Representative Tlaib asks a great question

In a recent Bridge post, I suggested that Congress should ask Jay Powell the following questions:

1. Do Fed officials believe that the Federal Reserve currently has adequate tools to achieve their mandate at the zero lower bound, without assistance from fiscal policy?

2. Would the Fed be more confident in its ability to achieve the dual mandate of stable prices and high employment if it were authorized to buy a wider range of assets at the zero lower bound?

3. Suppose the Fed were allowed to boost its capital by retaining several years’ worth of profits. Would this make the Fed more willing to provide adequate liquidity at zero interest rates, knowing that it is less likely to become insolvent if the assets on its balance sheet declined in value?

Yesterday, Rep. Tlaib asked Powell the following question:

What additional tools or authority do you need to prevent another downturn?

Great question!!  Unfortunately, Powell didn’t provide a good answer:

I think we have the tools that we need.  I think what we would hope for is support from fiscal policy.

If you are hoping for support from fiscal policy, then you most certainly do not have the tools that you need.  There is no reason to expect any significant support from fiscal policy during the next downturn.  The deficit has soared to nearly a trillion dollars during a boom period—does anyone seriously think Congress will run a $2 trillion deficit in the next recession?  And does anyone think that a Congress where the two parties barely speak to each other will suddenly come together and agree on a tax cut during the next recession.  (I’m not even considering government output, as there are basically no shovel ready projects in the modern world of infrastructure.)

And even if we did run a $2 trillion deficit, it would have little impact on GDP.  Remember 2009?  How about 2013?

Here’s what Powell should have said:

It would help if Congress gave us additional tools, or at the very least clarified that we were authorized to use current tools as aggressively as necessary to prevent a recession, even if that means buying unconventional assets, and even if it runs a small risk of capital losses for the Fed.

If Congress doesn’t want us to do whatever it takes to prevent the next recession at the zero lower bound, and would prefer to handle more of the load with fiscal policy, it would help if they clearly spelled out what they did expect from us.  But I have to be honest with you, given the current budget deficit it’s very unlikely that fiscal policy will be effective in the next recession.

Powell did a good job discussing monetary policy, explaining why a rate cut is now appropriate.

The NYT reports that Powell is increasingly skeptical of the Phillips Curve:

Representative Alexandria Ocasio-Cortez, Democrat of New York, later asked, “Do you think it’s possible that the Fed’s estimates of the lowest sustainable unemployment rate may have been too high?”

“Absolutely,” Mr. Powell replied, adding that the Phillips curve, the statistical relationship between low joblessness and higher inflation that has been central to Fed policymaking for decades, is showing itself as but a “faint heartbeat.”

This is good news.  Like all “reasoning from a price change” models, the P.C. is not reliable enough for policy purposes.  The Fed needs to focus on NGDP growth, not unemployment, when looking for indicators of overheating.

I’ve been arguing that now is a perfect time for the Fed to ask for more power, as both parties would be on board with giving the Fed the tools to prevent a recession.  Here’s the NYT:

It probably also helps that the Fed is now under pressure, from both conservatives and liberals, to increase economic growth.

The Fed needs to wake up.

HT: JW Mason

Democracy and GDP

We’ve long known that democratic countries tend to be richer than dictatorships. There’s also evidence that this understates the advantages of democracies. For instance, democracies are also less prone to experiencing famines, even compared to equally poor dictatorships. But is there a causal link? Here’s Alex Tabarrok:

In their sample of 175 countries from 1960 to 2010, Acemoglu et al. find that democracies have a GDP per-capita about four times higher than nondemocracies ($2074 v. $8149). (This is uncorrected for time or other factors.) But how much of this difference is explained by democracy? Hardly any. Acemoglu et al. write:

Our estimates imply that a country that transitions from nondemocracy to democracy achieves about 20 percent higher GDP per capita in the next 25 years than a country that remains a nondemocracy.

