Friday, December 30, 2011

The Burden of the Debt

Paul Krugman has several posts discussing the burden of the national debt.  Some readers have asked me for my take on the topic.  Let me refer them to this old paper I wrote with Larry Ball.  It provides a nontechnical overview.  Even though it is 16 years old, I think it holds up pretty well.

Wednesday, December 28, 2011

Ricardian Equivalance Heat

Here's the latest word from Paul Krugman on Ricardian equivalence. First Lucas doesn't understand it. Now, not only does David Andolfatto not understand it, he can't read either. What's the world coming to? Who taught that idiot Andolfatto anyway? Send him back to Surrey for reading lessons. Maybe he should consider going back to drywalling.

Here's what Krugman says:
I accused Lucas of not understanding Ricardian equivalence. Here’s Lucas’s argument:

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

That’s saying that the spending response to expected future taxes leads to a fall in consumption that exactly offsets the expansionary fiscal policy. If that’s not a Ricardian equivalence argument, what is it?
What's Lucas saying? There's a bridge, it's funded by increasing taxes. Lucas says it doesn't make any difference that the government does this. He also says the answer doesn't change if the taxes that pay for the bridge are current taxes or future taxes. The last part of that is Ricardian equivalence. So what is wrong with that argument? It could be the spending actually matters, regardless of how it is financed, and we could argue about that. It could be that Ricardian equivalence does not hold in practice, and we could argue about that. Does Lucas somehow indicate in that line of reasoning that he doesn't understand Ricardian equivalence? Absolutely not. I was telling people that I thought Krugman had to understand Ricardian equivalence. My undergraduates get it. Why can't he? I don't want to be accusing the poor man of lack of understanding or poor eyesight. Maybe he can clear this up?

Here's another puzzler for you:
Then Andolfatto says that Lucas was arguing that it matters how government spending is financed. No, he wasn’t. Right there, he argues that government spending doesn’t matter at all:

If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

So he was saying that government spending can’t raise aggregate demand. Period.
Figure that one out and I'll give you a prize. Krugman starts off by tellling us he's going to show us that Andolfatto was wrong. But put this Lucas quote together with the previous one, and Andolfatto's interpretation seems to be exactly what Lucas said. Lucas told us in the first quote that the government spending won't matter if it's paid for through taxation (present or future). Then, in the second quote, he says that it will matter if the Treasury issues debt to finance the expenditure, and the Fed buys the debt. What Krugman says to summarize, i.e. "so he was saying the government spending can't raise aggregate demand," is essentially correct, but that is not in contradiction to what Andolfatto said. I would not use the words "aggregate demand" in relation to what Lucas was talking about, but we'll let that one go.

Here's where Krugman heads for the gutter:
Look, I know people want to defend Lucas and hit at me, but what Lucas said there betrayed a fundamental failure to understand the implications of debt-financed spending — followed by an outright smear against Christy Romer.
A fundamental failure to understand...? That's not the problem here at all. One could construct a coherent set of debating points, based on theory and empirical work, to counter what Lucas is saying, but there's no fundamental failure to understand something. I think it would be fun to have that debate, and I'm sure Lucas would be game. On Christy Romer, it helps to read the whole transcript of Lucas's talk, which is available here. The earlier quotes were taken from the main talk, which apparently was never written down. It looks like Lucas is making it up on the spot, presumably from notes. The Christy Romer stuff is in the Q&A at the end. Here's the relevant part:
QUESTIONER: Ben Steel, Council on Foreign Relations. Bob, I edit a journal called International Finance and I get a lot of submissions from people who build big models -- big economic models -- and the shortest referee reports I get back condemn these submissions by saying this model is subject to the Lucas critique. In the last session, we had quite an animated discussion which spilled over into the lunch about models on fiscal multipliers, what they are.

On the one extreme, we have models by people like Mark Zandi at Moody's who say that the fiscal multiplier for the spending initiatives we're discussing are on the order of 1.5. On the other hand, we have people like Robert Barro at Harvard who say there's zero or negative. How would you go about applying the Lucas critique to these types of models to sort of educate us in how we should think about the validity of these models?

LUCAS: Do I need the Lucas critique for -- I'm with Barro is the short answer. (Laughter.) The Moody's model that Christina Romer -- here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.

So she scrambled and came up with these multipliers and now they're kind of -- I don't know. So I don't think anyone really believes. These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics.

Maybe there is some multiplier out there that we could measure well but that's not what that paper does. I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons. I don't -- I'd like to talk about the Lucas critique but I don't -- I don't think we can -- (chuckles) -- deal with that issue.
The question is about models and multipliers. Lucas tells us a story about how he imagines Christy Romer does her job. In fact, you can see how she does it in this speech from February 2009. She talks about how she and Jared Bernstein used some "very conventional macroeconomic models" to come up with a multiplier of 1.6, which she thinks is on the low side. As Lucas says, he thinks exercises like that are "schlock economics," and he's right. The "very conventional macroeconomic models" Romer is talking about are large-scale macroeconometric models which are fundamentally the same as the ones constructed in the 1960s and early 1970s - the FRB/MIT/Penn model for example. Those were the models Lucas criticized when he wrote this paper, which is part of what the question was about. It's not a smear to question someone's methods. Sorry, Paul.

Here's the finishing paragraph, and it's a winner:
Ever since I started writing about the failures of modern macro, I’ve been attacked by people claiming that I just don’t understand the depth of their thought. Each time it turns out that they either are making basic errors or simply can’t manage to read what I and others actually wrote. And here we have another example.
You have to pity the poor man who wrote that. Viciously attacked by arrogant failures who just can't get it right.

Well, give me a break. What does Paul Krugman want exactly? If you go around badmouthing the cumulative work over 40 years of many macroeconomists - work that has been vetted by mainstream economic journals, hashed over in many hours of seminars and conferences, and awarded many prizes, including several Nobels - do you want a pat on the back, or what? The smearing isn't being done by Bob Lucas here.

Tuesday, December 27, 2011

Jeremy Stein to the Fed

President Obama has nominated my Harvard colleague Jeremy Stein to become a Federal Reserve Governor.  This is an excellent choice.  Congratulations, Jeremy!

(The President has also nominated Jerome Powell, whom I do not know.)

How do the rich earn their livings?

Here is an interesting paper that answers the question.  Some highlights from Table 3 about the top 0.1 percent:
  • 18 percent are financial professionals.
  • 42 percent are executives, managers, or supervisors in nonfinancial businesses. More than half of those are in closely-held (presumably often small) businesses.
  • 7 percent are lawyers.
  • 6 percent are in medicine.
  • 3 percent are in arts, media, or sports.
  • Less than 1 percent are professors or scientists.  :(

War On Shallowness

I'm pleased to hear that Paul Krugman does not like shallowness, particularly in the blogosphere. My guess is that most people would have a hard time putting his post into context, but I think he wrote it as a reply to my last post. Follow the "pulling rank" link in his last paragraph. Too bad that Krugman went shallow on this one. It would be much more interesting if he actually addressed the issues.

As an update on John Quiggin and Zombie Economics, (which initially set Krugman off on his "pulling rank" nonsense), if you have not read my longer critique of Quiggin's book, it is published in the Australian National University E Press. The paper is not just about Quiggin's book. It also serves as a response to the people who think that all of modern macroeconomics needs to go out the window because the financial crisis happened. Apparently Quiggin seems bothered by my critique, though he does not address the substance. It seems he would be happier if it had been written by an Australian, and not just another colonial.

I win a journalism award

Sort of.  NY Times blogger Gene Marks puts one of my columns on his list of the Best Reads of 2011.

