When it doesn’t matter, and when it does

One learns macroeconomics by learning a bunch of “it doesn’t matters.”  And then learning when they do and don’t apply.  Here are a few:

1.   It doesn’t matter whether you have a 10% wage tax or a 10% consumption tax.

2.  It doesn’t matter if you increase M by 10% as all nominal quantities rise by 10%, except the nominal interest rate, which is unchanged.

3.  It doesn’t matter if you depreciate your currency by 10%, because your price level will rise to offset any advantages to exporters.

4.  It doesn’t matter who is legally liable, the parties will negotiate the same (efficient) outcome either way.

5.  It doesn’t matter whether you buy a one year bond paying 3.0% or a two year bond paying 3.4%.  Because both have a 3% expected return over the next twelve months.

6.  It doesn’t matter if Korea puts a 10% tax on imports and a 10% subsidy on exports; their effects cancel out.

7.  It doesn’t matter if you can earn a higher interest rate in Australian banks than Japanese banks, as the expected gain is offset by an expected depreciation in the Aussie dollar.

8.  It doesn’t matter if Europeans exempt exports from their VAT, as their exchange rate rises to offset any advantage to exporters.

9.  If doesn’t matter if the trend rate of inflation rises, as the steady state nominal interest rate rises in proportion.

10.  Tax cuts don’t spur demand, because they leave the public no richer than before—hence they are saved.

11.  It doesn’t matter whether the payroll tax is put on workers or employers.

Update:  I forgot Modigliani/Miller—It doesn’t matter whether you finance with debt or equity.

Micro has lots of quasi “it doesn’t matters,” where it doesn’t matter in the way the average person might expect:

1.  It doesn’t matter if you require companies to offer worker benefits; they’ll just pay lower wages to offset the cost.

2.  It doesn’t matter if you force banks to charge lower fees in one area; they’ll just charge higher fees in another.

3.   It doesn’t matter if you require jobs to be safer, or products to be more durable, companies will simply adjust the wage/price.

In these micro cases it does matter for allocative efficieny, but that’s another story.

The various macro neutrality conditions form a beautiful theoretical structure.  Unfortunately, some of them are not always true.  The trick is to figure out when and where they apply.

Most people approach macro from the opposite perspective.  They’ll start with the exceptions, and then gradually those exceptions will take over their entire mental universe.  Here’s an example:

Because wages and prices are sticky in the short run, a sudden increase in the money supply will often depress nominal interest rates for a period of time.  If wages and prices were completely flexible, monetary policy would have no effect on interest rates.  Indeed this has been proven via a special type of monetary policy shock called a “currency reform.”  In a currency reform the government might take 100 old pesos and convert them into one new peso.  The money stock falls by 99%.  Importantly, they also make all wages and prices completely flexible at this point in time, by executive decree.  Thus a worker employed on a 120,000 peso a month labor contract, automatically slides over to a 1200 new peso a month labor contract.  There is no effect on unemployment, and no effect on nominal interest rates.

The majority of people see monetary policy very differently from me.  For them the side effect becomes the policy itself.  Changes in nominal interest rates are no longer a temporary effect of money supply changes in the face of sticky prices, but the policy itself.  This gets them in trouble in the longer term, as the neutrality conditions do eventually hold, and cause the interest rate-focused person to become hopelessly confused.  Countries fall into deep depression and deflation “despite” the ultra easy monetary policy of near-zero interest rates.  Or countries fall to succeed in international trade, “despite” repeated devaluations of their currency.  And so on.

Don’t get me wrong, the non-neutrality conditions are very important in the real world.  Negotiations do require transactions costs, hence liability often matters.  But that doesn’t mean the Coase theorem tells us nothing.  It correctly tells us that there is no rationale for regulating workplace smoking, for instance.  And wage/price stickiness is very important, indeed in my view it explains the Great Contraction (but not the slow recovery.)  But it’s not so important that it produces a permanent trade-off between inflation and unemployment (as we saw in the 1970s.)   And non-traded goods are very important, which explains why PPP doesn’t hold between the US and China.  But they aren’t so important that they prevent rising inflation in China from increasing its real exchange rate, when the Chinese government is too slow to adjust the nominal rate.

Macro is all about balancing the “it doesn’t matters” with the “it does matters.”  Let me give you an example of where I used this framework today.  Nick Rowe has a very interesting post arguing that if we are in a liquidity trap and if the Fed is pegging rates, then higher default risk on T-bonds is expansionary, as it lowers the risk-adjusted cost of private borrowing.  Private debt with the same risk as the now risky government debt sees its yield fall to the rate on T-bonds.

I used the expectations hypothesis to try to refute Nick’s argument.  I’m still not sure I’m right, but here’s my thought process.  The expectations hypothesis of the yield curve says the expected return from holding a 10 year bond for one year, should be the same as the expected return from holding a one year T-bill.  But if the T-bill yield is near zero, then the expected one year return on T-bonds is also near zero, despite their 3% yield to maturity.  So if a 1% default risk it added on, (as Nick assumed) the expected one year yield goes negative.  Now everyone sells all the T-bonds to the Fed, and the Fed must buy because Nick assumed they hold rates steady.  You are left with nothing but cash in circulation, and there is no relative gain for private sector debt, because cash has always been a zero yield/zero default risk asset.

Now I know some of you commenters are chomping at the bit to tell me that the expectations hypothesis of the yield curve is “false” and has been “disproved.”  But that’s where it’s important to always keep in mind what matters, and what doesn’t.  Because even if you are right it doesn’t help Nick’s argument.  That’s because if T-bonds and T-bills are not close substitutes, and if T-bonds yield 3%, then you are not in a liquidity trap in the first place.