In other words, if the average nondemocracy in their sample had transitioned to a democracy its GDP per capita would have increased from $2074 to $2489 in 25 years (i.e. this is the causal effect of democracy, ignoring other factors changing over time). Twenty percent is better than nothing and better than dictatorship but it’s weak tea. GDP per capita in the United States is about 20% higher than in Sweden, Denmark or Germany and 40% higher than in France but I don’t see a big demand in those countries to adopt US practices. Indeed, quite the opposite! If we want countries to adopt democracy, twenty percent higher GDP in 25 years is not a big carrot.

There are many economic reforms that countries can do.  Thus the US could do tax reform, zoning reform, occupational licensing reform, reduce subsidies to health care and education, remove rent controls, remove tariffs and quotas, and many other types of reforms.  Considered individually, each reform would only have a very small impact on GDP. 

Democracy is different. I can’t think of any potential policy reform that even comes close to boosting GDP by 20%, other than democracy.  It seems to me that it is by far the most powerful growth enhancing reform available to countries. In that sense I disagree with Alex; I view this study as incredibly good news for democracy.  It is the ultimate low hanging fruit.

So if 20% is so big, then why don’t European countries emulate the US economic model?  Suppose they did adopt our relatively low tax regime, and suppose this boosted hours worked up to US levels.  In that case, they might also be able to boost GDP per capita close to US levels.  After all, the main difference between the US and northwestern Europe is hours worked, not labor productivity.  So why don’t they adopt the US model?

Perhaps the Europeans see two downsides to the American model.  First, they’d lose a lot of leisure time.  Second, they’d lose the revenue to support their huge welfare states, and that might increase inequality.  I still believe that they should switch to a lower tax model—Switzerland has done very well with this approach—but I can also see what holds them back.

In contrast, it’s hard to see any downsides from moving toward democracy.  Consider the things that don’t show up in GDP, such as leisure, a clean environment, human rights, avoidance of regional famine.  In all cases, it hard to see how democracy would make those conditions worse, and indeed in most cases it seems like the exact opposite is true—democracies also do better in terms of “intangibles” that don’t show up in GDP data.  Dictators don’t care as much about the public having human rights, clean air, leisure time, and a stable food supply.  They want power.

In the article discussed by Alex, the authors note the following:

With the spectacular economic growth under nondemocracy in China, the eclipse of the Arab Spring, and the recent rise of populist politics in Europe and the United States, the view that democratic institutions are at best irrelevant and at worst a hindrance for economic growth has become increasingly popular in both academia and policy discourse. For example, the prominent New York Times columnist Tom Friedman (2009) argues that “one-party non democracy certainly has its drawbacks. But when it is led by a reasonably enlightened group of people, as China is today, it can also have great advantages. That one party can just impose the politically difficult but critically important policies needed to move a society forward in the 21st century. ”

This is a very weak argument. The world is full of horrible dictators in places like Turkmenistan, Cuba, North Korea, Central African Republic, Venezuela, Equatorial Guinea, and dozens of other places. And because the democracy skeptics are able to find one allegedly well functioning dictatorship, this is supposed to be a powerful argument for autocracy? (And don’t forget the human rights disaster in Xinjiang.) What are the odds that you end up with an “enlightened” dictator?

But it’s even worse. Mainland China clearly lags far behind democratic Taiwan. Even worse, the Chinese Communist Party caused the worst disaster in human history in 1959-61. All they have done recently is move from disastrous Maoism to a much less bad mixed economy, which has pushed Chinese GDP/person from extreme poverty up to the level of a middle-income country like Mexico. If someone has their foot on my throat, and then eases up a bit so I can breath better, am I supposed to praise them for making me feel good? That’s the successful “model” for rejecting democracy?

I’m actually open to the argument that dictatorships might be better, but pointing to anecdotal examples such as China is not going to convince me. You’d need to provide systematic evidence. If the evidence from 175 countries suggests that democracy boosts GDP by a huge 20%, and if democracy also leads to gains in all sorts of intangibles, then why wouldn’t all countries wish to go that direction?