Monday, December 26, 2011

Ricardian Equivalence Redux

I just read Paul Krugman's most recent blog post. This is typical. Krugman is repeating an argument he has been making for a long time. He wants you to think that he has it right, and that there are some "freshwater" (whatever that is) bad people out there who have it all wrong. How could they be so stupid?

For reference, here's something I wrote back in March of this year on Ricardian equivalence, when Krugman was on about this before.

Krugman tries to pick on Lucas in his blog post, as "betraying a complete misunderstanding of his own doctrine," and quotes this, which comes from a panel discussion at a conference:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.
I don't agree with everything Lucas said in that quote, but I think I can safely say that I know Lucas better than Krugman does. I think I understand what ideas he is attached to, and there is nothing in the quote that is inconsistent with those ideas. Further, for something pulled out of an off-the-cuff panel discussion, it's reasonably coherent.

Lucas of course was a primary force behind the revolution in macroeconomic thought that occurred post-1970. But he is also very much an old-school Milton Friedman quantity theorist - an Old Monetarist if you like. That's what is behind the first part of the quote. He's thinking that it's monetary policy that is important, and that monetary policy effects will drive the effects of the stimulus. You may think that's wrong, but that's part of what he thinks.

In the latter part of the quote he has a particular view of the effects of the spending package put in place in 2008. Supposing it is funded by taxation - current or deferred - he thinks it doesn't matter much. Now, even in the context of non-Keynesian macroeconomics, there are reasons why government spending can matter. There are wealth effects; public spending and private consumption might be complementary; a recession may be a good time for public investment in infrastructure. Maybe in the context of the 2008 spending package, Lucas thinks that those things do not matter so much. Maybe he thinks that the planned spending was not thought through very well, and we are better off without it. In any event, I don't see anything in the quote that we would want to condemn Lucas for. The weird part of this is that Krugman is picking on Lucas over Ricardian equivalance. The only piece of the quote that relates to that is the last part: "And then taxing them later isn't going to help, we know that." That's just stating the Ricardian equivalence proposition, which is that the timing of taxation does not matter. Tax me now; tax me later; it does not make any difference. Lucas certainly isn't getting anything wrong.

Next, Krugman wants you to think, not only that Lucas is confused, but that he's somehow besmirching Christina Romer. If you read the quote, Lucas is not saying anything bad about Romer, he's just thinking about the realities of government. In my opinion, Christina Romer deserves besmirching, but all Lucas is saying is that, likely, Romer was not driving the policy, and that her job was to defend it, which is what she did.

Here's the really funny part of Krugman's post:
I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.
Apparently that is supposed to be an "intuitive" way to think about Ricardian equivalence. This is an excellent illustration of Krugman's confusion. The example actually tells you nothing about Ricardian equivalance, or anything remotely related to the effects of government actions on the behavior of private economic agents.

What's going on? In Krugman's example, a family takes out a $100,000 mortgage loan to purchase a house. This family now has $100,000 in debt, and someone else in the economy has a $100,000 asset. What is happening in the aggregate? If this is a new house, then the private sector collectively is foregoing current consumption, and investing in a house which will provide a future stream of consumption. If it's an existing house, then this could be a wash. For example, suppose that the family that sold the house takes the $100,000 it receives from the sale and puts it in a bank that makes the mortgage loan to the family that buys the house. Where is the Ricardian equivalence lesson in all that?

Ultimately, Krugman should be able to do better than this. We're accustomed to his nasty side, but at least he could provide some useful instruction.

Saturday, December 24, 2011

I wish you all a Merry Christmas, and also a New Year full of miracles

Why, who makes much of a miracle?
As to me I know of nothing else but miracles,
Whether I walk the streets of Manhattan,
Or dart my sight over the roofs of houses toward the sky,
Or wade with naked feet along the beach just in the edge of the water,
Or stand under trees in the woods,
Or talk by day with any one I love, or sleep in the bed at night
with any one I love,
Or sit at table at dinner with the rest,
Or look at strangers opposite me riding in the car,
Or watch honey-bees busy around the hive of a summer forenoon,
Or animals feeding in the fields,
Or birds, or the wonderfulness of insects in the air,
Or the wonderfulness of the sundown, or of stars shining so quiet
and bright,
Or the exquisite delicate thin curve of the new moon in spring;
These with the rest, one and all, are to me miracles,
The whole referring, yet each distinct and in its place.

To me every hour of the light and dark is a miracle,
Every cubic inch of space is a miracle,
Every square yard of the surface of the earth is spread with the same,
Every foot of the interior swarms with the same.
To me the sea is a continual miracle,
The fishes that swim--the rocks--the motion of the waves--the
ships with men in them,
What stranger miracles are there?

-- Walt Whitman

Thursday, December 22, 2011

The Ron Paul Portfolio

As reported by the Wall Street Journal:
Most members of Congress, like many Americans, hold some real estate, a few bonds or bond mutual funds, some individual stocks and a bundle of stock funds. Give or take a few percentage points, a typical Congressional portfolio might have 10% in cash, 10% in bonds or bond funds, 20% in real estate, and 60% in stocks or stock funds.
But Ron Paul’s portfolio isn’t merely different. It’s shockingly different.
Yes, about 21% of Rep. Paul’s holdings are in real estate and roughly 14% in cash. But he owns no bonds or bond funds and has only 0.1% in stock funds. Furthermore, the stock funds that Rep. Paul does own are all “short,” or make bets against, U.S. stocks. One is a “double inverse” fund that, on a daily basis, goes up twice as much as its stock benchmark goes down.
The remainder of Rep. Paul’s portfolio – fully 64% of his assets – is entirely in gold and silver mining stocks....
At our request, William Bernstein, an investment manager at Efficient Portfolio Advisors in Eastford, Conn., reviewed Rep. Paul’s portfolio as set out in the annual disclosure statement. Mr. Bernstein says he has never seen such an extreme bet on economic catastrophe. ”This portfolio is a half-step away from a cellar-full of canned goods and nine-millimeter rounds,” he says.

The secret is out

Click on image to enlarge.

Tuesday, December 20, 2011

Holiday Gift Suggestions

If you are looking for gift ideas for that special econonerd in your life, let me suggest a couple of books I recently enjoyed:
  1. Grand Pursuit: The Story of Economic Genius by Silvia Nassar.
  2. Boomerang: Travels in the New Third World by Michael Lewis.
Both are intelligent, well written, and fun.

Monday, December 19, 2011

A Family Holiday Trip to NYC

I just returned from New York City.  My wife, three kids, and I went down to the city for a couple days, mainly to see the Broadway show How to Succeed in Business Without Really Trying before Daniel Radcliffe and John Larroquette step down from the lead roles.

It was much fun.  Daniel Radcliffe in particular was fantastic.  He provided the Mankiw family much consumer surplus.

Saturday, December 17, 2011

Are economists selfish?

Yoram Bauman takes up the question in a NY Times opinion piece, based on his research.  In essence, he finds that being an economics major and taking classes in economics are negatively correlated with how much students donate to two particular charities: WashPIRG and Affordable Tuition Now.

I agree with Yoram's concluding sentence: "Learning about the shortcomings as well as the successes of free markets is at the heart of any good economics education, and students — especially those who are not destined to major in the field — deserve to hear both sides of the story." 

Yet I am not persuaded by the evidence he gives that economics classes are failing to do that.  Maybe, having heard both sides of the story, the students make better decisions, just not the ones that Yoram appears to approve of!  Perhaps the students were persuaded by this famous insight: "By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it." 

And no, that is not Gordon Gekko.

Wednesday, December 14, 2011

Back to the Old Grind

I've been taking a bit of a break from full-scale Krugman confrontation lately. What he writes here, in his "wonkish" way, is basically more of the same, but I thought I would extract this bit and comment on it:
Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap. This is a situation in which even a zero short-term interest rate isn’t low enough to restore full employment; it is, if you think through the logic, a situation in which desired saving, or more accurately the savings people would make if we were at full employment, exceed desired investment even at a zero interest rate.

