom, don't like minimum wages, unions, protectionism, and government control, it makes little sense to switch sides on this one issue.

Lazear on Dodd-Frank and Capital

Ed Lazear has a nice WSJ oped, "How not to prevent the next financial meltdown." (Also available here via Hoover.) The main points will not be new to readers of this blog, or my much longer essay but the piece is admirable for putting the basic points so clearly and concisely.

The core problem of focusing on institutions not activities:

The theory behind so-called systemically important financial institutions, or SIFIs, is fundamentally flawed. Financial crises are pathologies of an entire system, not of a few key firms. Reducing the likelihood of another panic requires treating the system as a whole, which will provide greater safety than having the government micromanage a number of private companies.

A crisis is a run:

The risks to a system are most pronounced when financial institutions borrow heavily to finance investments. If the value of the assets falls or becomes highly uncertain, creditors—who include depositors—will rush to pull out their money. The institution fails when it is unable to find a new source of funds to meet these obligations.

Uncle Sam Spam

I talked a bit to Binyamin Applebaum about his article in the New York Times, Behaviorists Show the U.S. How to Improve Government Operations. As preparation, I read the Social and Behavioral sciences team annual report which he was covering.

Applebaum's article reflects much of the usual New York Times cheerleading for behaviorism and nudge/nanny programs.

Reading the report, I came away more approving of some aspects than blog readers might think, but a little more skeptical of some aspects than Applebaum's article.

• The bottom line is spam. The government wants to send you letters, email, and text messages to sell its programs.  The limits and objections to the program are pretty obvious once you recognize that fact. Spam gets ineffective pretty quickly, and once we start getting spam from 150 different programs nudging us to do different things, spam will get even more ineffective even more quickly. 
• If it's a good idea for the government to send us spam email and text messages, why are academic behavioral scientists the ones to do it, not professional spammers (sorry, "direct marketers")? The actual end result of this is more employment and consulting contracts for academic behavioral economics. 
• The numbers in the report are surprisingly small. Sending spam raises the number of people taking advantage of some program from 2% to 2.2%, which can be sold as a 10 percent increase.  Even I, somewhat of a skeptic to start, am amazed how low the effects are. And both before and after numbers are incredibly small. The big news in this report is that we're full of government programs that only a few percent of the available people are taking advantage of! That might be great news for the budget, but shocking news of effectiveness.  

Japan Deflation

Deflation returns to Japan. Tyler Cowen has a thoughtful Marginal Revolution post, expressing puzzlment. Scott Sumner discussion here, and Financial Times coverage.

Let's look at the bigger picture. Here is the discount rate, 10 year government bond rate and core CPI for Japan. (CPI data here if you want to dig.)

If you parachute down from Mars and all you remember from economics is the Fisher equation, this looks utterly sensible. Expected inflation = nominal interest rate - real interest rate. So, if you peg the nominal interest rate, inflation shocks will slowly melt away. Most inflation shocks are individual prices that go up or down, and then it takes some time for the overall price level to work itself out.

After the ACA

After the ACA, a longish essay on what to do instead of Obamacare. Relative to the policy obsession with health insurance, it focuses more on the market for health care, and relative to the usual focus on demand -- people paying with other people's money -- it focuses on supply restrictions. Paying with your own money doesn't manifest a cab on a rainy Friday afternoon, if you face supply restrictions.

Long time blog readers saw the first drafts. Polished up, it is published at last in the volume  The Future of Healthcare Reform in the United States edited by Anup Malani and Michael H. Schill, just published by the University of Chicago Press.

The rest of the volume is interesting, and the conference was enlightening to me, a part-timer in the massive health-policy area. As the U of C press puts it with perhaps unintentional wry wit: "By turns thought-provoking, counterintuitive, and even contradictory, the essays together cover the landscape of positions on the PPACA's prospects."

Who is walking who?

Click here for the rest

It's a graphic novel treatment of Gene Fama's Does the Fed Control Interest Rates? paper, from the Booth school's Capital Ideas magazine, by Eric Cochrane (yes, we're related). If it appears squished, use a wide browser window. The art is better in the printed form. 

Eric captured cointegration and error correction, and Gene's regressions of short and long-term interest rates, cleverly with the story. Does Sally take Lucy for a walk, or is Lucy really leading Sally around?  Well, when Lucy goes off hunting for a squirrel, who then moves to catch up?  

Is the Fed Pulling or Pushing?

