Monday, December 31, 2012

President rejects his bipartisan commission

The fiscal deal struck last night makes one thing clear: President Obama must have really hated the recommendations of the bipartisan Bowles-Simpson commission that he appointed. The commission said that we needed to reform entitlement programs to rein in spending and that increased tax revenue should come in the form of base broadening and lower marginal tax rates. The deal appears to offer no entitlement reforms, no tax reform, and higher marginal tax rates. After all the public discussion over the past couple years of what a good fiscal reform would look like, it is hard to imagine a deal that would be less responsive to the ideas of bipartisan policy wonks.

The Neverending Quest for a More Redistributionist Tax System

I just listened to President Obama's latest remarks on fiscal policy.  This passage caught my attention:
I want to make clear that any agreement we have to deal with these automatic spending cuts that are being threatened for next month, those also have to be balanced, because, remember, my principle always has been let’s do things in a balanced, responsible way. And that means the revenues have to be part of the equation in turning off the sequester and eliminating these automatic spending cuts, as well as spending cuts.

Now, the same is true for any future deficit agreement. Obviously we’re going to have to do more to reduce our debt and our deficit. I’m willing to do more, but it’s going to have to be balanced. We’re going to have do it in a balanced responsible way.

For example, I’m willing to reduce our government’s Medicare bills by finding new ways to reduce the cost of health care in this country. That’s something that we all should agree on. We want to make sure that Medicare is there for future generations. But the current trajectory of health care costs has gone up so high, we’ve got to find ways to make sure that it’s sustainable.

But that kind of reform has to go hand and hand with doing some more work to reform our tax code, so that wealthy individuals, the biggest corporations, can’t take advantage of loopholes and deductions that aren’t available to most of the folks standing up here; aren’t available to most Americans.

So there is still more work to be done in the tax code to make it fair, even as we’re also looking at how we can strengthen something like Medicare.

Translation: The deal we are about to strike will raise taxes on the rich. But the fiscal imbalances we face will remain unsustainably large.  So I will ask for more tax increases on the rich later.

Friday, December 28, 2012

Theater Recommendation

For those in the Boston area: Yesterday, my family and I enjoyed one of our Christmas presents from Santa and went to the new production of the musical Pippin at the American Repertory Theater in Cambridge. I recall seeing the original Broadway production in the 1970s when I was in high school and liking the play then. I went to see it yesterday with a bit of trepidation, wondering whether my sensibilities had changed too much over the past four decades for me to still enjoy it. But the play did not disappoint, not even one bit. This new production is absolutely terrific: great acting, music, dancing, and even acrobatics. Everyone had a blast, from my teenage sons to my 85-year-old mother.

The play's run lasts until January 20. Go see it if you can.

Thursday, December 27, 2012

Glaeser on Disability

Ed considers what might be behind this fact:
Thirty years ago, there was a 40-to-1 ratio between the total labor force and those workers receiving Social Security disability payments. Today that ratio is less than 18-to-1.

Monday, December 24, 2012

A Reading for Christmas

My favorite Christmas-themed economics article is this one by Steve Landsburg. From 2004, but truly timeless.

A Krugman Puzzler

I often disagree with Paul Krugman, but I usually understand him.  Lately, however, I have been puzzled about his view of the bond market.  In a recent post, he takes President Obama to task for believing that the failure to deal with our long-term fiscal imbalance might cause a spike in interest rates:
America can’t run out of cash (except politically, if Congress refuses to raise the debt ceiling); it basically can’t experience an interest rate spike unless people see an increased chance of economic recovery and hence a rise in short-term rates. And the people who have been predicting an interest rate spike any day now for four years shouldn’t have any credibility at this point.

But back in 2003, when the fiscal imbalance was much smaller, he wrote:
With war looming, it's time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.... 
How will the train wreck play itself out? Maybe a future administration will use butterfly ballots to disenfranchise retirees, making it possible to slash Social Security and Medicare. Or maybe a repentant Rush Limbaugh will lead the drive to raise taxes on the rich. But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. 
And as that temptation becomes obvious, interest rates will soar. It won't happen right away. With the economy stalling and the stock market plunging, short-term rates are probably headed down, not up, in the next few months, and mortgage rates may not have hit bottom yet. But unless we slide into Japanese-style deflation, there are much higher interest rates in our future. 
I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared -- the ultra-establishment Committee for Economic Development now warns that ''a fiscal crisis threatens our future standard of living'' -- investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions -- and I've locked in my rate.
I am having trouble reconciling these points of views.  Has Paul changed his mind since 2003 about how the bond market works?  Or are circumstances different now?  If anything, I would have thought that the fiscal situation is more dire now and so the logic from 2003 would apply with more force.  I am puzzled.

Update: Several people have emailed me possible resolutions of the puzzle, but none is really satisfying.

One group of emailers says that things are different now because we are in a liquidity trap.  But back in 2003 the federal funds rate was at about 1 percent, so we were very close to the zero lower bound.

Another group of emailers says that Paul has admitted that his 2003 forecast was mistaken.  But that is not the issue.  Of course, we can look back and say it was mistaken.  No big deal.  Any economist who has ever made a forecast has made some mistaken forecasts.  The puzzle to me is how Paul can act so certain that the outcome he viewed as likely in 2003 is now beyond the realm of the plausible, even though the fiscal imbalances are much larger.