The liquidity trap — which is in effect a special case of IS-LM analysis — has some special properties. Notably, even large government borrowing won’t drive up interest rates (not unless the borrowing is enough to restore full employment), and you can print as much money as you like without causing inflation.

1. This is not a "classic" liquidity trap. As I discuss at length here, in a classic liquidity trap the central bank is essentially trying to accomplish something by swapping currency for government debt, and those two assets are essentially the same. The nature of the liquidity trap we are now in is that a swap of interest bearing reserves for T-bills accomplishes nothing, because those two assets are the same, and that would be true whether the interest rate on reserves were 0.25%, 5%, or 20%. What gives rise to the modern-day liquidity trap is that there is a large positive stock of excess reserves in the financial system. Further, this liquidity trap is even more damning, as quantitative easing will not accomplish anything either - swaps of short-term debt for long-term debt simply get undone by the private sector.

2. Make government borrowing large enough, and interest rates will go up alright, liquidity trap, no liquidity trip, "full employment" (whatever Krugman thinks that means) or no full employment. We understand what that is all about. Make the government debt large enough, and it's unsustainable.

3. You can't "print as much money as you want without causing inflation." In spite of the fact that, in our modern-day liquidity trap, swapping reserves for government debt does not matter, the fact that the reserves are out there can matter for future inflation, but that depends on future central bank actions. If something happens to make the banks less willing to hold the reserves, the Fed can increase the interest rate on reserves so that the banks want to hold the reserves, with no resulting inflation. If Krugman means to say that the banks are going to hold the reserves indefinitely at 0.25%, then that's not right.

4. To say that IS/LM - a model with no dynamics, two assets ("money" and "bonds"), no credit, no default - is going to enlighten us, in the way Krugman thinks it does, about "how the world works," is a pretty bold statement, to say the least. More on that here.

Krugman finishes up with:
The moral of the story, then, is that one view of macroeconomics has held up very well in the Lesser Depression; the alternatives have been shown wrong again and again.
How are we supposed to evaluate that? IS/LM seems a complete non-starter. How can you say it "holds up?" What are the alternatives that he wants to compare this to anyway? Are those alternatives something anyone even thinks about? As usual, you know the answers. The alternatives are straw men that exist only in Krugman's mind.

Books on Inequality

Recommendations from MIT's Daron Acemoglu.

Tuesday, December 13, 2011

Positional Goods for the Holidays

Not content with the Santa-on-the-roof from days of yore, positionators have now discovered the two-storey inflatable reindeer. A status-enhancer if I ever saw one. You're saying that if boot polish applied to your balding head was good enough for Grandpa, that it's good enough for you. Forget it. We now have the hands-free hair rejuvenator. At $699.95, this will position you well. However, if that is a strain on your positional budget, $69.95 will get you a room-tidying pickup robot.

Shiller on Neuroeconomics

Bob describes the research frontier at the border between economics and brain science.

Monday, December 12, 2011

Saturday, December 10, 2011

The World According to Frank, Part II

This is a followup to my previous post. Robert Frank likes to talk about "positional goods." These are goods I like, not because they confer any direct benefit on me, but because I feel happy when I have more of this type of good than what others have. Similarly, I feel worse when others have more of this good than I do. Examples are large houses that are mostly empty or Beamers driven by people who couldn't tell the difference between riding in a Beamer and riding in a Hyundai if they closed their eyes. An extreme example is this house in India. Frank thinks that positional goods are ubiquitous and lead to social waste - basically, a lot of time and resources wasted over nothing. From his point of view the social welfare loss is large, and can be corrected with a progressive consumption tax.

But hold on. Aldo Rustichini likes to study envy and regret. He is an economic theorist who also has in interest in economic experiments and neuroeconomics. Rustichini likes to view envy and regret as elements of psychology that propel learning and economic development. Envy is a force that makes me want to replicate the successful behavior of others, while regret is a force that helps me to correct my own errors so that I can become successful.

To motivate these ideas, Rustichini likes to talk about how performance is evaluated in elementary schools in the United States. I went to elementary school in the 1960s in Canada, where we were graded in each subject, and were given a report card to take home with little else other than the odd short comment next to the grade - "shows promise," "improvement needed," etc. Grades were of course supposed to be private, but we knew what was going on. I felt good. Some others felt bad. Concern that some children in elementary school might feel bad led people in Schools of Education to push for changes in performance measurement in elementary schools. By the time my own children went to elementary school in the United States, grades had been ditched in favor of a lot of words that the teachers had to put together to describe performance on a report card. The parents get roughly the same message, but now the kids have a harder time figuring out who the top performers among their peers are.

Rustichini seems to think that grades in elementary school are a good thing, and that the modern wishy-washy approach to student evaluation is thwarting envy, which will actually reduce the amount of learning that takes place. If you know who the top performers are in your class, you can watch them, see what they do, and try to replicate it. Maybe you can get them to show you a few things.

What about "positional" goods? These can actually be performing a useful economic role, even if they are pure "waste" in the conventional sense. This is what signaling is all about. In a signaling model, acquiring a signal may be costly and a pure waste, but it reveals information because the signal is less costly to acquire for "good types." Sometimes people argue that there is a signaling component to higher education. It doesn't matter that you didn't learn anything in college, because employers know that only the smart and diligent ones actually finish.

To get envy working as a force for social good, we need to be able to correctly identify economic successes. How are we going to do that if the successful people hide their wealth? Someone who pushes her Beamer off a cliff in public is demonstrating to us that she is successful - so successful that she can waste resources. I see this and it makes me curious. How does a person get so rich that they would be willing to destroy their Beamer? Maybe I can replicate her behavior and get rich too, not because I want to destroy Beamers, but because I want to relax my budget constraint in a big way.

You don't want to tax the positional goods or pass laws against having them, for the same reason that you don't want to take grades away from the elementary school kids. In doing so, you are thwarting envy. When you do that, you will get less learning and less innovation, and on average we will all be worse off.

Steve Marglin on Heterodox Economics

This is a talk from a few days ago, as part of the "Occupy Harvard" movement. Steve says a lot of interesting things here, and I agree with more than many in the audience might suppose. A main disagreement I have with Steve is pedagogical. I believe his critiques of mainstream economics should be presented after students have had a standard course like ec 10. That is, I would suggest Steve aim his course at sophomores rather than freshmen. If he did, he could attract a lot of economics majors who had just finished ec 10, rather than nonmajors who are avoiding it.

Coffee and the Age of Reason

Thursday, December 8, 2011

Inequality and Taxation

This seems what everyone is focused on - occupiers, partiers, people who want to stay in office, people who want to kick those people out of their offices, etc. Plenty has been written on this, but I'll extract a small sample here in an attempt to sharpen the ideas.

Let's start with the series that Robert Frank recently contributed to Slate. If you're unfamiliar with Frank, his view of the world is dominated by externalities. Why is inequality bad? That's because the filthy rich make the poor feel so bad that the poor will do any number of reprehensible things in an attempt to consume more. Frank is concerned with "habit."

Economists like to think about two kinds of habit - internal and external. With internal habit I care not only about my current consumption, but about my current consumption relative to my past consumption. I'm better off with more current consumption, but more past consumption makes me currently worse off. With preferences like these, I become accustomed to a high standard of living. I'm much happier if I have always been poor than if I am poor today and rich yesterday. Internal habit is used a lot in macroeconomics. You see it in estimated New Keynesian models, for example Christiano/Eichenbaum/Evans, and in work on asset pricing. I think this has more to do with adding free parameters to fit the data than any micro evidence to support the idea, but there you are.