I’m not saying that my reasoning is necessarily right here.  But I thought it might be interesting for you to see how my mind works on these problems.  I start with all the beautiful neutrality conditions, and then start considering where they might not hold, for how long they might not hold, how empirically important the non-neutralities are, and what sort of implications they have for the rest of my theoretical edifice.  You need to balance a lot of different factors, and I’m sure I often make mistakes when doing so.  When you read other economists, you can see the ones that tend to have this theoretical edifice in the back of their minds, and those who don’t.  I won’t name any names.

Update:  I will name one economist that definitely does have the beautiful neutrality conditions in his mind; Paul Krugman.  Here he has a similar response to Nick’s hypothesis.


Tags:

 
 
 

54 Responses to “When it doesn’t matter, and when it does”

  1. Gravatar of K K
    25. July 2011 at 10:58

    Scott:  I think I see a possible source of disagreement.  Lets take Nick’s example where there is a sudden transition from 0% annual expected loss to 1% annual expected loss (under the risk-neutral measure). Lets assume the short end of the curve (out to e.g. one year maturity), was previously yielding less than 1%.  Now there is no way the CB can maintain the yield on those bonds where they were before.  They’d have to buy them all, since the market isn’t going to hold securities at an expected return inferior to the expected path of the short rate.  But for the bonds that were previously yielding above 1% (i.e. those maturing well beyond the expected end of the liquidity trap), they could (under the same theory that CB is currently able to influence yields via QE), bring the yields down to where they were before the event.

    Then for the expected period of the liquidity trap, long bond holdings will have an expected return of 0%.  If there is no default they will return 1%, which is offset by an expected loss of 1% from default.

  2. Gravatar of Lee Kelly Lee Kelly
    25. July 2011 at 11:13

    I am not sure I understand your or Nick’s arguments, but I can’t see how downgrading government debt is expansionary.

    A liquidity trap occurs when there is frustrated demand for safe and liquid assets at the lower nominal bound. Since the demand has to go somewhere, and the closest substitute is money itself, there will be an increase in demand for money. In other words, there is a shortage of safe and liquid assets and downgrading government debt will only intensify it. That said, the substitution effect may be mitigated if people take these fiscal shenanigans to imply that U.S. dollars have a higher inflation risk.

  3. Gravatar of K K
    25. July 2011 at 11:24

    Let’s be really explicit:

    1-year yield is at 0%
    2-year yield is at 2%

    Therefore the 1-year to 2-year forward is at 4% (roughly, we are going to ignore compounding here).

    1-year zero coupon bond (zcb) is at 100
    2-year zcb is at 96

    Then expected loss from default goes to 1% per year all the way out the curve.

    1y zcb goes to 99
    2y zcb goes to 95

    CB buys bonds back up to their original price. The new interest rates now are:

    1-yr risk free rate is 0% (it can’t go lower)
    2 yr risk free rate is 1% (2% yield minus 1% expected loss)

    The 1-year to 2-year forward is now at 2%.

    At 100, the expected return on the 1 yr bond is -$1, which is below the risk free rate. So nobody will hold it.

    At $96 the price of the 2-year bond nows reflect $2 of discount for risk free interest and $2 of expected loss. At the end of one year, the expected value of a portfolio holding the bond is $96, for a first year return of 0%. This comes from the expected price at end of 1 year conditional on no default of $97 minus the expected loss from the default in the first year of $1. (The expected price conditional on no default comes from the 2% forward interest rate plus the 1% forward expected loss rate).

  4. Gravatar of Nick Rowe Nick Rowe
    25. July 2011 at 11:33

    Lee: you are thinking like a monetary disequilibrium theorist (unsurprisingly ;)). Now think like a Keynesian. Forget about money. Think about the paradox of thrift, where an excessive demand for saving, in the form of government bonds, creates the recession. If government bonds now look less attractive, people will want to either stop saving and consume, or else invest in real assets.

  5. Gravatar of Ron T Ron T
    25. July 2011 at 11:47

    #2 is wrong, the price level wil not move, MMT-ers explained this to you 3 posts down, plus Bernanke showed it in practice in 2008-2009.

  6. Gravatar of Jason Jason
    25. July 2011 at 12:01

    This is a great post; I like to learn about these thought processes — maybe even more so than actual policy ends.

    Your statement on monetary policy and interest rates made me think of this:

    http://en.wikipedia.org/wiki/Endergonic_reaction#Making_Endergonic_reactions_happen

    Versus this:

    http://en.wikipedia.org/wiki/Newton's_laws_of_motion#Newton's_third_law

    A policy prescription from the former analogy would be increasing the money supply is an “exergonic reaction” that pushes interest rates to undergo an “endergonic reaction” and decrease. However, the former doesn’t require the latter while the latter requires the former.

    A policy presciption from the latter analogy is that low unemployment generates higher inflation, so higher inflation should generate lower unemployment (ceteris paribus).

  7. Gravatar of Lars Christensen Lars Christensen
    25. July 2011 at 12:17

    I have been playing with the same idea for some time, but in a slightly different model set-up – and I reach worrying conclusions…

    Lets imagine we have a liquidity trap and/or we are trapped in some deflationary spiral combined with a Sargent-Wallace model of “some unpleasant monetarist arithmetic”.

    Then the policy recommendation would be to appoint Zimbabwean central bank governor Gideon Gono as Treasury Secretary. Hence, everybody in the financial markets would know that a completely irresponsible person with about no credibility would now be in charge of US fiscal policy and the logic of the monetarist arithmetic would mean that sooner or later that would lead to Zimbabwean scale money printing and inflation expectations would spike dramatically and immediately solve the liquidity trap problem and hence would be expansionary in the same way as you suggest.