I did a little interview with Mary Kissel of the Wall Street Journal, following up on thursday's oped. Mary is, as you can tell, a well-informed interviewer and asks some tough questions. She did a great job of pushing hard on the usual Wall Street wisdom about how the Fed, though it has not done anything but talk in years, is secretly behind every gyration of stock or housing prices.

The central point came to me hours later, as it usually does. Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view, clearly expressed in Mary's questions.

5 million thanks

OK, it's not Marginal Revolution. It's not even tops in my own family -- My kids' high-school animation videos do better (8 million here, 5.8 million here). But this blog has worked out far better than I hoped when I started, and I appreciate all of you who read, comment, or otherwise participate.

WSJ oped, director's cut

WSJ Oped, The Fed Needn’t Rush to ‘Normalize’ An ungated version here via Hoover.

Teaser:

The outcomes we desire from monetary policy are about as good as one could hope. Inflation is low and steady. Interest rates are lower than Americans have seen in generations. Unemployment, at 5.1%, has recovered to near normal. And banks and businesses sitting on huge piles of cash don’t go bust, a boon to financial stability.

Yes, economic growth is too slow, too many Americans have dropped out of the workforce, earnings are stagnant, and the country faces other serious challenges. But monetary policy can’t solve long-term structural problems.

Opeds are real Haikus -- 950 words is torture for me. So lots of good stuff got left on the cutting room floor, especially acknowledgement of objections and criticisms.

Yes, I'm aware of recent empirical work that QE has some effect:

Conundrum Redux

FT's Alphaville has an excellent post by Matthew Klein on long-term interest rates, organized around Greenspan's "conundrum." The "conundrum" was that Greenspan couldn't control long term rates as he wished. Long rates do not always track short rates or Fed pronouncements.  As the post nicely shows, it was ever thus.

The following graph from the post struck me as very useful, especially as so much bond discussion tends to have short memories.

If the 10 year rate had followed the pink line,  you would not have made any more buying 10 year bonds than buying short term bonds. (The pink line is the forward-looking moving average of the one year rates.)

What the graph shows beautifully, then,  is this: Until 1981, long-term bonds were awful. You routinely lost money buying 10 year bonds relative to buying one year bonds. It goes on year in and year out and starts to look like a constant of nature.

From 1981 until today, the actual 10 year rate has been well above this ex-post breakeven rate. It's been a great 35 years for long-term bond investors. That too seems like a constant of nature now.

Of course, inflation going down was good for long term bonds. But we usually don't think there can be surprises in the same direction 35 years in a row.

Two for growth

I saw two very nice, short views on growth: John Taylor Can We Restart This Recovery All Over Again? and Andy Atkeson, Lee Ohanian, and William E. Simon, Jr., 4% Economic Growth? Yes, We Can Achieve That.

John gets the art prize

Andy, Lee and William get the boil-it-down-to-basics prose prize

 Safety-net policies should not discourage work through high implicit tax rates resulting from means-tested programs. Regulatory policies should not erect barriers to competition and raise costs. Education policies should expand competition and reward the most successful teachers. Immigration policies should expand the number of skilled workers and immigrant entrepreneurs. And tax policies should simplify the tax code, reduce business and personal marginal income tax rates and broaden the tax base.

Sargent on Friedman

I ran across a little gem by Tom Sargent, "The Evolution of Monetary Policy Rules." Alas, it's gated in the JEDC so you'll need a university IP address to read it, and I haven't found a free copy. It's a transcript of a talk, so doesn't have Tom's usual prose polish, but insightful nonetheless.

Milton Friedman, like the rest of us, changed his mind over the course of a lifetime.

Coordinating monetary and fiscal policy:

...At different times, Friedman advocated two apparently polar opposite recommendations. In Friedman (1948), he proposed the following rule. He recommended to the fiscal authorities that they run a balanced budget over the business cycle. And he said what the monetary authorities should do, whatever the fiscal authority does, is to monetize 100% of government debt. That monetary rule implies that the entire government deficit is going to be financed with money creation. That is it.

It is interesting to contemplate what Friedman׳s monetary policy rule would imply if the fiscal authority chooses to deviate from Friedman׳s fiscal recommendation by running sustained deficits over the business cycle. Friedman׳s monetary rule then throws responsibility for inflation control immediately at the foot of the fiscal authority. Friedman׳s (1948) monetary rule tells the fiscal authority that if it wants stable money, then it better do the right things. If you want a stable price level, you had better recognize that you need a sound fiscal policy, period.  The division of responsibilities between monetary and fiscal authorities is clearly and unambiguously delineated. It is a completely clean set of rules. And this is what Friedman advocated until 1960.

