Category Archives: Notes

Show Me The Model

Three opinion leaders in the blogosphere have laid out how they think about the macroeconomy. They talk about “models” but unfortunately don’t deliver. Instead, they provide lists of beliefs or facts to be explained. Economics is a science precisely because it has progressed beyond such lists. Economists build models—consistent, well-structured and clearly specified (and thus, mathematically formulated) stories.

But here are the lists: Scott Sumner’s “Musical Chairs model” (blog):

In the short run, employment fluctuations are driven by variations in the NGDP/Wage ratio.

Monetary policy drives NGDP, by influencing the supply and demand for base money.

Nominal wages are sticky in the short run, and hence NGDP shocks cause variations in employment in the same direction.

In the long run, wages are flexible and adjust to changes in NGDP. Unemployment returns to the natural rate (currently about 5% in the US.)

Tyler Cowen’s “model” (blog):

In world history, 99% of all business cycles are real business cycles.  No criticism of RBC can change this fact.  Furthermore the propagation mechanism for a “Keynesian business cycle” (arguably a misleading phrase) also relies on RBC theory.

In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks.  I consider the Christina and David Romer “shock identification” paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics.  Sometimes central banks tighten when they shouldn’t, and this leads to a recession, due mainly to nominal wage stickiness.

Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.

Overall I favor a nominal gdp rule for monetary policy.  But most of its gains would come in a few key historical episodes, such as 1929-1932, or 2008-2009.  In most periods I don’t think we know what the correct monetary policy should be, nor do we know that it matters.  Still, that uncertainty does not militate against an ngdp rule.

Once workers are unemployed, nominal wage stickiness is no longer the main reason why they stay unemployed.  In fact nominal wage stickiness is largely taken out of the equation because there is no preexisting nominal wage contract for these workers.  There may, however, be some residual stickiness due to irrational reservation wages, also known as voluntary unemployment due to stupidity.  (You will find a different perspective in Scott’s musical chairs model, which I may cover more soon.)

Monetary stimulus to be effective needs to be applied very early in the job destruction process of a recession.  It is much harder to put the pieces back together again, so urgency is of the essence.

The successful reemployment of workers depends upon a matching problem, a’la Pissarides, Mortensen, and others.  Yet this matching problem is poorly understood, and it can involve a mix of nominal and real imperfections.  Sometimes it is solved more quickly than expected, such as in the recent UK experience, and other times more slowly than expected, as in current Spain.  Most of the claims you will read about this reemployment of workers are wrong, enslaved to ideology or dogmatism, or at the very least unjustified.  Hardly anyone wants to admit this.

Really bad recessions involve deficient aggregate demand, negative shocks to intermediation, some chronic supply-side problems, negative wealth effects, and increases in the risk premium, all together.  It is hard to find a quick fix.  Furthermore models where AS and AD curves are independent and separable are often misleading, despite their analytic convenience.

Given that weak AD is only one of the problems in a bad downturn, and that confidence, risk, and supply side problems matter too, the best question to ask about fiscal policy is how well the money is being spent.  The “jack up AD no matter” approach is, in the final political equilibrium, not doing good fiscal policy any favors.

You should neither rule out nor overstate the relevance of Hayek and Minsky.  Their views have much in common, despite the difference in ideological mood affiliation and who — government or the market — gets blamed for the downturn.  For really bad recessions, usually both institutions are complicit to say the least.

All propositions about real interest rates are wrong.

The Economist’s Free Exchange response to Cowen’s model (blog):

Supply-side policy is hard. Why is America the richest large economy in the world? Well, because output per person has grown at about 2% per year, on average, for a very long time. How did it manage that? I have a long list of policy choices and characteristics and historical accidents that I believe contributed, but I would find it very difficult to say which of those factors were most important. If someone gave me free reign over the German economy and asked me to raise its output per person to American levels, I know the sorts of things I would do, but I have a low level of confidence that I could succeed, or even close much of the gap, within a generation.