    I might add that the problem with the “Gono as Finance Minister”-model is that Japan seems to have pursued the policy recommendation of the model for years without having the expected impact…Maybe Barro can explain why the model has failed in Japan;-)

    PS I would agree with Lee Kelly (as would Nick I guess…)…but it’s about how different models can lead us to “insane” conclusions…

  8. Gravatar of Scott Sumner Scott Sumner
    25. July 2011 at 12:39

    K, That’s a good point, but then the country was never in a liquidity trap in the first place. After all, the Fed could right now buy up all T-bills, and then start lowering the yield on longer term bonds.

    So I think you are right, but for reasons that have nothing to do with risk. Even at zero risk the Fed can do exactly what you suggested. What interested me about Nick’s post was the suggestion that it somehow provided monetary stimulus, where normally that would be impossible due to a liquidity trap. But it’s very possible I misinterpreted what he was getting at. My point was that this doesn’t provide some new method of lowering rates, where previously that wasn’t possible due to the liquidity trap.

    Bottom, line, it still depends on what the Fed is trying to accomplish, which is where I believe things have been from day one.

    Lee, Nick assumes the Fed is pegging interest rates, hence they’d need to add enough new money to prevent deflation from occurring.

    Nick, That’s right.

    Ron, You said;

    “plus Bernanke showed it in practice in 2008-2009.”

    This is wrong for two separate reasons. First, the money that was injected was interest-bearing, and my example assumed non-interest-bearing money.
    Much more importantly, the injection must be permanent, and Bernanke made it quite clear that the injection was temporary–hence you wouldn’t expect much inflation.

    In 2008 I predicted the Fed injection of money would have little impact on the price level. And I’m a fan of the QTM.
    God I hope the MMTers aren’t using QE2 as a test for the QTM, if so, they’re even more behind the times than I thought. That was Keynes’s argument in 1933. “Modern” monetary theory??

    And no, MMTers didn’t explain anything to me, they tried to explain their theory to me.

    Jason, Those are interesting analogies.

  9. Gravatar of Scott Sumner Scott Sumner
    25. July 2011 at 12:42

    Lars, I certainly agree that the Keynesian model has some insane implications, but I just don’t see where Nick has proved what he wanted to prove. But I’m not the one to ask–it’d be more interesting to see what Keynesians think.

  10. Gravatar of Lee Kelly Lee Kelly
    25. July 2011 at 12:48

    Scott,

    I was also assuming the Fed would prevent deflation; my argument was just that it would have to, i.e. a default wouldn’t be expansionary in and of itself. But thinking again, I might be wrong about that. This is what I wrote over at Nick’s blog:

    “All else being equal, further reducing the supply of safe and liquid assets would tend to increase money demand, but all else is not equal. If the Fed can’t withdraw money from circulation, then the inflation risk on money rises. The question is: does the opportunity cost of holding money instead of U.S. government debt remain constant? If it does, then a default might be expansionary after all, because opportunity cost of holding money and U.S. government debt will have increased relative to everything else.”

  11. Gravatar of Lars Christensen Lars Christensen
    25. July 2011 at 12:51

    Scott, I think that Nick have proven your point that even in Keynesian model there is really no such a thing as a liquidity trap. And my version of Nick’s challenge to the liquidity trap – an insane finance minister in a Sargent-Wallace model proves the same point: If you want to increase inflation expectations and escape the liquidity trap it can be done by appointing a insane Finance Minister – in the present US situation the paradox is of course that the “Insane Finance Minister” is the Republicans. By the way it seems like the market has called the GOP’s bluff – is not the unpleasant monetarist arithmetic would have told us that TIPS breakeven inflation expectations would have spiked. That has not happened…

  12. Gravatar of John John
    25. July 2011 at 12:58

    Frankly a lot of that was over my head, but I thought the proposition that taxes don’t spur demand because they are saved was ridiculous. What is the point of saving if not to spend or invest at a later date. People don’t save or hoard money in order to bury themselves with it (save Egyptian Pharoahs).

    It seems to me that economists, and especially liberal ones, have some kind of hatred of savings. Maybe it was passed down from Karl Marx. To paraphrase Mises, Keynesianism (of which monetarism is a variety) is a deliberate misunderstanding of the role that savings and capital accumulation play in the improvement of economic conditions. Today we are the lucky ancestors of men who underconsumed in order to create the capital goods we take for granted today. Without these capital goods, the productivity of labor would be very low and we’d all be very poor.

    It’s high time that economics rediscovered the importance of saving. It’s the sine qua non of economic growth. I don’t think it’s an understatement to say that future improvements in society depend on it. It its importance is not recognized the US and the developed world will continue to muddle in debt and stagnation, passing along lower living standards to our children.

  13. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2011 at 13:11

    I think it kinda funny you think macro has all these “it doesn’t matter” and then have like three for micro.

    macro doesn’t even really exist. aggregates are a nearly a figment. micro is all you need to know.

    Note: it is conversations like this that convince MMTers the state has a monopoly on money. the reality is MMTers prove the state shouldn’t be anywhere near it.

    We’re going to do to the world, what Mundell did to Europe: global monetary union without political union.

    100 years from now government won’t run money.