In any case, internal habit is not going to help the arguments of people who want to redistribute income from rich to poor. Internal habit will tend to favor the status quo, as there will be large transition costs in terms of lost welfare from making the rich poorer. Further, if everyone in the economy has preferences with internal habit, I'm not sure what is Pareto efficient, or if anyone has even solved that problem. For all I know, you solve the problem and it looks completely goofy.

Frank is concerned with external habit - envy, essentially. This is an externality, sometimes called "keeping up with the Joneses." I am worse off the better off my neighbor is. In Frankworld the poor are so overcome by envy that we might as well take the wealth of the rich and throw it away. This would make the poor feel immensely better. Something like kicking a banker in the nuts. Conversely, the rich get some of their happiness from having more possessions than the poor, and flaunting all that stuff. Seymour Cray, for example, liked to build a sailboat every year, but apparently did not sail it. Each year, he would burn the old boat to make room for the new one. However, it's not clear we want to think of Seymour Cray as an example of the typical behavior of rich people. His Wikipedia entry tells us:
Another favorite pastime was digging a tunnel under his home; he attributed the secret of his success to "visits by elves" while he worked in the tunnel: "While I'm digging in the tunnel, the elves will often come to me with solutions to my problem."

Frank seems to think that external habit implies that we should all consume the same quantity. Thus, no more envy. Let's explore this idea further. External habit tells us something about the types of neighbors we like to have. Frank says that the best neighbor the richest person in the population could have is the poorest one in the population, as that makes him or her feel really good. But there is a problem, which is that the best neighbor the poorest person can have is the next poorest one. If you let everyone choose their neighbors, what will they do? This problem has actually been solved. Some of Ken Burdett's marriage models with search fit this exactly. The result is that there is positive assortative matching. Like types tend to match - poor with poor and rich with rich. Frank's theory thus explains neighborhood stratification, something which happens everywhere, and with a vengeance in St. Louis. So far, the theory looks pretty good.

However, note that you would also get positive assortative matching if the externality goes the other way. If any individual feels happier the richer their neighbor is, then we get exactly the same outcome, with the same neighborhood stratification. Similarly, suppose in the marriage matching story that every individual prefers a taller partner to a shorter one. Then, there will tend to be matching of tall types with tall types, and short types with short types. But if each individual prefers a short partner to a tall one, you get the same result.

So, which do you think it is? Do I prefer having a rich neighbor or a poor neighbor? If it's the former, and we follow Frank's logic, he has a lot of explaining to do. Given the conclusions he makes in the latter case, in the former case it would be a better society if we made one person enormously rich, with the rest of us living at subsistence.

What does Frank think explains the recent increase in income dispersion in the United States? The received explanation for this is basically "supply, technology, and trade." Changes in technology have changed the relative demands for high-skill and low-skill workers, high-skill workers are scarce because it is very costly to acquire the skills, and low-skill-intensive goods can be produced more cheaply abroad than used to be the case. A small amount of the increase in dispersion in income is due to the US income tax becoming less progressive. But Frank has a different idea. This also has something to do with technology, though.

Frank uses the example of music. Everyone in the world can now hear the best guitar player in the world, without going out of the house. So why should I pay any attention to the second-best guitar player in the world? Ultimately, the best guitar player in the world gets a huge market share, and second best gets close to nothing. Society then consists of a small number of stars getting enormous salaries and the rest of us getting close to nothing. But surely if second-best is willing to work for a little less, I might prefer that. Or seeing #500 guitar player in the local bar for a $5 cover charge could dominate paying $200 to sit in a nosebleed seat in Madison Square Garden to see #1.

What seems to make Frank's argument fall apart is congestion and scale economies. You can see this when he gets to his other examples. Frank wants to think of his university president, David Skorton, as one of these superstars. First, contrary to what Frank seems to think, my guess is that Skorton earns something in the range $500K-$600K. An odd characteristic of the market for university presidents is that the high-paid ones are mostly at schools you have never heard of. There may be a theory that explains that, but I don't think it's the one Frank has in mind. Second, Skorton was my university president once as well. People at the University of Iowa thought of Skorton as a good guy, but I don't recall the word "superstar" floating around.

Frank wants to dismiss corporate governance explanations for high executive compensation, but I'm not sure he's right. Small differences in the ability of a CEO may indeed make huge differences in corporate outcomes, but it's very difficult for a Board to discern those differences. How do you tell a good one from a bad one? Thus, you can't rely on those small differences to explain huge differences in compensation.

Finally, Frank gives us his solution to inequality, which is a progressive consumption tax. A consumption tax is sometimes thought to have some virtues relative to the income tax as a means for generating revenue, but as typically envisioned, it would also be less progressive than the income tax. Replace the current federal income tax with flat-rate value-added tax generating the same revenue (I'm neglecting the issue of deductions), and income dispersion will increase.

The problem is that, if the consumption tax is collected at the point of sale, it has to be a proportional tax. We can't have retailers checking their customers' total consumption, and even if they could there would be ways to game the system. Frank's suggestion is that consumers report their incomes and net asset positions, from which we can determine individual consumption, which we then tax progressively.

Frank thinks that a progressive consumption tax will cure all our problems. Frankly, I don't see it. First, Frank has not thought through the tax evasion problem. How easy would it be to cheat in this system, relative to the current one? The cheating one would want to do is to under-report income and over-report asset accumulation. The income under-reporting problem is one that exists currently, so that is no different. However, over-reporting of assets is something new altogether. One could imagine that over-reporting could be quite easy. This might amount to shady appraisals or asset valuation that could be very difficult to check.

Second, even if you can solve the evasion problem, what do you gain relative to a progressive income tax? With a progressive consumption tax, individuals have a greater motive for consumption smoothing over time. This works like an increase in risk aversion - not clear this is a good thing. Also, the consumption tax does not actually promote savings relative to the income tax, except because people are effectively more risk averse and will self-insure by saving more. Again, this is hardly a good thing. Otherwise, saving is just postponed consumption. If my current consumption is taxed and my future consumption is taxed, that's a wash in terms of the effect on savings. Indeed, ultimately the distortion shows up in labor supply.

Next, some people have shown interest in this paper by Diamond and Saez. A key result that seemed to get these people excited is the calculation of a top optimal marginal tax rate (including all taxes) of 73%, relative to the current rate of 42.5%. There are two key assumptions that Diamond and Saez make to come up with the 73% optimal rate. First, we should not care about the welfare (at the margin) of the rich people. This argument is based solely on the notion that marginal utility of income is low for the top income-earners. Second, Diamond and Saez use a "behavioral elasticity" of tax revenue with respect to the tax rate of 0.25. To see how this matters, if you use their formula and an elasticity of one, you get an optimal top tax rate of 40%.

Now, I know it is fashionable to dump on rich people, but I'm not sure we want to discount their welfare as much as Diamond and Saez want to. Preferences will matter here. For example, if we take internal habit persistence seriously, as some people like to, that could make us want to weight the rich and poor equally, by Diamond and Saez's logic. I'm not committed to habit persistence, but there may be some features of behavior that are not consistent with log utility, for example. Further, Diamond and Saez are thinking in static terms. In reality, there is mobility within the income distribution, and how much mobility is an important issue here. Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich.

