Interest rates will be low for a long time

I don’t know by what mechanism expectations are set. Conditioned on this mysterious process connecting Fed policy and the public’s expectations, people should know the Fed plans to keep interest rates low for a long time. This probably means they will be low even after recovery starts and that definitely means there will be inflation.

Got that you public? There will be inflation, damn you! Hey you over there socking cash under the mattress: cash will be worth less in the future and your better off investing it. Seriously. The Fed is dead set about making that cash worth less!

Now, credibility sets in, bringing about recovery. I’m holding my breath.

(PS – Prof. Sumner, Fed GDP forecasts are nominal targets. Forecasting is the only credible way to create targets.)

UPDATE 5am – Ooops… See how easy it is to condense all types of monetary policy into “interest rates”!

Sumner on monetary policy

My favorite paragraphs:

The key insight of rational expectations (which should be called consistent expectations) is that if you model the economy in a way where policy X produces result Y, you should not assume the the rest of the public believes policy X produces result Z. This is especially true of public policies. It is very unlikely that a policy regime will be effective if it is based on the assumption that the public will respond foolishly to your policy. They might behave foolishly, but you can’t count on it.

The rational expectations revolution also showed that:

1. Today’s AD will be heavily influenced by changes in tomorrow’s expected AD, and thus by changes in the expected future path of monetary policy.

2. Changes in the expected future path of policy show up immediately in the auction-style commodity, stock, and bond markets.

The idea is the world is classical in the long run (permanently doubling money, doubles prices), but prices are slow to adjust in the short run. Some prices adjust faster than others so today’s GDP can change in response to expected future changes in monetary policy. So even in a weak monetary trap (where short-term rates are zero) if the monetary authority can affect expectations, they can have an affect on GDP.

The predicate — “if the monetary authority can affect expectations” — is where the disagreements are. Krugman thinks normal open market operations are the only mechanism for the Fed to affect expectations. Most everyone else thinks otherwise. Read the rest of the Sumner article to get six reasons to think Krugman is wrong.

“Good banks, bad banks… doesn’t matter. What we need is new banks.”

Buiter’s idea to create new banks with bailout funds, seconded by Paul Romer and discussed by David Warsh is endorsed by uber-entrepreneur Marc Andreessen in this great video:

My better half, The Real Scientist, tells me that I should learn to compromise and my analysis should be conditioned on the fact that politicians will feel the need “to do something”. So getting angry about the mess they make (e.g. the disincentive to work created by the mortgage bail-out) when doing nothing would be optimal is like cursing the sun for rising in the morning. If the government feels the need to spend a ton of money fixing the banking system, investing in new banks is a good way to spend that money.

PS – No really. I’m off blogging for the rest of the week.

Technological regress

An old joke about Real Business Cycles is that they assume recessions are caused by technological regress. Without other frictions, the only way for an economy to get lower output given the installed capital and the number of workers is to have a sudden drop in productivity of those inputs.

Well, who in the hell ever heard of a technological regression? What, did people forget how make stuff? lose the blueprint? Ha ha ha… those stupid RBC theorist. What a bunch of mathematical masturbation!

Ahem. Well, here are three examples of technological regress. First, the financial mess can be seen as throwing sand in the works. Its harder to get working capital — if your bank is skittish you have to walk down the street to get your loans from somewhere else — so production is more expensive. Second, here’s Willem Buiter entertainingly complaining about centralization causing technological regress. Third, an increase in distortions in the finance sector where it is harder for some sectors to get financing can *look* like technological regress.

The last point was explained by Prof. Kehoe at the loooooooooooooong session on monetary policy at the AEA meetings (see day two part 1). He shows a simple single sector growth model with plain vanilla productivity shocks (i.e. technological regress) is observational equivalent to a more sophisticated two sector model with sector specific labor costs (e.g. costs in working capital). The more sophisticated model tells a story for why there is “technological regress” but it doesn’t necessarily tell us more about the economy. For that, the model would need to generate other testable predictions.

The RBC literature found “technological shocks” were important for explaining business cycles. Many, perhaps more conservative, economists took this result literally… variation in stuff policy makers have no control over, namely exogenous technology, cause business cycles so policy can’t help smooth cycles. For this literal interpretation of “technology shocks” those economists were rightly ridiculed, but the lesson of RBC models is exactly what it should be: these models identified a fundamental cause of business cycles and they pointed the way to a deeper understanding. To understand business cycles, we need to understand “technological shocks”. RBC models aren’t wrong; they’re just not right enough.

Macro-prudential regulation

Prof. Philippon summarizes three reports on financial regulation and reviews proposed changes to regulation. My favorite paragraph:

I very much doubt that we can agree on a set of objective measures of ‘excessive’ credit expansion (let alone bubbles). I think that the best we can expect is a powerful regulator running systemic stress tests based partly on historical data and partly on subjective forward looking scenarios. The critical issue in my view does not lay in the construction of an appropriate cyclical index, but rather in making sure that the regulator is powerful enough to enforce tighter prudential regulations based in part on subjective and debatable interpretations of economic data. The financial industry will not like it, and it has a strong track record of capturing its regulators, so this will not be easy.

