David Beckworth on the floor vs. corridor system

David Beckworth has a new Mercatus paper that examines the Fed’s decision to adopt a “floor” system for interest rates.  Beginning in October 2008, the Fed began paying interest on bank reserves.  This effectively created a floor on market interest rates, as banks would have no incentive to lend money at rates lower than they could receive on reserves held on deposit at the Fed. Prior to 2008, the Fed controlled short-term interest rates by adjusting the supply of base money, a “corridor system”.  Now they have two independent policy tools, changes in the money supply (open market operations), and changes in money demand (done via interest on reserves.)

David sees several flaws in this new system:

The Fed’s floor system, then, may be a drag on economic growth for two reasons. First, it may weaken aggregate demand growth by setting the target interest rate above the natural interest rate. Second, it may inhibit credit and money creation by removing banks’ incentives to rebalance their portfolios away from excess reserves. If so, the critics are right to be worried about the Fed’s floor system, because it would constitute a Great Divorce for monetary policy.

I worry that deposit insurance biases banks toward too much lending, so at the moment I’m most worried about the first issue.  In monetary history, one recurring theme is central banks misjudging the stance of monetary policy because they focused too much on interest rates and not enough on the money supply.  Thus during late 2007 and early 2008, the Fed wrongly assumed that it was “easing” monetary policy, even as the growth in the monetary base came to a halt.

Admittedly, this excessive focus on interest rates can occur even without IOR.  But the system of interest on bank reserves makes the mistake even more likely to occur, as the quantity of money becomes even less informative.  Monetary policy is seen as being all about changes in interest rates, not changes in the supply and demand for base money.  The Fed’s monetary policy stance during the fall of 2008 would have almost certainly been less contractionary if Congress had not authorized the Fed to pay interest on reserves.

Wasteful interstate competition

Arms control agreements occur when there is a divergence between the interests of individual countries and the interests of countries considered as a group. It’s a way of overcoming the “prisoner’s dilemma”.   Derek Thompson discusses the concessions that Amazon was able to extract from state and local governments, and then suggests that a sort of fiscal competition disarmament is needed:

Why the hell are U.S. cities spending tens of billions of dollars to steal jobs from one another in the first place?


Every year, American cities and states spend up to $90 billion in tax breaks and cash grants to urge companies to move among states. That’s more than the federal government spends on housing, education, or infrastructure. And since cities and states can’t print money or run steep deficits, these deals take scarce resources from everything local governments would otherwise pay for, such as schools, roads, police, and prisons.

I suppose one could argue that tax breaks don’t use up real resources, but they do make the economy less efficient.  And since the location of these investments is roughly a zero sum game, this subsidy competition is wasteful from a national perspective.  If only states could come together and agree to unilaterally disarm.  Thompson suggests several promising approaches:

First, Congress could pass a national law banning this sort of corporate bribery. Mark Funkhouser, a former mayor of Kansas City, Missouri, envisions the law as the domestic version of the Foreign Corrupt Practices Act, which makes it illegal for Americans to bribe foreign officials.

It’s not entirely clear whether that would pass constitutional muster. . . .

Second, Congress could make corporate subsidies less valuable by threatening to tax state or local incentives as a special kind of income. “Congress should institute a federal tax of 100 percent” on corporate subsidies, Jack Markell, a former governor of Delaware, wrote in The New York Times.

PS.  A week ago I said:

The Dems need to adopt a “patriotism, not nationalism” theme.

French President Macron must have been reading my blog, as a few days later he suggested:

Patriotism is the exact opposite of nationalism. Nationalism is a betrayal of patriotism. By saying our interests first, who cares about the others, we erase what a nation holds dearest, what gives it life, what makes it great and what is essential: its moral values.

I like Macron.  Of course if I was French I’d hate him.  The French always hate their presidents.