Finally, I have no idea where that "behavioral elasticity" is coming from, and I don't trust it. My best guess is that it includes none of the factors that I think are important in addressing the problem. What we need here is a dynamic general equilibrium model that can take account of the short run and long run effects of a change in the income tax schedule. My best guess is that "behavioral elasticity" means that Diamond and Saez are measuring the effects of tax evasion and the intensive margin of labor supply, and that's all. If so, I think they miss most of what is important:

1. There's also an extensive margin. Tax people at a higher rate, and some drop out of the labor force.
2. Taxes affect occupational choice. Some work by Manuelli/Seshadri/Shin says that the effect of taxes on human capital is big time. Why do I want to undertake a costly and risky investment for a very small payoff?
3. Entepreneurial activity has to be very elastic with respect to tax rates at the top end. Why would I want to risk my own wealth or that of my close family for a very big payoff with very low probability, if that big payoff is taxed at 73%?
4. The United States is highly dependent on highly-skilled labor that migrates here from other countries. With a top tax rate of 73%, the Indian engineers might prefer to work in India, and the Canadian professors might prefer Canada.

Thus, I think it is likely that tax revenue is much more elastic with respect to the tax rate, particularly in the long run, than Diamond and Saez are letting on. To evaluate this properly, you need a serious model, and they have not provided one.

Taylor versus Krugman

  1. John summarizes a recent Hoover conference on restoring robust economic growth.
  2. Paul is annoyed at John.
  3. John is annoyed at Paul.

Wednesday, December 7, 2011

The Education of the One Percent

The case for graduate school:
Apart from their bank accounts, Gallup finds education to be the greatest difference between the wealthiest 1% of Americans and everyone else. The Gallup analysis reveals that 72% of the wealthiest Americans have a college degree, compared with 31% of those in the lower 99 percentiles. Furthermore, nearly half of those in the wealthiest group have postgraduate education, versus 16% of all others.

Tuesday, December 6, 2011

Discount Window Lending, Part III

As a followup to this post and this one, I think we finally have this sorted out. Some people were arguing that the Fed's lending to financial institutions during the financial crisis was subsidizing those financial institutions. But the bulk of lending was through the Term Auction Facility (TAF), and it appears that, if there was any subsidizing, that it had to occur through TAF. But, we have a record of all the loans made through TAF in the excel spreadsheet here. As you can see, the best deal that anyone was getting on a TAF loan was 0.20%, and all those loans occurred on January 2, 2009. Otherwise, the best deal was 0.25%, and no one could make a profit on that, given that the interest rate on reserves was 0.25% at the time, and the fed funds rate was lower than that, as were short T-bill rates.

So, was the Fed doing the appropriate thing? Maybe reading Lombard Street will help us? Fat chance. As Andolfatto can tell us, there's not a lot in Bagehot to go on. Bagehot tells us that the lender of last resort should "lend freely and at a penalty rate" during a crisis, which if anything seems like a contradiction. If you really want the banks to take the liquidity injection, you should not be penalizing them. Of course it makes sense that the Fed should not set up lending facilities which allow banks to simply make arbitrage profits, but that does not appear to have been happening during the financial crisis. Further, if the Fed was giving the posted collateral the correct haircuts, it was not taking on undue risk, and certainly the Fed does not seem to have come out on the short end of the stick on its lending. I have some too-big-to-fail moral hazard concerns, but that is about it.

The key question with these lending programs, as with any lender-of-last-resort lending, is why the central bank should not just buy the assets, instead of extending loans and taking the assets as collateral. I think the basic logic has to be that the central bank could buy the assets at their market price, but the market price is viewed as being inefficiently low. Instead, the central bank extends a loan for more than the market price of the collateral, and essentially takes the assets at a high price, temporarily. But, alternatively, the central bank could make an offer to buy quantity x of asset y at price p, and see how many offers come at that price. If total offers exceed x, then the central bank uses a lottery to choose.

Questions like this come up when we try to model how collateral is used in financial transactions. Indeed, I have never seen a satisfactory model of collateral. Basically, you have to explain why it is that someone who wants to borrow, and has an asset that they can use as collateral, does not just sell the asset. One can see how this works with mortgage lending, but in general it seems a difficult problem.

Update on Discount Window Lending

As an update to this post, Ben Bernanke has sent a letter to the Senate Banking Committee defending himself against news reports from last week. Some of the defense deals with various double counting in the reports, which seemed obvious. Here is an interesting part at the end:
Most of the Federal Reserve's lending facilities were priced at a penalty over normal market rates ...
The Bloomberg story says:
During the crisis, Fed loans were among the cheapest around, with funding available for as low as 0.01 percent in December 2008...
Of course, those two statements can both be true.

A Discussion of Inequality

A recording of a recent panel at Harvard's Kennedy School, including my economics department colleagues Larry Katz and Ed Glaeser. It takes over a hour.

Monday, December 5, 2011

Eichengreen on U.S. Fiscal Policy

Barry writes:
Given low interest rates and the still-weak U.S. economy, it will be tempting for the U.S. government to continue running deficits and issuing additional debt. At some point, however, investors will recognize this behavior for the Ponzi scheme it is.
Continue reading here.

15 Years Later

It was fifteen years ago today that Fed Chairman Alan Greenspan gave his famous "irrational exuberance" speech, which suggested that U.S. equities were overvalued. 

Between then and now, on an annualized basis,
Score that as one point for Alan.

Sunday, December 4, 2011

Raquel Fernandez the Cynic

Here's an interview with Raquel Fernandez. This concludes with:
Economists essentially have a sophisticated lack of understanding of economics, especially macroeconomics. I know it sounds ridiculous. But the reason why I tell people they should study economics is not so they’ll know something at the end—because I don’t think we know much—but because we’re good at thinking. Economics teaches you to think things through. What you see a lot of times in economics is disdain for other's lack of thinking. You have to think about the ramifications of policies in the short run, the medium run, and the long run. Economists think they’re good at doing that, but they’re good at doing that in the sense that they can write down a model that will help them think about it—not in terms of empirically knowing what the answers are. And we have gotten so enamored of thinking things through that the fact that we don’t know anything needs to bother us more. So, yes, it’s true that the average guy on the street doesn’t understand economics, and it’s also true that we don’t understand economics. We just have a more sophisticated lack of understanding than the guy on the street
Fernandez knows something, about which she is quite certain. As economists, we really don't know anything at all. Apparently we are good at thinking, but it's just fooling around - nothing more serious than video games.

Fernandez is frustrated:
The methodology of economics is so strong that we have had a large impact on many fields, from political science to sociology and even neuroscience. It’s been a very successful paradigm in that what economics does very well is think rigorously. But sometimes that’s not been very fruitful in the sense that there are certain questions that you can’t ask because you don’t know how to model them.
Ah, those pesky models, getting in the way of fruitful science.

Fernandez thinks we're not scientists:
... as “scientists” we often don’t have much to say. I don’t think we are scientists. I think we’re more like doctors in the sense that we do research, but in the end there’s a patient, and you have to say, given one’s knowledge, what’s the best way to treat the patient?
Well, when I think about my doctor, what she does looks to me like applied science. She wants to do some tests on me. I ask her some questions about it. She cites scientific evidence from published research. When I talk to Jim Bullard I get the same vibes. He's doing applied science. He knows what's in the journals. He talks to his staff and other economists, and uses frontier knowledge to argue for good policy choices. That frontier knowledge is based on theory, i.e. models, and empirical evidence. Science, basically.

Fernandez thinks we don't love Paul Krugman enough:
But the people who go and give advice usually end up with a very bad rap in economics. I am amazed at how much hatred—and I will say hatred—Paul Krugman evokes from some fellow economists. But one of the reasons for this is that he says things for which there is not “scientific” support and which go against what these people believe is "good" economics.
She's confused here. Krugman does not get a bad rap because he chooses to give advice. He gets a bad rap because some people, me included, think he is giving bad advice. We don't hate the man, we just disagree with him. And yes, this has a lot to do with science (no scare quotes).

