Archive for May 2014


Tim Duy on how Fed policy keeps rates low

Garrett pointed me to a very good Tim Duy post on Fed policy:

The Federal Reserve has set reasonably clear expectations that rates will remain low for a long time.  That path, however, seems to be a consequence of doing too little now to ensure a stronger recovery.  In other words, the Fed seems to be taking a lower-rate future as a given rather than as a result of insufficient policy.  Instead of acting to ensure a stronger forecast, they seem more interesting in acting to lock-in the lower path of activity.  And that in turn will tend to lock in a low level of long-term rates. This, I think, is the best explanation for the inability of markets to sustain higher rates.  It is simply reasonable to expect that the conditions which justify higher long rates will be met with tighter policy sufficient to contain growth to something closer to the current path of output than to current estimates of potential output.

This is actually pretty close to Milton Friedman’s 1998 claim that rates in Japan were low because money had been tight.  Or Nick Rowe’s upward sloping IS curve. Duy doesn’t use the term “tight money”, but the phrase “doing too little now to ensure a stronger recovery” implies money is tighter than Duy and I might consider optimal, and that easier money would eventually lead to higher rates.  If you put aside my idiosyncratic definition of “easy” and “tight” money (I use NGDP growth, not interest rates and money growth as policy indicators), my views are actually similar close to those of a mainstream macroeconomist like Tim Duy.  The substance of what we are saying on monetary policy and interest rates (and also monetary offset) is very close, once you get beyond framing effects.

Have our views always been close on these issues?  I’m not sure.

Reasoning from multiple price changes

There’s been a lot of recent discussion about the disconnect between the stock and bond markets. Stocks are hitting records (suggesting strong growth ahead) while bond yields are falling (suggesting slow growth ahead.)  I don’t have any definitive answers, but a few words of caution:

Many factors affect stocks and bonds, not just growth.  Some of those factors affect the two markets in very different ways.  For instance, suppose the investment schedule shifted to the left due to slower population growth, while the global saving schedule shifted to the right because of growing Asian prosperity.  In that case global real interest rates might fall sharply:

Screen Shot 2014-05-16 at 9.19.45 PM

Indeed this is pretty much what happened to real interest rates on 10 year Treasury bonds over the past 33 years.  They have fallen from about 7% to about 0%. And yet saving and investment haven’t changed all that much as a share of GDP. Some of the recent drop was caused by weak economic growth, but the big drop from 1981 to 2007 cannot be explained by slower growth.

Now let’s suppose that real interest rates dropped for some reason unrelated to slowing economic growth. How would that affect the stock and bond markets?  Stock prices would obviously rise, and bond yields would fall. Indeed this might even occur if expected real GDP growth slowed slightly.  So while economic growth often causes stock prices and bond yields to move in the same direction, there are plenty of exceptions to this pattern.  The current mix of high stock prices and low bond yields might be a bit unusual, but it’s hardly unprecedented.  Even if the factors I cite are not correct, dozens of other factors might explain the paradox.

Some people have asked me about a paper by John Cochrane, which advocates making permanent the policy of a large Fed balance sheet combined with interest on reserves.  I’d slightly prefer the old system of no IOR, but I don’t really have any strong objections to the policy.  The real issue is what sort of policy target should the Fed have, and how should they achieve that target.  I seem to recall that Cochrane likes my futures contract targeting proposal, but prefers a CPI target to a NGDP target.

Cochrane’s analysis is based on the “fiscal theory of the price level.”  I think that theory makes sense for a place like Zimbabwe, but not the US.  In the US it seems to me that the Fed is the dog and fiscal policymakers are the tail.  The Fed determines NGDP growth, and the fiscal policymakers must live with that constraint.

I also believe that Cochrane exaggerates the impact of IOR:

However, interest on reserves, together with the spread of interest-paying electronic money, radically changes just about everything in conventional monetary policy analysis. Standard answers to fundamental questions like the determination of inflation, the ability of the Fed to control real and nominal interest rates, the channels of the effect of monetary policy especially on the banking system, and so forth all change dramatically in a regime of interest on reserves and large balance sheet. The Fed anticipates some, but not others. Old habits die hard, and clear thinking is needed to dispel them.

I guess I’m too old for clear thinking, because I don’t see how anything important changes.  In the old days the Fed controlled the price level by controlling the supply of base money (through OMOs and discount loans) and influencing the demand for base money (by changes in reserve requirements.)  Now they’ll have two tools for influencing base demand; RRs and IOR.  The quantity theory still holds–a permanent doubling of the base will, other things equal, cause the price level to be twice as high as it would otherwise be.  MV=PY will still be perfectly true each and every second, because it’s a DEFINITION.  However (base) velocity will be far less stable.  The velocity of the broader aggregates that the old monetarists care about would presumably be about the same.

