Thursday, June 30, 2011

Is Government the Answer, or the Question?

In honour of Canada's 144th birthday, which I'm sure you are celebrating tomorrow, today we'll look at some Canadian data. I'm not just drawing attention to Canadians to make them feel good. Indeed, some Canadians are so shy that they would rather be ignored. I'm thinking this exercise might actually shed some light on some recent issues. My title is inspired by a prolific Canadian who is endowed with a surplus of integrity, Neil Young, who once wrote (and sang): "love's the answer, love's the question." Sounds very sixties, and it seems somehow profound, but I can't tell you why.

In this previous post, I looked at some trends in US GDP, which basically replicated part of what Lucas was discussing in these slides. Basically, if you look at departures of US real GDP from a linear trend, the current observation is substantially below trend. Indeed, the data we have seen is consistent with either of two views. In one view there was a level adjustment in US real GDP that put us on a lower growth path. In the other view we will return to the trend growth path we were on previously.

Now, the standard Keynesian narrative we hear - and it's hard not to hear it as these people are blasting it at us every hour of the day - is that aggregate demand is too low, i.e. deficient, and the government is the answer. The US federal government can, and should, purchase more goods and services and/or cut taxes, and this will return us to trend. Lucas's slides suggest another explanation. He considers the possibility that there has been a level adjustment in the real GDP growth path, so that we are now on a trajectory that looks more like that of Western Europe than the US in days of yore. Why would this happen? Lucas argues that we may now have too much government rather than too little; various incursions or expected incursions of the federal government have essentially made us less productive, or potentially less productive in the future.

What do we make of this? Well, rather than comparing ourselves with Western Europe, let's go the back yard, as it were, and see what the Canadians (our socialists to the north) have been up to. The first chart shows what has happened to real GDP in Canada and the US since the beginning of the last recession. The recession in Canada was clearly shorter, and not quite as severe, and Canada is now doing somewhat better than the US, relative to where it was at the beginning of the recession. This is to be expected since, as everyone knows, Canada went through the financial crisis with no significant problems in the banking sector, there was no collapse in housing prices, and residential construction bounced back in the recovery. Still, the Canadian experience is not that different.

Further, the next chart shows a longer time series for the log of real GDP in Canada, with a linear time trend. Over this period, the average rate of growth is essentially identical to what it was in the US, roughly 3.1% per year. What is striking is the next chart, which plots the deviations of the log of real GDP from a linear trend for both the US and Canada. The US and Canada are currently in about the same place, i.e. about 10% below trend; indeed the US is doing a little better. This certainly is not consistent with what Lucas is suggesting. If more government intervention, or the threat of it, caused a negative level adjustment to the real GDP growth path, then there should be a negative level adjustment relative to the Canadians who, if anything, are moving in the direction of less intervention.

So is government the answer? We can certainly look at what governments have been doing recently in the US and Canada. The next chart shows the total government surpluses in the US and Canada as percentages of GDP. Now focus on the time series since 2000, when the US and Canada are in approximately the same fiscal position. The Bush tax cuts contribute to what looks like a drop of about 4% in the surplus in the US relative to GDP. Then, during the recent recession, there is a drop in peak-to-trough surpluses of about 7.3% of GDP in Canada, and about 8.9% of GDP in the US, presumably reflecting a bigger stimulus program in the US. So, whether you think that deficits work as Keynesian aggregate-demand-boosters or that tax cuts work to encourage labor supply, you have a lot of explaining to do. Why does 10% of GDP in stimulation in the US, and 4% in Canada, put both countries in the same place, at 10% below trend?

Now, finally, what is also very interesting is how the relative GDP paths in Canada and the US compare to relative labor market performance in the two countries. The next chart shows unemployment rates. Before the recent recession, the behavior of the unemployment rates in the two countries is typical, i.e. the Canadian unemployment rate is about 2 percentage points higher, due to more generous unemployment insurance and a somewhat different sectoral composition of employment. During the recession, that relationship flips. The US unemployment rate increases by about 5 percentage points during the recession, while in Canada the increase is 2.5 percentage points. Further, the unemployment rate has dropped faster in Canada during the recovery. Indeed, the Canadian unemployment rate is at its 2003 level, while the US unemployment rate is three points higher than in 2003.