Sargent and Sims

There is a nice profile of the new Nobelists in today's NY Times.  Here is an excerpt for my army of ec 10 teaching fellows (and for teachers of introductory economics everywhere):
Economics, rather than politics, became his life’s work partly because of an inspiring teaching assistant named Jerry Kenley. Fifty years later, sitting in his office at N.Y.U., Mr. Sargent remembers his old T.A.  
“Jerry liked to say, ‘Economics is organized common sense.’ I still think that’s about right,” Mr. Sargent says. Those early classes touched on everything from farm subsidies to taxation. “Wow, it really got me going,” he says.

Saturday, December 3, 2011

My View of the Ec 10 Walkout

Click here to read my column in Sunday's NY Times.

Discount Window Lending, Secrecy, and Stigma

This story is months old, but received some attention in the last week. In March, the Fed released the details of its lending during the financial crisis, under court order. Whether it took Bloomberg 9 months to process the information, or the timing just seemed right, Bloomberg had a story this week (I think; there is no date on the post) on the details. Further, Eliot Spitzer (how could we forget him?) and Jon Stewart picked up on it.

It has of course been well-known for a long time that the Fed lent to financial institutions, particularly large ones, in a massive and unprecedented fashion during the financial crisis. This is the first instance I know of the release of information about the details of the Fed's lending operations - who received the loans, how much, and at what interest rates. Typically we know the total quantities of discount window lending through the Fed's primary and secondary facilities, which appears in the Fed's reported balance sheet numbers, but little else.

It would be useful at this point to review the Fed's key lending programs to financial institutions that were active during the crisis. In the chart, I show the Fed's lending through the Term Auction Facility (TAF), the Term Asset-Backed Loans Facility (TALF), primary credit (regular discount window lending), and the specific AIG lending program (which gets its own line on the Fed's balance sheet).

As you can see in the chart, total lending by the Fed gets up to at most $600 billion - nowhere close to the $7 trillion that got gasps from Jon Stewart's studio audience, but nevertheless some serious pocket change, considering that the size of the Fed's balance sheet pre-crisis was about $900 billion. The interesting thing here is that, early in the crisis, lending to AIG and through the primary credit facility totaled less than $200 billion at most, with the majority of the lending conducted through the TAF. Thus, most of the discount window lending during the crisis occurred by way of auctions rather than through conventional lending. Note that some of the media stories focused on the fact that some of the loans went out at 0.01%, when the discount rate (the rate on the primary facility) was 0.5% at its lowest. These 0.01% loans had to occur through TAF.

The Bloomberg story makes a calculation that the Fed gave away $13 billion to various financial institutions, but if most of the funds were auctioned off, this can't be right. But how could a financial institution win an auction at 0.01% when the funds could be held as overnight reserves and earn 0.25%? The usual answer for this is "stigma," which actually seemed to be a concern of the Fed during the crisis. The Fed wanted to inject more liquidity into the financial system, and sometimes seemed to think that financial institutions were unwilling to take this as loans from the Fed. Why? There is empirical evidence and theory (in this paper by Huberto Ennis and John Weinberg) that banks are reluctant to borrow from the Fed because this might signal that they are in trouble.

But why would banks face stigma if the Fed keeps the details of its lending programs secret? Apparently there are ways to figure these things out, at least for large institutions. For example, a large quantity of lending in the Richmond Fed district is likely going to Bank of America. So if financial market participants can figure these things out anyway, why should the Fed keep its lending a secret? Why indeed?

Central bank lending is typically rationalized by appealing to the lender-of-last-resort role of a central bank. The conventional view is that there is some temporary market failure that makes the assets of some financial intermediaries temporarily illiquid, or there is an inherent vulnerability of illiquid banks to panics. Thus, it might seem useful for the central bank to lend to financial intermediaries during a crisis. The central bank takes the "illiquid" assets as collateral on its loans, potentially giving the collateral a haircut commensurate with its "true" market value. Central banks are supposedly wary of lending to banks which are actually insolvent rather than just illiquid. It is certainly not economically efficient to prolong the life of a bank that will fail anyway.

But run your mouse over the chart in this Bloomberg post. The three largest borrowers from the Fed during the crisis were Citigroup, the Bank of America, and the Royal Bank of Scotland. It seems widely recognized that the first two were essentially insolvent during the financial crisis, if not now, and the last one essentially failed during the crisis. Lending to these banks certainly does not appear to have been simple liquidity-easing.

I think one could make a case that the details of all of the Fed's activities, including its lending, should be made public, at the time these activities take place. Surely, there is stigma in borrowing from the Fed only if the Fed lends to banks that are essentially insolvent. If the Fed sticks to its appropriate lender-of-last-resort role, then it is only correcting short-term liquidity problems. Indeed, if the Fed is doing its job, then a Fed loan should be a certificate of viability.

In any case, we need more serious research on central bank lending, when it is appropriate and when it is not, what is appropriate collateral for a central bank loan, what are appropriate collateral haircuts, what is the role of central bank lending relative to conventional and unconventional open market operations, etc.

Death to Pennies

A theme I have written on before. Hat tip to Alex Tabarrok.

Friday, December 2, 2011

Is my ideology that obvious?

A perspective on the Ec 10 walkout from Connel Fullenkamp, a former student who now teaches at Duke:
I really don’t think that Professor Mankiw was trying to brainwash his students with any conservative ideology or agenda. I make this statement based on my own experiences.... I was a teaching assistant for Mankiw’s first-year Ph.D. course in macroeconomics for two years, which means that I sat in on his entire course twice.
If there’s any strong ideological undercurrent in Mankiw’s teaching, I would say that it’s Nerdism: the belief that people should listen to, and learn from, nerds.  Because believe me—and I say this with genuine respect and affection—Mankiw is a nerd’s nerd.

The Draghi Deal

If I understand the news coming out of Europe correctly, the new head of the European Central Bank is offering a simple deal: If fiscal policy becomes hawkish, monetary policy will be dovish.  In other words, as government spending is cut to put European governments on a sounder financial footing, monetary policy will do its best to ensure that any adverse impact on aggregate demand is kept to a minimum. 

That seems a sensible compromise, given all the competing risks.  Indeed a similar deal might well make sense for the United States.

My more liberal friends argue, based on Keynesian principles, that we need dovish fiscal policy as well.  They often argue for short-run fiscal expansion coupled with long-run fiscal contraction. The problem is that fiscal policymakers cannot bind their future selves. It is hard to make commitments to future fiscal contraction credible, especially as short-run actions expand the budget deficit.

My more conservative friends argue, based on monetarist principles, that a dovish monetary policy risks future inflation.  In my view, however, there are bigger risks than inflation just now.  They include prolonged high unemployment and meager growth.

So I see Draghi as a fiscal hawk and monetary dove (at least under present circumstances).  I wonder, which U.S. central bankers are in the same camp?

Monday, November 28, 2011

Have lunch with me

To current ec 10 students (only):

I will take up to ten students out to lunch after Wednesday's lecture at Yenching, my favorite Chinese restaurant in Harvard Square. Email me if you are interested in joining the group. First come, first served.

Richard Epstein on Inequality

Watch on PBS. See more from PBS NEWSHOUR.

Saturday, November 26, 2011

Wednesday, November 23, 2011

Tuesday, November 22, 2011

The FOMC Narrowly Dodges Some Bad Policies: FOMC Minutes, November 1-2

The minutes from the last FOMC meeting are interesting. There was a long discussion of proposals to change Fed policymaking in some fundamental ways. The proposals were:

1. Explicit Inflation Targeting Inflation targeting is standard policy at a number of serious central banks in the world. Why not do it here?
Many participants pointed to the merits of specifying an explicit longer-run inflation goal, but it was noted that such a step could be misperceived as placing greater weight on price stability than on maximum employment; consequently, some suggested that a numerical inflation goal would need to be set forth within a context that clearly underscored the Committee's commitment to fostering both parts of its dual mandate.
I think the people making this argument are less concerned with satisfying the constraints on monetary policy set by Congress, than with using the dual mandate as an excuse to pursue active Keynesian stabilization policy. If the Fed wanted to, it could set explicit inflation targets, and argue convincingly that this kills two birds with one stone. A stable inflation rate also "promotes maximum employment." Indeed, there are even versions of New Keynesian models that can produce that result.