That doesn’t mean that supply-side policy should be ignored. Supply-side reforms (of the sort this newspaper tends to favour) are politically difficult to achieve, but many of them are probably at least somewhat useful and should be undertaken whenever the political environment is amenable (though with very modest expectations regarding detectable effects on growth).

With supply-side policy, the precision of a policy action is not the problem; accuracy is. With demand-side policy, it is the opposite: it is pretty easy to meet broad policy goals, so long as you’re not too concerned about hitting them square on the nose.

We know what an economy with way too much demand looks like. It has high and accelerating inflation.

We know what an economy with way too little demand looks like. It has high unemployment and deflation.

Within those two extremes, it can be tricky to identify exactly where an economy stands: how close or far away from potential output it is.

Both too much and too little demand are economically costly, but history suggests that too little demand is far more economically costly and politically risky than too much demand. So policy should err on the side of too much demand rather than too little.

The determined use of monetary policy is almost always going to be sufficient to generate the right sort of “too much demand”. But an independent central bank might not always be able to muster the appropriate determination. In some cases a central bank may flounder until a clear political consensus emerges supporting the determined use of monetary policy.

It is generally unwise for countries to sacrifice monetary-policy autonomy, either by adopting a constraining exchange-rate regime or by introducing an excessive level of capital-account openness.

In countries with autonomous monetary policy, which are stuck at the zero lower bound on interest rates, fiscal policy is almost by definition too tight, and it is probably quite difficult to conduct fiscal stimulus in a way that generates long-run economic costs. That is because the long-run supply-side and fiscal benefits of getting off the ZLB are probably pretty large.

Fiscal policy is subject to political constraints, and it may be easier to introduce a large stimulus in emergency situations if the pre-emergency public-debt burden is low. That suggests that prudence in normal times is a good idea (though do remember point number 10).

Don’t subsidise debt.

The level of financial- and banking-sector liberalisation at which it can be demonstrated persuasively that further liberalisation will generate net benefits is probably not that high.

Microsoft Buys Credibility in Germany

In the FT, Murad Ahmed and Richard Waters report about Microsoft’s strategy to regain customer trust in cloud services in light of widespread US government surveillance. According to the report, Microsoft outsources data storage to a German company. The idea is that

T-Systems will act as a “trustee” of the facilities, with Microsoft insisting its employees will have no access to the data held at the facilities without the German company’s permission. The companies believe this arrangement means Microsoft will not have to respond to governmental demands for information held in these data centres, forcing official requests to go through German authorities instead.

Government Debt Management

In his FT blog, Larry Summers argues for a “quite radical” change in government debt-management. He proposes several lessons:

  • “Debt management is too important to leave to Federal debt managers and certainly to leave to the dealer community. … when interest rates are near zero, it has direct implications for monetary and fiscal policy and economic performance … and … financial stability.”
  • “… it is fairly crazy for the Fed and Treasury, which are supposed to serve the national interest, to pursue diametrically opposed debt-management policies. This is what has happened in recent years, with the Fed seeking to shorten outstanding maturities and the Treasury seeking to term them out.”
  • “Standard discussions of quantitative easing … are intellectually incoherent. It is the total impact of government activities on the stock of debt that the public must hold that should impact on financial markets.”
  • In the US, “the quantity of long-term debt that the markets had to absorb in recent years was well above, rather than below, normal. This suggests that if QE was important in reducing rates or raising asset values it was because of signalling effects … not because of the direct effect of Fed purchases.”
  • “The standard mantra that federal debt-management policies should seek to minimise government borrowing costs is … wrong and incomplete. … it is risk-adjusted expected costs that should be considered. … it is hard to see why the effects of debt policies on levels of demand and on financial stability should be ignored.”
  • “The tax-smoothing aspect, which is central to academic theories of debt policy, is of trivial significance.”
  • Rather than providing opportunities for carry trade, “[t]reasury should reverse the trend towards terming out the debt. Issuing shorter term debt would also help meet private demands for liquid short-term instruments without encouraging risky structures such as banks engaged in maturity transformation.”
  • “Institutional mechanisms should be found to insure that in the future the Fed and Treasury are not pushing debt durations in opposite directions.”