Thus, in spite of similar GDP performance in Canada and the US, behavior in the labor market is remarkably different. You can't reconcile these differences with some story about "aggregate demand deficiencies," which at the best of times is not helpful anyway, being another way to say "output is below trend." I did not calculate productivity numbers for the US and Canada, but the flip side of the labor market and GDP observations has to be reflected in different average labor productivity growth too.

My conclusion is that, to understand why the US recovery is weak, and what this means for the future, we should not be thinking about the government. In my mind, the answers will come from understanding the barriers to mobility in labor across sectors, sectoral productivity, and links between the labor market and financial factors. Government may or may not be the answer, but you have to know what the question is first.

Sunday, June 26, 2011

Canadian Tire Money

In response to my last post, Angelo Melino (University of Toronto) sent me to this post, which informs us that Canadian Tire money might soon meet a sad end.

For non-Canadians, Canadian Tire money is issued by the Canadian Tire Corporation, which operates ubiquitous retail outlets across Canada. A Canadian Tire store looks something like a Sears. They sell hardware, auto parts, miscellaneous department store items, cheap auto repairs, gasoline, and of course tires. Canadian Tire notes come in denominations from 5 cents up to 2 dollars, and are issued to you when you purchase something at a Canadian Tire store. In the old days, one would receive 5% of the value of the purchase in Canadian Tire notes, but the rebate has fallen to 0.4%. My memory may be faulty, but I think it was the case (and may still be the case) that one could never be rid of Canadian Tire money, except in the limit, or by virtue of free disposal, as you would receive the rebate even if you made the purchase with Canadian Tire money.

Now, the experience with Canadian Tire money can tell you something about what the promotors of Bitcoin are up against. As you can see here from this 10-cent note, issued, I believe, in the 1980s, Canadian Tire money looks pretty convincing. Canadian Tire has actually gone to some trouble to design the note to avoid counterfeiting. It has a serial number on the back, and a detailed picture on the front of Sandy McTire, the thrifty Scot. Further, as stated on the note, it is redeemable in merchandise (at the Canadian Tire store of course), and to hammer that home, that's stated in both official languages. Thus, Canadian Tire money has Bitcoin beaten on at least two dimensions. It looks something like government-issued currency, which would encourage adoption, and it is a promise to pay something specific on redemption. Further, redemption is not difficult, as essentially any reasonably-sized community in Canada has a Canadian Tire store.

So, you might think that Canadian Tire money might circulate, and be accepted in transactions other than purchases of goods and services at Canadian Tire stores. Not so. There is the odd anecdote, including the one in this Minneapolis Fed Quarterly Review paper by Eichenbaum and Wallace about circulation of Canadian Tire notes but, as most Canadians will tell you, Canadian Tire money tends to sit in desk drawers and closets, and not in wallets. Further, serious experimental evidence strongly supports the view that Canadian Tire money not only does not circulate, but tends to accumulate in hordes that cannot be found when it is time to visit the Canadian Tire store.

One experiment was carried out by yours truly and Mike Stutzer. Stutzer and I designed the experiment. I supplied the Canadian Tire money from my desk drawer, and Stutzer did the field work. Stutzer took a sailing trip from Duluth Minnesota to Thunder Bay Ontario, and attempted to pass the notes in various Thunder Bay bars. As Mike will attest, he got plenty of laughter, but no beer in exchange for his Canadian Tire money.

Of course the problem may have been that Mike tried to exchange the notes in a manner that was most likely to be met with laughter and no beer, as Stutzer may be one of the funniest people on the planet. Mike is a native of St. Louis Park, Minnesota, in a cohort that included Joel and Ethan Coen, (sons of Edward Coen, one-time professor of economics at the University of Minnesota) and Al Franken. St. Louis Park is in part the subject of A Serious Man, and filming took place there and in other Minneapolis suburbs. What is it about a time and place that makes people funny (or maybe people from St. Louis Park have always been funny)? I don't know.