He suggest the powerful regulator should be the Fed. He seems frustrated that there’s not more specific policy proposals and the ones that exist are bad: “I would therefore consider any future report that does not include tables, figures, numbers, equations, and specific proposals to be useless rhetoric.” Here are his concluding remarks:

This issue reminds me of the paradox of free trade. The benefits of free trade are widespread and difficult to grasp, while its costs are concentrated and easily publicized. Public support for free trade is therefore structurally weak. Moral hazard created by implicit guarantees is also widespread and difficult to grasp. It shows up in spreads lowered by a few basis points here and there, in slight distortions of comparative advantages, and in overall weaker governance. But the costs of LCFI [wa: firms that are “too-big-to-fail”] failures are large and concentrated. It is therefore tempting for regulators to focus too much on bailouts, and too little on incentives. But this is clearly the wrong policy for the long run. Incentives and accountability must be improved, even if it means fighting a regulatory battle with the industry.
Sir Winston Churchill famously remarked that “Britain and France had to choose between war and dishonour. They chose dishonour. They will have war.” If in the hope of ending the crisis quickly, we choose to bail out the banks without making their managers, shareholders and creditors accountable, then we choose dishonour, and we will have more devastating crises.

The impact of the stimulus

The stimulus bill has been passed and it awaits the signature of the President. So what impact will it have?

The key question for understanding if the stimulus will work or not ((“work” in the improve welfare sense, not the improve GDP statistics sense)) is “what percentage of Americans are non-savers?” How many Americans act like Keynes’ hand-to-mouthers and how many act like Barro’s Ricardian savers?

Sarah at a great looking new blog called “Pensons” (not “pensions” as I first read it… talk about instantaneously going from boring to cool) finds evidence that a lower bound for the percent of Americans who are non-savers is 23%. If you believe this high estimate, the percent of “underbanked” Americans is a little less than 40%.

So how well will the stimulus work?

The CBO estimates there will be $584.3B in deficit spending in the next two years. I’ll take this to be the stimulative part of the bill (the rest is just public investments, to be kind). Reading off this chart, the income multiplier will be 1.3 and the consumption multiplier will be 0.4 (and there will be negligible crowding out of investment). This suggests GDP will increase by about $760B and consumption will increase by about $230B relative to the baseline ((actually, I’m not sure what the baseline in Gali’s model is; potential income? How would the analysis change if we linearized that model around below the steady-state?)). Consumption last quarter $450B in annualized terms, relative to the trend in the 10 quarter previous to 3rd quarter 2008.

If last quarter’s drop represents the total drop in consumption we’d see in this recession without the stimulus, the stimulus makes up for about 50% of lost consumption. On the other hand, the stimulus makes up for more than the drop GDP.

Talking past each other?

This post referencing an article by Prof. Delong makes me think people are talking past each other.

Delong and compatriots say that monetary policy has failed and so fiscal policy is necessary. They then mention things about how people are suffering and how we need to alleviate that suffering. They don’t go this far, but at least rhetorically they connect fiscal policy with reducing that suffering, as if its the only way to do so.

Barro et al say monetary policy hasn’t run out of steam and traditional fiscal policy is ineffective. The later point is irrelevant to the economic debate, but key to the policy debate. There are some “untraditional” fiscal policies that would act to improve expectations of inflation. Also rhetorically, at least, these folks are concerned about smoothing out the business cycle.

The thing is smoothing the business cycle and alleviating suffering are the same thing. We all share the same goal! The weird thing is, if you sat everyone around the table, they’d all agree the best way to smooth the business cycle (and alleviate suffering) is to have a constant level of inflation and the best way to do that is to have constant expectations of inflation.

The honest to god dispute is which policies will bring about constant expectations of inflation. Right now traditional monetary policy isn’t workable. The options are non-traditional fiscal stimulus (e.g. “helicopter drops”), quantitative/qualitative easing or both. The policy we’re seeing is traditional fiscal stimulus and tons of qualitative easing.

My take on the stimulus package is that it won’t be very helicopter drop-ish ((and I suspect this fiscal policy may actually slow down recovery by slowing down sectoral shifts, but that’s pure speculation)). Our real hope for recovery is in the untraditional monetary policy being pursued by the Fed. So far, contra-Delong, I think its working given indicators of inflation expectations, though, I’ll admit these measures of expectations are very noisy.

Rules vs discretion

Will Wilkinson is “extremely suspicious of what strike me as intellectually contentious, ad hoc interventions into the economy aimed at expectation management.”

