Asking the wrong question

David Beckworth recently directed me to a paper by Gauti Eggertsson and Kevin Prouix, discussing how much QE a central bank might have to do when in a liquidity trap:

The required intervention in real assets needed to generate this outcome in Eggertsson (2003) corresponds to about 4 times annual GDP. Moreover, the intervention is conducted under the ideal circumstances under which the assets bought are in unlimited supply, their relative returns are not affected by the intervention (but instead equal to the market interest rate in equilibrium), and assuming that the world is deterministic so there are no risks associated with using real asset purchases as a commitment device.

More generally, however, if the government buys real assets corresponding to something like 400 percent of GDP it seems exceedingly likely that all of these assumptions will be violated in one way or the other. First, an operation of this kind is likely to have a substantial distortionary effect on pricing – which is not modeled. Second, it is likely that the government may run into physical constraints such as running out of assets to buy. Third, as the scale of the operations increases and uncertainty is taken into account, the risk to the government’s balance sheet may be deemed unacceptable, thus lessening the power of this commitment device. Finally, with an intervention of this scale it is very likely that the central bank will hit some political constraints, either due to public concerns, or concerns from trading partners in the case the assets in question are foreign. Indeed, all the considerations mentioned above have proved to be relevant constraints for banks conducting large asset purchases since 2008.

I don’t wish to contest the specific technical findings of this paper, or their political analysis. All you need to do is look at the central bank balance sheets of Japan and Switzerland to see that QE is not a panacea. Rather, I warn against misinterpreting these findings. Indeed the authors conclude their paper with a similar warning:

We do not wish to interpret this as suggesting that monetary policy is impotent at the zero bound, however.

They advocate monetary/fiscal coordination, but I don’t believe the fiscal aspect adds much. Instead, central banks need a new policy regime, such as level targeting at a growth rate high enough to generate positive nominal interest rates, combined with a “whatever it takes” approach.

Eggertsson’s paper is pushing back against the thought experiment that argues, “Of course sufficient QE must work, otherwise a central bank could buy up the entire world without creating inflation.”

Here I’d like to reframe the debate. Asking how much QE is needed is no more useful than asking how far interest rates need to be cut. If the policy is truly effective, then you don’t need to cut interest rates at all, nor do you need to do any QE.

I’ll illustrate this with an alternative thought experiment. Suppose the BOJ promises to depreciate the yen by 5%/year against the US dollar. Because of interest parity, nominal short-term interest rates in Japan will immediately rise to about 6.5% (5% plus the US short-term rate.) Also assume the BOJ pays zero interest on bank reserves.

Obviously, this policy would be highly inflationary over time. (If you don’t believe me, replace 5% with 50%). But would the BOJ actually be able to do this? One counterargument is that they’d have to do a lot of QE to depreciate the (normally strong) yen so sharply, exactly the problem discussed by Eggertsson and Prouix.

But that can’t be right, because the demand for yen base money at 6.5% nominal interest rates is likely to be quite low, say less than 10% of GDP. In fact, the BOJ would probably have to reduce the monetary base by roughly 90% after this policy was established and made credible.

The US would complain about this sort of (exchange rate-oriented) policy regime, but almost the same results would occur if the BOJ targeted CPI futures contracts at a price rising at 6.5%/year, combined with a “whatever it takes” commitment to keep CPI futures prices growing along the target path.

The willingness to do “whatever it takes” creates an equilibrium where you don’t have to do anything, indeed you do less than nothing, you actually reduce the monetary base sharply.

This is why these estimates of QE at levels of 400% of GDP can be misleading if not interpreted in the proper context. They describe what might be done in a dysfunctional monetary regime, not what would be required in a sensible monetary regime.

One final point. The central bank balance sheet will depend on the trend rate of growth in NGDP (and inflation). There’s no point is whining about the need for a large central bank balance sheet. Ultimately, central banks must always accommodate the demand for base money if they wish to prevent severe deflation. (Indeed even if they don’t want to, as the ECB discovered in the mid-2010s.) If you don’t want a big balance sheet, then set the NGDP growth rate (or inflation) path high enough to so people don’t want to hoard lots of your zero interest base money.

PS. Some people worry about the “credibility” issue. I don’t. If the central bank plans to actually do it, they will be believed. Past examples of credibility problems occurred where markets were rightfully skeptical of the central bank’s commitment. If you build it, they will believe you.

How do conservatives feel about this?

This survey caught my eye:

Western conservatives tend to dislike Islamic fundamentalism.

Western conservatives tend to dislike atheism.

So here’s a question for conservatives: If these surveys are correct (a big if), what does it portend about the future of civil society in the Middle East?