In any case Canadian Tire money is sadly not what it used to be, and may meet its end. In addition to being issued in smaller quantities, it can no longer be redeemed in gasoline, and seems to be shunned by a younger generation of Canadians. Soon, Canadian Tire money could fade from memory, much like the Diefendollar.

Friday, June 24, 2011


Bitcoin is a form of cyber-money that has been with us since 2009. In order to understand it, and why it may or may not be interesting, it helps to review other more or less conventional monetary arrangements. The three I've chosen, as each shares something with bitcoin, are commodity money, fiat money, and private money.

Commodity money
The earliest forms of money were commodity monies, primarily gold and silver. It's not hard to see why gold makes a good commodity money. It is scarce, it is difficult to replicate (i.e. counterfeit), and it is relatively easy to carry around, at least in the quantities one would need to make day-to-day transactions. The scarcity comes from the fact that it is costly to dig the gold out of the ground, and its physical characteristics make counterfeiting costly as well. These properties of gold of course did not prevent people from trying to scam the system. Alchemists tried in vain to create gold out of nothing (or, one step up, urine), and counterfeiting and debasement made quality-monitoring necessary.

Commodity money systems were not without their costs. If gold is used as money, then its value in exchange causes its price in terms of goods and services to be higher than it would otherwise be. There is a "gold bubble" in the sense that gold trades at a price higher than it would if gold were used only as an input in production or for consumption purposes. This higher price of gold makes it more profitable to dig the stuff out of the ground, so there is a resource cost to society of supporting the monetary system. Another problem is that, under a commodity money system, we are at the mercy of changes in technology or in the demand for the commodity for other purposes than as money. For example, if gold is used as money, then a better technology for extracting gold from the ground, or a reduction in the demand for gold jewelry, will reduce the price of gold relative to other goods and services. This is inflation of course, which we know is socially costly.

Fiat Money
Modern-day fiat money evolved by way of commodity-backed paper money (e.g. the gold standard). In the US, Federal Reserve notes are not explicit promises to pay anything in the future; the Fed will not redeem the currency it issues in the form of some other commodity or asset. Things are a little tricky though, as the Fed actually lists currency as one of the items on the liability side of its balance sheet, and there are indeed assets on the other side of the balance sheet that represent backing for the Federal Reserve notes. Indeed, the Fed does not create the notes "out of thin air" but issues them in exchange for other assets, which are typically obligations of the US Treasury (though some other stuff currently appears on the asset side of the Fed's balance sheet). Thus, there is a sense in which Federal Reserve notes are ultimately backed by the power of the US government to tax us.

A fiat money standard potentially eliminates some of the costs of a commodity money system. First, paper is cheap to produce and, second, we can solve the problem of price level stability if we can trust the issuer of fiat money to manage the stock of the stuff appropriately. However, we are now faced with some new problems. Counterfeiting now becomes potentially much more severe, which is clearly why it took so long for fiat money systems to evolve. We had to wait for a good anti-counterfeiting technology to arrive. Once it did, the government needed to work continuously to keep one step ahead of the counterfeiters. A good anti-counterfeiting technology is one which makes it very low cost for the average person to tell the difference between a counterfeit and the real thing, and makes it very high cost for a counterfeiter to replicate the real thing (and obviously these two things are related).

Another problem with a fiat money system is that we now have to support an elaborate structure for managing the money supply and monitoring the money-supply managers. The cost of operating the Federal Reserve System and checking up on what it is doing is clearly significant. Sometimes fiat money systems do not work so well, and we get phenomena like this.

Private Money
There are plenty of examples of the use of circulating private money, typically issued by banks. During the US "free banking era," 1837-1863, state-chartered banks issued small-denomination pieces of paper that were the dominant media of exchange. This era was somewhat chaotic, with many attendant problems, though the success of the system is subject to some debate. Well-functioning private money systems existed in Scotland in the early 19th century and in Canada before 1935. Private money issue in these systems was by no means a free-for-all, as there were well-established rules under which note-issuing banks operated. In the Canadian system for example, it was difficult to obtain a bank charter with note-issuing privileges, the notes were required to be redeemable in gold, and notes were required to be senior claims on the bank's assets. There are modern examples of private monies in North America, which I think we could categorize as curiosities. These include Canadian Tire money and Ithaca Hours.