By the way, my column coming out in Sunday's NY Times touches on these issues, which is why the puzzle came to mind.

Thursday, December 20, 2012


Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? Though this article is not about the economics of the problem, it has something to say about the practicalities of regulation. Regulating guns through the U.S. Consumer and Product Safety Commission is a start, and using some of the strategies that were used against tobacco is another useful step.

What's the problem here? People buy guns for three reasons: (i) they want to shoot animals with them; (ii) they want to shoot people with them; (iii) they want to threaten people with them. There are externalities. Gun manufacturers and retailers profit from the sale of guns. The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. People shooting at animals can hit people. People who buy guns intending to protect themselves may shoot people who in fact intend no harm. People may temporarily feel compelled to harm others, and want an efficient instrument to do it with.

There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax. Tax the source of the bad externality, and you get less of it. How big should the tax be? An unusual problem here is that the size of the externality is random - every gun is not going to injure or kill someone. There's also an inherent moral hazard problem, in that the size of the externality depends on the care taken by the gunowner. Did he or she properly train himself or herself? Did they store their weapon to decrease the chance of an accident?

What's the value of a life? I think when economists ask that question, lay people are offended. I'm thinking about it now, and I'm offended too. If someone offered me $5 million for my cat, let alone another human being, I wouldn't take it.

In any case, the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

Addendum: See this related piece by Louis Johnston.

The Confused and the Confusing

I don't know why, but I find Paul Krugman's behavior interesting. Here's his reply to my previous post. This is typically the way he does it. For some reason Noah Smith is always the conduit.

The first thing to note is this:
For newbies: saltwater is the kind of macro practiced at MIT, some of Harvard, Princeton, etc., macro that still finds Keynesian ideas useful and argues that monetary and fiscal policy can be effective; freshwater is Chicago, Minnesota, etc. insisting that business cycles are optimal responses to real shocks.
This is not actually a message for newbies. Krugman seems to be hoping that these "newbies" are Rip Van Winkles who have been asleep for 30 years rather than 20. Or maybe he thinks that repeating this enough will make it true. From my previous post:
What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.
If Krugman can't figure out what is going on in his own department, do you think you can trust him to take the pulse of the profession?

A second thing:
So yes, the equations in one of Mike Woodford’s papers look a lot like the equations coming out of Chicago or Minneapolis. And a few years ago it was possible to delude oneself into believing that this represented a true convergence of thought.
There's much more to it than equations. Here's an example. In fall 2008, I went to this conference at the Federal Reserve Bank of Minneapolis. What was it about? Monetary Policy and Financial Frictions. That's in the middle of the crisis, and it was certainly topical. I didn't see anyone there obsessing about TFP shocks. People came from across the country - Princeton, Chicago, MIT, Northwestern, Stanford, Columbia, etc.

One paper I saw was Mike Woodford's work with Curdia. Woodford/Curdia start with a basic NK framework and add a financial friction, in part by introducing some heterogeneity to generate borrowing and lending. When I first saw the program, I was wondering why Andy Atkeson was discussing the paper. I wouldn't have thought that Andy knows much about NK models. Wrong. Actually, what Mike was doing uses some ideas from the market segmentation literature that Andy has done work in. There was basically a set of shared ideas, techniques, and tricks for getting the job done. Cross-fertilization! Market segmentation is about studying the distributional effects of monetary policy - a nonneutrality of money. Mike works in models where the nonneutrality generally comes from price stickiness. Andy was a Sargent student at Stanford. His first job was at Chicago, and he is now at UCLA. Mike at one time also worked at Chicago, and he was at Princeton, then Columbia.

Here's something I could have said:
I’m not saying that the NK approach is necessarily right; but it’s a serious intellectual effort, undertaken by people who thought they were part of an open professional dialogue.
So Krugman and I have something we can agree on.

Krugman seems to want us to be at each others' throats. Only he can tell us why.

Monday, December 17, 2012


I thought I would offer some light entertainment today. This Paul Krugman post struck me as perhaps more deranged than usuual on the topic of macroeconomists.

Here are the two closing paragraphs, to give you the idea:
In fact, the freshwater side wasn’t listening at all, as evidenced by the way 80-year-old fallacies cropped up as soon as an actual policy response to crisis was on the table; and as for changing views in response to facts, well, we all know how that has gone.

The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.
Like most of the macroeconomists I know and talk to, I try to keep up with my field, and with what is going on in the rest of economics. That's a hard thing to do of course. It burns all the time that is left after teaching students, trying to do one's own research, and doing whatever else we need to do to get on with life.

It doesn't surprise me that Paul Krugman isn't up on what is going on in macroeconomic research. Why should we expect him to go to macro conferences, spend time in seminars, and talk to his colleagues at Princeton? He has plenty on his plate, what with delivering two NYT columns per week, blogging, talking to pundits, and giving speeches. But if he's not up on the field, what purpose does it serve to make up outlandish stuff for people to read? Maybe this just motivates the Krugman base. I have no idea.

Some of the following ideas you can find in other forms if you search my archive, but these things bear repeating once in a while.

