John Cochrane’s view of the recession

John Cochrane has an interesting paper on the current economic crisis.  I agree with some but not all of his analysis.  Naturally I will focus on areas where I disagree.  Here’s how he opens the paper:

I offer an interpretation of the macroeconomic events in the great recession of 2008-2009, and the subsequent outlook, focused on the fiscal stance of the U. S. government and its link to potential inflation. What happened? How did policies work? Are we headed for inflation or deflation? Will the Fed be able to follow an “exit strategy?” Will large government deficits lead to inflation? If so, what will that event look like?

I base the analysis on two equilibrium conditions, some form of which hold in almost every model of money and inflation: the valuation equation for nominal government debt and a money demand equation

We are both University of Chicago economists (although I suppose there is a slight difference between someone who teaches there and someone who merely took some classes.)   So I am surprised that he would try to answer question like “are we headed for inflation” with a mathematical model.  Why not just check out TIPS spreads?  (Later he explains why, a point I’ll return to.)

Next Cochrane explains what he thinks caused the crisis:

Why did a financial crisis lead to such a big recession? We understand how a surge in money demand, if not accommodated by the Fed, can lead to a decline in output. I argue that we saw something similar “” a “flight to quality,” a surge in the demand for all government debt and away from goods, services and private debt. In the fiscal context of (1), this event corresponds to a decrease in the discount rate for government debt.

Many of the Government’s policies can be understood as ways to accommodate this demand, which a conventional swap of money for government debt does not address.  This story is in contrast to “lending channel” or “financial frictions” stories for the recession, essentially falls in aggregate supply.

As you know, I agree that this is mostly an AD problem, not a recession caused by financial system distress.  I should add that as each day goes by the recession is less due to AD and more due to labor market rigidities.  But AD is still a big factor.  Were we differ is that he puts relatively more weight on fiscal policy:

Last, but perhaps most important: Will a fiscal inflation come with a boom or stagflation?

I argue that the fiscal valuation equation acts as the “anchor” for monetary policy, or the “expectation” that shifts the Phillips curve. A fiscal inflation is therefore likely to lead to the same stagflationary effects as any loss of “anchoring.”

Inflation can be explained from a fiscal perspective, but I see monetary policy as the dog and fiscal policy as the tail (except in places like Zimbabwe.)  The Fed determines inflation and the fiscal authorities adjust their policies to accommodate the Fed’s preferred inflation path.  Cochrane goes on to argue that future expected fiscal policy is the key:

Our most pressing question is, how might debt and deficits translate into inflation?  Equation (3) gives an unusual answer and a warning: Expected futuredeficits St+j cause inflation today. Inflation need not wait for large deficits to materialize, for large debt to GDP ratios to occur, for monetization of debt or for explicit seigniorage. As soon as people figure out that there will be inflation in the future, they try to get rid of money and government debt now.

Yes, future expected inflation determines current inflation, a point I keep emphasizing here.  But why the term ‘unusual answer?’  I thought this was now the standard (Woodfordian) view.  Current inflation and AD are driven by future expected inflation and AD, and hence future expected fiscal and monetary policy.  I suppose Cochrane is thinking of all those silly complaints that Obama wasn’t responsible for the economic deterioration in early 2009 because the stimulus money hadn’t been spent yet.  Certainly the smarter sort of new Keynesians should have known better than to make that argument.  (On the other hand some of the smarter Keynesians may occasionally let ideology cloud their judgment.)

Then Cochrane presents some evidence on the relationship between deficits and inflation:

One might well ask, “What surpluses?” as the U.S. has reported continual deficits for a long time. However, equation (3) refers to primary surpluses, i.e. net of interest expense.  Figure 1 presents a simple estimate of the primary surplus, taken from the NIPA accounts, and expressed as a percentage of GDP. In fact, positive primary surpluses are not rare.  From the end of the second world war until the early 1970s, the US typically ran primary surpluses, and paid off much of the WWII debt in that way. 1973 and especially 1975 were years of really bad primary deficits, on the tail of a downward trend, and suggestively coinciding with the outbreak of inflation. The “Reagan deficits” of the early 1980s don’t show up much, especially controlling for the natural business cycle correlation, because much of those deficits consisted of very high interest payments on a stock of outstanding debt. The return to surpluses in the late 80s and the strong surpluses of the 1990s are familiar, and suggestively correlated with the end of inflation. Our current situation resembles a cliff, motivating some of the concerns of this paper.

Regarding the last sentence; when the model says inflation and the markets say disinflation, a UC professor should go with the markets.  In addition, I just don’t see the correlations he refers to (check graph on page 5.)  The rate of inflation picked up in the 1960s, when we were still running primary surpluses.  What caused that upsurge in inflation?  I say monetary policy.  And why did inflation slow sharply in the early 1980s?  I don’t see his model giving any explanation.  Maybe I missed something.  I’m not saying there is no story you could tell.  Maybe in 1982 people began anticipating the Clinton administration surpluses.  But that doesn’t seem likely.

Then Cochrane applies his model to the current crisis:

The first issue is, why was there such a large fall in output? For once in macroeconomics we actually know exactly what the shock was “” there was a “run” in the shadow banking system (See for example Gorton and Metrick, 2009b, or Duffie, 2010). But how did this shock propagate to such a large recession?

We have long understood that a sharp precautionary increase in money demand, if not met by money supply, would lead to a decline in aggregate demand. With price-stickiness or dispersed information, a decline in aggregate demand can express itself as a decline in real output rather than a decline in the price level. This is in essence Friedman and Schwartz’s explanation for the great depression. However, this story cannot credibly apply to the 2008-2009 recession. The Federal Reserve flooded the country with money (reserves). There is no evidence for a flight to money at the expense of government bonds.

Two p0ints.  I agree that there was an increase in the demand for both money and T-bonds.  But I disagree about the Fed flooding the economy with money (and later I’ll argue that Cochrane also disagrees with this assertion.)  Interest bearing reserves are not “money,” at least not the non-interest-bearing asset that Friedman and Schwartz had in mind.  Nevertheless, the non-interest-bearing base did rise by quite a bit in Japan–so I won’t belabor this point.

Cochrane continues:

As the financial crisis took off in the third week of September 2008, the Federal reserve swiftly cut the Federal Funds target to a range between 0 and 25 bp, and signaled it would leave interest rates there for a long time (Figure 4). Inflation declined, never turned to deflation so real rates on these assets remained near zero.

Expected inflation did turn negative, and the real interest rate on 5 year TIPS rose from 0.5% to 4.25% between July and November 2008.  But I agree that real rates don’t provide a reliable indicator, so let’s skip over this issue.

Excess reserves rose from $6b to $800b. While it’s hard to disprove anything in economics, it certainly seems an uphill battle to argue that the recession resulted from a failure by the Fed to accommodate shifts in money demand.

We will see about that.

The combination of near-zero government rates and reserves paying interest, means that the distinction between government bonds and money (reserves) was a third-order issue for financial institutions, especially compared to the very high interest rates, lack of collateralizability, and illiquidity of any instrument that carried a whiff of credit risk. If they wanted more of either, they wanted more of both.

.   .   .

The Fed has also started paying interest on reserves. Reserves that pay interest are government debt. By creating such reserves the Fed can rapidly expand the supply of shortterm, floating rate debt, without needing any cooperation from the Treasury or a rise in the Congressional debt limit. It also can execute massive open-market operations at the stroke of a pen. With a trillion dollars of excess reserves, changing the interest on reserves from 0 to the overnight rate is exactly the same thing as a trillion-dollar open-market operation.

