Krugman and Keynes, Part II

I am currently on vacation in the back woods west of Ottawa, but my brother just had internet service put in, and I made the mistake of catching up on my email. Someone was urging me to write something about this emission by Paul Krugman, who is writing about a piece he read by Ezra Klein in the Washington Post. Let's just work from the last paragraph:

Klein suggests that what went wrong in the Great Depression was that people hadn’t read Keynes yet; well, what went wrong and continues to go wrong in the Lesser Depression is that eminent economists, or at those so judged by their peers, turned their back on everything Keynes learned.

First, what do you think Keynes actually learned? No one really seems clear on this. In what profession are people still arguing about the meaning of a book written in 1936? As best we can make out, there are two more-or-less coherent modern versions of Keynesianism. One model is the multiple-equilibrium coordination failure version of Keynes, that comes to us by way of John Bryant, Peter Diamond, Russ Cooper, Andy John, Roger Farmer, Jess Benhabib, etc. A calibrated version of this type of model was fit to the data by Farmer and Guo. A second model is that developed by Mike Woodford, and subsequently (with many bells and whistles) fit to data by Smets/Wouters and Christiano/Eichenbaum/Evans.

Both of these modern Keynesian models are actually versions of a basic Cass-Koopmans-Brock-Mirman-Kydland-Prescott neoclassical growth model - the basic framwork we teach to graduate students as a starting point in all serious contemporary macroeconomics core courses for PhD students. As such, modern Keynesianism is just another tweak. Add some increasing returns and you get multiple equilibria, and maybe some role for government in coordinating on good equilibria. Add some sticky prices and wages, and you get some role for government in correcting relative price distortions.

Of course, these are not the only tweaks we might want to think about. Search frictions are useful for thinking about the dynamics of the labor market and unemployment. Private information and limited commitment are useful for thinking about the role of assets in exchange, monetary policy, and how credit markets work (or do not work).

Now, if you were to choose your tweaks in order to make sense of the financial crisis and the recent recession, what would those tweaks be? Well, I am not a betting person, but if you forced me to put up some cash, it would not be riding on sticky wages and prices. I've thought about that (go back and search my posts) and I can't force it to make sense. As for multiple equilibria, maybe one could get some mileage out of that, but I don't see anyone trying. Want to learn about financial crises and what governments should do about them? Want to understand unemployment and why it so high? Turn your back on Keynes.

FOMC Minutes

FOMC minutes from the June 21-22 meeting are posted here. There are a few interesting things in there. First, there is a discussion, continued from the previous meeting, on the exit strategy. Basically, the FOMC plans to first stop reinvesting principal payments on the securities it holds, and will then begin increasing the fed funds target rate. Mortgage-backed securities (MBS) and agency securities will then be sold off over a three-to-five-year period. The minutes say:

In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.

That's vague, but I take it to mean that, after three to five years, excess reserves will be zero.

There is a bit of funny stuff:

When economic conditions warrant, the Committee's next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy. During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.

The truth of the matter is that, over the period discussed here, where excess reserves are positive, the FOMC actually has no control over the fed funds rate, as that is determined by the interest rate on reserves (IROR), which is set by the Board of Governors. Further, in this regime, "adjustments...to the level of reserves" are irrelevant for the fed funds rate.

On the current policy stance, there seems to be a divergence of opinion on the committee:

On the one hand, a few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run. On the other hand, a few members viewed the increase in inflation risks as suggesting that economic conditions might well evolve in a way that would warrant the Committee taking steps to begin removing policy accommodation sooner than currently anticipated.

Thus, some people on the FOMC think that we should be considering QE3. Obviously, they think QE2 worked, which I think is incorrect. Others are actually more worried about inflation than at the last meeting, and think that the Fed will have to start executing its exit strategy sooner rather than later.

Here's another interesting tidbit:

In the discussion of inflation in the statement, members decided to reference inflation--meaning overall inflation--rather than underlying inflation or inflation trends, in order to be clear that the Committee's objective is the level of overall inflation in the medium term.

Thus, the FOMC wants it to be known that it cares about headline inflation, not core inflation.

John Cochrane and the Krugmaniacs

John Cochrane has apparently created a stir among the usual blogosphere types, not so much for what he writes about, but for who he eats dinner with and how much they pay for the wine. This has caused Krugman to come unhinged.