Fukuyama was right; the world will become democratic.

Why is inflation so stable?

Three different people directed me to a Robert Barro column that asks how the Fed achieved its recent success in inflation targeting:

Judging by the US inflation rate over past decades, the Fed’s monetary policy has worked brilliantly. Annual inflation has averaged only 1.5% per year since 2010, slightly below the Fed’s oft-expressed target of 2%, and has been strikingly stable. And yet, the question is how this was achieved. Did inflation remain subdued because everyone believed that anything significantly above the 1.5-2% range would trigger a sharp hike in the federal funds rate?

Barro discusses research by Emi Nakamura and Jón Steinsson in the Quarterly Journal of Economics, which finds evidence that “a contractionary monetary shock – an unanticipated rise in the federal funds rate” – reduces inflation, but that significant effects occur only after 3-5 years.  And there’s an even greater mystery in this study:

Although unexpected increases in the federal funds rate are conventionally labeled as contractionary, Nakamura and Steinsson find that “forecasts about output growth” actually rise for the year following an unexpected rate hike. That is, a rate increase predicts higher growth, and a decrease predicts lower growth. This pattern likely occurs because the Fed typically raises interest rates when it gets information that the economy is stronger than expected, and it cuts rates when it suspects that the economy is weaker than it previously thought. . . .

[T]he puzzle is how the Fed can keep inflation steady at 1.5‑2% per year by relying on a policy tool that seems to have only weak and delayed effects. Presumably, if inflation were to rise substantially above the 1.5-2% range, the Fed would initiate the type of dramatic increases in short-term nominal interest rates that Volcker carried out in the early 1980s, and these changes would have major and rapid negative effects on inflation. Similarly, if inflation were to fall well below target, perhaps becoming negative, the Fed would sharply cut rates – or, after hitting the zero-lower bound, use alternative expansionary policies – and this would have major and rapid positive effects on inflation.

According to this view, the credible threat of extreme responses from the Fed has meant that it does not actually have to repeat the Volcker-era policy. Rate changes since that time have had modest associations with inflation, but the hypothetical possibility of much sharper changes has remained powerful.

Frankly, I am unhappy with this explanation. It is like saying that the inflation rate is subdued because it just is.

Some economists believe that fiscal policy determines the inflation rate. For that group, the answer to the question in the post title is simple: Since 1990, Congress has been taken over by a set of economic geniuses, who have deftly steered fiscal policy in a way that keeps inflation close to 2%, something not seen in earlier periods of history. (Inflation averaged near zero under the gold standard, and was very erratic on a year-to-year basis.  It averaged far above 2% during 1966-90.)

Barro and I prefer a monetary explanation for inflation.  His textbook entitled “Macroeconomics” provides what I regard as the clearest and most elegant model of important nominal variables such as the price level and interest rates.  (At least the best model at the first year econ grad student level.)  He does a beautiful job discussing money neutrality and super-neutrality.  He argues that changes in the price level are best modeled in terms of changes in the supply and demand for base money.  That’s also my preference.

His textbook model shows how the Fed could control prices by adjusting the supply of base money and, after 2008, also the demand for base money (via changes in IOR.)  Thus in a technical sense there is no mystery at all.  The Fed adjusts the base and IOR as needed to stabilize inflation at close to 2%.  The fact that the Fed uses interest rate targeting is a mere technical detail—prior to 2008 they adjusted the fed funds rate by moving the supply of base money.  In Barro’s model, it is the supply and demand for base money that matters.

So where is the “mystery” that Barro refers to?  I see two possibilities:

1. The Fed’s monetary instruments have behaved in an unusual fashion in recent years.  The relationship between the base and the price level is much weaker than before 2008.

2. The long lags identified by Nakamura and Steinsson raise the question of how the Fed knows where to set their policy instruments today, in order to hit inflation goals 3 to 5 years into the future.