.   .   .

The fact that reserves now pay interest dramatically changes our interpretation of the data. Reserves that pay market interest are debt, not money.

Exactly.  These reserves are debt, not money.  So in fact this case does not provide much evidence against the monetarist view.  Cochrane continues:

This is not how the Fed thinks about its policy actions, at least as I interpret Fed statements. The first stage, trading private for government debt without increasing money, was, to the Fed, a way to support private credit markets without the inflationary effect that increasing M might have had. The Fed wanted to stimulate in a noninflationary way, an idea beyond my simple analysis.

Yes, how the Fed came to the conclusion that it was possible to boost AD without boosting inflation is also something far beyond my simple analysis.  I am as puzzled as Cochrane.

Many critics objected that fiscal stimulus won’t stimulate in time, because the spending will come too late, after the recession is over. This reflects the standard analysis, enshrined in undergraduate textbooks since the 1970s, that fiscal policy, affects “demand” as it is spent. Equation (14) suggests the opposite conclusion. In order to get stimulus (inflation) now, future deficits (St+1 for large pi) are just as effective as current deficits, and possibly more so.

Again, this just floors me.  Cochrane may be right, but I am stunned that the standard view of fiscal policy doesn’t take expectations into account.  If there are any grad students out there, please “say it ain’t so.”

But then Cochrane seems to assume modern monetarism is equally ignorant of expectations:

But in our framework, it’s hard to see how quantitative easing can have any effect. The Fed can increase reserves M and decrease B, but nobody cares if it does so. Agents are happy to trade perfect substitutes at will. Velocity V will simply absorbs any further changes. The argument must rest on the idea that V is fixed, but why should the relative demand for perfect substitutes be fixed? (With interest on reserves, the same logic applies even at nonzero interest rates, and one would expect the argument to hold as an approximation at small positive rates.)

Cochrane is comparing an outdated monetarist model where current monetary policy drives current and future AD, with a sophisticated fiscal model where current AD is driven by future expected deficits.  But that’s not fair.  We have known for a long time that it is future expected monetary policy that drives current AD.  The fact that money and T-bills are now almost perfect substitutes does not in any way inhibit the Fed from targeting the price level (unless you assume that the liquidity trap will last forever.)  Believe me, when T-bill rates get up to 2% or 3%, then non-interest-bearing reserves will not be considered perfect substitutes for T-bills, demand for excess reserves will fall almost to zero, and the Fed will have its usual ability to control the price level path that comes from its position of being the monopoly producer of the stuff we carry around in our wallets.  I don’t plan on carrying T-bills to go shopping at Wal-Mart.  The quickest way to get out of the liquidity trap is to target a much higher NGDP growth path than what is currently expected.  That will dramatically lower the demand for base money.  (And of course they can also pay negative interest on bank reserves.)

What about a “helicopter drop?” Wouldn’t this increase money M and inflate? A helicopter drop is at heart a fiscal operation. To implement a drop in the U. S., the Treasury would borrow money, issuing more debt. It would spend the money as a government transfer.  Then the Federal Reserve would buy the debt, so that the money supply increased. A real drop of real cash from real helicopters would be recorded as a transfer payment, a fiscal operation. Conversely, even a helicopter drop would not be “stimulative” if everyone knew that the money would be soaked up the next day in higher taxes, or by the Fed, i.e. by future taxes.

Thus, Milton Friedman’s helicopters have nothing really to do with money. They are instead a brilliant device to dramatically communicate that this cash does not correspond to higher future fiscal surpluses; that this money will be left out in public hands as in a currency reform. To be effective, a monetary expansion at near zero rates must be accompanied by a non-Ricardian fiscal expansion as well. People must understand that the new debt or money does not just correspond to higher future surpluses.

I’m glad this came up, as I was about to do a post on the widely misunderstood “helicopter drop.”  These money drops don’t do anything that an open market purchase can’t do, unless it changes fiscal policy expectations.  An OMP at the zero bound will be highly inflationary if it is expected to be permanent, and not at all inflationary if it is expected to be temporary.  And exactly the same is true of the helicopter drop.  There is a strong effect if expected to be permanent, and almost no effect if expected to be temporary.

Cochrane does not explicitly forecast higher inflation.  But his model suggests that it is likely to be a problem, as the graph on page 5 shows a fiscal situation that is far worse than what we saw in the 1970s.   Here he first discusses three reasons why the Fed doesn’t fear inflation, and then hints that he sees worrisome signs of inflation:

The first asserts that “inflation expectations have been relatively stable” and points to a graph (figure 2) of actual inflation. The second (under “prices”) summarizes median survey data, excusing a jump in short-term expectations by energy prices and pointing to more stable long-term expectations. The third inferred expectations from Treasury vs. TIP yields, again arguing that “short-term” expectations might have risen but “long-term” expectations had not changed much. In evaluating the latter, we should remember that neither surveys nor long-term yields gave any warning of inflation in the 1970s nor disinflation in the 1980s. These are the only mention of expectations or documentation of the FOMC and Chairman’s assertions in the document. Occasionally, sophisticated Fed statements allude to the New-Keynesian idea that expectations are anchored by a belief that the Fed will respond quickly to inflation, though not why people should have such a belief. The volume of popular press coverage of deficits and inflation “” clearly about expected future inflation “” and even the ads for gold on cable TV suggest at least a more widespread concern about inflation than has been present for some time.

I think he is grasping for straws here.  If you want a relatively direct take on inflation expectations you look at TIPS spreads and CPI futures markets.  Real gold prices are distorted by massive Asian demand.

I share many of Cochrane’s criticisms of Keynesianism.  I like his discussion of the need for a dynamic Laffer curve, and his contempt for “slack” models of inflation.  And I agree that a lack of AD, not financial turmoil, explains the severe phase of the recession.  But I disagree on a few key points:

1.   Because money and T-securities are not close substitutes during normal times, the Fed can control the price level in the long run.

2.  This means that open market purchases that are permanent do affect the price level.  They affect future expected prices and hence current prices.

3.  The Fed can create expectations that open market purchases are permanent if it sets an explicit target for the price level or NGDP.

4.  Monetary policy is the dog in America, fiscal policy is the tail.  This may reverse in the future, but . . .

5.  Markets aren’t afraid of fiscal inflation.  They saw what happened in Japan.   TIPS markets are much better inflation indicators than gold prices.

BTW, this post was inspired by another post called “Is John Cochrane Sumnerian Now?”  I vaguely recall that he had a more finance-oriented view of the recession when we debated last year.  But that is probably wishful thinking on my part.  My memory may be faulty, and even if it isn’t I doubt I had any effect on his views.

HT:  123


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53 Responses to “John Cochrane’s view of the recession”

  1. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    22. June 2010 at 12:17

    Scott,
    you said:
    “Because money and T-securities are not close substitutes during normal times, the Fed can control the price level in the long run.”

    Cochrane said in his paper:
    “In short, something like the “special” or “liquidity” services we usually associate with money applied to all government debt for these central actors. Those services were related to liquidity, transparency on balance sheets, acceptability as collateral, and absolute security of nominal repayment, rather than the acceptability as means of payment in transactions that we usually emphasize in money-demand theories.”
    What he said applies also during normal times. Treasuries are as liquid as reserves because of the repo market.