Central Bank Communication

How should central banks communicate? In his blog, Ben Bernanke makes the case for the US system which has recently been criticized as resulting in “cacophony.” His points are:

  • Public speeches of FOMC participants “are a forum for elaborating and providing evidence for their positions.”
  • “The open airing of policymakers’ opinions and analysis actively engages the public in debates about critical issues.” For example, it may generate a debate in academia which benefits the quality of Fed decisions.
  • “For democratic legitimacy and accountability, the Fed needs to be transparent about how it makes monetary policy decisions. … It should also be reassuring to those who disagree with Fed decisions to know that, more often than not, their point of view is being represented in the Fed’s internal debates.”

 

Lack of Trust in the European Commission

In the FT, Henry Foy reports about critical comments by Jeroen Dijsselbloem. The chair of the Eurogroup has argued that the Euro area needs an independent fiscal oversight body to disperse fears of “politicised” European Commission decisions when it comes to evaluating national budgets.

Naturally, lack of trust in the Commission is widespread. But now it seems to have reached the higher echelons of EU institutions themselves.

In the meantime, Tony Barber writes (also in the FT) that “The eurozone’s fiscally lax nations are at it again”.

Tax Federalism

In the NZZ, Marius Brülhart and Kurt Schmidheiny discuss the Swiss experience with a federalist tax system. Cantonal and municipal taxes average roughly 40 percent of the total tax take in Switzerland, see the first figure.

grafik-1

The decentralized tax system, tax competition between cantons and communities as well as mobility of high income tax payers imply that the effective average income tax rate substantially falls short of the unweighted average tax rate on high incomes. In fact, the effective average tax rate is degressive for high incomes, see the second figure (which the authors reproduce from an article by Roller and Schmidheiny (2015)).

grafik-2

Switzerland will Vote on “Vollgeld”

A group of Swiss citizens lobbying for monetary reform has succeeded: after collecting more than 100,000 signatures a referendum will have to be held in the next years. In the ballot, Swiss citizens will vote on no more or less than the future of the monetary system in Switzerland.

According to the group’s proposal inside-money creation by banks will eventually be prohibited. Deposit claims vis-a-vis commercial banks would be transformed into claims vis-a-vis the central bank and deposit liabilities of commercial banks would be transformed into liabilities of those banks vis-a-vis the central bank. Within a certain time span, commercial banks would have to repay those liabilities. Moreover, they would be prohibited from ever creating deposits again—that is, all money should be base money.

Here are previous blog posts on the topic: the initiative; comment; narrow banking proposals; Icelandic debate.

Update: Discussion by Alex Tabarrok in a marginal revolution post.

Decentralization through the Blockchain?

The Economist reviews the blockchain technology underlying Bitcoin—“a way of making and preserving truths.”

It is the blockchain that replaces this trusted third party. A database that contains the payment history of every bitcoin in circulation, the blockchain provides proof of who owns what at any given juncture. This distributed ledger is replicated on thousands of computers—bitcoin’s “nodes”—around the world and is publicly available. But for all its openness it is also trustworthy and secure. This is guaranteed by the mixture of mathematical subtlety and computational brute force built into its “consensus mechanism”—the process by which the nodes agree on how to update the blockchain in the light of bitcoin transfers from one person to another.

One interesting aspect of the blockchain technology is that it provides incentives for “mining”, rendering it self-sustainable. The future may lie in blockchain applications beyond payments, for example in securities clearance, certification and the like.