This is actually a relatively tranquil time in the field of macroeconomics. Most of us now speak the same language, and communication is good. I don't see the kind of animosity in the profession that existed, for example, between James Tobin and Milton Friedman in the 1960s, or between the Minnesota school and everyone else in the 1970s and early 1980s. People disagree about issues and science, of course, and they spend their time in seminar rooms and at conferences getting pretty heated about economics. But I think the level of mutual respect is actually relatively high. There seem to be more serious disputes, for example, between structural and astructural labor economists than among macroeconomists.

Back in the day, there was a revolution in macro, beginning with the Phelps volume, and Lucas's "Expectations and the Neutrality of Money." At the time, this revolution was widely-misperceived as a fundamentally conservative movement. It was actually a nerd revolution. The people who led it were an inarticulate and socially awkward bunch who were not let into (or were kicked out of) the Ivy League. They had to persevere outside of the mainstream, in underdog places like Carnegie-Mellon, Rochester, and the University of Minnesota, not to mention the Federal Reserve Bank of Minneapolis.

What these people had on their side were mathematics, econometrics, and most of all the power of economic theory. There was nothing weird about what these nerds were doing - they were simply applying received theory to problems in macroeconomics. Why could that be thought of as offensive?

Since the 1970s, it is hard to identify a field called macroeconomics. People who call themselves macroeconomists have adopted ideas from game theory, mechanism design, general equilibrium theory, finance, information economics, etc. to study problems of interest to policymakers and the public at large. Sometimes it's hard to tell a macroeconomist from a labor economist, from someone working on industrial organization problems. What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.

The truth is that we have all moved on from the macro world of the 1970s. Methods that seemed revolutionary in 1972 are the methods everyone in the profession uses now. The nerds who had trouble getting their papers published in 1972 went on to run journals and professional organizations, and to win Nobel prizes. This isn't some "cult that has taken over half the field," it's the whole ball of wax. Rotten? No way!

Economic science does an excellent job of displacing bad ideas with good ones. It's happening every day. For every person who places obstacles in the way of good science to protect his or her turf, there are five more who are willing to publish innovative papers in good journals, and to promote revolutionary ideas that might be destructive for the powers-that-be. The state of macro is sound - not that we have solved all the problems in the world, or don't need a good revolution.

A Cartoon for the Pigou Club

Asness on Buffett

Warren may be a great investor, but he really doesn't cut it as a policy wonk.

Thursday, December 13, 2012

Interpreting the Fed

My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:

I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dicates.

In my estimation, the pre-crisis TR is something like the following for the real interest rate r:

r = 2.0 - (1.5)(u-u*) + (0.5)(pi-2.0).

Let’s say u* is still 5.0. Then if u=6.5 and pi=2.5, the TR says r = 0, which implies the nominal interest rate is i = 2.5. Yet the Fed says that i will still be zero!

Some argue that u* has risen above 5.0. That would raise the i implied by the TR, strengthening the conclusion that the Fed’s new rule is more dovish than the TR.

Some argue that r* [the constant term in the TR] has fallen from 2.0 to 1.0. I doubt it, but even with that change, the TR still implies i = 1.5. My conclusion about dovishness is robust.

This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. I believe the numbers for 2003 are roughly u=6.0, u*=5.0, and pi=1.0. For the TR shown above, the 2003 numbers imply r =0 and i=1.0, which is about the same as the actual i.

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

Wednesday, December 12, 2012

Why We Shouldn't Feel Well-Guided

Today's FOMC statement was as expected on the quantitative easing (QE) side of policy. The Fed will continue to purchase $40 billion in mortgage-backed securities (MBS) per month, and will be purchasing $45 billion per month in long Treasury securities outright, rather than swapping short Treasuries for long ones.

There were some surprises (for me) in the change in forward guidance. Let's see what the statement says, so we can parse it:
the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
The first part of this, is a trigger at at a 6.5% unemployment rate. Actually, it's not a trigger, as the 6.5% unemployment rate is just a necessary condition for tightening. The second part - the inflation trigger - is pretty weird. A second necessary condition for tightening is an inflation forecast -one to two years ahead - that exceeds 2.5%. Note the following:

(i) The FOMC is going to ignore actual inflation. Apparently that's irrelevant.
(ii) Whose forecast is this? You know whose. It's the Fed's own forecast. If you're paying attention to the Fed's forecasts, you'll understand that they basically make it up so that it's consistent with their own policy.

We're also told that inflation expectations becoming unanchored would be grounds for tightening. What is that supposed to mean? Then we're told that, of course, the Fed will look at everything, just as it always does.

If the goal was to provide a more precise statement about what will trigger a tightening of policy in the future, the FOMC has failed dismally. This statement is more vague than the last one, in October, which contained a calendar date.

What about policy after liftoff? We're told that the committee"...will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent." I'm worried that this is balanced like Fox News. The last reference to "balanced approach" I saw was in a speech by Janet Yellen. The balanced approach, as far as I can tell, represents a marked change in monetary policy, toward an activist approach rooted in the belief that short-run non-neutralities of money are a very big deal. The Fed has just told us that they care a lot less about inflation. They're losing sight of what their job is.

Option C

In the negotiations over the fiscal cliff, many people think the House Republicans are in a tough spot.  The logic is that they have little leverage, because they face only two choices:

A. Concede to most of the president's demands.
B. Take the economy over the cliff, and get blamed for it.

As a result, the logic goes, they will end up doing A, because B is so much worse.