  2. Gravatar of mlb mlb
    22. June 2010 at 12:24

    A thought experiment – if growth in the money supply were matched dollar-for-dollar with purchases of gold couldn’t there be a scenario whereby it is impossible for the Fed to impact the overall price level at ANY level of money supply?

    Obviously there would be some small bump in the price level as gold miners bought more equipment and as jewelry increased in price but I think both would be negligible.

    That is an extreme scenario, but it seems to be essentially what the market (i.e., investors) is trying to do.

  3. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    22. June 2010 at 12:26

    via DeLong, here is Cochrane’s answer to market-based inflation predictions:

    “Cochrane: Reasons to fear that the term structure is not giving us a read on rational expectations of the future:

    Perhaps China–or some other non-market actor–is the marginal holder of U.S. Treasury debt.
    Perhaps some important friction here: lots of implicit government guarantees floating around, and borrowing cash short for nearly free, buying long-term Treasurys, collecting coupons, and hoping to get out before the crash comes an attractive strategy. See Rogoff, “Bubbles Lurk in Government Debt”), “From Financial Crisis to Debt Crisis”…””

    (source: http://delong.typepad.com/sdj/2010/04/liveblogging-the-berkeley-finance-seminar-john-cochrane-2010-understanding-policy-in-the-great-recession-some-unpleasan.html)

  4. Gravatar of ssumner ssumner
    22. June 2010 at 12:32

    123, First of all you need to distinguish betwee the part of the base that is held as cash and the part held as reserves. Cash and T-bills are not at all close substitutes. When I go shopping I don’t think about whether I should take cash or T-bills to the store.

    Yes, T-bills might be cloase substitutes for excess reserves (obviously not required reserves, which are a legal obligation). But ERs are usually less than 1% of the monetary base. So any new injection of base money goes almost entirely into cash, not ERs. Thus the liquidity issue raised by Cochrane is only of importance when rates are near zero, and banks are willing to hold substantial ERs.

    I really shouldn’t even talk about the base, I should just talk about the Fed controlling cash (i.e. currency) held by the public. Then the distinction would be obvious. No one thinks of cash and T-bills as being close substitutes, they play completely different roles in our economy. People who hold lots of cash have no interest in T-bills, and vice versa.

    What Cochrane calls “central actors” are presumably banks and other institutions. But banks demand very little base money when interest rates are positive. They are not an important part of the demand for base money. Think of cash as Treasury debt for suckers, and you will see the distinction. When interest rates are positive those “central actors” aren’t suckers. They want to earn interest.

  5. Gravatar of mlb mlb
    22. June 2010 at 12:32

    “Real gold prices are distorted by massive Asian demand. ”

    This is an ENORMOUS cop-out. US-traded gold vehicles are also in demand. As much as economists hate to admit it, the truth is that the market 1) knows the Fed is committed to avoiding inflation (i.e., will continue to print money), 2) does not want to own overvalued financial assets (overvaluation is somewhat inevitable when yields are low). That is why gold is surging.

    Gold can go to ANY price without a meaningful supply or substitution response. In other words, if the market distrusts the Fed it will be able to sterilize any increase in the money supply via a flight to gold.

    Until economists can explain 1) why gold is surging, 2) why it takes ever-larger increases in the money supply to generate incremental AD, and 3) why banks will not lend despite adequate reserves and high spreads on loans, it is hard to take them seriously.

  6. Gravatar of ssumner ssumner
    22. June 2010 at 12:40

    mlb, I don’t follow, are you talking about a fixed price of gold in dollar terms (like the gold standard) or just gold as an asset? In the latter case I don’t see how it prevents inflation, although the fiscal burden of buying all that gold could discourage the Fed from inflating. It would be a weird thing to do, however.

    123, Thanks for the link. There are lots of reasons to believe that inflation isn’t coming.

    1. Falling asset prices (houses, etc.)
    2. CPI futures markets.
    3. Japan went through this 20 years ago, and still has falling prices. Why do we expect a different result?
    4. Lots of savvy non-Chinese investors hold T-bonds. There’s nothing stopping them from switching to TIPS.

    Why does Cochrane think he sees something the markets don’t see?

  7. Gravatar of mlb mlb
    22. June 2010 at 12:45

    scott, I mean gold as an asset. How could gold at any price create meaningful inflation? Gold is not a cost of living. And the gold mining industry is tiny. Further, I would think that subject to meaningful cost inflation the gold miners would just stop mining as the market would begin to value them on resources in the ground. Where is the conduit to the overall price level? I fail to see it.

  8. Gravatar of ssumner ssumner
    22. June 2010 at 12:51

    mlb, Sorry, but if you are going to accuse me of a copout, you need to explain why. The US is not the only country in the world. Gold is traded in world markets. Arbitrage equalizes the gold price everywhere in the world. All the articles I read say Asian demand is far more important than US demand. I don’t doubt that some Americans are buying gold, but some Americans voted for Ron Paul, that doesn’t make them the marginal actor in the marketplace.

    Bond yields are a far more reliable inflation indicator than gold. I’m sure you could have found Japanese investors buying gold in the 1990s. It was a far better investent than Japanese bonds. But it did not prove to be a reliable indicator of inflation in Japan, and it won’t be a reliable indicator of inflation in the US.

    Gold soared from about $200 in the late 1970s to $850 in 1980 and a year later a 30 year disinflation set in–how reliable was that call?

    Last year I had all kinds of Austrians commenting on how inflation would soar in 2010. How’s that prediction working out? Those are the kind of people who invest in gold.

    And of course gold did not predict the huge inflation of 1966-82, it was a lagging indicator

  9. Gravatar of ssumner ssumner
    22. June 2010 at 12:53

    mlb, If gold is just an asset, it plays no role in inflation. Inflation would be determined by monetary policy, as it usually is.

  10. Gravatar of mlb mlb
    22. June 2010 at 13:08

    “If gold is just an asset, it plays no role in inflation. Inflation would be determined by monetary policy, as it usually is.”

    I agree, however every other asset has a feedback loop through to AD and the price level. If stocks go higher companies have more money to invest and hire. If bonds go higher rates help borrowers, etc. If gold goes higher there is no feedback loop through to the price level other than via a tiny slice of the mining industry.

    I don’t think it matters much at this stage of the game, but as a thought experiment I think it is significant to realize that there is a theoretical state of the world where the Fed simply cannot influence the overall price level. It is intriguing to me that the market resembles this state of the world more every day.

    As for Asian vs US demand, there have been massive inflows into GLD, PHYS, and other US-listed ETFs (inflows, not just higher prices). If the price were moving higher via Asia you’d see GLD go up but its shares outstanding remain steady. It’s shares outstanding have exploded higher….and that is despite a slew of new gold ETFs that have taken a lot of share away from GLD.

  11. Gravatar of Benjamin Cole Benjamin Cole
    22. June 2010 at 14:49

    Well, much of the Cochrane piece was over my head, but I thought he took a cheap shot at “entitlement programs” as the cause of the federal deficit.

    The huge entitlement programs, in fact, are largely self-financing through payroll taxes, including Social Security and Medicare, which ran surpluses for years.

    If you want to cut entitlement programs, say so, and I may even support it (I wonder if minimum pension age should be boosted to 67 for everyone, including federal military employees).