It Pays to Have Academic Economists on the Board

In a Bank of Finland discussion paper, Bill Francis, Iftekhar Hasan and Qiang Wu argue that there is evidence for academic economists to be useful after all. Academics on the board of directors “are valuable advisors and effective monitors.” The authors write in the abstract:

Directors from academia served on the boards of around 40% of S&P 1,500 firms over the 1998-2011 period. … We find that companies with directors from academia are associated with higher performance and this relation is driven by professors without administrative jobs. We also find that academic directors play an important governance role through their advising and monitoring functions. Specifically, our results show that the presence of academic directors is associated with higher acquisition performance, higher number of patents and citations, higher stock price informativeness, lower discretionary accruals, lower CEO compensation, and higher CEO forced turnover-performance sensitivity. Overall, our results provide supportive evidence that academic directors are valuable advisors and effective monitors and that, in general, firms benefit from having academic directors.

Birth Order Matters—Marginally

That’s the finding of a large study by Julia Rohrer, Boris Egloff and Stefan Schmukle.

Abstract:

… Empirical research on the relation between birth order and intelligence has convincingly documented that performances on psychometric intelligence tests decline slightly from firstborns to later-borns. By contrast, the search for birth-order effects on personality has not yet resulted in conclusive findings. We used data from three large national panels … In our analyses, we confirmed the expected birth-order effect on intelligence. We also observed a significant decline of a 10th of a SD in self-reported intellect with increasing birth-order position, and this effect persisted after controlling for objectively measured intelligence. Most important, however, we consistently found no birth-order effects on extraversion, emotional stability, agreeableness, conscientiousness, or imagination. On the basis of the high statistical power and the consistent results across samples and analytical designs, we must conclude that birth order does not have a lasting effect on broad personality traits outside of the intellectual domain.

ScienceDaily report.

Chicago Economics

Chicagonomics, a new book by Lanny Ebenstein, describes the evolution of the Chicago school. The book is reviewed by Tyler Cowen in a blog post and by the Economist. From the latter review:

Before the 1940s, Chicago’s professors were much closer to the liberalism of British political economists such as Adam Smith, Jeremy Bentham and John Stuart Mill than the libertarianism of Hayek and Friedman in the 1980s and early 1990s. Mr Ebenstein looks at the ideas of scholars such as Jacob Viner and Frank Knight, and concludes that while they favoured individual freedom, their policy prescriptions did not exclude government action. Both perceived Smith as justifying the state intervening in the economy at times, such as with the provision of infrastructure, education for the young and the funding of arts, culture and science.

By the 1940s, the use of redistribution to ensure that everyone had a basic standard of living was accepted by most Chicago economists. For instance, Henry Simons, when he worked at Chicago between 1939 and 1946, set out how redistribution, by diffusing economic power in a society, was necessary in a free society. Even Hayek, in his libertarian polemic of 1944, “The Road to Serfdom”, supported the use of environmental regulation and state-run social-insurance systems.

After they retired Hayek and Friedman became deeply libertarian. Mr Ebenstein says “the virtual neoanarchism that both preached” later on placed them “outside the classical liberal tradition”. Hayek argued that citizens should have the right to have their taxes refunded if they did not consume government services and Friedman railed “against government at almost any time”. Both enjoyed being in the limelight, even though their views did not fit with their earlier scholarly work. Mr Ebenstein bemoans the current popular perception of the Chicago school, as well as conservatives’ embrace of it, as based on these more extreme later utterances.

 

Cochrane for Growth

In a blog post, John Cochrane proposes step-by-step (politically unattractive) measures to increase growth:

  • Smarter (growth-oriented) regulation, in particular
  • Higher equity requirements and less short-term funding rather than complex financial regulation
  • Deregulation of health care supply
  • More cost-benefit analysis in environmental policy
  • Broad-based consumption rather than investment taxes
  • Clear separation of allocative and distributive fiscal policy
  • Focus on distortions in social programs
  • Deregulation of labor markets
  • Rational immigration rules distinguishing between permits to entry, reside, or work and citizenship
  • Less government intervention in the student loans market
  • Less protection, more free trade
  • More spending for the legal and criminal justice system
  • Etc.