  14. Gravatar of Lars Christensen Lars Christensen
    25. July 2011 at 13:14

    John…

    Statement 1:

    “What is the point of saving if not to spend or invest at a later date. People don’t save or hoard money in order to bury themselves with it”

    Statement 2:

    “Today we are the lucky ancestors of men who underconsumed in order to create the capital goods we take for granted today. Without these capital goods, the productivity of labor would be very low and we’d all be very poor.”

    Statement 1 assumes (correctly in my view) rationality of man. Statement 2 seems to indicate that you think that rationality lead to too low savings which in some way is evil…

  15. Gravatar of James Oswald James Oswald
    25. July 2011 at 13:21

    I love your “This is how I think” posts. I have gotten so much milage out of your “Never reason from a price change” advice. Time will tell if this is a useful approach to macro reasoning for me.

  16. Gravatar of K K
    25. July 2011 at 13:42

    Scott: “My point was that this doesn’t provide some new method of lowering rates, where previously that wasn’t possible due to the liquidity trap.”

    No, you’re right.  All Nick did was to lower real risk free rates by 1% across the curve, via a lot of QE.  The CB could, of course, have done that
    independent of the loss of govt credit worthiness.

    Scott: “So I think you are right, but for reasons that have nothing to do with risk.”

    My only point was that the Fed wouldn’t end up owning all bonds whose *risk free yield* was initially higher than 1%.  I think I’m right about that *for the reasons I said.* Though I guess you could characterize more simply by saying that the Fed can’t lower risk free real rates by 1% when yields are less than 1%.  Yup, that would have been simpler.

    Scott: “That’s a good point, but then the country was never in a liquidity trap in the first place. After all, the Fed could right now buy up all T-bills, and then start lowering the yield on longer term bonds.”

    OK, but like you said, the important thing about a liquidity trap is that *all capital assets* (not just treasuries) have the same expected short term  risk adjusted return as cash. I.e. *zero*. I.e. you don’t need to have liquidity reasons to hold cash since in fundamental ways, it is as good an asset as any other. That is qualitatively different from when the short rate is above zero.

    Lars Christensen: “the logic of the monetarist arithmetic would mean that sooner or later that would lead to Zimbabwean scale money printing and inflation expectations would spike dramatically and immediately solve the liquidity trap problem and hence would be expansionary in the same way as you suggest.”

    It’s not just about the expected path of inflation/rates.  Where there is significant uncertainty there will also be large risk premia in asset prices. If you put Gideon Gono in charge, risk premia will dominate the expected path of risk free rates in determining long term yields. That will be a major drag. This is the principal reason why an economy cannot function at a high rate of inflation: It’s not that the future price level is too high; it’s that it’s too uncertain.

    Also, as much as you may not like Japan’s fiscal policy, all evidence points to the market having an extremely high opinion of their credit quality.  So Japan doesn’t provide any evidence either way on the matter of whether sovereign credit risk could constitute fiscal stimulus.

  17. Gravatar of Lars Christensen Lars Christensen
    25. July 2011 at 14:12

    K,

    In regard to Japan I am not talking about that proving anything. Rather I say Japan’s is a challenge to the idea that an unsustainable fiscal policy would lead to a spike in inflationary expectations. Furthermore, I did not talk about fiscal policy being expansionary. Rather I talked about the dynamics between the expectations for future MONETARY policy in the case of unsustainable fiscal policy – this is the point in Sargent and Wallace paper on “some unpleasant monetarist arithmetic”.

    In terms of the risk premium I am not saying that the model that I describe is “realistic” or the correct model to use. My “real world” view is that an actual US default would likely the US economy to the brink of depression – and the reasons for this are as Lee Kelly has described above. However, the exercise here was to illustrate different models in which we would get insane or at least counterintuitive results of a US default. Nick Rowe suggested a New Keynesian model – I suggested a model based on (quasi) monetarist arithmetics.

  18. Gravatar of Scott Sumner Scott Sumner
    25. July 2011 at 14:35

    Lee, Yes, inflation risk could reduce currency demand.

    Lars, But even the liquidity trap proponents would never deny that a crazy finance minister is a way out. Krugman argues the liquidity trap is caused by the conservatism of the government, which leads to low inflation expectations. I don’t see where Nick refutes that.

    But again, I don’t believe there are liquidity “traps.” albeit for very different reasons. I hope I’m wrong and that Nick has some ironclad refutation of the LT, but I very much doubt it.

    John I agree about saving, I’d guess that I’m the most pro-saving blogger in the blogosphere. I’d like to see us save lots more.

    Morgan, If there is a single world money, I’m pretty sure there will be a government of some sort running it. The ECB is a government institution.

    Thanks James,

    K, Yes, I think you are right in your defense, I probably didn’t make my point clearly.

    You said;

    “OK, but like you said, the important thing about a liquidity trap is that *all capital assets* (not just treasuries) have the same expected short term risk adjusted return as cash. I.e. *zero*. I.e. you don’t need to have liquidity reasons to hold cash since in fundamental ways, it is as good an asset as any other. That is qualitatively different from when the short rate is above zero.”

    I guess I’m still a bit confused. Let’s say there is no default risk issue. So we are in the current real world. Let’s also suppose the Fed buys up all securities with yields currently below 1%-say up to 3 or 4 years maturity in the Treasury market. And they keep buying until the security that used to have a yield of 1.01% now has a yield of 0.01%. Does that policy do the same thing as Nick’s?

  19. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2011 at 15:54

    Whoa! Modigliani/Miller???

    “It doesn’t matter whether you finance with debt or equity.”

    Ok, now wait.

    Unlike the weirdo MMTers, my own monetary crazy idea is Natural Money:

    http://www.naturalmoney.org/

    Which is horribly polluted by the fact that somehow it makes usury sound like a Jewish conspiracy.