    Meanwhile, nearly 70 percent of federal outlays financed by income taxes consist of Department of Defense, VA, USDA, Commerce, Interior, Homeland Security and Civilian Defense outlays.

    You will note these are all the above programs that enjoy the backing, largely, of “conservative” office holders, and, of course, funnel money into conservative districts.

    The CBO also estimates the cost of Iraqistan at $3 trillion and counting, all financed by debt. We never raised a war tax to fight these wars.

    Moreover, if you look at the federal budget geographically, you will find that urban states subsize rural states (Tax Foundation). The federal budget, net, funnels hundreds of billion annually into rural areas through highways, power, water, railroad, telephone, airports and crop subsidies. Money is siphoned out of urban states.

    Cochrane thus debases his analysis by descending into cheap, trite, and inaccurate, political carnards.

  12. Gravatar of David Pearson David Pearson
    22. June 2010 at 15:43

    Scott,

    According to World Gold Council statistics, total world jewelry remand peaked at 2400 tons in 2007, fell to 2200 in ’08 and 1800 in ’09. Since the end of ’06, the gold price has doubled.

    As for India, imports fell by 18% in ’09, when the gold price rose. Further, Indian gold demand peaked at 800tons in 1998 and did not recover this level until 2006. Indian gold demand fell during 2000-2003. During this time, the gold price was rising.

    Gold demand statistics are available from the World Gold Council.

    This quote reflects the recent Indian demand downturn after a strong start of the year. It is from May, 2010:

    Gold imports by India, the world’s biggest market for the precious metal, could drop for a third straight year in 2010 as record high prices scare off traditional buyers.

    Traders expect to spot the first sign of this trend at next week’s Hindu festival of Askhay Tritiya, when demand usually jumps because it is considered an auspicious time to buy jewellery and coins.

    “Forget buying for the festival, on the contrary people are selling,” said Suresh Hundia, president of the Bombay Bullion Association in Mumbai.

    “There is a queue of sellers.”

  13. Gravatar of Indy Indy
    22. June 2010 at 17:27

    Guess who the world’s #1 gold producer is, and after displacing South Africa which held the top spot for over a century?

    China. They produce over 300 tons a year – somewhere between 12 and 15% of the global total even though they only have about 7% of known reserves. Chinese production has nearly doubled in the last 20 years, while it has tended to stagnate or decline in the other major producers due to exhaustion and greater expenses.

    But high gold prices will probably encourage a new boom in production in those high-cost countries, while China keeps expanding – and then we can can probably expect the inevitable glut and bust in a few years time as gold comes back to earth.

  14. Gravatar of tinbox tinbox
    22. June 2010 at 18:48

    “CPI futures?” Where?

    TIPS may be a better indicator of near-term CPI numbers, but that’s not really the inflation that most people are worried about, especially when they are considering gold as an investment alternative.

  15. Gravatar of Bill Woolsey Bill Woolsey
    22. June 2010 at 18:54

    The Fed holds next to no T-bills. So why do we go on and on about how purchasing near zero interest T-bills with base money has no effect? Or will have an effect if they are permanent?

    Look at the Fed’s balance sheet. They are holding a variety of government notes and bonds. And they don’t have near zero interest rates.

  16. Gravatar of StatsGuy StatsGuy
    22. June 2010 at 19:14

    Ben Cole:

    “The huge entitlement programs, in fact, are largely self-financing through payroll taxes, including Social Security and Medicare, which ran surpluses for years.”

    They would (almost) be, if not for the Boomer population bulge that is creating a massive intergenerational transfer, coupled with longer life spans. They ran a surplus only because of the population hourglass.

    ssumner:

    “Cochrane does not explicitly forecast higher inflation. But his model suggests that it is likely to be a problem, as the graph on page 5 shows a fiscal situation that is far worse than what we saw in the 1970s.”

    Cochrane has part of this right, and part wrong. He focuses almost exclusively on public debt, but in fact much of the problem was really private debt in 2008. What we observed over the last 3 years, and for the next 2 to 5 years, was/is the socialization of private debt, made worse by declining tax revenues due to an AD collapse.

    That said, there are massive off balance sheet obligations (entitlements, pensions, health care) that were incurred under the Boomer reign and one could argue the bond markets did express skepticism in early 2008 (commodity bubble, dollar flight) about future ability to repay in non-inflated dollars. In this cynical view, the Fed deliberately triggered the recession to (temporarily) put an end to what they thought was an inflationary runup and run against the dollar in early 08. (Remember Peter Schiff’s the dollar is doomed, and the de-coupling thesis?) We now have the San Fran Fed calling for -5% rates to hit employment numbers. If we forced -5% rates (or the equivalent in QE), what do you think the reaction from markets would be? Do you think the Fed is nimble enough and credible enough to thread that needle? The point is that the debt creates a credibility problem for the Fed, and forces the Fed to overshoot in the other direction to avoid the appearance of being weak on the deficit. That’s the cynical view (not mine).

    So Cochrane has a point in that fiscal obligations constrain the Fed, but all the Fed is really doing is just buying time and kicking the can down the road, praying that we’ll somehow “grow” out of the problem.

    Finally, I disagree with one point about the problem increasingly becoming the rigid labor market. I think the problem WAS the labor market, for the last 20-30 years. Inflation indexing public employee wages, public retirement systems, health care, and social security means that the ENTIRE burden of the adjustment will fall on some mix of bondholders and current/future employees (through taxes). Private sector wages have proven remarkably downwardly mobile. Meanwhile, note how all the “reforms” to pensions etc. are leaving current and soon-to-be-retirees grandfathered…

    http://finance.yahoo.com/focus-retirement/article/109867/in-budget-crisis-states-take-aim-at-pension-costs?mod=fidelity-readytoretire

  17. Gravatar of Doc Merlin Doc Merlin
    22. June 2010 at 19:24

    “As you know, I agree that this is mostly an AD problem, not a recession caused by financial system distress.”

    Isn’t financial panic and low AD the same thing.
    Low NGDP,
    low AD,
    financial panic,
    excessive monetary contraction (or insufficient expansion),
    demand side recession,
    and excessive debt to expected income ratio, isn’t this all the same thing?

    “I should add that as each day goes by the recession is less due to AD and more due to labor market rigidities.”

    This statement is one I completely agree with! This is absolutely true.

    “If gold is just an asset, it plays no role in inflation. Inflation would be determined by monetary policy, as it usually is.”

    Gold isn’t really a traditional non-monetary asset, it is really more like a foreign currency. This is why its price rises both in times of high monetary expansion and in times of flight to safety.

  18. Gravatar of Benjamin Cole Benjamin Cole
    22. June 2010 at 21:14

    Stats Guy-

    Well, I agree with you, although you may wish to consider they ran surpluses for years. I am fine with raising the retirement age to a minimum of 67, and accepting “death panels” to limit the huge spending that goes on to keep 80+year old corpses alive for another couple weeks or months. If that doesn’t work, then cut SS benefits by 10 percent across the board.

    However, that will still not solve the federal deficit, nor lower federal income taxes. We must cut Defense, USDA, Commerce, Homeland Security, Civilian Defense, Commerce, and certainly the Education Department.

    BTW, I am not liberal as this sounds–I just believe that liberals refuse to consider how ineffective social welfare spending has been, while conservatives refuse to consider how wasteful defense, agriculture, homeland security and civilian defense spending has been.