Keith Hennessey points out that there is also option C: Extend the tax cuts, except at the top, for one year. Apparently (and I was not aware of this), Senate Democrats passed a bill doing exactly this back in July.  If the House passes it now, it goes to the President's desk, and he would have a hard time vetoing it.

This is not great policy, as it sets up another fiscal cliff one year from now, and it does not address all the spending cuts that are part of the fiscal cliff.  But from the Republicans' point of view, it may be better than either A or B.  Keith argues that the ability of Speaker Boehner to fall back on this option should give him more bargaining power as he negotiates with the president.  That is, because the president won't like option C either, the possibility that it could occur may make him more willing to compromise.  From the president's perspective, it is better to make concessions today than having to do this whole fiscal-cliff thing again a year from now.

Tuesday, December 11, 2012

Fed Update

The FOMC is meeting today and tomorrow. What is on its collective mind? There are two issues which are likely to be on the agenda relating, respectively, to the two legs of the Fed's current unconventional policy actions: quantitative easing and forward guidance.

Quantitative Easing
The Fed's "operation twist" will end at the end of this month. Recall that this asset swap program began in September 2011, and was extended in June of this year. The program involves sales of Treasury securities with remaining maturities of 3 years and less in exchange for Treasury securities with remaining maturities 6 years or more. Those swaps have been proceeding at a rate of $45 billion per month. Even if the Fed wanted to continue that program, it would not be feasible, as the short-term Treasury securities on the Fed's balance sheet are all but depleted.

Since September, the Fed has been purchasing $40 billion in mortgage-backed securities (MBS) per month - the "QE3" program. This is also an asset swap, but in this case a swap of reserves for MBS. QE3 is an open-ended program, which will continue under conditions stated, for example, in the last FOMC statement:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
My best guess is that the committee will not think of the new information received since the last meeting as indicating "substantial" improvement in the labor market, and they will be looking to keep their policy stance the "same" as it was at the last meeting. But they can't do that, as it's impossible to continue the twist asset swap. What's the next best thing? Well, if you believe that QE works to actually ease something, as the FOMC certainly does, then you should also think that there is little difference between swapping short Treasuries for long Treasuries and swapping reserves for long Treasuries. What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month. In terms of total purchases, that's a little larger than QE2, which involved purchases of about $75 billion per month (all Treasuries). The Fed could of course buy more than $40 billion in MBS per month, but that would signal a change, and they're not likely to do it (I'm not sure about the feasibility either - how big is that market?).

Some concerns:
1)The Treasury and the Fed are clearly thinking about debt management in completely different ways. As for example James Hamilton and David Beckworth have pointed out, the Treasury has been systematically increasing the average maturity of the outstanding government debt in the hands of the public, while the Fed is systematically reducing it. The Treasury might be thinking that it can save a huge amount on debt service in the future by, for example, locking in a 30-year borrowing rate of 2.84%. The Treasury seems to think it is looking after us by lengthening the average maturity of government debt, lowering borrowing costs, and presumably lowering our future tax burden. But the Fed thinks that we get more real economic activity (temporarily, permanently?) if the average maturity of government debt is lower. The Fed also thinks it is looking out for us. Maybe Ben Bernanke should walk down the street and try to sort this out with Tim Geithner (or his successor).
2)Short of a theory of QE - or more generally a serious theory of the term structure of interest rates - no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it's irrelevant, it doesn't do any harm. But if the FOMC thinks it works when it doesn't, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

Forward Guidance
This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. Until now, the FOMC's forward guidance statements have included a calendar date for "liftoff" - the date at which the Fed's policy rate (the interest rate on reserves currently, given the large stock of reserves outstanding) rises above 0.25%. The last FOMC statement says that date is "likely" to be mid-2015.

After living with calendar dates in the forward guidance language since August 2011, FOMC members now appear to think they are a bad idea. Why? The Fed generally likes the idea of forward guidance, as it is another tool the Fed thinks it can use when it is up against the zero lower bound. Support for the idea comes from New Keynesians - Woodford et al. - and New Keynesian models. But Woodford is on record as thinking that a calendar date is a bad idea. One may think that extending the liftoff date will be more accommodative, as this increases anticipated inflation and lowers the real rate of interest, but extending the liftoff date also conveys pessimism.

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0. The argument for triggers is that a calendar date can lead to policy errors, or negates the intent of the policy. If the Fed commits to the calendar date, it risks waiting too long to tighten, or it tightens too soon. But if the Fed appears willing to move the calendar date in response to new information, the forward guidance becomes meaningless. With triggers, the FOMC can state the policy once, commit to it, and move forward.

Here are the problems with triggers:
(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it's pretty bad. It's hardly a sufficient statistic for everything the Fed should be concerned with.
(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this "unusual" circumstance, those same people will wonder what makes other circumstances "normal." Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

My overriding concern is that the Fed's unconventional policy moves - one on top of the other - are digging a deep hole that it will find it difficult to get out of. Of course, Ben Bernanke seems likely to leave at the end of his term in about a year's time, so it won't be his problem.