I’m not conservative, and I don’t see this as either good or bad. But it may be a symptom of certain trends, which might be good or bad.

PS. This caught my eye:

In a poll conducted last year by the Pew Research Center, only 25 percent of white evangelical Christians said the United States has a responsibility to accept refugees, while 65 percent of those not affiliated with a religion affirmed that duty. 


HT: Sam Bowman

Rate cuts increase the Fed’s “ammunition”

I keep seeing this sort of comment:

Federal Reserve Bank of Atlanta President Raphael Bostic said he opposed last week’s interest rate cut because two earlier reductions had provided insurance against global risks and the central bank needed to preserve its ammunition.

It would be interesting to do a search of the Fed minutes and see how many Fed officials are mixed up on this issue.

The worst president ever

Dozens of sources provide similar accounts, but this WaPo story is especially vivid:

Senior Trump administration officials considered resigning en masse last year in a “midnight self-massacre” to sound a public alarm about President Trump’s conduct, but rejected the idea because they believed it would further destabilize an already teetering government, according to a new book by an unnamed author. . . .

The author — who first captured attention in 2018 as the unidentified author of a New York Times opinion column — describes Trump careening from one self-inflicted crisis to the next, “like a twelve-year-old in an air traffic control tower, pushing the buttons of government indiscriminately, indifferent to the planes skidding across the runway and the flights frantically diverting away from the airport.” . . .

“It’s like showing up at the nursing home at daybreak to find your elderly uncle running pantsless across the courtyard and cursing loudly about the cafeteria food, as worried attendants tried to catch him,” the author writes. “You’re stunned, amused, and embarrassed all at the same time. Only your uncle probably wouldn’t do it every single day, his words aren’t broadcast to the public, and he doesn’t have to lead the US government once he puts his pants on.”

The book depicts Trump as making misogynistic and racist comments behind the scenes. . . .

The author alleges that Trump attempted a Hispanic accent during an Oval Office meeting to complain about migrants crossing the U.S.-Mexico border.

“We get these women coming in with like seven children,” Trump said, according to the book. “They are saying, ‘Oh, please help! My husband left me!’ They are useless. They don’t do anything for our country. At least if they came in with a husband we could put him in the fields to pick corn or something.”

I said this about Trump from the beginning, back when people told me that a person couldn’t possibly become a billionaire if they were an idiot. People will of course deny this anonymous account, but since Trump seems the same way in public, I’m inclined to accept it.

Look for Trump to be re-elected in 2020 during a period of very low unemployment, even as he loses the popular vote by millions.

Why?  Because of the dysfunctional Democrats.

If you aren’t confused by the lack of mini-recessions, then you don’t understand the issue

It’s often said that if you think you understand quantum mechanics, then you don’t actually understand it. That may not be true of Eliezer Yudkowsky, Scott Aaronson and Robin Hanson, but it’s true of most average people. (Thankfully, I don’t even think I understand it.)

Whenever I discuss the lack of mini-recessions, commenters will offer explanations. One argument is that the highly diversified nature of the US economy leads to shocks in one sector being balanced out with growth in other sectors.

That might be in some way relevant to the issue (indeed I suspect it is.) But it’s certainly not an explanation. After all, we do have medium size recessions and large recessions. So this “explanation” actually explains far too much.

Think of it this way. Everyone should agree that some factor causes recessions in the US, on average once about every 5 years. Let’s call this factor X, or factors X, Y and Z, if you think there are three primary causes. If big X shocks cause big recessions, and medium X shocks cause medium recessions, why don’t small X shocks cause small recessions?

Maybe there are no small X shocks. But why not? Everything we know about both the natural world and the human world suggests that small shocks are almost always more common than medium shocks, which are more common than big shocks. This is obviously true of things like earthquakes, but also true of human shocks like murders, traffic accidents and wars. Single murders are more frequent than mass murders, single and two car accidents are more common than 10 car pile-ups. Small wars are more frequent than world wars.

It is true that medium recessions are more frequent than big recessions. So why aren’t small recessions even more frequent? Indeed why don’t we have ANY mini-recessions, defined as unemployment rising by 1.0% to 2.0%, and then falling back.

My hunch is that it has something to do with interest rate targeting, procyclical monetary policy, and policy lags, but I can’t quite figure out exactly how. If the Fed shifts to level targeting and we start having mini-recessions, then that would confirm the role of monetary policy.

PS. The closest we’ve come is the 1959 steel strike, when the unemployment rate rose by 0.8%, and immediately fell back again.  Otherwise, a 0.6% rise is the largest increase short of a recession:

PPS.  Off topic, you really should be reading Slate Star Codex.  Scott Alexander is not an economist, but his posts on economics are often better than 95% of the posts written by economists.