    I won’t even get into the huge asset misallocation caused by the unlimited federal mortgage interest tax deduction. While everyone beats up on Fannie and Freddie-for good reason–everyone who buys a home has their eye on the interest tax deduction. But no peeps about that!

  19. Gravatar of StatsGuy StatsGuy
    23. June 2010 at 04:28

    Ben Cole:

    “However, that will still not solve the federal deficit, nor lower federal income taxes.”

    Not that I necesarily disagree on certain cuts, but in fact we could easily balance the budget by solely targeting transfer programs and defense. The rest of the future discretionary budget is small next to these programs. Here’s 2006.

    http://taxation-business.com/justthefacts/2008_01_12_2006_fed_expenditures.jpg

    Save for the “stimulus” and financial bailouts, non-defense discretionary is relatively small, has shrunk as a % of the budget, and will shrink even more as a % of the budget in future years. Real federal investment dollars have been consumed by defense and social programs.

    That’s not to say that these other programs lack wasteful spending – however, many of them also have useful spending. If we’re going to have an SEC, we should at least fund it. Same with the EPA. If we took 1/3 of the defense budget and put it into DOE for the next 10 years, then even if we spent it woefully inefficiently on general tax credits and targeted investments for renewable energy research/production/conservation, it would probably still be a decent real investment compared to other potential uses for that money (even in the private sector). (Of course, if we spent it on carbon sequestration and clean coal, I give up.)

  20. Gravatar of OGT OGT
    23. June 2010 at 04:43

    Sumner- I am pretty sure you’ll be interested in this take on Bernanke in the NYT by David Leonhardt:

    Ben Bernanke believes that he and his Federal Reserve colleagues have the ability to lift economic growth at their meeting this week. The Fed, he has said, “retains considerable power to expand aggregate demand and economic activity, even when its accustomed policy rate is at zero,” as it is today.

    Mr. Bernanke also believes that the economy is growing “not fast enough,” as he recently put it. He has predicted that unemployment will remain high for years and that “a lot of people are going to be under financial stress.”

    Yet he has been unwilling to use his power to lift growth and reduce joblessness from near a 27-year high.

    http://www.nytimes.com/2010/06/23/business/economy/23leonhardt.html?ref=business

  21. Gravatar of mlb mlb
    23. June 2010 at 05:21

    Interesting article. Another quote…

    “Above all, top Fed officials are worried that financial markets are fragile. They are not so much worried about inflation, the traditional source of Fed angst, as they are about upsetting the markets’ confidence in Washington. Yes, investors remain happy to lend the United States money at rock-bottom interest rates, despite our budget deficit and all of the emergency Fed programs that will eventually need to be unwound. But no one knows how long that confidence will last.

    In effect, Mr. Bernanke and his colleagues have decided to accept an all-but-certain downside “” high unemployment, for years to come “” rather than risk an even worse situation “” a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply.”

    In my opinion this is exactly what macroeconomists miss (it would help if they all had to trade real markets for a decade). They cannot quantify this risk of sudden market dislocations so they largely ignore it and assume that month-to-month market moves provide some feedback on month-to-month policy actions. This is wrong. Markets will more or less ignore bad policy until is crosses some undefined threshhold…then they will react sharply and in a manner that is tough to combat.

    In the US example, we essentially have a store of goodwill in the USD from years of good economic management. That is why we are able to print money now with few inflationary repurcussions. However, we have no way of knowing when that goodwill runs out – at which point, just one additional USD printed will equal capital flight – most likely into gold and other commodities as policy makers would be helpless to “fix” that.

  22. Gravatar of Philo Philo
    23. June 2010 at 06:45

    You write: “The quickest way to get out of the liquidity trap is to target a much higher NGDP growth path than what is currently expected.” When you say ‘target’, you mean, at least in part, *intend to do whatever it takes* to bring about higher NGDP growth. But I think you also mean *communicate this intention (to, at least, the economically most important–“central”–agents) in a credible way*. And the communication will be credible only if the target audience believes that the Fed has the means to bring about higher NGDP growth and that it knows what these means are (and is willing to use them). Now, I take it the means you have in mind are *creating new money and buying things with it* (or giving it away). Do you also have in mind some sort of priority ordering of the “things” to be bought””e.g., first short-term U.S. government debt, then long-term U.S. government debt, then other government debt (states, municipalities, foreign governments), then debt of highly rated corporations, then . . . etc., etc.? (Mortgage-backed securities? Credit card debt? Common stocks? Nothing [e.g., helicopter-dropping]?) Or do you not care what (if anything) the Fed buys””farmland, art, collectibles, commodity futures, whatever.?

    I have the impression that your term ‘target’ may carry a more complex meaning than would be evident to the casual reader.

  23. Gravatar of Morgan Warstler Morgan Warstler
    23. June 2010 at 07:56

    mlb, on gold. I think you are exactly right. Gold is the proof the market believes inflation is coming. More importantly, while the cost of oil fluxuates directly on the strength or weakness of the dollar…. the oil suppliers refuses to be paid some set price in weak dollars, unless we are shopping in foreign countries we don’t notice, particularly when we keep getting more minutes and data for our same $100 cell fone bill, and as rents continue to decline because of housing oversupply, and car leases stay low because the money factor is virtually nil…. meanwhile gold is the storehouse for people who need to diversify out of government backed currencies.

    When gold goes back down, the money supply will actually be retracting.

    And yes, when the markets decide, we’ll really find out which macroeconomists have been swimming naked.

    Philo,

    This is exactly what I keep trying to ask scott, what is the exact mechanism for targeting NGDP?

    And if he doesn’t care HOW, then how do we keep Obama and Democrats from claiming the stimulus worked, when scott’s miracle cure comes riding to the rescue.

  24. Gravatar of scott sumner scott sumner
    23. June 2010 at 08:33

    mlb, You said;;

    “I don’t think it matters much at this stage of the game, but as a thought experiment I think it is significant to realize that there is a theoretical state of the world where the Fed simply cannot influence the overall price level. It is intriguing to me that the market resembles this state of the world more every day.”

    This seems a complete non-sequitor. Yes, gold is not that important, but the Fed has plenty of other tools to boost prices. I must be missing something.

    Regarding gold demand, I need numbers. Going from $1 to $100 is explosive in percentage terms, but trivial in absolute terms. How much of newly-mined gold is bought here, and how much in Asia?

    Even if I am wrong on this technical point, it would affect my broader views. But I still think I am right.

    Benjamin, I don’t agree that entitlements are self-financing. Right now some of the programs are, but the future growth cannot be supported by our tax regime. And Cochrane is focusing on future deficits, not current deficits.

    I support cutting back the military and all those rural subsidies that you mention, so we agree there. And I agree that conservatives are often hypocrites on spending.

    David Pearson, That data in no way contradicts my assertion. A big part of Asian demand is Asian (and Russian) central bank demand. As these countries grow rapidly, they want their central banks to hold gold just like the big boys. And the dollar is expected to depreciate against the yuan even w/o high US inflation.

    Indy, Maybe, But I have also read that the world is just about out of unexplored areas, and that diminishing returns will now set in (We are taking opposite positions from our coal debate.)

    tinbox, I think gold demand has risen partly because the variance of inflation forecasts is now higher. But the TIPS market is more accurate. I think Bloomberg.com has the CPI market, but I forgot where the link is, maybe someone else can supply it.