Now, to get to the point, what is Bitcoin? The orgins of this cyber-money are somewhat obscure, as the author of the underlying code apparently chooses to remain anonymous. Bitcoin is exchanged on an anonymous person-to-person network, which anyone can join by downloading the relevant software from here. The stuff is created essentially by solving a puzzle. I can solve it, you can, or Justin Beiber can solve it, given enough computing power and time. There is nothing creative about solving the puzzle, but it is costly as it burns power (see this) and occupies computing capacity. Further, in creating new bitcoins I have to do some checking of previous transactions on the network, which is in part how good behavior is enforced. A bitcoin is then a string of bits, and it can be traded.

The Bitcoin web site claims that some people are willing to accept bitcoins in exchange for goods and services, and some are willing to exchange bitcoins for US dollars (and presumably other currencies). The algorithm is designed so that solving puzzles becomes progressively more difficult, which targets the growth path of bitcoins so that the quantity converges to 21 million in about 2140.

Bitcoins share some of the features of a commodity money, in that there is a natural scarcity - the stuff is hard to produce. This comparison helps us think about some of the potential problems as well. What prevents modern-day alchemists from coming up with a way to replicate a bitcoin? Success certainly seems much more likely than for the old-time alchemists, since the bitcoin algorithm was created by a human being. All it takes is a smarter human being to beat it.

A bitcoin is also somewhat like fiat money, in that it is not redeemable. However, in contrast to central bank money, there are no assets backing the stuff. Further, while I can identify Fed officials, and I know how they are appointed, I have no idea who invented bitcoin. How do I know the inventor does not have a second set of software that will allow him to claim all the seignorage when he or she thinks the time is right? While libertarians appear to be attracted by the idea, I don't think the general public will take well to a medium of exchange for which we can't hold anyone responsible. Certainly these people have a problem with it.

One sense in which bitcoins differ dramatically from fiat money is in terms of the anonymity of the transactions. One of the virtues of currency (and also one its downfalls, since this makes it easy to steal) is that it is very low-tech and easy to transfer, and lacks memory. While there is a sense in which the bitcoin network is anonymous, in another sense it is most definitely not. The system tracks the machines on which the bitcoins reside, and appears to record the entire history of such residence.

Like historical private money systems, bitcoin involves a system of private issuers, but the private money systems I discussed above operated within a well-defined legal framework. Any system of monetary exchange requires enforceable rules concerning contracts, and bitcoin has none of this. Further, Timothy Lee, who appears to know what he is talking about, sees a potential collusion problem in the bitcoin system. Whether this is any worse a problem than what existed, for example, in the Canadian banking system pre-1935, I'm not sure.

In spite of the fact that I think bitcoin is a curiosity, on the order of Canadian Tire money or Ithaca Hours, it would be wrong to criticize it for being a "pyramid scheme," or a "bubble." Indeed, modern fiat money is both of those things. One could imagine getting a fiat money system off the ground and observing time series of prices for the stuff that look much like what you can find here. As fiat money becomes more widely acceptable, its price in terms of goods and services rises, and people who "got in early" can make a profit. Fiat money is a bubble in the purest sense, in that its fundamental value is zero, but nevertheless people are willing to give up goods, services, and other assets in exchange for it. Bubbles can be good things, as any asset which is used widely in exchange will trade at a price higher than its "fundamental," and the asset's liquidity premium - the difference between the actual price and the fundamental - is a measure of the asset's social contribution as a medium of exchange.

Sunday, June 19, 2011

Krugman and Keynes

Cambridge University is running a conference, commemorating the 75th anniversary of Keynes's General Theory. This certainly seems like a useful opportunity to look back on the last 75 years and ask what Keynes has done for us, and how his ideas have shaped modern macroeconomics. As one might expect, Woodford is on the program, and there are papers by Gali/Smets/Wouter and Koop/Pesaran/Smith that are representative of empirical research on New Keynesian models. You could argue with some of the choices on the program. Maybe the organizers could have reduced the average age of the speakers, and some Keynesian critics might have been helpful for the state of discourse in the science, but generally there is serious academic work being presented, and there are opportunities to learn state-of-the art work.