The Poverty Trap in France

From Forbes:
Let’s take an unemployed mother living alone with two children between six and 10 years old. In 2010, there were 284,445 French families in this situation that were on welfare.
This mother will be given the “Active Solidarity Income.” Since she has two children, the amount will be $1,100. If she is renting an apartment with a $650 rent, she will be given the “Housing Customized Aid,” amounting to $620. Then she will receive “Family Allowances,” which amounts to another $160. Finally, let’s add the payment known as “Allowance for the start of the school year,” which is $750 once a year, or $62.50 per month. (She might even benefit from other aids, but these are the most common.) She will be given a total of $1,942.50 per month.
Now imagine that this mother has found work and will be paid the “legal minimum wage,” which amounts to $1,820 gross—or $1,430 after taxes. Since she would be earning $1,430, she will no longer receive the “Active Solidarity income.” Her “Housing Customized Aid” will be lowered to $460, but she will still be given “Family Allowances” and the “Allowance for the start of the school year.” Therefore, her total income will amount to $2,112.50....
For this mother of two, working again will bring her family an additional income of only $170. Moreover, this $170 is likely to be lost in the cost of transportation to work, since the cost of gas in France is $7 per gallon. In any case, such a small amount of money is not an incentive to go back to work. Between staying home and working, the choice is simple: welfare is a better deal.

Make Your Own Deficit-Reduction Plan

The Wall Street Journal's interactive graphic lets you choose from a menu of options.

Sunday, December 9, 2012

Gaps and Triangles

James Tobin once said:
It takes a heap of Harberger triangles to fill an Okun gap.
Gregory Mankiw once discussed gaps versus triangles in the context of fiscal policy issues (the 2009 stimulus package). According to Mankiw, Keynesians think of Harberger triangles as small potatoes, and output gaps as large potatoes; non-Keynesians think the opposite. That's certainly consistent with Paul Krugman's view of the world. Krugman quotes Tobin in his post, and states:’s a more general observation that even bad microeconomic policies, which lead to substantial distortions in the use of resources, have a hard time doing remotely as much damage as a severe economic slump, which doesn’t misallocate resources — it simply wastes them.

What's a Harberger triangle? It's a partial equilibrium measure of the welfare loss from a distortion - a tax or monopoly power for example. Total welfare from the production and consumption of a given good or service can be measured as consumer surplus plus producer surplus, which is the area under the demand curve minus the area under the supply curve, calculated given the quantity traded in the market. Total welfare is maximized at the competitive equilibrium quantity and price, but a proportional tax, for example, reduces the quantity traded, and the welfare loss (when we include the revenue generated from the tax) is a triangle - indeed a Harberger triangle.

In the 1950s, Harberger measured the welfare loss from monopoly in the United States, essentially by adding up these triangles for monopolized industries. He came up with a small number - about 0.1% of GDP. Thus, if we were to use Harberger's methods to add up the heap of Harberger triangles arising from tax distortions, monopoly, various trade restrictions, and other synthetic obstacles to exchange, the welfare loss we obtain should be small.

Are output gaps large? Certainly Paul Krugman thinks so.
Right now the U.S. economy is operating something like 6 percent below capacity.
A 6% output gap is what you get if you use the Congressional Budget Office's (CBO's) measure of potential output. The chart shows this measure, along with actual real GDP. Suppose we take the CBO output gap of 6% of GDP as an accurate measure of what could be achieved if the fiscal and monetary authorities in the United States behaved appropriately. Also suppose that 0.1% is a good part of the heap of Harberger triangles in existence in the US economy. Then, indeed, the heap of triangles looks trivial relative to the gap.

But this isn't as obvious as it might look to some of you. Let's go back to Tobin's article ("How Dead is Keynes?"), where the quote comes from, and try to figure out what he was trying to say. Perhaps surprisingly, he wasn't comparing the welfare cost of business cycles to the welfare costs of "micro" distortions. In his article, Tobin said that 1977 policymakers were between the rock and the hard place. To achieve disinflation would require some sacrifice in terms of lost output. But further monetary accommodation would just lead to self-fulfilling increases in inflation. According to Tobin, "the way out, the only way out, is incomes policy." Then he states:
Most of you will, I'm sure, have no idea what "incomes policy" is, and that's a wonderful thing. "Incomes policy" sounds innocuous. What could be wrong with a government policy that looks after our incomes, presumably making them larger? Well, incomes policy is actually wage and price controls. In the pre-Volcker era, wage-price controls were very much on the table as a means for controlling inflation. Wage and price controls were introduced by the Nixon administration, and were in effect from 1971 to 1974 in the United States. I had the misfortune to live through the era of the Anti-Inflation Board in Canada, 1975-1978. The key achievement of Milton Friedman and the Old Monetarists was to convince everyone that inflation control is the job of the central bank. It's hard to find anyone today who disagrees with that view, and I think that's a good.

The funny, and I think key, point comes out of Tobin's confusion about gaps and triangles. Relative to what he's discussing, the gap and the triangles are actually exactly the same thing. Early in his paper, Tobin discusses the "central propositions" of Keynes's General Theory. To start:
So, inefficiencies arise because prices and wages are not at their market-clearing values, and quantities traded are demand-determined. In this context, how would we measure the efficiency loss in a particular market? Guess what, it's a Harberger triangle. The inefficiencies Tobin envisions arising from wage and price controls arise from what? From wages and prices that deviate from their market clearing values. What's the efficiency loss? It's a Harberger triangle. It takes a heap of Harberger triangles to fill a heap of Harberger triangles.