    Bill, Keynes claimed that long term rates can’t be reduced below some minimum. I presume that is the Keynesian argument today. But in a model with expectations, none of this makes any difference. Even buying zero rate T-bills is expansionary if the monetary injection is viewed as being permanent.

    Statsguy; You said;

    “Do you think the Fed is nimble enough and credible enough to thread that needle?”

    With inflation targeting maybe not, with price level or NGDP level targeting yes. The Fed can also watch TIPS spreads, by the way. If the market knows that the Fed will react to nudge us back on course, inflation expectations won’t drift very far in the first place. But they need to be explicit, and unfortunately they seem incapable of doing that.

    I recently saw data from the US government that wages (actually employee comp) is up 4% over the past two years. That is nowhere near enough flexibility. Higher minimum wages, health care mandates, 99 week unemployment comp, are all making the labor market more rigid.

    If the markets don’t expect inflation, no U of C professor should be worried about it.

    Doc Merlin, The financial distress school says the banking crisis would have caused a recession even if NGDP kept growing at 5%. They see it as a big real shock. I see it as a little real shock.

    Benjamin#2, I completely agree.

    Statsguy; You said;

    “If we’re going to have an SEC, we should at least fund it. Same with the EPA.”

    I say let’s not have an SEC, and let’s not fund it if we do. The EPA is more defensible.

    OGT, Thanks, that’s pretty much what I said in October 2008 and NOBODY IN THE ENTIRE WORLD SEEMED TO SHARE MY VIEW. Yes, I’m exaggerating. But I felt that way sometimes.

    mlb, You said;

    “In effect, Mr. Bernanke and his colleagues have decided to accept an all-but-certain downside “” high unemployment, for years to come “” rather than risk an even worse situation “” a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply.””

    Yes, and how could the Fed not understand that the markets were panicking from too little inflation, not too much. And how could they have failed to notice that stocks and output fell when long rates fell, and rose later in 2009 when long rates rose? Are they blind?

    You said;

    “However, we have no way of knowing when that goodwill runs out – at which point, just one additional USD printed will equal capital flight – most likely into gold and other commodities as policy makers would be helpless to “fix” that.”

    Sure we know. We know the markets like 2% inflation and 5% NGDP growth, but will panic if the core inflation rate moves up to 4%, or higher. Commit to level targeting and the market will be reassured that mistakes will be quickly corrected.

    Philo, I mean target a long run 5% path, level targeting. No one disputes that the Fed can do this when not in a liquidity trap. They must commit to do so know, and that will eliminate any “trap.” Then they just need to accommodate the demand for base money at that anticipated nominal growth rate. They can use the TIPS spreads to help guide them, but an NGDP futures market would be better. If they are afraid of printing lots of base money, they can do this with a lower monetary base by having negative interest on ERs. No need to buy exotic assets at all. Just buy T-bills and T-notes. There are more than enough out there.

  25. Gravatar of scott sumner scott sumner
    23. June 2010 at 08:36

    Morgan, Yes, the gold market correctly predicted inflation—in Zimbabwe. Of course it was wrong about the US. Why does every American think the whole world revolves around the US? The biggest commodity consumer today is not the US, it’s China–look there if you want to explain commodity prices.

  26. Gravatar of Doc Merlin Doc Merlin
    23. June 2010 at 10:01

    ‘Morgan, Yes, the gold market correctly predicted inflation””in Zimbabwe. Of course it was wrong about the US. Why does every American think the whole world revolves around the US? The biggest commodity consumer today is not the US, it’s China-look there if you want to explain commodity prices.’

    Again, much of gold value isn’t a commodity in the tradition sense, but more like a currency. This is why its value goes up in times of flight to safety and in times of high inflation (somewhere in the world). I also agree, we didn’t get huge inflation in the US (although I believe CPI greatly understates it) we got huge inflation in China and Zimbabwe.

  27. Gravatar of StatsGuy StatsGuy
    23. June 2010 at 10:21

    ssumner

    “I recently saw data from the US government that wages (actually employee comp) is up 4% over the past two years.”

    I believe that was largely attributable to unemployment benefits. Even including those, here’s the weekly average private wages (nominal) from bls, showing a sharp drop in 2008:

    Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
    2006 346.73 346.55 345.00 347.35 345.17 343.16 347.21 350.30 350.12 352.11
    2007 349.46 348.79 350.53 351.28 350.44 351.52 350.75 349.53 350.64 348.84 347.58 348.42
    2008 345.45 345.32 348.23 346.31 345.86 343.96 341.06 341.83 342.67 346.49 353.27 355.37
    2009 355.13 353.21 353.04 352.21 352.29 349.09 349.37 349.34 349.10 348.13 350.01 348.23
    2010 350.80 350.23 351.04 352.63(P) 355.34(P)

    The past 3 months starts to support your case. But the average obscures the median, and we know that % of people paid less than minimum wage has increased.

    http://www.bls.gov/ro3/mwpac1.gif

    The hourly rate is a bit more stable (suggesting there’s loss of work hours, consistent with your argument). But it looks like until april this year, there was no weekly growth and some decline in 2008 perhaps, while at the same time % at/below minimum wage was rising – suggesting that median wages were dropping, but that average was bouyed up by high income earners (concentrated, certainly, in finance).

    The interesting thing about Cochrane is that it’s the first time I’ve seen a UC guy characterize the recession as a debt problem, not just a wage problem.

    Why is this important? Because the characterization has implications about recommendations: If it’s a debt problem, then dropping wages (and busting unions) may feel good for conservatives, but it doesn’t solve much. It it’s a wage problem, then inflating/reneging on debt will cause lots of inflation and underinvestment, but not solve the excess wage problem.

    Of course, it could be both, and it could also be a _sectoral_ problem too.

    In this context, it’s hard to tell current workers that they should suffer the adjustment costs as wage losses after socializing the investment losses of creditors (and by creditors, I include retirees). We’re going to see some generational conflict before this is all over.

  28. Gravatar of scott sumner scott sumner
    24. June 2010 at 06:14

    Doc Merlin, Why can’t gold prices rise if central banks hoard gold? That happened in the early 1930s, when the real value of gold went up, despite deflation.

    Statsguy, Any time I refer to wages I mean hourly wage rates, the weekly data is simply not relevant to business cycle models. It would be like trying to estimate changes in the price level by looking at weekly sales at retailers. You mix a price and a quantity.

    BTW, I am also a “Chicago guy” who doesn’t think wages are the problem, I think deflationary monetary policies are the problem. By analogy, Keynesians who have ‘sticky price’ models are not blaming sluggish retailers for the recession.

    I don’t know who is calling on workers to suffer more. I favor policies that would help workers, even if it reduced real wage rates. Cutting minimum wage rates helps workers. If I am wrong then we should raise the minimum wage to $15 dollar an hour. Real wage rates soared in the early 1930s, but I doubt whether workers thought Hoover’s high wage policy was helping them.

  29. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    25. June 2010 at 04:59

    Scott, you said:

    “No one thinks of cash and T-bills as being close substitutes, they play completely different roles in our economy. People who hold lots of cash have no interest in T-bills, and vice versa.”

    Cash is used to pay for groceries, treasuries are used to pay for other financial assets. 100$ bills are used to pay for drugs, 10c coins are used to pay for bubblegum. But still 10c coin and T-bill are substitutes, even though people who like bubble gum usually are not active participants of repo market.