Low Interest Rates

In the 17th Geneva Report on the World Economy (Low for Long? Causes and Consequences of Persistently Low Interest Rates), Charles Bean, Christian Broda, Takatoshi Ito and Randall Kroszner take up the theme of a recent report by the White House Council of Economic Advisors (see previous blog post). In the abstract, some of the authors’ conclusions are summarized as follows:

… aggregate savings propensities should fall back as the bulge of high-saving middle-aged households moves through into retirement and starts to dissave; this process has already begun. And though Chinese financial integration still has some way to run, the net flow of Chinese savings into global financial markets has already started to ebb as the pattern of Chinese growth rotates towards domestic demand rather than net exports. Finally, the shifts in portfolio preferences may partially unwind as investor confidence slowly returns. But … the time scale over which such a rebound in real interest rates will be manifest is highly uncertain and will be influenced by longer-term fiscal and structural policy choices.

One chapter in the report discusses the Japanese experience.

Regulation, Elimination of Cash, and Organized Crime

In a blog post, Gilles Saint-Paul describes how organized crime exploits the arbitrage opportunities that (bad) regulation creates.

He predicts that eliminating cash transactions by decree, along the lines of policy proposals currently en vogue, will lead organized crime to establish alternative, sound mediums of exchange that the general public might adopt.

Banks Face Wipeout in some Financial Services

In the FT, Martin Arnold summarizes a McKinsey study on banking. Arnold entitles his article “McKinsey warns banks face wipeout in some financial services.”

According to the report, competition arises from technology companies that deliver specific financial services at much lower cost.

McKinsey said technological competition would reduce profits from non-mortgage retail lending, such as credit cards and car loans, by 60 per cent and revenues by 40 per cent over the next decade. … It predicted a smaller, but still significant, chunk of profits and revenues would be lost from payments processing, small and medium-sized enterprise lending, wealth management and mortgages. These would decline between 35 and 10 per cent, McKinsey said.

See my previous posts on structural change in banking and fintech competition for banks.

Sterilized Exchange Rate Intervention

In a Baker Institute working paper, Jeffrey Frankel reviews the Plaza Accord 30 years ago. Regarding the effectiveness of sterilized intervention, he argues that

… purchases and sales on the scale that governments are generally prepared to make will not have much effect if the market is already firmly convinced of the proper value of the currency. … The successful effect of intervention comes when the market holds weak views as to the true worth of the currency, particularly in the case of a speculative bubble, and is willing to be led by the authorities. A good example of this was the dollar in 1985.

The effort generally has an effect within the first few days or weeks if it is going to have an effect at all.

… operations are more likely to be effective if they are “concerted,” i.e., coordinated among a number of major central banks as they were in 1985 and subsequent years. It is particularly important that the U.S. be one of the countries participating.

… the major effect comes via expectations.

… authorities are not necessarily able to affect the exchange rate for a long period, absent a corresponding change in fundamentals.

In recent years, interventions in foreign exchange markets have mostly been confined to emerging markets.

European Monetary Union: A Status Report

In the NZZ (August 7, 2015), René Höltschi provides an excellent overview over the status of European Monetary Union (EMU).

Issues:

  • EMU combines centralized monetary policy authority with decentralized fiscal powers. This creates the risk that national governments try to free ride.
  • Heterogeneity across Euro Zone member states renders centralized monetary policy difficult. Without national monetary policy instruments, prices and wages need to adjust more in the face of asynchronous business cycles.

Previous solutions:

  • The stability and growth pact was meant to address the first issue. It failed, for political reasons. Markets didn’t impose sufficient discipline either; they anticipated bailouts.
  • Hopes for reduced heterogeneity—as a consequence of EMU—have been shattered.

Reforms so far:

  • During the crisis, member states established rescue funds and agreed on various crisis measures.
  • They pursued a two-pronged strategy. On the one hand, they tried to build on the decentralized approach of the Maastricht treaty. On the other, they aimed at closer integration in the form of banking, fiscal and eventually, political union.
  • Major responsibilities in the area of banking supervision and resolution have been transferred to the European Central Bank. Bail-in procedures have been agreed upon.
  • No major changes occurred in the fiscal policy domain. The “Six-pack” and “Two-pack” measures to strengthen fiscal discipline, coordination and supervision have proved ineffective (e.g., no action against France).