To sort out the players here, remember that Cochrane wrote this in response to Krugman's 2009 New York Times Magazine piece. It's likely that, in the absence of his Krugman-critique, Cochrane would never have appeared on Krugman's radar screen, much like the rest of the the economics profession or, indeed, economics in general. However, Cochrane now has a place of honor on Krugman's list of bad guys, and serves as a convenient foil, particularly given his University of Chicago affiliation.

Krugman's blog piece gives us the usual message. In Krugman's mind there is a Chicago school of arrogant freshwater economists who can't bear the humiliation of facing up to the fact that Old Keynesians are oh-so-right. Since this is more of the same, I'll refer you to my earlier post, and this one.

Now, to get to something more constructive, this reminded me that I had not looked at this paper by Cochrane, which someone recommended to me. The paper was written almost a year ago, and it's Cochrane's attempt to make sense of the financial crisis and policy in the context of the crisis, looking through a fiscal-theory-of-the-price-level lens.

Cochrane claims that he can make a model-free argument based on two equations. The first is a "valuation equation for government debt," which states that the current real value of the debt (money plus bonds) is equal to the expected discounted value of future primary government surpluses. Essentially, the total consolidated-government debt is valued according to "fundamentals." The second equation is an old-fashioned money-demand function, of the sort that would fall out of a cash-in-advance environment, for example.

There are two ideas in the paper that I like. First, Cochrane points out that the "flight to quality" during the financial crisis represented an increase in the demand for all consolidated-government liabilities, not just currency, as occurred for example during the banking crisis in the Great Depression and in National Banking era banking panics. You'll find that idea in these slides as well, and in the associated paper.

Second, I liked the emphasis on the relationship between fiscal policy and monetary policy. As Cochrane points out, those ideas go back to the 1980s, and can be found in Sargent and Wallace's "Unpleasant Monetarist Arithmetic" paper, and other work by Tom Sargent.

What I do not buy into are the ideas that come from the fiscal-theory-of-the-price-level literature, which Cochrane contributed to, along with Sims and Woodford. This is where Cochrane gets his conclusions about the relationship between anticipated government deficits and inflation. Cochrane is incorrect in stating that he can get results from two equations, without fleshing out a complete model. Indeed, I can think of models where his equation (1) on page 2 of the paper does not hold, and this actually has an important bearing on how we think about the financial crisis.

Here's a counterexample. Take any pure-currency monetary model where we derive a role for money from first principles. There is just one asset, fiat money, in fixed supply, and the environment is stationary. The deficit is zero forever, so that the right-hand side of equation (1) is zero. But there exists an equilibrium where the price level is constant, money is valued, and the left-hand side of equation (1) is greater than zero, so the equation does not hold. That's if the money is an endowment for economic agents in the first period. But what if money is injected initially by way of lump sum transfers? Then the right-hand side of the equation is negative, so it still does not hold.

What is going on? Money is a bubble. It deviates from its fundamental value, which is zero. In general, any asset can exhibit such bubbly properties if it is used in exchange and is sufficiently scarce. For example, there can be a liquidity premium on Treasury bills due to their value in exchange. During the financial crisis, it seems clear that all government liabilities were scarce, real rates of return on safe assets were low, and the marginal liquidity value of government debt in financial exchange was high.

In principle, one could construct a model of the runup in house prices after 2000 and the subsequent bust, based on incentive problems leading to lending to the wrong people, and the use of mortgage-backed securities (MBS) in financial exchange, which not only creates a liquidity premium for MBS, but a liquidity premium on the underlying assets - houses. The key question is whether the theory could produce a liquidity premium large enough to match the data. Note that this has nothing to do with the way that Robert Shiller, for example, thinks about bubbles.

On another Cochrane matter, I ran across this piece from last month, which I thought was pretty good. Cochrane looks at the bond yield data and argues that QE2 was a failure, and goes on with this:

Both sides ignore an inescapable conclusion: With near-zero short-term interest rates, and bank reserves paying interest, money is exactly the same thing as short-term government debt. A bank doesn't care whether it owns reserves or three-month Treasury bills that currently pay less than 0.1 percent.

This is what drove the Fed to QE2 in the first place. Conventional easing -- buying short-term Treasuries in exchange for reserves -– obviously has no effect now. Taking away your green M&Ms and giving you red M&Ms instead won't help your diet.

But if exchanging money for short-term debt has no effect, it follows inescapably that giving banks more money is exactly the same as giving them short-term debt. All QE2 does is to slightly restructure the maturity of U.S. government debt in private hands.

Now, of all the stories we've heard to explain our sluggish recovery, how plausible is this one: “Our big problem is the maturity structure of Treasury debt. If only those goofballs at Treasury had issued $600 billion more three-month bills instead of all these five-year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this tragic mistake.” That makes no sense.