    By the way Cochrane’s high inflation scenario is compatible with at least some versions of EMH if we postulate that forecasts of future deficits are non-biased and all that changes is the discount rate used to value fiscal liabilities. Change in the discount rate might reflect changed taste for risk.

  30. Gravatar of Doc Merlin Doc Merlin
    25. June 2010 at 07:29

    “Doc Merlin, The financial distress school says the banking crisis would have caused a recession even if NGDP kept growing at 5%. They see it as a big real shock. I see it as a little real shock.”

    I do not understand. How is this a real shock instead of a nominal shock? It is affecting money supply directly, it only affects production of goods indirectly.

    “Doc Merlin, Why can’t gold prices rise if central banks hoard gold? That happened in the early 1930s, when the real value of gold went up, despite deflation.”

    That qualifies as a flight to safety just done by central banks instead of private individuals. My point was that gold doesn’t usually follow price indexes during deflation, like it would if it behaved like a commodity. It tends to behave as if it was a foreign currency. So, when central banks and fiscal policymakers misbehave, gold rises in price. When they finally start behaving properly, gold crashes.

  31. Gravatar of ssumner ssumner
    25. June 2010 at 12:27

    123, I disagree. As long as cash is used for completely different types of transactions, and it is, they are not close substitutes. T-bills aren’t just a bad way of buying ordinary items, they are an absolutely horrible way. I’d use a check or credit card or debit card long before I’d use a T-bill at WalMart. So if you increase the supply of cash, (assuming cash isn’t being hoarded) then its value will fall.

    DocMerlin, No, the banking crisis did not reduce the money supply.

    Regarding gold, the argument seems to sometimes involve expectations of future inflation, and at other times current inflation. Either way it is an incomplete argument. Gold often fails to predict future inflation, and it obviously isn’t now reflecting current inflation.

  32. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    26. June 2010 at 02:15

    Scott, you have described a process whereby a permanent doubling of currency would double the price of groceries. Cochrane could describe a process whereby a permanent doubling of government debt would double the price of real financial assets. Why groceries are more important than financial assets?

  33. Gravatar of ssumner ssumner
    26. June 2010 at 06:37

    123, I have no idea what “real financial assets” means. Do you mean stocks? In any case, if that is his argument then I don’t agree. Only cash is a medium of account. The value of a T-bond can fall in half without any change in the price level (or goods, services or even common stocks). By definition, if the value of cash falls in half then the price level doubles.

  34. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    26. June 2010 at 13:01

    If the value of T-bonds fall in half, it means that there is a huge increase in interest rates. But we know that high interest rates mean that money is easy.

  35. Gravatar of thruth thruth
    26. June 2010 at 14:03

    @Scott Sumner:”No need to buy exotic assets at all. Just buy T-bills and T-notes. There are more than enough out there.”

    I think I’m still a little confused by the mechanism here. Is the important part of the QE that it is unsterilized or do you think the mere act of the Fed shifting the composition of its balance sheet to long term securities is enough? I have a hard time believing the latter, but perhaps I’m just not seeing this the right way. For unsteralized interventions there’s still a question of how long they will remain unsteralized for.

  36. Gravatar of ssumner ssumner
    27. June 2010 at 07:03

    123, Yes, but that doesn’t support Cochrane’s money plus debt formulation, unless he is using the par value of the debt. Maybe he is, but then how can one explain the price level in Australia, which has almost no public debt. You can explain Australian prices looking at their monetary base, but not by looking at the base plus Australian government debt.

    thruth, Don’t worry, this is very confusing stuff. Changing the current monetary base, by itself, has almost no effect on the price level, even during normal times when not in a liquidity trap. What affects prices is changes in the expected future base. Because in the long run you are not expected to be in a liquidity trap, the purchase of any asset will work equally well, as long as it is expected to be permanent. How do you create the expectation of permanence? But setting a price level or NGDP target. But if that target it credible, then it does all the “heavy lifting,” and there is no point looking for a “mechanism” by which monetary injections boost AD. Instead, the OMOs merely accommodate the public and banks’ demands for base money at the Fed’s price level or NGDP target.

  37. Gravatar of thruth thruth
    27. June 2010 at 08:24

    “thruth, Don’t worry, this is very confusing stuff.”

    I’ll muddle along…

    “Changing the current monetary base, by itself, has almost no effect on the price level, even during normal times when not in a liquidity trap. What affects prices is changes in the expected future base.”

    I’m going to interpret this as expanding the base as required to maintain credibility of the target (presumably expectations of changes in the future base must rely on the base actually being expanded via central bank activities at some point for the policy to be credible). Would you then say that if and when it become time to do QE, a sterilized QE or QE with an IOR policy won’t do the job?

  38. Gravatar of ssumner ssumner
    28. June 2010 at 07:09

    thruth, It all depends on how the action affects expectations. The QE itself matters much less than the context—what signals the Fed sends about its objectives. QE can work if it leads to higher inflation expectations–but to get that you need some helpful communication from the Fed.

  39. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. June 2010 at 13:22

    Cochrane’s formulas have both debt at par value and debt at market value (see his discussion of intertemporal inflation tradeoff at page 8).

    Australian case is easy, as you should always look at the consolidated fiscal+monetary balance sheet and debt that is held by the central bank is always ignored.

  40. Gravatar of ssumner ssumner
    29. June 2010 at 08:00

    123, That doesn’t change anything significant–the Australian monetary base can’t be that large, can it?

    Why does Australia have slightly higher inflation than other Western countries?

  41. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    30. June 2010 at 06:53

    Scott,
    1. Cochrane’s formulas are correct by definition. The answer must be the discount rate used to value fiscal liabilities. Australians are happy with their private sector assets, so they use relatively high discount rates for fiscal liabilities.
    2. inflation should be compared to the growth rate of M0+fiscal liabilities, not to the level of M0+fiscal liabilities
    3. exchange rate movements are important consideration if we compare sizes of M0+fiscal liabilites
    4. if we include off-balance sheet fiscal liabilities things are not so different in Australia as elsewhere

  42. Gravatar of ssumner ssumner
    30. June 2010 at 07:10

    123, Yes, I know the consolidated fiscal and monetary balance sheets must balance out in the long run. But that tells us nothing about whether discretionary fiscal policy decisions create inflation. Reagan ran unsustainable fiscal deficits in the early 1980s. But it didn’t create a lot of inflation? Why not? Because the Fed wouldn’t monetize the debts. So Reagan had to fix Social Security in 1993, and Clinton raised income taxes. Thus the unsustainable debt problem was fixed (temporarily) without printing money. Cochrane’s theory assumes fiscal policy is the dog and monetary policy is the tail. But that’s not how things work in most developed country. Sure he starts with an identity, but it doesn’t have much predictive power outside Zimbabwe. Where is the high Japanese inflation?

    Regarding you second point, I was talking about the price level, not inflation. The QTM can explain the price level. It seems to me that the fiscal view adds nothing to the QTM in Australia. If you are going to argue that there are all sorts of implicit public liabilities, that is fine. But they can’t be quantified, so there is no way to know whether they are important. The US Supreme Court says that Social Security is not a right, so in what sense are future payments public liabilities? Congress can change them anytime they wish.