If I were a hardcore Keynesian - New, Old, whatever - how would I measure the costs of business cycles? Well, to start, I would accept Tobin's first central proposition from the General Theory. Inefficiencies arise because wages and prices are misaligned. To calculate welfare losses I would add up Harberger triangles across markets. The inefficiencies that arise in New Keynesian models are indeed identical to the ones which would be generated by a set of good-specific taxes.

What's the conclusion? Keynesians - Paul Krugman in particular - can't have it both ways. Macro does not "trump" micro. This is a no-trump world. If I argue that Keynesian sticky wage/price distortions are large, and that tax distortions are small, that's a contradiction.

But it's not a contradiction to say that sticky wage/price distortions are small, and other inefficiencies that we face are large. Is 6% of GDP a serious measure of the current effects of sticky wage/price distortions? Of course not. Read this document and see if you think the CBO measures potential output the way any sensible macroeconomist would measure it. Yikes. I don't think so.

There are of course plenty of models around now that take wage and price stickiness seriously, and also contain a multitude of shocks that allow those models to fit the data. Christiano/Eichenbaum/Evans is one of those. It seems straightforward to take a model like that, turn off the wage/price rigidity, compare business cycles without the wage/price rigidity to those with it, and ask what the agents in the model would pay to live without the wage-price rigidity (this is with monetary and fiscal policies that are not correcting the inefficiencies). I don't know if that has ever been done.

We could think of such an experiment as giving us an upper bound on the welfare loss from wage/price rigidity. There are plenty of reasons to think that standard New Keynesian models exaggerate the effects of wage/price stickiness. For example, Calvo pricing is suspect. If the losses from wage/price rigidity are such a big deal, there are large surpluses left on the table that inventive buyers and sellers of labor, goods, and services, would be happy to have.

So, there are good reasons to think that the welfare losses from wage/price rigidity are small. There is also plenty of evidence that other inefficiencies matter a great deal. This paper by Hsieh and Klenow shows how the misallocation of resources in China and India is a big deal - for aggregate TFP (total factor productivity) and GDP. There is an upcoming special issue of the Review of Economic Dynamics on misallocation and productivity. This includes a paper by Greenwood, Sanchez, and Wang, showing that financial misallocation can be big-time. In the United States, we have experienced a decade where resources were apparently reallocated, inefficiently, to the housing and mortgage markets, with disastrous results. We understand more about that episode than we used to, but we have a lot to learn. What people should come to terms with, is that wage and price rigidity likely had little to do with that experience, and the sooner economists recognize that, the more progress we'll make.

Fiscal Cliff Fact of the Day

As reported in the NY Times:
Even if Republicans were to agree to Mr. Obama’s core demand — that the top marginal income rates return to the Clinton-era levels of 36 percent and 39.6 percent after Dec. 31, rather than stay at the Bush-era rates of 33 percent and 35 percent — the additional revenue would be only about a quarter of the $1.6 trillion that Mr. Obama wants to collect over 10 years.

Wednesday, December 5, 2012

An Unfortunate Broken Promise

Back in 2008, when President Obama was running for his first term, he promised to be a post-partisan leader.  While a Democrat, he said he would accept good ideas when they came from Republicans.  At the time, I believed him, at least to some degree.  And I wrote about it in this NY Times column.

Sadly, I was wrong.  The short version of the story is this: As a candidate, President Obama campaigned on a platform of raising taxes on the rich.  Yet he and his economic advisers also said they wanted to raise dividend taxes only slightly, from 15 to 20 percent.  For reasons I explained in the Times article, keeping dividend taxes low was a position bolstered by good economics. Now, however, the president wants to raise dividend taxes to ordinary income tax rates (plus, for high-income taxpayers, the new tax of 3.8 percent that is part of the Obamacare legislation).

To put it another way, he campaigned as a moderate, willing to concede that the other party had some good ideas on tax policy.  Once in office, he gave up on those ideas.

A similar thing happened with Bowles-Simpson.  During his first term, he appointed a bipartisan panel, which concluded we could address our long-term fiscal problem with lower tax rates and a broader tax base.  Now, the President goes around the country lambasting that approach.

Reasonable people can disagree about whether President Obama is a good or bad president.  But the claim that he has tried to transcend partisanship and find a middle ground is just impossible to square with the facts.

Monday, December 3, 2012

A Reading for the Pigou Club

From The New Yorker.  One disappointing quotation:
"We would never propose a carbon tax, and have no intention of proposing one," [White House spokesman Jay] Carney told reporters.

Some Advice on Tax Planning

I don't normally give advice on personal finances, but in light of the fiscal situation we are facing, I will pass along one tidbit.  Consider converting some of your retirement savings into a Roth IRA. Over the past few years, I have converted all that I can, which is about half of my retirement savings. 

To make the best of a Roth conversion, you need liquid assets outside of retirement accounts to pay the resulting tax liability.  But if you can do this, you will shelter more of your savings from capital taxation, and you will avoid required minimum distributions when you turn 70 1/2, which means tax-free accumulation for a longer period of time.

To read more about this option, click here.

Saturday, December 1, 2012

Why the President is Not So Keen on Just Limiting Deductions

From the White House blog.  Bottom line: If you apply a $25,000 deduction cap only to households with income above $250K, phase in the cap gradually as income rises above $250K, and exclude charitible giving from the cap, you increase revenue by only $450 billion over ten years.