    But generally, I’m very much intrigued by money that cannot be hoarded, as in:

    – a holding tax, which amounts to 0.5% to 1.0% a month;
    – a complete ban on usury, which is charging interest on money;
    – a money supply that is constant;
    – a complete ban on credit, which is creating money out of nothing.

    —–

    I understand that this idea gets hacked apart in reality by Islam, but…

    The entrepreneur in me LOVES THIS idea. It means that wealth must exist exclusively in equity and assets.

    It means there is NO SAFE INVESTMENT. Everyone must be constantly hyper-aware of the profit taking market they own a piece of. EVERYONE must be an entrepreneur.

    So how exactly does Modigliani/Miller get around the premise that the BEST KIND OF PEOPLE benefit from pure equity money?

  20. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2011 at 16:01

    “Morgan, If there is a single world money, I’m pretty sure there will be a government of some sort running it. The ECB is a government institution.”

    Scott, you don’t have a cell phone.

    But you have at least looked into bitcoin.

    Between those two things, it is unfathomable to me that government will run money.

    Capital and labor will be globally friction-less. WHY would any country trying to sell itself to those groups think it can do anything other than keep the money supply limited and divisible?

    Just look at what the ECB has been able to do to Greece.

  21. Gravatar of K K
    25. July 2011 at 16:19

    Scott:

    If they did that, and then also bought treasuries further out the curve until all those had rallied by exactly 1%, then they would have done what Nick is proposing, whether the treasuries were default risky or not.  

    Which nicely makes the point that treasuries are nothing more than an instrument that happens to be convenient because it is risk free.  But any bonds will do. So long as they have the requisite sensitivity to changes in particular risk free yields then buying them will have the required effect of reducing those yields.

    But there is a bit of a simplification in the way the problem is framed.  We are assuming that the expected loss rate, i.e. the credit spread is 1%, and that this number is independent of Fed buying.  In reality both the term structures of the risk free rate and the term structures of hazard rates are subject to a wide distribution of estimates of market players.  So if the Fed starts buying default risky securities, both market implied risk free rates and market implied expected loss rates (credit spreads) would decrease.  The Fed would be reducing both rates and government credit risk.
    But in our thought experiment, the expected loss on government bonds is mysteriously known to be exactly 1% per year.  Therefore, no amount of buying can change the credit spread, and only the risk free portion of the yield will drop.

    Lars:

    Sorry, I thought you were mocking the possibility of using raised
    inflation expectations as a tool to escape a state of deficient demand. (Don’t you know the proper use of invoking Gideon Gono in a monetary policy debate! 🙂 But you were actually advocating the Gono model!

    And my point about risk premium had nothing to do with *default risk premium*.  It was really about rate volatility risk premium in a state of high inflation, being the principal reason why we need to avoid that state.

    As far as the failure of Japan goes… Instead of high quality bonds, they should have been buying NGDP futures. Then they would have lost a pile of money, destroyed their balance sheet, and caused some decent inflation fear! Of course, it would be still pretty straightforward to achieve the same thing by following the Ron Paul prescription of burning the bonds on their balance sheet.  I wonder what they are waiting for?

  22. Gravatar of John John
    25. July 2011 at 16:30

    @ Lars

    I think the lack of saving today is the result of government policies designed to spur consumption not a flaw in markets or human nature.

  23. Gravatar of John John
    25. July 2011 at 16:33

    I don’t believe that the government should do anything to encourage or discourage savings. Savings should reflect consumer preferences for present vs future goods which would guide productive processes onto sustainable paths via market interest rates.

  24. Gravatar of Morgan Warstler Morgan Warstler
    25. July 2011 at 16:51

    John, consumption taxes make sense tho

  25. Gravatar of K K
    25. July 2011 at 17:24

    John: “I think the lack of saving today is the result of government policies designed to spur consumption not a flaw in markets or human nature.”

    The lack of saving is due to government policies designed to subsidize the financial sector like essentially free deposit insurance, implicit bailout guarantees, tax credits for mortgage interest, 401k deductions, etc… You can’t increase consumption, since consumption must equal production.  Through these policies you actually *decrease* consumption by distorting the market which decreases production.  But you *do* massively increase debt which pushes a huge chunk of the cash in the direction of financial sector, which is the whole point.  The point is, that in a free market equilibrium we’d all have more consumption *and* more savings.

  26. Gravatar of Eric Dennis Eric Dennis
    25. July 2011 at 17:45

    Great point about the first-order truth being conservation laws (or equivalently, as you formulate it, symmetry principles). Now please indulge my attempt to hoist you on your own petard.

    During tight money, it is not merely a uniform fall in prices that wreaks havoc, because in that case business inputs would fall by the same fraction as outputs, and there would just be an effective redenomination of money (one of your stated symmetry principles). So it is only the non-uniformity of the deflation that scrambles relative prices and, given sticky wages, tends to strike at business profits, hence at the demand for credit, bringing about a downward spiral.

    Now let me invoke a symmetry principle: the exact same thing (in mirror image) happens under loose money. If your 5% NGDP target is too high, and if the Fed forces us into that trend, non-uniformities in how the excess money supply works its way into the economy will cause overvaluation of certain forms of capital (e.g. housing) and an upward spiral of certain capital-intensive projects. This malinvestment is just as unreflective of the actual state of savings as the deflationary spiral induced by tight money and so, in principle, just as destructive of real wealth.

    So I put it to you, wouldn’t it be strange if the Fed, whose public choice incentives are tilted more often toward loose money, were to *always* err on the side of tight money? — which seems to be your view of the last 20 years.