Money will still be neutral in the long run, and short run non-neutralities will come from sticky wages and prices.  Irving Fisher and even David Hume would have had no trouble understanding a world of IOR.

But it will become harder to teach monetary theory.  Zero interest base money makes the “hot potato effect” really easy to explain.

Mark Sadowski nails it again

The GDP data just came in, and Mark Sadowski continues to demolish the experts:

Actual RGDP growth:  minus 1.0%

Mark Sadowski’s initial forecast:  minus 1.4%

Initial Consensus:  PLUS 1.0% to 1.5% (depending on source)

NGDP came in at 0.3%, slightly below Mark’s 0.5%.  I don’t have the consensus, but it must be around 3.0%

In the 4th quarter of 2013 the consensus RGDP growth rate was around 3.8% or 3.9%.  Mark forecast 2.5% and the actual was 2.6%.  Mark forecast 4.2% NGDP growth, and the actual was 4.2% NGDP growth.

I can only find one other Sadowski GDP forecast, for the second quarter of 2013.  The consensus called for 1.0% RGDP growth, Mark forecast 2.0%, and the actual was 2.5%.

If he’s not snapped up by an investment bank in the next 30 days I am going to have to revise my views on the EMH.  Don’t make me do that.  Mark understands government data better than anyone I’ve ever met.

PS.  I notice that the fall in NGDI was entirely due to a collapse of corporate profits, which fell 10% in the first quarter (from the previous quarter.)  That’s an annual rate of decline of 34.4%!!  Does anyone know the explanation for that? Was it measurement error?  Does it comport with the numbers being reported on Wall Street?

Tim Duy on monetary offset

Tim Duy was recently interviewed by Bloomberg:

The Fed ramped up its quantitative-easing program late in 2012, helping to keep the recovery on track last year in the face of higher taxes and reduced government spending. With that drag set to fade this year, the central bank started to scale back its stimulus in December.

Offsetting Austerity

“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”

Soss said Fed officials may be realizing there are limits to how much they can spur growth in the aftermath of a financial crisis that’s made consumers and companies more cautious.

Some policy makers are becoming wary of the potential costs of providing more stimulus to the economy.

“We’re exactly on the right track” with current policy, Federal Reserve Bank of San Francisco President John Williams said in an April 21 interview, predicting unemployment will fall to 5.5 percent by the end of next year.

People have all sorts of ideas on how to speed up the recovery.  Everything from boosting mortgage lending (Congress and Obama) to building more infrastructure (Larry Summers.)  Unfortunately you can’t really do anything meaningful when the Fed thinks the economy is “exactly on the right track,” and does whatever is necessary to keep it on that track.

It’s the Fed’s nominal economy, we just live in it.

How to think about France

About once a year Paul Krugman does a post discussing the difference between the US and French economies.  Here is Krugman in 2011:

So, here are some [2008] ratios of France to the United States:

GDP per capita: 0.731

GDP per hour worked: 0.988

Employment as a share of population: 0.837

Hours per worker: 0.884

So French workers are roughly as productive as US workers. But fewer Frenchmen and women are working, and when they work, they work fewer hours.

Why are fewer Frenchmen working? As I’ve pointed out, during prime working years they’re as likely to work as Americans. But fewer young people work (in part because of more generous college aid); and, mainly, the French retire earlier. The latter is arguably the result of misguided policies: Mitterand made early retirement alarmingly attractive. But it’s not a problem of weak productivity or mass unemployment.

And why do the French work shorter hours? Probably for the most part because of government policies mandating vacation time.

The bottom line is that France is a society with the same level of technology and productivity as the US, but one that has made different choices about retirement and leisure. Vive la difference!

I’m an academic like Krugman, and not surprisingly I also prefer more leisure time to more GDP.  But one “difference” Krugman does not mention is unemployment, which has generally been higher in France than the US over the past 30 years, often by a wide margin (and hence it’s not just the euro problem.)

A few months ago Krugman noticed that France isn’t just poorer than the US, it’s also growing more slowly.  That made him slightly less optimistic about France (as compared to the Ostry et al paper he discusses in this post):

Once you delve into this low labor input, it starts to look like the result of some very specific policies rather than redistribution in general: a pension system that encourages early retirement, regulations that give the French shorter hours and much more vacation time than we get.

Overall, I am still mostly persuaded by the Ostry et al work, but I think we need to acknowledge that it’s not quite as slam-dunky as liberals might like.

And now he has a new post emphasizing the fact that France actually has a higher employment rate than the US among prime age workers (25 to 54.)  He seems to think that undercuts supply–side position that Europe is depressed due to high taxes and benefits:

The truth is that European-style welfare states have proved more resilient, more successful at job creation, than is allowed for in America’s prevailing economic philosophy.