Proposals and discussion:

  • The recent “Five-presidents’ report” distinguishes between short-term (until 2017) and longer-term (until 2025) measures (see below). The report proposes to strengthen the existing framework before moving towards closer integration (Euro treasury, macroeconomic stabilization, fiscal and political union). France and Italy have voiced support.
  • Fiscal union entails a common budget and potentially, a common unemployment insurance. Unity of liability and control would require that fiscal competences are centralized as well. In turn, this would require changes of the European treaties.
  • A further strengthening of banking union, e.g. delegation of banking supervision to a newly created European authority (rather than the European Central Bank), also would require treaty changes.
  • But throughout Europe, there is no desire to delegate powers to “Brussels.”
  • Instead, skeptics like the Bundesbank or the German Council of Economic Experts advocate a bankruptcy procedure for Euro-zone governments: to strengthen discipline and encourage monitoring by financial markets any assistance by the European Stability Mechanism should be preceded by private creditor bail-ins (extensions of maturity, haircuts).
  • Some observers also advocate exit from the Euro zone as an ultima ratio measure. But others argue that this very possibility would undermine the stability of the Euro area.

Five-president’s report:

  • Commissioned in October 2014 by the heads of state and government, the report has been published in June 2015 by presidents Jean-Claude Juncker (European commission), Donald Tusk (European council), Jeroen Dijsselbloem (Euro group), Mario Draghi (European Central Bank) and Martin Schulz (European parliament).
  • In the short term, the report proposes: to improve elements of the previous “six-pack” and “two-pack” reforms, including streamlined coordination and supervision of national fiscal policies;
  • a common backstop for national deposit insurance systems;
  • a European fiscal council serving as watchdog; and
  • independent national agencies to monitor competitiveness.
  • For the longer term, the report proposes: completion of monetary union and fiscal union;
  • macroeconomic stabilization, stopping short of permanent transfers or income equalization schemes; and
  • a Euro zone treasury.
  • Accountability as well as the role of national parliaments and the European parliament in coordinating fiscal policy is to be strengthened. The Euro zone is to be better represented vis-a-vis third parties. Intergovernmental arrangements (for example the European Stability Mechanism) that were created during the crisis are to become integral parts of the EU treaties.

Previous Cohorts’ Household Debt Was Much Lower

In a blog post, May Rostom documents that “secured debt is rising super-fast for the young.”

Over the life cycle, each generation accumulates household debt until reaching age forty or fifty, and repays afterwards. But the level of indebtedness (in real terms) has increased from cohort to cohort, and peak indebtedness has shifted to older age. The amplitude of the income paths has not changed to the same extent—“income growth has been unable to keep up with the pace of house price inflation.” Moreover, while “the younger groups have taken the lion’s share of the increase in debt from 1995-2012, … the biggest winners [when it comes to wealth accumulation] have been the older generations.”

Crime and Punishment

In a blog post, Alex Tabarrok argues that Gary Becker was wrong to argue that an optimal punishment system combines a low detection and punishment risk with a very severe punishment conditional on detection. Tabarrok argues:

We have now tried that experiment and it didn’t work. Beginning in the 1980s we dramatically increased the punishment for crime in the United States but we did so more by increasing sentence length than by increasing the probability of being punished. …

Why did the experiment fail? Longer sentences didn’t reduce crime as much as expected because criminals aren’t good at thinking about the future; criminal types have problems forecasting and they have difficulty regulating their emotions and controlling their impulses. … As if that weren’t bad enough, by exposing more people to criminal peers and by making it increasingly difficult for felons to reintegrate into civil society, longer sentences increased recidivism.

Instead of thinking about criminals as rational actors, we should think about criminals as children. … So what is the recommended parenting approach? … one thing all recommendations have in common is that the consequences for inappropriate behavior should be be quick, clear, and consistent.