Obviously these two issues are related.  If base velocity is unstable, or if the natural rate of interest is unstable (or both), it’s not at all clear how the Fed is able to figure out where to set their instruments today in order to achieve their long run policy goals.

My best guess is that the Fed relies on the following three assumptions:

1. Stabilizing the future expected price level goes a long way toward stabilizing near-term inflation.  As an analogy, imagine the government wanted to stabilize the price of gold, but its only tool (digging new gold mines) took 3 to 5 years to implement.  Could they stabilize current gold prices, with such long lags?

The answer is probably yes, as even stabilizing expected gold prices 3 to 5 years in the future will tend to stabilize current gold prices.  No one would sell gold for $800 or buy gold at $1200 today if they thought the government would move gold prices to $1000 in 4 years.  The same applies to the overall price level, which depends heavily on the future expected price level. (This is not just my view, but also the implication of more sophisticated macro models.)

That still doesn’t answer Barro’s question, but it gets us part way there.  There are two more components:

2. The Fed reacts to previous misses in its target, with easing or tightening of monetary policy.

3. The Fed also pays some attention to market forecasts, which provide additional policy guidance, beyond recent macro data.

Think of a ship captain steering a tanker across the ocean, toward NYC.  Even if the captain is relatively clumsy, and doesn’t have a very good idea as to how much to adjust the steering wheel when he gets off course, he should be able to eventually reach NYC under these conditions:

1. He knows where NYC is.

2. He knows which way to turn the wheel when he gets off course.

3. He has enough power to overcome wind and waves.

Central banks generally have enough power to steer nominal aggregates, even at the zero bound.  (Although there may be a few cases where they do not, due to strict constraints on what they can buy at the zero bound.)  They know which way to adjust monetary policy when they get off course.  And they have a 2% inflation goal and know when they have gotten off course.

The tendency of the current inflation rate to be heavily influenced by the future expected price level makes inflation relatively inertial under an inflation-targeting regime (but not under a 1970s-type regime).  And because of this inertia, even relatively “clumsy” central bankers can target inflation fairly effectively, because they can eventually get the price level back on course.  Greenspan was viewed as a “maestro” for his policy successes, but other central banks did roughly as well after 1990, a sign that it was the new inflation targeting regime, not the skill of the leader, that was decisive.

The ship analogy actually understates the ability of central banks to control inflation.  In the world of sailing, trend reversion does not reduce the severity of wind and waves.  But in the world of monetary economics, a credible policy of stabilizing long run inflation tends to reduce “shocks” such as fluctuations in velocity and or the natural rate of interest.  The better they do their job, the easier the job gets.

The head of the Australian central bank has an easier job than the head of the Japanese central bank, a country where previous tight money mistakes led to deflation that reduced velocity and the equilibrium interest rate, necessitating far more drastic actions by the BOJ today.

PS.  I did not discuss the real growth puzzle in the Nakamura and Steinsson study.  I suspect that Barro is correct that it reflects policy responses to expected future changes in growth.  Indeed we are seeing something like that today, with likely rate cuts in anticipation of slower growth ahead.  This is part of the broader “identification problem” in monetary economics, aka “never reason from a price change”.

HT:  Nicolas Goetzmann, Ramesh Ponnuru, Stephen Kirchner

NBA earthquake

I recently did a post pointing out how the coastal areas are pulling away from older interior cities:

Visiting both San Francisco and San Jose on this trip, it was clear how much these cities have pulled away from middle American cities like St. Louis and Cleveland. The wealth and sophistication in the Bay Area is visible everywhere . . .

Last night I felt a rolling earthquake, and soon after a major trade represented an earthquake for the NBA.  In the past few days, 4 of the top 10 players have moved to NYC or LA teams, and a top 15 player also moved to NYC.  Last year one of the two greatest players of all time moved to LA.  These two cities are absorbing top NBA talent at a dizzying rate.

The most recent Super Bowl was Boston vs. LA, as was the most recent World Series.