I mostly agree with Krugman on the facts, but I see them as strongly confirming the Prescott/Mulligan view of the world.  Perhaps there’s a framing affect problem here, as Prescott once compared France to Depression-era America, mostly on the basis of the very low level of hours worked.  But let’s get past that misleading analogy, and think about what the supply-side model actual predicts.  Keep in mind that France has a wide range of policies that reduce aggregate supply:

1.  High taxes and benefits, which create high MTRs.

2.  High minimum wages and restrictions on firing workers.

What should we expect from these “bad” supply-side policies?  I’d say we should expect less work effort at almost every single margin.  Earlier retirements, more students staying longer in college, longer vacations, and a higher unemployment rate.  And that’s exactly what we see.  We might also expect lower productivity.  After all, those high tax rates should discourage capital formation, which would result in lower productivity.  And yet the figures Krugman cites suggest that productivity is only 1.2% lower than in the US.  That doesn’t seem so bad.

But here’s what Krugman misses.  His other argument, that prime age employment in France is pretty high, strongly suggests that the productivity numbers are distorted by composition bias.  Think about the people who are not employed in France, but who would be employed in America.  The rate of employment among French immigrants from North Africa is presumably lower than among Latino immigrants in the US (which seems like the most comparable ethnic group.)  The young in France are less like to work, as are the elderly.  Given that French employment is much more heavily concentrated in prime age workers, I’d expect higher hourly productivity in France.  I wonder how productivity varies controlling for age and ethnicity?

That’s not to say the supply-side model explains everything.  I’m not sure why the rate of employment for prime age workers is lower in the US than France, but I’d guess it reflects the fact that the French model does have some advantages over the US model.  Just off the top of my head I could imagine these might include a better K-12 system, less incarceration for drug “crimes,” fewer people on disability, etc.

But overall France conforms to the predictions of supply-side economics.  The French are smart enough and efficient enough to spread the cost of not working far more effectively than did the US in the 1930s.  The psychic pain of being unemployed is much less if you are a young person in school, or someone who retires early, or are spending the month of August in Provence.  But their regime is not cost-free.  They do have much higher unemployment, and that does impose psychic costs.  Liberals constantly remind us (correctly) that unemployment is a devastating problem. And their per capita GDP is only 73% of US levels (in 2008, surely even less today.)  And that percentage is gradually declining.  Migrants from China and India tend to prefer the US model.  So while I think France has a lot of good qualities such as top-notch infrastructure, and indeed arguably has close to the highest quality of life in the world, there is always room for improvement.  And the labor market is one area where France falls short, just as the supply-side model predicts.  Even modest reforms (say along German lines, not American lines) would deliver important gains.  Instead, Germany is moving in France’s direction.

And finally, I don’t think it makes much sense to compare a medium size homogenous country like France to a large heterogeneous country like the US.  Krugman has another post pointing out that the European welfare state model doesn’t work as well in Italy.  His post is entitled “What’s the Matter with Italy?” and ends with the following:

I’m not going to answer this; truly, I don’t know. But it’s important.

He’s addressing the terrible Italian productivity numbers since 2000.  I also don’t know why Italy has declined so sharply in recent years.  But there is one thing we do know about Italy, the low level of per capita GDP (compared to France) is almost entirely due to an absolutely horrendous performance in southern Italy, where roughly 1/3 of all Italians live.  And there is a lot of circumstantial evidence that at least part of the difference between southern and northern Italy is cultural.  Not “cultural” in the sense that some people use the term (a code word for lazy.)  After all, southern Italians do quite well in America.  Rather cultural in the sense that everyone’s hobbled by a culture of corruption than no single Sicilian or Neapolitan is in a position to change.

So I don’t believe you can think about France vs. the US without also thinking about southern Italy.  That’s part of the rich mosaic that is the Welfare States of Europe (the WSE), just as South Dakota Indian reservations, and McAllen Texas, and rural Mississippi are part of the United States of America (USA), the world’s richest big economy.  It would probably make more sense to compare France to an above average region of the US, such as New England or the mid-Atlantic states.  In that case the problem with the French labor market model would be easier to see.  The problem is not that the French model has “failed,” as some conservatives suggest.  The problem is that France has not achieved Swiss or New Hampshire levels of success, despite having the human capital and cultural traditions needed to do so.  They should aim even higher.

HT:  Edward

PS.  In 2012 the World Bank has French GDP/person (PPP) at 71.1% of US levels.  In 2013 the IMF has French GDP per capita at 67.4%, while the CIA has 67.6%.  I suppose you could argue the drop since 2008 is cyclical, except no one is predicting French GDP/person to rise faster than US GDP/person over the next few years.  It looks permanent to me.

As a point of comparison, African American housholds make 65.3% of the US average, and Hispanics make 76.5% of the average.  Is that comparison misleading?  That’s an understatement; it’s utterly and completely misleading.  Apples and oranges.  I simply provide the data for all the fools who think income data tells us something useful about issues like economic inequality.

PPS.  I just noticed that Tyler Cowen has an excellent post on this topic.