  27. Gravatar of Lee Kelly Lee Kelly
    25. July 2011 at 18:35

    Eric,

    That’s why I agree with Woolsey: 3 percent would be better. Some years will get a little inflation and others deflation, but the price level will be about constant in the long run. I think Sumner favours 5 percent because it’s the historical norm: the problems you (correctly) associate with too rapid growth in NGDP are mitigated by adaptive expectations.

  28. Gravatar of John John
    26. July 2011 at 04:03

    I agreed with Scott, Morgan, Dennis, and K. First time I’ve agreed with that many people on this blog.

  29. Gravatar of Scott Sumner Scott Sumner
    26. July 2011 at 06:38

    Morgan, It matters in the real world because equity is taxed and debt isn’t. Those usury ideas are nuts, BTW.

    K, I also thought about the fact that Fed buying would change the perceived risk, but I took Nick at his word, and assumed it wouldn’t. You might want to check Krugman’s post, he had a very similar take to mine.

    John, I advocate forced saving in place of forced taxes. The US has forced taxes, Singapore has forced saving. I like their system better.

    Also recall that current government policy massively discourages savings, I’m just trying to make the government more neutral.

    Eric, You said:

    “So I put it to you, wouldn’t it be strange if the Fed, whose public choice incentives are tilted more often toward loose money, were to *always* err on the side of tight money? “” which seems to be your view of the last 20 years.”

    I agree with much of what you say, but this is completely false. I’m 55 years old. Until 2008 I’d basically never criticized the Fed for tight money (as far as I recall.) Perhaps you are confusing me with Yglesias. I’ve been a hawk many more years than I’ve been a dove–not even close.

    Lee, I’m fine with 3% if we go to level targeting, which Woolsey favors. If we had done 3% since 2008, we’d be waaaaay better off now.

  30. Gravatar of Cahal Cahal
    26. July 2011 at 11:27

    ’11. It doesn’t matter whether the payroll tax is put on workers or employers.’

    Small point, but I thought the general consensus was that employers was worse, because it increases unemployment, whereas for employees it doesn’t stop them from working because the substitution effect is stronger?

  31. Gravatar of Kendall Kendall
    26. July 2011 at 14:19

    I don’t understand some of these “doesn’t matters”.

    4. A car company won’t pay me for getting hurt in an accident unless they are liable due to a car defect so how is #4 true?

    5. If the rate changes at the end of one year then the 2 year bond holder is either in a better or worse position than the 1 year bond holder so how is this true?

    8. If this is true why are economists against tariffs? Wouldn’t the exchange rates cancel out the tariff effects?

    Thanks for any explanations!

  32. Gravatar of Eric Dennis Eric Dennis
    26. July 2011 at 15:19

    Sorry if I mischaracterized your view. I recall you denying loose money as a major cause of the housing bubble due, I take it, to your sympathy for the EMH. I was trying to point out a symmetry between the inflationary bubble and the deflationary spiral in that they both violate the EMH and, in both cases, because a critical assumption of the EMH isn’t operative: market prices, in particular the market price of credit.

  33. Gravatar of W. Peden W. Peden
    26. July 2011 at 15:34

    Kendall,

    The exchange rate operates to offset the advantages of tariffs because it appreciates and reduces the quantity of trade. This is why import control policies don’t actually improve the balance of trade; they just reduce trade. Reducing trade, of course, is a negative for welfare.

  34. Gravatar of Jonathan Jonathan
    26. July 2011 at 19:44

    I’m starting to really love this blog.

    Scott: My search didn’t find much on your blog on Modigliani-Miller. I would love to hear your thoughts on when/whether MM matters in the current debate on the socially optimal capital cushions required of financial intermediaries. I work in the fin reg field and still get irked that MM generally isn’t the starting point in this discussion (at least w.r.t. effects on lending and growth). Perhaps I’m missing something?

    Jonathan

  35. Gravatar of Kendall Kendall
    27. July 2011 at 05:57

    W. Peden,
    Thanks for the info. Could you be more specific on what it means for the exchange rate to appreciate? eg If two euros = 1 dollar and the US puts a 10% tariff on cars how will the rate change and how will the rate change effect items without a tariff? Thanks!

  36. Gravatar of Scott Sumner Scott Sumner
    27. July 2011 at 07:39

    Cahal, No, that’s not right. The only case where it matters is in the short run, when nominal wages are sticky. In that case, the employer version costs jobs, until wages readjust.

    Kendell, Google the Coase theorem for a discussion of when the liability issue matters, and when it doesn’t.

    A VAT is nothing like a tariff. A VAT does not discourage trade, as it taxes all consumption equally. A tariff discourages trade, and hence is distortionary.

    I don’t follow your interest rate example, but if you google the expectations hypothesis of the yield curve you might find an explanation.

    Jonathan, It matters now because we tax equity but not debt. It may also matter for things like the agency problem, but corporate finance in not my forte. (So I don’t plan to blog on M/M.)

  37. Gravatar of Scott Sumner Scott Sumner
    27. July 2011 at 07:42

    Eric, I don’t understand what you mean by market prices of credit not being present. Are you talking about the tax distortion? In any case, I don’t see the EMH depending on market prices for credit.

  38. Gravatar of StatsGuy StatsGuy
    27. July 2011 at 11:43

    Krugman’s post rested on the distinction between cash and debt (in so far as inflation adjusts the values of both, while default does not). I would add, more importantly, private debt and other assets that are dollar-denominated.

    The issue with default is the RELATIVE adjustment of asset values, not the total. In other words, the real problem is the distributional consequences imposed, and the transactional/liquidity costs of dealing with these consequences and the contractual conflicts surrounding them.