2. Conditional Commitment This part of the discussion seems odd. It starts with this:
As noted in the staff briefing, economic theory and model simulations suggested that a policy strategy involving such commitments could foster better macroeconomic outcomes than a discretionary approach of reoptimizing policy at every meeting, so long as the public understood the central bank's strategy and believed that policymakers would follow through on those commitments.
Note here that the notion is that the change under consideration - making conditional commitments about future policy - involves commitment vs. discretion. Later in the discussion, people are much more explicit about what they mean by conditional commitment:
In this vein, a number of participants expressed support for the possibility of clarifying the conditionality of the Committee's forward guidance about the trajectory of the federal funds rate through setting numerical thresholds for unemployment and inflation that would warrant exceptionally low levels for the policy rate.
The key point here is that, in fact, the proposal involves abandoning commitment. The current commitment involves "reoptimizing policy at each meeting," which is taking into account all the unforeseen circumstances that occurred since the last FOMC meeting. Conditional commitment is bad commitment, as we cannot commit conditionally to a policy response to an event that is not foreseen. Such events can in practice swamp everything else. Committing to a policy of reoptimizing at each meeting is in fact good commitment.

3. Nominal GDP/Price Level Targeting Here's the discussion:
The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate.
The key question is what model the staff was using. Most likely it was the FRB US Model. If so, this is bogus. As members of the public, we cannot look at this model, but you can find bits and pieces of it in Fed publications. While there are words in those publications that might make you think this model might have some connection to any macroeconomics done post-1970, I don't think so. Best guess is that the FRB US model looks like the typical expanded IS-LM macroeconometric models developed pre-1970. If so, we can't take it seriously. Who cares if NGDP targeting "works" and price-level targeting does not, in that context? Get serious. See my post on NGDP targeting.

In any case, the FOMC decided not to take action on any of these proposals for now. There are some bad ideas floating around though, so beware.

Dan Hammermesh

Did Hammermesh suffer a trauma at the hands of some macroeconomist? Did Ed Prescott make fun of him? What do you think explains this? The relevant passage is this one:
Interviwer: Here is one of the questions I wanted to ask you, with regards to Heilbroner’s book. With the economics profession, in the aftermath of the financial crisis, being somewhat in disrepute…

Hammermesh: Stop! Stop, stop, stop. The economics profession is not in disrepute. Macroeconomics is in disrepute. The micro stuff that people like myself and most of us do has contributed tremendously and continues to contribute. Our thoughts have had enormous influence. It just happens that macroeconomics, firstly, has been done terribly and, secondly, in terms of academic macroeconomics, these guys are absolutely useless, most of them. Ask your brother-in-law. I’m sure he thinks, as do 90% of us, that most of what the macro guys do in academia is just worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.

Interviewer: I’m not sure most people in the outside world would make a distinction between macro and microeconomists.

Hammermesh: I know. It’s up to us to educate them. I got this line from a friend in architecture the other day. He said exactly the same thing. I went through the same litany, trying to disabuse him of this notion. It’s like pushing a stone up a giant hill. It’s not going to get me very far, I agree. But nonetheless it is the case that most of us, and most of what we do, remains tremendously useful, tremendously relevant, and also fun!

Interviewer: The point I was going to make is that with the public perception of economics being on the negative side right now, and the limitations of economics being highlighted in the media, this book, The Worldly Philosophers, is just fantastic at showing what an amazing thing economics was, what amazing insights it brought to bear on the world. People just hadn’t thought about things in that way before.

Hammermesh: I agree, and a lot of the insights are still very much valid. Nonetheless, all the people in the book have been defunct for at least 60 years now. There have been some great economists since then, in the last 30 to 40 years. For example, George Akerlof, with his notion of asymmetric information and the failure of markets. It’s a truly brilliant idea and it’s ubiquitous in our lives. There’s Gary Becker, who in my view is the top economist of the last 50 years. His notions of family bargaining and how families behave are terribly important, and affect how, in the end, we all think. These guys who Heilbroner is talking about and the other ones of the last 50 years – none of whom is a macro person, by the way – have had equal influence. It goes on. It just is no longer stuff that is relevant to the macroeconomy. Unfortunately that’s a very important area and we have been derelict on it.

Interviewer: What’s the solution, do you think?

Hammermesh:* I do believe in markets. People are interested in being useful in this profession. It doesn’t mean the people who were the bad guys from the last 20 years in macro are going to be doing anything different. They’re incapable of doing anything different! But markets do work and the dead and useless get shoved aside by the young and useful. I’m a tremendous optimist. I do believe markets work and that people run to fill niches. There’s an obvious niche here, and you’re already starting to see it being filled. I’m sure the journals in academe are going to reflect this change too.
The interviewer actually has got the picture here, when she says: "I’m not sure most people in the outside world would make a distinction between macro and microeconomists." Indeed, that was what the post-1970 revolution in macroeconomics was all about. The early revolutionaries - Lucas, Sargent, Wallace, Prescott, for example - had and have a tremendous amount of respect for the advances made in microeconomics. They, their students, their students' students, etc., used those advances to move the science of macroeconomics forward. It seems extremely odd that Hammermesh does not embrace modern macro. Maybe he doesn't know what it is? I'm sure Ed Prescott's views of Becker's work, and of Akerlof's early contribution to information economics are not that different from Hammermesh's. Hammermesh should read my defense of contempoary economics.

There is actually nothing new about Hammermesh's views of modern macro, which predate the financial crisis. Just ask some of those excellent macroeconomists who no longer work at UT Austin. One of the amusing aspects of this is that Hammermesh is the author of "Professional Etiquette for the Mature Economist." How do you put these two sentences in the context of maturity and etiquette?
I’m sure he thinks, as do 90% of us, that most of what the macro guys do in academia is just worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.

*This appears to have been edited from a previously-posted version, where Hammermesh's answer to the question read:
I do believe in markets. We had some useless macro guys here who just left, thank God, and we’re now looking for replacements. I do think the failure of these people is conditioning how we search for a replacement. I’m quite sure the journals in academe are going to reflect this too. People are interested in being useful in this profession. It doesn’t mean the people who were the bad guys from the last 20 years in macro are going to be doing anything different. They’re incapable of doing anything different! But markets do work and the dead and useless get shoved aside by the young and useful. I’m a tremendous optimist. I do believe markets work and that people run to fill niches. There’s an obvious niche here, and you’re already starting to see it being filled.
Notice what got deleted.

Advice for Lost Graduate Students

From Ariel Rubinstein.

Polling Economic Experts

Chapter 2 of my favorite textbook has a table showing various propositions about which economists largely agree.  It is based on the published results from several surveys.  A new project by the IGM Forum is now regularly polling a diverse group of top economists on a variety of policy-related questions.  It is a good way to see whether a professional consensus exists.  You can follow the project by clicking here.

If you are curious, I declined being a member of the panel, mainly because time is scarce.  Moreover, I have various other ways to let my opinions be known.

Sunday, November 20, 2011

The ECB and Last-Resort Lending

There is a lot of talk recently about the possibility that the European Central Bank (ECB) could act as a "lender of last resort" to mitigate the European sovereign debt crisis. The Germans are against it, and the southern Europeans (who might stand to gain from such as policy) are for it. France may be sympathetic.