The plenary talk is another story. It’s Krugman, of course, and his talk is posted here. To his credit, Krugman understands that he may not be up to the task:

It’s a great honor to be asked to give this talk, especially because I’m arguably not qualified to do so. I am, after all, not a Keynes scholar, nor any kind of serious intellectual historian. Nor have I spent most of my career doing macroeconomics. Until the late 1990s my contributions to that field were limited to international issues; although I kept up with macro research, I avoided getting into the frontline theoretical and empirical disputes. So what am I doing here?

Now, if you thought that Krugman was going to be humble, there are two clues in this first paragraph that he won’t be. One is the use of “arguably” in the first sentence. The second is in the third sentence, where he claims to have “kept up with macro research.” We all know that Krugman has not kept up, let alone understood what happened in the 1970s.

Of course it’s all downhill from here. Krugman thinks he was invited, (i) because he knows what a liquidity trap is, and (ii):
The other reason I’m here, I’d guess, is that these days I’m a very noisy, annoying public intellectual, which means among other things that I probably have a better sense than most technically competent economists of the arguments that actually drive political discourse and policy.

What’s that “technically competent” about? Is Krugman telling us he is not technically competent? Surely not. He passed the MIT prelims, was granted a PhD from the same institution, published some papers, and was granted a Nobel Prize in Economics. I think he means that he is a member of the set of technically competent economists, but he has some special qualifications, which are apparently being noisy and annoying. I can also attest that he can produce several blog posts per day, two New York Times columns per week, and can use FRED. I’m a little puzzled as to what insight this gives him into the world of policymaking relative to say, the set of residents of Manhattan, most of whom could also easily be trained to use FRED and blog for the New York Times. However, maybe Krugman wrote this in a hurry, so we should a least give him a chance. Maybe he has something new to say?

There is some talk about the General Theory. Here’s a puzzler.
Chapter 12 is a wonderful read, and a very useful check on the common tendency of economists to assume that markets are sensible and rational. But what I’m always looking for in economics is intuition pumps – ways to think about an economic situation that let you get beyond wordplay and prejudice, that seem to grant some deeper insight. And quasi-equilibrium stories are powerful intuition pumps, in a way that deep thoughts about fundamental uncertainty are not. The trick, always, is not to take your equilibrium stories too seriously, to understand that they’re aids to insight, not Truths; given that, I don’t believe that there’s anything wrong with using equilibrium analysis.

Intuition pumps? Going beyond prejudice and wordplay? What is the man trying to get across?

There’s more in here. We are reintroduced to the Keynesian Cross and IS/LM, which Krugman feels are sadly neglected, by graduate students:
But you can see right away part of our problem: who teaches the Samuelson cross these days? In particular, who teaches it in graduate school? It’s regarded as too crude, too old-fashioned to be even worth mentioning.

Actually, I like to talk about the Keynesian Cross in intermediate macro. It takes about five minutes and, indeed, most students have never seen it. One student said that he saw it in the appendix to his book in a high school AP macro course, i.e. the Keynesian Cross was the deep model that was deemed too difficult for the average student. What I use Keynesian Cross for, though, is something that Krugman would not approve of. It's a vehicle for showing the students what an Old Keynesian sweeps under the rug. To "crude, too old-fashioned," we can add "wrong."

Section 4 of the talk is titled "The Strange Death of Keynesian Policy." Where do people get these ideas? Would they like a world where macroeconomists thought about nothing but Keynes? When did Keynesian policy ever die? Here is what Krugman has in mind.

It [central banking] worked in part because the political insulation of central banks also gave them more than a bit of intellectual insulation, too. If we’re living in a Dark Age of macroeconomics, central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world. Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters, the research departments of the Fed system continued to study counter-cyclical policy in a relatively realistic way.

Now, in how many ways can I show you that this paragraph is out to lunch in a severe way?