Friday, November 30, 2012

The Gray Lady's Misleading Headline

Over my coffee this morning, I read the following headline on the front page of The New York Times: "Complaints Aside, Most Face Lower Tax Burden Than in the Reagan ’80s."  Below it was a graphic comparing average tax rates for various income groups in 1980 and 2010.

The problem is that Reagan did not become president until January 1981, and his tax policy was not fully implemented until a couple of years later (and arguably not until his second term, when we got very significant tax reform).  So the headline should have read, "Complaints Aside, Most Face Lower Tax Burden Than in Carter's 1980."  That makes the story very different, as 1980 was the year the incumbent Carter was defeated by the challenger Reagan, who was proposing significant tax reduction as a key part of his campaign.

By the way, the online version of The Times omits the mention of Reagan in the headline.  There, the headline is the more accurate "Complaints Aside, Most Face Lower Tax Burden Than in 1980."

Addendum: Using the Times online interactive graphic, you can compare the average tax rates between any two years.  Here, by income level, is how the average tax rate changed from 1988, Reagan's last year in office, to 2010, the most recent year available.

0 to 25K, fell by 4 percentage points
25 to 50K, fell by 3 percentage points
50 to 75K, fell by 2 percentage points
75 to 100K, fell by 2 percentage point
100 to 125K, fell by 1 percentage point
125 to 150K, fell by 1 percentage point
150 to 200K, unchanged
200 to 350K, rose by 2 percentage point
350K+, rose by 1 percentage point

That is, according to the Times numbers, since Reagan left office, tax rates have risen at the top and fallen for the middle class and especially the poor.

Thursday, November 29, 2012

Quick Movie Reviews

Over the last week, I saw two of the movies that critics have been raving about: Lincoln and ArgoLincoln was okay but a bit disappointing compared to expectations.  It is too hagiographic for my taste.  Argo was great.

Wednesday, November 28, 2012

The Coming Tax Hikes

Donald Marron of the Urban-Brookings Tax Policy Center explains the tax increases that are part of the upcoming fiscal cliff.

Dividing Household Chores

Advice from economist Emily Oster.  A good reading to assign when teaching the theory of comparative advantage.

Tuesday, November 27, 2012

Monday, November 26, 2012

SED Newsletter: Lucas Interview

The November 2012 SED Newsletter has some useful information on upcoming meetings. There is also an interview with Robert Lucas, which is a gem. Some excerpts:

On the Lucas Critique:
But the term "Lucas critique" has survived, long after that original context has disappeared. It has a life of its own and means different things to different people. Sometimes it is used like a cross you are supposed to use to hold off vampires: Just waving it it an opponent defeats him. Too much of this, no matter what side you are on, becomes just name calling.

Business cycles are all alike?
As I have written elsewhere, I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

ED: If the economy is currently in an unusual state, do micro-foundations still have a role to play?
RL: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.
What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence (Friedman and Modigliani). An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe (Mehra and Prescott). Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence (Rogerson). This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.

This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can, consistent with the same theory. If you can reduce a 3 orders of magnitude discrepancy to 1 order of magnitude you are making progress. Real science is hard work and you take what you can get.

"Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

A Master of Tax Avoidance

Warren Buffett has an op-ed in today's NY Times on one of his most popular themes: The rich should pay more in taxes.  At first blush, his position seems noble: A rich guy says that people like him should pay more to support the commonweal.  But on closer examination, one realizes that Mr Buffett never mentions doing anything to eliminate the tax-avoidance strategies that he uses most aggressively.  In particular:

1. His company Berkshire Hathaway never pays a dividend but instead retains all earnings.  So the return on this investment is entirely in the form of capital gains.  By not paying dividends, he saves his investors (including himself) from having to immediately pay income tax on this income.

2. Mr Buffett is a long-term investor, so he rarely sells and realizes a capital gain.  His unrealized capital gains are untaxed.

3. He is giving away much of his wealth to charity.  He gets a deduction at the full market value of the stock he donates, most of which is unrealized (and therefore untaxed) capital gains.

4. When he dies, his heirs will get a stepped-up basis.  The income tax will never collect any revenue from the substantial unrealized capital gains he has been accumulating.

To be sure, there are pros and cons of changing the provisions of the tax code of which Mr Buffett takes advantage. Tax policy always involves difficult tradeoffs.  But it seems odd to me that whenever Mr Buffett talks about taxing the rich more, the "loopholes" that he uses never seem to enter into the conversation.

Solow on Hayek and Friedman

From The New Republic.

Wednesday, November 21, 2012

What the Economics Profession Looks Like to Yglesias

It took three weeks for Matt Yglesias to figure out that I was having fun at his expense. As my mother would have said, better late than never.