He should be suspicious because when policy makers have discretion, outcomes are worse. This is because people know the government can cheat by trying to exploit short-term trade-offs between outcomes and inflation. Because the government has discretion and they can cheat, people expect governments will cheat and increase inflation — by spending a bizzilion dollars for example — thus increasing their expectations of future inflation. This high expected inflation translates to actual inflation and thus a worse outcome.

On the other hand, if policy makers can commit themselves to a particular policy and that commitment is credible, expectations of inflation are lower, actual inflation is lower and outcomes are better.

How do policy makers credibly commit themselves to policy rules? Well, they don’t increase spending by almost 10% of GDP willy-nilly. Better is to have over 20 years of policies that lead to stable levels of inflation. Too bad we’re going to get the former and no-longer have the latter.

(Lectures 11-14 here are a pretty good and thorough introduction to these ideas. I just found it from googling so there may be something better out there.)

The extent of our knowledge

One of the reasons I think modern macro is successful is that it cleanly separates what we know from what we don’t know. Making assumptions about how people make decisions and assumptions about how those decisions interact, modern macro models give expected behavior. In our models we capture all that we don’t know in what are called “exogenous shocks”. They’re “exogenous” because they’re outside the model and they’re “shocks” because they’re exact value is unpredictable even if the economic agents inhabiting the model’s world knows their distribution.

Given the behavior of exogenous shocks and the predicted behavior of the model’s agents to those shocks, we can take the output of the model and compare it to real data. If a model replicates real data then its assumed this is due to the assumptions about shocks and behavior. Because the shocks represent things we don’t know, we’d like to have the most simply shocks possible and therefore have the structure of the model explain as much of the data as possible.

Similarly, we can compare models by seeing which explains the most patterns in the data (or at least the patterns we care about) using the same exogenous shocks. If one model explains more data, we say that one tells us more about whatever is being studied. The shocks, however, continue to reflect our ignorance.

I like this paper by Eggertsson (h/t EotAW) because it shows how important the assumptions on exogenous shocks can be. Cole and Ohanian have several papers (findings summarized here) that show New Deal policies (by which they and Eggertsson mean industrial and union policies increasing monopoly power) were contractionary. This is actually the standard view that follows from microeconomic theory.

Eggertsson shows that after you include some standard modern macro model features (e.g. sticky prices, monopolistic competition) and you change the assumption on the exogenous shocks, these New Deal policies are, to my surprise, expansionary. The reason is at the zero lower bound for interest rates, without these policies, expectation for inflation doesn’t materialize and the economy falls into a deflationary spiral. When the government gives unions and big companies monopoly power, on the other hand, people expect those unions and big companies to use that power to raise prices. In this way, New Deal policies take over traditional monetary policies roles in setting inflation expectations.

But I really, really like the paper because it makes explicit that the reason its results are different from standard results from Cole and Ohanian is because of the assumptions about the shocks. In both sets of research, the shock is to preference for precautionary savings (“animal spirits”). Cole and Ohanian assume the 1929 crash and the bungles of Hoover were the exogenous shock and when Roosevelt took office that shock began to dissipate. Eggertsson, though, assumes the shock persisted through the great depression. Which is the right assumption, nobody knows.

The paper has very nicely separated what we know from what we don’t know. This makes task for future research very clear… what were the nature of those shocks to animal spirits?

To me, this strand of modern macro literature is encouraging. Everyone’s assumptions are laid out on the table, theories are making heavy contact with data and progress can easily be identified. Its almost like this is science.

Rodrik clarifies the debate?

Rodrik observes, as Wilkinson suspected, the margin on which economists are debating the fiscal stimulus isn’t economics. Instead the Krugman vs. Chicago debate is “philosophical, political, and practical–revolving around the role of government, the extent of rent-seeking and public-choice concerns in government programs, and the right mixture of prudence and boldness that the situation requires.”

I’m not convinced. There’s the issue of whether monetary policy is impotent or not given zero interest rates. Krugman says “traditional” money policy — swapping treasuries for cash — is impotent and he’s right. If the policy choice was just between traditional money policy and fiscal stimulus than Krugman would be right about the necessary policy and Rodrik would be right that this was a debate about ideology. Big government types observe traditional money policy is broken and advocate government expansion. Small government types hate that idea and rail against it.

The choice, though, isn’t between traditional money policy and fiscal stimulus. There are a number of papers showing monetary policy doesn’t have to be impotent when we run up against the zero lower bound of interest rates. The ideological battle dissolves (unless you really, really want fiscal stimulus) because with non-traditional monetary policy we’re still talking about huge government intrusion in markets — albeit temporary and reversible. Non-traditional monetary policy has the Fed intervening in capital markets — running them as Cochrane puts it — but this sort of policy is preferable to fiscal policy for a number of reasons outlined in that Cochrane article, but primarily because its much easier for it to adjust to prevent inflation.

In any case, we’re back to fighting over economics.