    My bottom line is that even in Cochrane’s paper, where you think he’d find empirical evidence that supports his theory, the evidence seems pretty weak to me. The Great Inflation of 1965-81 doesn’t correlate with big increases in fiscal obligations in 1965, nor big decreases in 1981. So what predictive power does this theory have?

  43. Gravatar of Ted Ted
    30. June 2010 at 08:26

    Scott, you are missing the point. The beauty of Cochrane’s theory is that it’s virtually unfalsifiable! His theory relies on the shift in expectations and until those expectations shift, if they ever do alone the lines of his theory, he can continue to pursue the scary story and just claim it hasn’t happened YET! I suspect what Cochrane would say is that in the 1980s people still believed our politicians would resolve the budget situation with fiscal adjustment. But now, he believes, that people’s expectations might shift because of the political situation we find ourselves in and people might begin to believe the central bank will lose its independence.

    I view that scenario as highly unlikely, and I think most of the public does also. Cochrane’s theory is inherently one of political economy, yet he doesn’t seem to realize how difficult it would be for politicians to begin to monetize the debt. We have a system of checks and balances (not to mention the filibuster) so you’d have to get a lot of support behind monetizing the debt in order to get that passed. Also, it would even be more difficult to get the votes since monetizing our debt would be deeply unpopular among voters, and nobody wants to lose their seat. If people are rational (at least approximately) they should realize how difficult it would be for politicians to monetize the debt and so his theory shouldn’t really ever hold in the United States.

    If you are going to write a political economy theory, which is what this theory really is, you should at least consider the relevant aspects of political economy – like our electoral and legislative structure.

    Also, Cochrane seems to claim the 1965-81 inflation and the 80s lack-of-inflation DOES support his theory. He has a graph of primary surpluses / GDP and show how it decreased in the mid-70s, rose in the mid 80s, stayed high in the mid-90s etc. I don’t buy his graph though. For one, shifts in monetary policy can basically explain all of that. But, more importantly, I think Cochrane misunderstands his own theory. His whole theory is about expectations of future fiscal deficits. So, why does he use real-time data to support his theory? Primary deficits in the 1970s should be irrelevant for inflation in the 1970s for his theory, because it’s about expectations of future deficits. Real-time transitory surpluses and deficits shouldn’t make a difference in his theory – only expectations of future surpluses and deficits. His use of this evidence makes zero sense to me and seems inconsistent with his own theory.

  44. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    1. July 2010 at 05:12

    “But that tells us nothing about whether discretionary fiscal policy decisions create inflation. Reagan ran unsustainable fiscal deficits in the early 1980s. But it didn’t create a lot of inflation? Why not? Because the Fed wouldn’t monetize the debts. So Reagan had to fix Social Security in 1993, and Clinton raised income taxes. Thus the unsustainable debt problem was fixed (temporarily) without printing money. Cochrane’s theory assumes fiscal policy is the dog and monetary policy is the tail. But that’s not how things work in most developed country. Sure he starts with an identity, but it doesn’t have much predictive power outside Zimbabwe. Where is the high Japanese inflation?”

    According to Cochrane, maturity structure of M0+fiscal liabilities determine the timing of inflation. In early 1980s combined effect of monetary and fiscal policy was to postpone inflation, and this postponed inflation was resolved by 90s fiscal tightening.

    In Japan scary gross debt/GDP ratio should be ignored, as net debt/GDP ratio is much smaller. Also tax system there is much further away from Laffer peak there.

    Predictive value of Cochrane’s model comes from the fact that he incorporates maturity structure and treasury yield curve into his model. Also, if we compare monetary velocity to Cochrane’s discount rate used to value fiscal liabilities I’d say both indicators are quite useful.

  45. Gravatar of Scott Sumner Scott Sumner
    1. July 2010 at 12:16

    Ted, You said;

    “Scott, you are missing the point. The beauty of Cochrane’s theory is that it’s virtually unfalsifiable!”

    No I am not missing the point, as I agree with what you say. I made the same point about the graph elsewhere. It does not support his story, as the inflation began long before the deficits got big, and inflation ended long before the deficits got small.

    123, Those explanations seem 100% ad hoc. In the graph he tries to show a correlation between the fiscal situation and inflation, and I just don’t see the correlation. You can’t tell me it’s not the right data, because it’s the very data he was using in his graph. Whatever data he tries to use, I just don’t see the correlation.

    I believe that Japan’s net debt is also extremely high, and they have a population that is expected to decline rapidly.
    Their fiscal situation looks extremely bad.

    I just don’t see any predictive power from the theory. If there is evidence in the Cochrane paper, it wasn’t very persuasive.

  46. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    2. July 2010 at 05:48

    The best evidence from the people who are using fiscal theory of price level for speculation is here (scroll down for the chart two):
    http://www.hussmanfunds.com/wmc/wmc100119.htm

    Perhaps Japanese should use higher discount rates for their fiscal liabilities.

  47. Gravatar of Scott Sumner Scott Sumner
    2. July 2010 at 06:01

    123, I don’t see chart 2 showing anything. The only correlation is in the middle part of the graph where inflation is extremely high. But in that case it’s obvious that federal spending would rise rapidly. Nominal spending on almost every category of NGDP will rise rapidly during double digit inflation. Some categories (Social Security) are explicitly tied to inflation. The causality goes in the opposite direction.

  48. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    3. July 2010 at 09:08

    In the chart 2 I see some rough evidence that the growth of federal spending might be a leading indicator of CPI.
    By the way the author of the chart has so far successfully predicted in February that markets will start pricing in more deflation in the near future.

  49. Gravatar of ssumner ssumner
    3. July 2010 at 09:49

    123, I just don’t see what you see. The early 1950s saw a lot of spending, but inflation didn’t rise. Maybe you could argue the late 1960s led to inflation. But if it is a leading indicator, then the contemporaneous relationship I pointed to (late 1970s) fails to predict, as inflation slowed first.

    He may be predicting deflation, but his chart predicts exactly the opposite. So he obviously is not using his chart in the recent forecast.

  50. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. July 2010 at 15:52

    Note that the chart has the current inflation and 4 year moving average of expenditure growth, so if the lines move together it means that expenditure growth is leading.

    John Hussman is was using fiscal theory of price level to predict deflationary pressures during next couple of years. His forecast was driven not by the growth of government debt. He forecasted that discount rates that are used to value fiscal liabilities will change in the near future.

  51. Gravatar of ssumner ssumner
    5. July 2010 at 11:26

    123, You said;

    “Note that the chart has the current inflation and 4 year moving average of expenditure growth, so if the lines move together it means that expenditure growth is leading.”

    I agree, but that doesn’t affect my argument at all. He should construct the graph in the way that makes the correlation look best. I assume he has done so, and I don’t see much correlation. Sure there is some correlation, but if I graphed nominal spending growth on dry cleaners and nominal GDP growth I’d find a similar correlation. Certainly the corrlation is not impressive, especially considering that I don’t buy the theory that underlies his model.

  52. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    6. July 2010 at 04:29

    But isn’t it true that we need some model that lets us value government debt in real terms? Is there any better model than the fiscal theory of price level?

  53. Gravatar of ssumner ssumner
    6. July 2010 at 06:49

    123, I don’t know enough to tell you whether it is a good theory of the real government debt. But it is not a good theory of the price level. The effect of more base money is very different from the effect of more 30 year T-bonds

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