Speaking of France, here’s an appropriate tweet:

Screen Shot 2018-11-13 at 3.39.26 PM

The magnificent seven

Boston, NYC, DC, Seattle, Bay Area, LA and San Diego.  What do those 7 metro areas have?  What’s their secret sauce?

Aaron Renn discusses the recent (rumored) Amazon decision to add headquarters in NYC and the DC area, and has a number of interesting observations:

Amazon chose not one but two elite coastal cities for its new headquarters.

There’s no other way to slice it: Amazon repudiated the heartland with this decision. This was probably the ideal case for a heartland choice. It was not just a small executive headquarters but a gigantic number of employees. And Amazon, having lower margins than say Google, has to be much more cost conscious. My own analysis turned on the question of whether or not Amazon would be concerned about costs. I thought they would be, but it turns out they didn’t care. No matter what subsides Amazon extracts from New York and Virginia, they certainly won’t offset the labor cost differentials in those locations.

Why not Chicago or Austin?

As one person tweeted, “A friend is the founder of a fintech company. They want to hire more college graduates to their Austin office instead of NYC. New talented recruits have multiple offers & most want to be in NYC, not Austin. Austin isn’t exactly a horrible place to live.”

At this level, cost is essentially irrelevant at present. The ability to attract A+ caliber talent is all.

That’s not to say heartland places can’t be successful in many ways. But it won’t be at the elite tiers of the economy.

The Biggest Loser

The biggest loser in this is Chicago. Chicago had the urban location, transit, a great pipeline of talent from the Big Ten, and lower costs. That’s why I picked Chicago as the favorite in my analysis. It checked every box at some level and had lower costs than the coasts to boot.

I’m too close to this to see the problem.  I grew up in the Midwest, at a time when the Midwest was quite prosperous.  I attended the University of Wisconsin and then Chicago.  The Windy City trails NYC in cultural sophistication, but it doesn’t trail the other 6 coastal stars in that regard.  Illinois has budget problems, but Texas doesn’t.  Why don’t they like us?

My wife told me I’m asking a silly question.  Of course the elite talent want to be on the coast, how could anyone think otherwise?  She has an Asian perspective, specifically Chinese.  In China, everyone wants to be in the sophisticated coastal cities, not the backward interior.  The Chinese associate the US East Coast with sophistication—Ivy League universities, etc. I’d guess the same is true of Indian immigrants.

While Asians are only 5.6% of the US population, they are 40% of the student body at elite West Coast universities.  You know, the ones that don’t discriminate on the basis of  . . . er . . . “personality”.  So maybe the Asian-American perspective does matter.

There’s plenty of work to be done by the bottom 99%, which is why the population of Dallas and Austin is growing much faster than the population of the coastal stars.  But it seems like the attraction of the coastal cities is so great that the elite talent will accept sharply lower real wages to work there.  Is it because the millennials are a post-materialistic generation?  They don’t want a 7000 sq. foot home in a Dallas suburb?  An 1800 square foot home in San Jose is plenty big for their web surfing and euro-style kitchen?  They’d rather walk to a restaurant?

Or is it some sort of environmental factor?  The West Coast is beautiful, and even the East Coast has some climate and scenery advantages over the Midwest.  Or is it cultural—once a critical mass of like-minded people form in an area, it starts snowballing? It’s obviously not crude economic factors like tax rates.

That doesn’t mean supply-side economics is wrong; the zero state income tax places are growing faster on average, just not with the top 1% talent (except Washington state.)

Are these trends important?  It’s not like the Midwest contains a bunch of dummies—they still attract the top 10% to 20% talent:

Having lived in both Chicago and New York I can tell you that the caliber of talent is as different as night and day. Chicago has a ton of solid Big Ten type recruits. They are drawing the top 10-20% type people. But Chicago is very weak in top 1-2% types, and that’s a huge handicap when you are trying to position yourself as an elite player. You can’t do it without elite talent, and Chicago doesn’t have nearly enough of it. I wouldn’t be surprised if this were the key factor for Amazon.