    Remember, “It doesn’t matter who is legally liable, the parties will negotiate the same (efficient) outcome either way.” ONLY applies when there are zero transaction costs and perfect information and infinite borrowing capacities.

    (I especially loved the infinite borrowing capacities assumption in general equillibrium theory and in Coase and other models. If two neighbors, Al and Bob, are in a dispute over land… Let’s say Al values the land more, but is dirt poor. Al loves the land – it means everything to him. There’s nothing he wants more than this land. If a judge awards land to Bob, Bob will sell to Al at the market price (sans Al) or Al’s reservation price (whichever is higher, assuming he knows it – let’s say there is a finite reservation price which is ridulously high). But Al can’t afford even the going market price. No problem! Al borrows money… At no point does the theory ever wonder WHETHER HE CAN PAY IT BACK? Maybe Al has cancer… Or is 80 years old. Maybe the reason he loves the land is he was born there and his wife died there, and that’s where he wants to be buried. So yeah, initial conditions DO matter.)

  39. Gravatar of Eric Dennis Eric Dennis
    27. July 2011 at 15:57

    Scott, I mean when the Fed is too loose, it’s fixing the price of credit (i.e. rates) below the market price, which sends a distorted signal about, among other things, the actual state of people’s time-preferences.

    The EMH is thus undermined. Why can’t we just figure out what the right price of credit should have been and profit on derivatives bets? For the same reason a central planning board can’t just play market — because the price system (or some critical component of it) has simply been abolished.

    Were we omniscient, we could figure out how the distortionary signals are working their way through capital markets and into individual sectors and businesses — just like omniscient people could figure out in detail how an excess money demand would work its ill effects on the balance sheets of productive businesses that are needlessly forced to contract. But we’re not omniscient, we can’t mentally reconstruct the whole matrix of abolished market processes, so we are stuck with the wealth-destructive effects of monetary disequilibrium, inflationary and deflationary.

  40. Gravatar of Scott Sumner Scott Sumner
    28. July 2011 at 06:00

    Statsguy, You said;

    “Krugman’s post rested on the distinction between cash and debt (in so far as inflation adjusts the values of both, while default does not). I would add, more importantly, private debt and other assets that are dollar-denominated.”

    Yes, and my argument rested on the same distinction.

    I agree with your other points, one has to know when to apply these neutrality conditions, and when they don’t apply.

    Eric, You said;

    “Scott, I mean when the Fed is too loose, it’s fixing the price of credit (i.e. rates) below the market price, which sends a distorted signal about, among other things, the actual state of people’s time-preferences.”

    I’m not sure why the signal would be distorted. In any case, the Fed doesn’t fix interest rates below their market level, it moves the market level, by adding money.

    Furthermore, easy money usually results in high rates, not low rates. Right now money is very tight, yet interest rates are low.

  41. Gravatar of Kendall Kendall
    28. July 2011 at 09:37

    Scott,
    Thanks for the reply. Don’t subsidies distort trade in the same way that a tariff does? The fact that Europe’s subsidy is the same size as the vat doesn’t change the effect the subsidy has does it?

    Maybe I don’t understand how bonds work. I thought if I buy $100 worth of 1 year bonds at 3% at the end of the year the bond issuer will owe me $103. If I repeat the process at the end of the second year I will have $106. But if I buy the two year bond at the end of two years I will have $106.40. So if nothing changes and I don’t need the money before then the two year bond is a better deal. If at the end of the first year the 1 year bonds are yielding 4% then I will have $107 after buying 1 year bonds two years in a row and that will be the better deal. Is this not how bonds work if you hold them to maturity? Thanks!

  42. Gravatar of Eric Dennis Eric Dennis
    28. July 2011 at 12:15

    Scott,

    Suppose the Fed were to decide that it wanted to target Cadillac Escalades at $1,000,000 per, which it were to achieve by continuously printing enough money, buying enough Escalades, and parking them all in a big underground vault. What would happen to the price of components that go into the Escalade, to the price of Escalade-related labor, to the price of food in towns with Escalade plants, etc.? Would this be distortionary or efficient? Would real wealth be greater or smaller as a result of all this?

    When I say the Fed fixes rates too low, I mean relative to the contemporaneous natural rate, not on some absolute/historical scale. In a later post, you say “The Fed can briefly push them [rates] out of equilibrium (due to sticky prices) but this triggers big changes in AD and the price level.” What if the price level would have been gradually decreasing, and the Fed’s distorted rate target acts to stabilize it? Yes, big changes in AD are occuring, relative to what would have been the case in monetary equilibrium, but people who believe in price level stability can’t tell and/or don’t care, so the distortionary forces can build up for quite a while.

  43. Gravatar of Scott Sumner Scott Sumner
    29. July 2011 at 10:32

    Kendall, Subsidies and taxes have opposite effects. Do both and you have no effect.

    No, if the 2 year bond yields 3.2%, then after one year the one year bond may be expected to yield 3.4%. Same total return either way. That’s the expectations hypothesis.

    Eric, The difference is that they’d have to buy a lot of Caddy’s for that to work. But OMPs can be done with a trivial amount of bond purchases, and hence don’t really distort the (huge) bond market significantly.

    If they pay IOR, the bond purchases may be much larger, but in that case they are exchanging one interest earning asset for another.