Sports fans will correctly argue that this isn’t exactly new, as big coastal teams have often been dominant (think NY Yankees.)  But the past week does represent a bit of a change from recent NBA history.  The NBA put into effect a draft lottery, salary caps, and “restricted free agent” rules which favor weaker teams.  For a while that seemed to at least slightly balance things out, as the NY and LA teams were no longer very good.  But now their pull is rapidly overcoming these artificial barriers to success.  You can only hold down a good city for so long.

PS. A few years ago, I criticized the tendency of fans and reporters to question the mental health of players who complain of hard to diagnose injuries that team doctors cannot understand.  In the past NBA finals a Warriors team doctor told Kevin Durant that his injury was healed, and then he immediately went down with a far more serious injury in the same foot area.  He’ll be out for a year.  His team was then beaten by a team led by Kawhi Leonard, who ignored the team doctor’s claim he was healthy, and waited until he was truly healthy before going back out to play.  (Leonard was called a “head case”.)  There’s a real conflict of interest problem with team doctors, and players should not be doubted just because their injury is hard to diagnose.  They know best.

Leonard was often discussed in a very condescending way by people who mistook his introversion for stupidity.  It turns out he is much shrewder than we imagined.

PPS.  Remember that the “free market” model has no relevance for sports, as the “product” is games, and is produced jointly.  Sports teams compete on the playing field, but in an economic sense they cooperate.  Entire leagues are competing with other forms of entertainment.  The league has an incentive to cartelize in order to make games exciting.  If one team (i.e. “firm”) drove the others out of business, it would also go bankrupt.  Sports is not like other industries.

PPPS.  I rated Kyrie as top 20, and AD, Kawhi, PG and KD as top 10.  I don’t think I need to indicate who’s top two of all time.  Other top 10 players include LeBron, Steph, Harden, Giannis, Embiid and  . . . I’m not sure.  Jokic?  Klay?  Dame?  Oladipo?  Westbrook?

PPPPS.  Go Milwaukee Bucks in 2019-20!

Falling in love

Here’s Judy Shelton, recently nominated for a position at the Federal Reserve Board:

Ms. Shelton has been a vocal defender of the Trump administration’s foreign policy. In a December 2017 opinion piece in the Journal, she praised Mr. Trump’s efforts to invest more in the military to counter antidemocratic threats abroad.

“No one would accuse Mr. Trump of mushy sentimentalism when it comes to foreign policy,” she wrote.

And here’s a typical recent news story:

“I was really tough and so was he, and we went back and forth,” Trump told an adoring crowd of thousands at Wesbanco Arena in Wheeling. “And then we fell in love, OK? No, really, he wrote me beautiful letters, and they’re great letters. We fell in love.”

North Korea’s foreign minister, however, suggested the bloom may be off the rose. Ri Yong-ho, speaking to the U.N. General Assembly in New York on Saturday, said his country won’t dismantle its nuclear weapons program [without?] seeing “trust-building” measures from the U.S.

Thank God that Trump is not a mushy sentimentalist.

Actually, I feel bad even joking around about this subject:

Presented to the War Crimes Committee in Washington D.C. in 2016, the defectors’ testimonies included accounts of prisoners being tortured or killed because of their religious affiliation, forced abortions, and infanticide. One account described a prisoner’s newborn being fed to guard dogs. Each year at one of the camps, according to defector testimonies, authorities deliberately overwork and starve to death between 1,500 and 2,000 mostly child prisoners. . . .

Before the report’s publication, former ICC judge Thomas Buergenthal, a child survivor of Auschwitz, told the Washington Post, “conditions in the [North] Korean prison camps are as terrible, or even worse, than those I saw and experienced in my youth in these Nazi camps and in my long professional career in the human rights field.”

Shelton has gone from favoring tighter money a few years ago to favoring looser money today, for reasons that I am not able to understand.

PS.  Christopher Waller of the St. Louis Fed was also nominated for a position at the Board.  He is appropriately skeptical of the utility of Phillips Curve models.