If Boeing didn’t have legacy investments, they’d want to be in Dallas or Chicago, not Seattle.  Elite tech firms seem different.

I encourage people to read his entire piece, and I welcome suggestions as to what I’m missing.  And then read Kevin Erdmann’s new book when it comes out in January.

PS. David Beckworth has a new podcast where he interviews me on monetary policy.  It was recorded at the University of Texas a few weeks ago.

PPS.  I feel sorry for my home state of Wisconsin.  They got conned by Foxconn into massive subsidies for a new TV flat panel manufacturing plant, and now it looks like Foxconn is backing off on its promises.  Scott Walker’s dumping the problem onto the next governor.

Peak fiscal indiscipline

For quite some time, I’ve been beating the drum on the reckless nature of fiscal policy, and now the media is getting on board.  Craig Torres and Liz Capo McCormick have an excellent piece in Bloomberg:

“Austerity is going to be on nobody’s platform for the foreseeable future,” said Lou Crandall, chief economist at Wrightson ICAP. Democrats and Republicans will push the U.S. toward “peak fiscal indiscipline” over the next couple of years, he said.

What both parties have learned is that, for now, the debt-carrying capacity of the economy appears to be high. One reason is the U.S. continues to be the world’s biggest provider of safe assets.

“We are the prettiest pig in the pig pen and we will be so for some time,” said David Beckworth, a senior research fellow at the Mercatus Center at George Mason University. “We have greater debt capacity than we thought we had.”

David’s right. Unfortunately it’s as if you told an alcoholic that they had more money in their bank account than they thought.  But now there’s a new concern; Congress is discovering that they passed a law back in 1978 that requires the Fed to engage in monetary offset:

Democrats soon to be in command of the House of Representatives are pushing for infrastructure spending and a wider distribution of gains to workers from a hot job market. Republicans want economic growth to accelerate from their tax cuts, deregulation and defense spending. Steadily rising interest rates can appear contrary to both goals. . . .

“On the House front, there will definitely be more criticism [of the Fed]. They will say clearly we have good outcomes, so what’s the hurry?” said Edward Al-Hussainy, a senior analyst for interest rates and currencies with Columbia Threadneedle Investments. “On the Republican side, the question will be, ‘If we roll out more stimulus, are you going to offset it? That doesn’t work for us.”

Offset!?!?  There’s that horrible word again.

I’m having a lot of trouble selling people on the idea of having the Fed self-evaluate past monetary policy decisions, and report the results to Congress.  People look on this as an ordinary public policy issue, where there are different points of view, different special interest groups, a CYA attitude among policymakers, etc. But monetary policy is nothing like ordinary public policy issues.  With a normal public policy issue, there might be a debate about whether higher interest rates are a good or bad idea, but at least both sides would agree as to what sort of policy produces higher interest rates.  In this case, Congress even lacks that basic knowledge.  Congress doesn’t have a clue as to how to evaluate monetary policy, and really does need help from the Fed.  I don’t doubt there are people in Congress who favor capping inflation at 2%, and who also want the Fed to engage in a pro-growth policy.

The Dems seem to think that easy money will raise real wage rates, as prices are more flexible than wages.  If anything, it would lower real wage rates in the short run.  Indeed real wage growth has slowed since Trump took office, partly because monetary policy has gotten easier.  The GOP seems to think that military spending will boost growth, which against seems very unlikely.  Although it’s especially difficult to figure out what the GOP believes, because their views seem to change radically from one year to the next.

During my first 7 years of blogging, I frequently pointed out that the GOP didn’t really favor small government, as when they finally took all three branches of government in 2001 they went on a deficit spending spree.  A number of commenters assured me that the Bush GOP was gone, and the party was now controlled by small government Tea Party types.  They were right in one respect, this is not the Bush GOP.  Deficit spending today is far higher than anything imagined by Bush, with the deficit expected to exceed $1 trillion next year, even as unemployment falls to 3.7%.  The Tea Party?  They love it, as long as Trump keeps trolling the liberals.