1. Central banks are intellectually insulated. A marked development in central banks since about 1970, in the United States and elsewhwere, is that central bank economists have become increasingly interactive with academics, and have become much more active participants in serious macroeconomic research. At one time, a central banking job was perceived to be a dead end for a macroeconomic researcher. Now, it is common for people to move between academia and central banking (as I have done myself), central banks have active programs for visiting academics, and they run conferences where high-level research is presented and debated. Further, the standards for publication in many central bank research departments are as high as they are in serious economics departments.

2. Central bankers are busy studying ancient texts, presumably the General Theory and such things. See (1) above. These people are as much on the frontier as anyone.

3. It is hard to publish models in which monetary policy matters. Here are some that slipped through, and they are just by one guy (and coauthors) - one of those dark age economists:

a) Expectations and the Neutrality of Money

b) Money and Interest in a Cash-in-Advance Economy

c) Liquidity and Interest Rates

d) Interest Rates and Inflation

e) Menu Costs and Phillips Curves

There is more whining in the talk about the "intellectual regression of too much of our profession," etc., but you get the idea.

I'm wondering how much the organizers of this conference paid for "Mr. Keynes and the Moderns?" Did Krugman get his usual $80,000 (or whatever) speaking fee, or what? If so, they didn't get much for their money, other than recycled blog pieces. Now, the key question is: What would Keynes think, if he were at this conference? He would be the guy with the mustache in the corner, muttering: "Who invited that obnoxious journalist?"

Friday, June 17, 2011

Money and Inflation

Since an FOMC meeting is coming up next week, and we have some more information on prices, it would be useful to review the current situation. In the first chart, I plot some price indexes, i.e. PCE deflator, headline CPI, and core CPI, relative to a 2% trend (the more-or-less explicit Fed inflation target) starting at the NBER-dated onset of the recent recession in December 2007. The inflation situation, by this measure, is not dire. Currently the PCE deflator is 1% below the 2% trend, headline CPI is 0.6% lower, and core CPI is 1.6% lower.

However, the recent history from mid-2010 is troubling. The Fed should clearly be concerned with the first derivative here, and the last CPI report should tell even those die-hard core-CPI-adherents (e.g. Dave Altig) that the inflation we are seeing may not be just some temporary relative-price phenomenon. In case you hadn't noticed, seasonally adjusted core cpi increased by 0.3% in May, and headline inflation increased by 0.2% in spite of a decrease in gasoline prices. Inflation is indeed a monetary phenomenon, and monetary policy is primarily about controlling inflation, though some of our pseudo-macroeconomist blogosphere types seem to think otherwise.

Now, suppose we look at how some monetary measures have been behaving, over the same sample as for the price indexes we looked at in the first chart. In the second chart, I show monthly seasonally adjusted M1, M2, and the currency component of M1, all from the beginning of the recent recession. I have also shown a 5% trend, the notion being that, if velocity were constant, if real GDP were growing at 3% per year, and if prices were growing at 2% per year, then money would grow at a 5% annual rate.

Clearly, M1 stands out here, in that it is currently 19.3% above the 5% trend, with currency 6.8% higher and M2 1.7% higher. Now, on the one hand we have to adjust for a financial crisis effect here, i.e. an increase in the demand for liquid assets due to the financial crisis, including an increase in the demand for US currency in the world at large. On the other hand, some of that demand has gone away, and ultimately we expect it to disappear. Further, it's possible we are too optimistic in expecting that we will soon, or ever, return to a 3% real GDP growth trend.

Therefore, if we are Old Monetarists, New Monetarists, or just sensible macroeconomists who understand that the Fed ultimately controls inflation by controlling growth in Fed liabilities used in exchange, we have to be worried if the Fed does not move to tighten. Barring some game-changing information, that tightening should at least happen by early fall.

In the current context, monetary policy should not be about futile attempts to manage the labor market. As I discussed here, it's best to view QE2 as irrelevant, in which case the fact that this asset purchase program concludes at the end of this month is also irrelevant. Even if we think that there are significant nonneutralities from monetary tightening, gradual increases in the interest rate on reserves in this context are certainly preferable to a large, quick tightening, which would entail potentially greater sacrifice.