  44. Gravatar of Eric Dennis Eric Dennis
    29. July 2011 at 14:35

    Scott,

    I’m still trying to understand this asymmetry in your account of inflationary vs. deflationary monetary disequilibrium. You agree that by supplying too little money (as measured by the difference between the natural and market rates, or by NDGP deviations, or whatever), the Fed can radically destabilize the economy. Why can’t an analogous destabilization happen were the Fed to supply too much money?

  45. Gravatar of Scott Sumner Scott Sumner
    29. July 2011 at 18:03

    Eric, It can, it can lead to high inflation, and too much output. But right now we need more demand. Inflation is not the main problem, too little NGDP is.

  46. Gravatar of Kendall Kendall
    30. July 2011 at 15:09

    Scott,
    So doesn’t the subsidy of refunding the vat cancel out the effect the vat would have had? If so how can it not make a difference? Thanks!

  47. Gravatar of Scott Sumner Scott Sumner
    31. July 2011 at 13:58

    Kendall, I don’t follow your question. I said an export subsidy and an import tariff cancel out–I didn’t mention anything about a VAT. In my VAT statement I said the benefit to exporters from exemption from a VAT is offset by a higher exchange rate.

  48. Gravatar of Kendall Kendall
    2. August 2011 at 12:21

    Scott,
    I’ve pasted the thread below to help me keep track of where we have gone. It seems to me the fact Europeans exempt exports from their VAT is a subsidy. The fact the subsidy is the same amount as what the companies had to pay in VAT doesn’t change the effect the subsidy would have. So I assume the claim is all advantages gained from subsidies are offset by a higher exchange rate (as far as trade between countries go). I thought a 10% tariff by country B on all goods country A sends to country B would have a similiar effect on trade as country B subsidizing all of its exports to country A by 10%. I wasn’t referring to how a tariff and subsidy work together, just that they both reduce the effiency of trade. If that is true then if the exchange rate adjusts to eliminate the advantage of subsidies wouldn’t it adjust to eliminate the disadvantage of tariffs? It may be I’m so lost it isn’t worth your time to try to explain. If so, thanks anyway!

    Scott:
    It doesn’t matter if Europeans exempt exports from their VAT, as their exchange rate rises to offset any advantage to exporters.
    Kendall:
    If this is true why are economists against tariffs? Wouldn’t the exchange rates cancel out the tariff effects?
    Scott:
    A VAT is nothing like a tariff. A VAT does not discourage trade, as it taxes all consumption equally. A tariff discourages trade, and hence is distortionary.
    Kendall:
    Thanks for the reply. Don’t subsidies distort trade in the same way that a tariff does? The fact that Europe’s subsidy is the same size as the vat doesn’t change the effect the subsidy has does it?
    Scott:
    Kendall, Subsidies and taxes have opposite effects. Do both and you have no effect.
    Kendall:
    So doesn’t the subsidy of refunding the vat cancel out the effect the vat would have had? If so how can it not make a difference? Thanks!
    Scott:
    Kendall, I don’t follow your question. I said an export subsidy and an import tariff cancel out-I didn’t mention anything about a VAT. In my VAT statement I said the benefit to exporters from exemption from a VAT is offset by a higher exchange rate.

  49. Gravatar of ssumner ssumner
    13. August 2011 at 11:39

    Kendall. A tax on gas reduces gas consumption. It distorts. A tax and subsidy on gas has no effect. The VAT doesn’t distort, as it applies equally to all consumption, regardless of where it is produced. The tariff makes the price of a product differ, merely on the basis of where’s it produced. EVEN in the same market. German cars in America may be cheaper than German cars in Germany. But they are taxed the same way as American cars in America–hence no distortion.

  50. Gravatar of Kendall Kendall
    13. August 2011 at 12:49

    So if Germany decides to subsidize all cars shipped to America to the extent they cost $1 for us to buy that doesn’t distort the market? If Germany elimates their VAT but continues to rebate the amount of money that formerly covered the VAT does the rebate not distort the market? The effect of the VAT doesn’t have anything to do with my question. My question is do subsidies distort the market? I don’t see how the justification for the subsidies have anything to do with whether or not they effect the market.

    You said “The VAT doesn’t distort, as it applies equally to all consumption, regardless of where it is produced.”. How does the VAT apply equally to a car made in America sold in Germany and a car made in Germany sold in Germany? I thought a VAT applied a small tax at each level of production. Can they apply a VAT to levels of production performed in the U.S.? If so, we should be able to charge a tax equal to the embedded tax costs in our products. Thanks again for your time!

  51. Gravatar of ssumner ssumner
    14. August 2011 at 08:15

    Kendall, A VAT taxes imports and repates the tax on exports–hence no distortion to trade, as the two cancel out. If you keep subidizing exports but stop taxing imports (no VAT) then you are subsidizing trade. It is then inefficient, just like any other subsidy. You do too much trade, and suffer a welfare loss. BTW, my views here are not controversial.

  52. Gravatar of Kendall Kendall
    14. August 2011 at 11:21

    I didn’t know the VAT applied to imports. I’m not claiming your views are controversial or wrong, I’m just trying to understand the situation. If the U.S. put a tax on imports equal to the embedded tax in the price of goods produced here and rebated that tax for our exports would that also not distort trade? I seem to remember we tried to do that and the WTO ruled against us. Thanks!

  53. Gravatar of ssumner ssumner
    15. August 2011 at 11:02

    Kendall, Yes, VATs are consumption taxes, and hence apply to imports. If the US put a 10% tax on imports, and a 10% subsidy to exports, it would have no effect on trade. It would be like having no tax or subsidy at all. It might change the exchange rate, however.

  54. Gravatar of Kendall Kendall
    16. August 2011 at 17:48

    Thanks for all your help!

Leave a Reply