What is a lender of last resort? A key role for a central bank of course, is in acting as a lender-of-last-resort to the private banking system. The conventional view of banking is that the key function of banks - transforming illiquid assets into liquid liabilities - leaves an individual bank open to runs. According to the standard logic an otherwise sound bank could fail due to an illiquidity problem. Depositors run to the bank to withdraw their deposits under the assumption that everyone else will do so. The bank is unable to sell its assets at their "full value" so as to satisfy withdrawal demand, and it fails. However, a central bank willing to accept the bank's assets as collateral can lend to the bank, allowing deposits to be converted into currency, and this can quell the panic. In a full-blown systemic financial panic, the central bank can extend this credit to the entire banking system.

The key problems for a central bank are in determining what will qualify as eligible collateral for a central bank loan, what the haircut might be on such collateral, and at what rate the central bank should lend. Moral hazard comes into play, and central banks are leery of extending the lives of banks which are actually insolvent and not simply illiquid.

The Diamond-Dybvig model is thought by some to justify a lender-of-last-resort role for a central bank, but that is incorrect. The original model, and its extensions, does not incorporate anything that resembles central banking - indeed the basic model is not monetary (Diamond Dybvig also has no role for deposit insurance, but that's another story). Some things though, such as the the liquidity transformation role of banks and moral hazard problems in banking, I think are well understood.

In general, there are not many complaints about the Fed's lender-of-last-resort role in the financial crisis. Though the Fed may have been overzealous in lending in unconventional ways to unconventional borrowers, mainstream opinion seems to be that the Fed's lending during the crisis was necessary.

But are demands that the ECB play a "lender of last resort" role in Europe simply requests for the central bank to perform its conventional role? The argument seems to be that Italy and Spain, for example, because they are not running primary deficits, are like the bank that is suffering from an illiquidity problem, and not like the bank that is actually insolvent. According to this argument, bondholders are "running" on Italy in the sense that they are demanding very high interest rates. In this sense, an Italian default could be self-fulfilling, just as failure could be self-fulfilling if there is a run on a bank. Then, according to the argument, it makes sense for the ECB to step in and buy Italian government debt - or the debt of any other European government subject to this "liquidity" problem.

But hold on here. In the case of conventional central bank lending, for example as one might envision in response to a pre-Federal Reserve or Great-Depression-era banking panic, the central bank is replacing the liquidity that the public has lost confidence in - bank deposits - with liquidity that it views as roughly equivalent - currency. Is that the case if the ECB buys debt issued by European governments? Well, maybe so. Deposits at the ECB are not quite the same as the safe government debt which the bondholders want, as central bank deposits are not as widely traded as government debt (not all financial market participants can hold an account with the ECB). But, anyone can hold a deposit with a bank in the EU, and banks in the EU hold reserve accounts at the ECB, so this does not seem to be a problem. Thus, it seems the ECB can indeed convert "illiquid" government debt into liquid central bank liabilities.

But to actually quell the panic, the ECB must be able to lower the bond yields on the debt it is purchasing. Is this actually possible? Let's take a look at the current ECB balance sheet. The size of the balance sheet is about 2.3 trillion Euros, as compared to about 1.5 trillion Euros in January 2008. Thus, the expansion in the ECB balance sheet is nothing like the tripling that occurred in the United States, but there are features that are qualitatively similar. For example, there has been an expansion in the debt obligations of ECB member countries held by the ECB(much like QE2, though a smaller intervention) and the ECB currently holds reserves in excess of requirements. On its most recent statement, the quantities apparently in excess of reserve requirements are 144 billion Euros in the deposit facility and 183 billion Euros in term deposits.

These quantities of excess reserves are not as large as in the United States, but I think you can see the effects of these reserves on interest rates in the European overnight market. Recent data shows the overnight rate near the bottom of the interest rate "channel," with the lower bound determined by the interest rate on the ECB's deposit facility, currently at 0.5%. Note, for example in early 2008, that the overnight rate would typically be close to the middle of the band.

Thus, my working hypothesis is that, given a sufficiently large stock of excess reserves in the EU, the interest rate on ECB deposits is determining the overnight rate in Eurpope, much as the interest rate on reserves in the United States is determining short-term interest rates here. Just as in the US then, purchases of government securities by the ECB do not matter, at the margin. The ECB can buy government debt, but in spite of the fact that the debt they are buying may be risky and the liabilities they are issuing may be much less so, the ECB has no advantage over the private sector in intermediating Italian debt, for example. Buying Italian debt will not change the path for prices, and cannot change the prospects for a default on Italian debt.

If the ECB were to lower the interest rate on its deposits, this would indeed raise the price level and allow all EU members to implicitly default on a piece of their debt outstanding. Some EU members obviously want this. Others, like Germany, understand that the reason they can borrow at low rates is because the ECB made a commitment in its charter to price stability.

In any event, just as quantitative easing is currently not a solution to anything in the United States, "lender-of-last-resort" lending by the ECB will do nothing for Europeans.

Saturday, November 19, 2011

Straight No Chaser

Last night was date night. My wife and I went to a concert by Straight No Chaser, the a cappella group famous for its rendition of the Twelve Days of Christmas.  The tickets were a gift from our daughter.  Thank you, Catherine.

The concert was terrific! A wonderful mix of music, from traditional holiday songs to Elvis Presley and Lady Gaga. You can find out if they are giving a show near you by clicking here.

Thursday, November 17, 2011

The View from Penn (a shameless plug)

My favorite textbook is used at the University of Pennsylvania.  The student newspaper writes:
[Mankiw's] textbook, Principles of Economics, has sold more than one million copies worldwide. It is used in his own class and in Economics 002, Introduction to Macroeconomics, at Penn. The class, taught by Luca Bossi, enrolls about 200 students in the fall semester and 500 in the spring. 
Bossi chose the textbook because he believes it is one of the best introductory macroeconomics texts available in the market. He adds that the material is “clearly explained” and does not contain any partisan slants. 
“I think the fact that Professor Mankiw has advised and still is advising Republican candidates running for office gives the impression to people that he is a conservative in the way he approaches economics,” he said. However, this “is not reflected in the content of the book.”

Wednesday, November 16, 2011

Ugly Discrmination

Chapter 19 of my favorite textbook has a case study on the economics of beauty, highlighting research by economist Dan Hamermesh.  So I thought some blog readers might enjoy this Daily Show clip featuring Hamermesh and his work on this topic.

Tuesday, November 15, 2011

The British 1 Percent

This figure, via Paul Krugman, shows the income share of the top 1 percent in the United Kingdom.  The broad pattern is very similar to what U.S. data shows.  The figure suggests that the explanation of growing inequality over the past several decades cannot be U.S.-specific but must have broader applicability.

You can generate more plots like this here.  You find a similar U-shaped pattern in Australia, Canada, Ireland, and New Zealand but much less so in France, Germany, Japan, and Sweden. Might the rising share of the top 1 percent be related to the increasing use of English as a global language?

Saturday, November 12, 2011

The Long, Sad History of Industrial Policy

Solyndra is only the latest chapter.

Supply-side Policies as a Way to Boost Aggregate Demand

A new paper from the Philadelphia Fed makes an important point:
This paper examines how supply-side policies may play a role in fighting a low aggregate demand that traps an economy at the zero lower bound (ZLB) of nominal interest rates. Future increases in productivity or reductions in mark-ups triggered by supply-side policies generate a wealth effect that pulls current consumption and output up. Since the economy is at the ZLB, increases in the interest rates do not undo this wealth effect, as we will have in the case outside the ZLB. We illustrate this mechanism with a simple two-period New Keynesian model. We discuss possible objections to this set of policies and the relation of supply-side policies with more conventional monetary and fiscal policies.