I like that, and it's consistent with what I wrote here.

Cochrane finishes with this comment on QE2:

Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power, when it is basically helpless. If Bernanke had admitted to Congress, “there’s nothing the Fed can do. You’d better clean this mess up fast,” he might have had a much more salutary effect.

Excellent.

Now, I'm reading Cochrane's stuff, and I'm finding it useful. I don't agree with everything, but he is using the economics he knows to effectively make some very useful points. I don't see any connection between what Krugman and friends are writing about the guy and what the guy actually writes.

Economic Welfare

I saw an interesting talk yesterday by Pete Klenow (Stanford) on this paper by Klenow and Jones. The basic idea is to use standard economic theory to come up with measures of economic welfare by country. The paper is quite nice, as the measure allows us to account for how each of the four factors considered contribute to the welfare measure. In general, welfare is increasing in consumption, increasing in leisure, increasing in life expectancy, and decreasing in a measure of inequality. As Klenow showed, while the US and Australia currently have about the same level of per-capita real GDP, the Australians are about 16% (this is the number I remember) better off, in units of consumption. The Australians in the audience certainly seemed to like this result. Australians are doing better as they live longer, enjoy more leisure, and have less income inequality than do Americans.

Comparisons between Western Europe and the US often focus on per-capita GDP, and some researchers, including Ed Prescott, attribute much of the income gap to taxation. But of course the Western Europeans are buying something with their taxes. They are on average healthier than Americans, they live longer, they do not work as hard, and they are better-insured against low-income states. In the year 2000, while Western European per-capita real GDP was 71% of what it was in the US, the Jones/Klenow Western European welfare measure was 87% of the US measure.

Now, a question came up in Klenow's talk about unemployment. Someone was upset that the welfare measure essentially treated not-in-the-labor-force and unemployment as identical states, i.e. leisure. I think Klenow viewed this as the cleanest way to think about this, but do we think there is something to be gained from treating unemployment differently? Certainly many people want us to think about the currently high rate of unemployment in the US as a tragedy, but do they have in mind that we should somehow independently take account of unemployment in a measure of aggregate welfare? Maybe all these people are thinking is that there is a set of policies that could make unemployment lower, and that this would simultaneously make average consumption higher and reduce inequality, thus giving us a welfare improvement by the Jones/Klenow measure?

What does theory tell us about the cost of being unemployed? In some search models, it is costly to look for a job, in terms of effort and the opportunity cost of time. Unemployed people are willing to bear these search costs as they perceive that their potential welfare from being employed is sufficiently high relative to their welfare from being unemployed, given the probability of obtaining work. Thus, costs of search contribute negatively to economic welfare, independent of the factors that go into the Jones/Klenow welfare measure. Of course the measurement here is problematic - the unobservability of search effort is in fact the key problem in designing unemployment insurance systems.

Do we want to think of the unemployment state as somehow more painful than not-in-the-labor-force, i.e. does the average person obtain fewer utils from an hour spent unemployed as opposed to an hour spent not-in-the-labor-force, everything else held constant? An unemployed person may face higher uncertainty, which makes him/her worse off, but is a day spent playing golf less satisfying if I am unemployed than if I am not actively searching for work? But maybe the unemployed person can't afford to play golf, i.e. there are complements to leisure time that we need to take into account.

Sometimes excessive focus on the levels of employment and unemployment as welfare measures can get us in trouble. For example, some people looked at the report of the Council of Economic Advisors on the effects of the stimulus package, which told us that $666 billion was spent to obtain 2.4 million jobs, put the first number in the numerator and the second in the denominator, and determined that each job cost $280,000. Seems like a bad deal. Of course, we know that this is a poor way to evaluate the stimulus program, as we need to take account of the effects on incomes, both now and in the future, among other things. I would be more worried about that 2.4 million number and where it came from.

However, you can't fault the people who made that $280,000 calculation for making it, as people like Paul Krugman are encouraging them to do it. The labor market is important, but if you focus on it too much it can come back to bite you.

Australia Talk

Here are some slides* for a talk that I'll be giving tomorrow morning at these meetings at ANU in Canberra, Australia. I'll actually be impersonating Brad DeLong, which is an interesting story in itself.

*Someone suggested that, since my Fed affiliations are on the slides, I should add the usual disclaimer, so here it is. As should be obvious, these are my views, and not those of the Federal Reserve System.