Friedman (1960) advocated what looks to be exactly an opposite set of rules for coordinating monetary and fiscal policy. Friedman now advocated that the Federal Reserve, come hell or high water – it is not a Taylor Rule (for technical reasons) – should increase high-powered money, or something close to it, at k-percent a year, where k is the growth rate of the economy. The Fed is told to stick to the k-percent rule no matter what, recession or no recession. Under this rule, the arithmetic of the government budget constraint will force the fiscal authority to balance its budget in a present value sense.

Cheaper sugar

A nice trade epigram from David Henderson

I don't think Trump understands that when we open trade to other countries, we gain not just as exporters but as consumers. But then, what U.S. politician running for president does? Marco Rubio? Rubio argued a few years ago that he would favour getting rid of quotas on sugar imports if we got something in return. But we do get something in return: it's called cheaper sugar. And getting cheaper sugar, by the way, might have caused LifeSavers not to move from Michigan to Quebec.

David might have added, we also get more exports automatically without political deals. When other countries sell us sugar, they get dollars, of every single one ends up buying US exports or invested in the US.

Nothing new. It's in Adam Smith. But nicely expressed. Economics needs good stories.

Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 

Historical Fiction

Steve Williamson has a very nice post "Historical Fiction", rebutting the claim, largely by Paul Krugman, that the late 1970s Keynesian macroeconomics with adaptive expectations was vindicated in describing the Reagan-Volker era disinflation.

The claims were startling, to say the least, as they sharply contradict received wisdom in just about every macro textbook: The Keynesian IS-LM model, whatever its other virtues or faults, failed to predict how quickly inflation would take off in the 1970, as the expectations-adjusted Phillips curve shifted up. It then failed to predict just how quickly inflation would be beaten in the 1980s. It predicted agonizing decades of unemployment. Instead, expectations adjusted down again, the inflation battle ended quickly. The intellectual battle ended with rational expectations and forward-looking models at the center of macroeconomics for 30 years.

Just who said what in memos or opeds 40 years ago is somewhat of a fodder for a big blog debate, which I won't cover here.

Steve posted a graph from an interesting 1980 James Tobin paper simulating what would happen. This is a nicer source than old memos or opeds from the early 1980s warning of impeding doom. Memos and opeds are opinions. Simulations capture models.

The graph:

Source: James Tobin, BPEA. 

I thought it would be more effective to contrast this graph with the actual data, rather than rely on your memories of what happened.

The black lines are the Tobin simulation. The blue lines are what actually happened. (I'm not good enough with photoshop to superimpose the graphs, so I read Tobin's data off his chart.)

The two curves parallel in 81 to 83, with reality moving much faster. But In 1984 it all falls apart. You can see the "Phillips curve shift" in the classic rational expectations story; the booming recovery that followed the 82 recession.

And you can see the crucial Keynesian prediction error: After the monetary tightening is over in 1986, no, we do not need years and years of grinding 10% unemployment.

So, conventional history is, it turns out, right after all. Adaptive-expectations ISLM models and their interpreters were predicting years and years of unemployment to quash inflation, and it didn't happen.

Whither inflation?

(Note: This post uses mathjax to display equations and has several graphs. I've noticed that the blog gets picked up here and there and mangled along the way. If you can't read it or see the graphs, come back to the original .)

The news reports from Jackson Hole are very interesting. Fed officials are grappling with a tough question: what will happen to inflation? Why is there so little inflation now? How will a rate rise affect inflation? How can we trust models of the latter that are so wrong on the former?

Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. (It's often called "new-Keynesian" but I'm trying to avoid that word since its operation and predictions turn out to be diametrically opposed to anything "Keyneisan," as we'll see.)

Here is the model's answer:

Response of inflation (red) and output (black) to a permanent rise in interest rates (blue). 

The blue line supposes a step function rise in nominal interest rates. The red line plots the response of inflation and the black line plots output.  The solid lines plot the answer to the standard question, what if the Fed suddenly and unexpectedly raises rates? But the Fed is not suddenly and unexpectedly doing anything, so the dashed lines plot answers to the much more relevant question: what if the Fed tells us long in advance that the rate rise is coming?

According to this standard model, the answer is clear: Inflation rises throughout the episode, smoothly joining the higher nominal interest rate. Output declines.