The Dems are deeply misguided on many economic issues, but at least the party still has tiny traces of idealism.  The idealists in the GOP are either dead (McCain), retiring (Ryan, Flake, Corker), or “changed” (Graham.)  No matter how cynical I get, I can’t keep up.

To be sure, there will be no immediate crisis.  The US has an enormous ability to borrow money, especially at these low rates:

Following the passage of the Republican’s Tax Cut and Jobs Act of 2017 — which rocketed projections for debt held by the public to 96.2 percent of gross domestic product by 2028 from 76.5 percent in 2017 — 10-year Treasury yields are hovering around 3.19 percent compared with 2.4 percent at the end of last year.

But keep two things in mind.  First, this trend is unsustainable.  Second, even this unsustainable path is the “rosy scenario”, assuming no recession in the next decade.  I’m actually more optimistic than the average economist on that score, but even I believe it’s unwise to base fiscal policy on that sort of optimistic assumption.

Politically, however, my argument is a loser.  The cost of a reckless fiscal policy, a reckless monetary policy, a reckless bank regulatory policy, a reckless global warming policy, and a reckless foreign policy, are not likely to occur until after the 2020 elections.  And to a politician, nothing after 2020 matters.

So how large a debt should we have?  I don’t know, but that’s not really the point.  Even if I’m wrong, and more US debt would be helpful in meeting the global need for “safe assets”, that is not a reason to run massive, irresponsible budget deficits.  Rather you’d want to create a sovereign wealth fund, and use the fund in later decades to meet the fiscal needs of retiring boomers. Of course we don’t have the foresight of a Norway or Singapore, and are becoming more banana republic-like by the day.

There’s a long historical record of populist economic policies, and in almost every case it hasn’t ended well.  Let’s hope Powell can withstand the pressure.

Those rootless cosmopolitans

When you read the history of interwar Europe, particularly the “alt-right”, one theme shows up over and over again. On one side is the authentic, patriotic working class, with a strong attachment to the home country. But they are continually being “stabbed in the back” by a class of “smelly, rootless cosmopolitans”, who have no national loyalty. Oddly this latter group is linked to both socialism and global capitalism.  (How is that even possible?)

Of course today we are far past that sort of crude rhetoric, as shown in a recent Financial Times story:

The White House’s top trade adviser has accused “globalist billionaires” of trying to pressure President Donald Trump into ending his tariff brinkmanship with China, saying their “shuttle diplomacy” to Beijing meant that any truce would have a “stench around it”.

Peter Navarro, the most prominent China hawk in Mr Trump’s inner circle of economic advisers, called on Wall Street to “get out of the negotiations” and warned that if a deal is reached when the president meets with Xi Jinping at a G20 summit in Argentina this month, it would have “imprimatur of Goldman Sachs”. . . .

Mr Navarro’s comments came as he mounted a robust defence of Mr Trump’s protectionist trade policies, saying the president had the “courage and wisdom to stand up to the globalist elite” that was using the US as the “bank of the world”. . . .

“He didn’t need the help of Wall Street, he didn’t need the help of Goldman Sachs, and he doesn’t need it now,” Mr Navarro said. “When these unpaid foreign agents engage in this kind of diplomacy, so-called diplomacy, all they do is weaken this president and his negotiating position. No good can come of this.”

The good news is that Trump is himself a billionaire, who cares a great deal about how the stock market is doing.  Navarro sounds like a desperate man, who attached himself to the wrong sort of demagogue.  He doesn’t understand that the 1930s are over.  Look for “globalist billionaires” to eventually win this battle.

PS.  When is that trade deficit going to begin shrinking?  And if Trump is right that the economy is doing spectacularly well, does that mean that our previous problems had nothing to do with the trade deficit?  Just asking.