Fannie, Freddie, and the Truth

Mark Thoma is worried that federal government credit policies are taking too much of the blame for the financial crisis. I wrote about this here. There are two competing narratives out there. The left-wing narrative is that the financial crisis was caused by some greedy Wall St. types, while the right-wing narrative is that the government, working by way of the CRA (the Community Reinvestment Act of 1977), Fannie Mae, Freddie Mac, and various government housing policies, caused the financial crisis.

As I wrote in my earlier piece, neither of those narratives gives you a good picture of the financial crisis and what it was about. That people on Wall Street are greedy is a given. That financial institutions were behaving in suboptimal ways was the fault of lawmakers and regulators. CRA, though wrongheaded, did not have much to do with the financial crisis. And, yes indeed, Fannie and Freddie were as much a part of the financial crisis as any of the other large financial institutions in the United States.

To remind you, Fannie and Freddie, formerly privately-owned (but "government-sponsored") enterprises, have been under government conservatorship since September 2008, and bailing them out will ultimately cost us in the neighborhood of $300 billion. Indeed, Fannie and Freddie appear to be the principal source of bailout losses to the federal government and the Fed. Fannie and Freddie are corrupt, they survive - indeed thrive and expand - because they are subsidized, and they perform no important economic role.

Now, where Thoma seems confused is in his characterization of this book by Gretchen Morgenson and Joshua Rosner:

That’s why I was so disappointed to see the new book by Gretchen Morgenson and Josh Rosner, Reckless Endangerment, blaming the financial crisis on Fannie, Freddie, and Democrats. The book has been highlighted recently by George Will and David Brooks, and it joins a chorus of conservative voices promoting the idea that government policies to encourage home ownership among middle and low income households is at the heart of the financial crisis.

If you read the reviews of the Morgenson/Rosner book here, you will find glowing ones from those right-wing nuts Bill Moyers and Simon Johnson. Morgenson works for that right-wing rag, the New York Times, and Rosner writes in the Huffington Post. I have not read the book, but the review here makes it sound more like the left-wing bad-Wall-Street-guys narrative. Don't worry Mark, I don't think anyone is seizing your narrative.

Ron Paul, Mankiw, and the Government Debt

Ron Paul recently suggested a solution to the debt-ceiling problem

"We owe, like, $1.6 trillion because the Federal Reserve bought that debt, so we have to work hard to pay the interest to the Federal Reserve," Paul said. "We don't, I mean, they're nobody; why do we have to pay them off?

Paul's logic is the following. The debt ceiling applies to all Treasury debt outstanding, but currently $1.6 trillion of the total $14.5 trillion in Treasury debt is held by the Fed. We all know that the Fed is a large leech sucking our blood, so why not call a temporary truce in the debt-ceiling/budget war by simply defaulting on the $1.6 trillion in debt held by the Fed?

Dean Baker likes the idea. He also seems to be thinking like the Fed Chairman of 1937 in that he thinks an increase in reserve requirements would be a great idea. This guy doesn't like Paul's idea as he thinks it would cause a hyperinflation.

Now, along comes Mankiw to the rescue. He poses the problem as an exam question, then gives you the solution, in a few lines. What Ron Paul is suggesting is only an "accounting gimmick," and it is actually irrelevant.

Now, to work through this, consider two alternative scenarios. First, suppose that, in the absence of Paul-default, the Fed holds the Treasury debt it has acquired until maturity. In this case, clearly Paul-default cannot make any difference. Without Paul-default, the Treasury makes the payments on the Fed's Treasury holdings to the Fed, and the Fed sends those payments back to the Treasury. With Paul-default, the net flow between the Fed and the Treasury is the same: zero.

The second scenario is the interesting one. Suppose that, in the absence of Paul-default, the Fed were to sell the Treasury debt before it matures, in a reverse-QE2 program. Under Paul-default, reverse-QE2 is not possible, as the Treasury has defaulted on the Fed's debt and therefore no one else wants it. According to Ben Bernanke and, more recently, Jim Bullard, QE2 works (worked), i.e. purchases of long-maturity Treasury securities by the Fed moves asset prices and increases the inflation rate. If QE2 works, then reverse-QE2 works too. Thus Paul-default, by foreclosing reverse-QE2, matters.

Not so fast, though. Actually the working hypothesis should be that QE2 was irrelevant (see this too), no matter what these people say. In that case, it's not going to matter whether the Fed holds its Treasury portfolio until maturity, or not. Mankiw is right, but the exam question is a little harder than he thought.