Yglesias tries to get my goat by arguing that people who talk about economic science are full of it. But here is something interesting:
Here's what I think about ambition. I think that if I were an ambitious monetary economist who believed in good faith that the current course being pursued by the FOMC will be ineffective in boosting employment and is likely to produce a troubling level of inflation, I'd be shouting that from the rooftops.
Why? Because when we're mired in inflation, all the whores and politicians will look up and shout "save us!" and they'll be shouting at the people who called it right. When Milton Friedman warned that the naive Phillips Curve economics being pursued by the Federal Reserve in the late-60s and 70s would lead to ruinous inflation, nobody listened to him. Until suddenly they did listen to him and low and behold Milton Friedman was super-famous. Developing a correct analysis of the situation and then explain it is obviously no guarantee of success in your career. But all else being equal, it tends to help. That said, sometimes things aren't equal. But I wonder what it is Williamson thinks isn't equal here? What job is Kocherlakota angling for? And how will pretending to believe something he knows is wrong help him get it?
This, I think, is a strange view of the economics profession, but possibly not so far away from how the average non-economist thinks. If you're an economist, you might be anticipating that Uncle Billy is going to ask you for a forecast tomorrow over Thanksgiving dinner, and you probably won't know what to tell him. Probably his forecast is as good as yours. Some economists are indeed forecasters, but most of us hardly think about the forecasting problem.

Yglesias has a story in his head about how Milton Friedman became "super-famous." Actually, Friedman was super-famous long before he made his 1968 address as President of the American Economic Association, and long long before the importance of that address was widely understood. Further, in terms of research impact, Friedman's influence today has more to do with the Friedman rule, the permanent income hypothesis, and the Monetary History.

Yglesias thinks that the way to get ahead in the economics profession is to make an outlier forecast, make a big noise about it, and hope that you're right. There's certainly a cynical view out there that says this works - Nouriel Roubini comes to mind. I guess Yglesias and I are very different. He puts himself in the shoes of an "ambitious monetary economist" and asks what he'd do. Maybe I'm not ambitious, or too old for it, but I think of everything I do as learning and teaching. I want to learn, and I enjoy passing the knowledge on to other people. Fame is for Yglesias and Lady Gaga.

On the particular questions at hand: First, it is indeed accurate that I think what the Fed has done recently (QE, Twist, forward guidance) matters little for US labor markets. Second, it is not accurate to say that I think a "troubling level of inflation" is "likely." Given current and planned monetary policy actions, and how I think the Fed will behave in the future, I can see an equilibrium path on which the inflation rate is higher than it should be. I can't say anything sensible about "likely." Actually, my hope is not that this comes to pass and people think I am remarkably prescient, but that I have some influence and it doesn't happen. That would be better for everyone, don't you think?

Second, there are plenty of economists for whom Narayana Kocherlakota is a puzzle. He may yet redeem himself, but my current thinking is the following. Nerds are valuable members of society. I think we should give them resources and room to work. But we should think twice about letting a nerd run anything.

Response to Diamond and Saez

In a widely discussed recent paper, Peter Diamond and Emmanuel Saez have suggested that the top tax rate should be very high--about 73 percent.  Tax Notes has a new commentary on their conclusion.

Shameless Advertising

The fourth Canadian edition of my intermediate macro book is now out, though the Pearson web page claims you can't actually buy it yet. I have a physical copy of the thing, so you should be able to get it soon.

One innovation in this edition is a version of the Mortensen-Pissarides search model of unemployment, for undergraduates. This model has been with us for a very long time, and has been responsible for some Nobel prizes, so I thought its introduction to undergads was long overdue.

Some people ask me what the difference is between my Canadian and US books. The straight answer is that some Canadian institutions are different, as is the data, and examples. I usually make a joke out of it, though, and tell people that I have to translate into Canadian.


US English: My friend and I were going to the hockey game. I hadn't put the snow tires on my car, and perhaps I had had too many beers, and I ran into a moose. Boy, am I a loser.

Canadian English: Well, me and my buddy were goin to da hockey game, eh. No snow tires on the car, so she was slidin around a bit, not to mention we had been at the hotel playing shuffleboard and had got plowed. A big moose in the road, eh, and we hit her. What a hoser.

Monday, November 19, 2012

The Future of Federal Reserve Policy

If the rumors are correct, Ben Bernanke is likely to leave his post when his term ends on January 31, 2014. Bernanke's likely successor is Janet Yellen, who is currently Vice-Chairman (official title - not sure why they haven't dropped the "man") of the Federal Reserve Board, and former President of the San Francisco Fed. How does Janet Yellen think? We can get some ideas about that from her most recent speech.

Yellen's speech is primarily a defense of mainstream views on the FOMC, and I find some of those views troubling. Yellen argues that, in contrast to the bad old days of central bank secrecy, we are now in an age of Fed transparency. What the Fed says matters, and she is on board with policies that use Fed statements about its future policy actions - forward guidance - to influence the behavior of private economic agents. With regard to policy goals, Yellen favors a "balanced approach," whereby unemployment matters as much as inflation to Fed decision-makers. But what would that mean for policy decisions? This gives you an idea:
Put differently, the purpose of providing greater clarity about the FOMC's longer-run inflation goal is to anchor inflation expectations more firmly. These more firmly anchored expectations in turn free the Committee's hand to more actively and effectively stabilize short-run fluctuations in economic activity. The Committee can act in this way because the FOMC can tolerate transitory deviations of inflation from its objective in order to more forcefully stabilize employment without needing to worry that the public will mistake these actions as the pursuit of a higher or lower long-run inflation objective.
So given that the Fed is now so transparent and able to speak directly and honestly to the public about its goals for long run inflation, it is free to do almost anything in the short run to influence real economic activity. This seems like an excuse for perpetual postponement of decisions to come to terms with inflation.

For Yellen, the Phillips curve is alive and well:
...the essence of the balanced approach, is that reducing the deviation of one variable from its objective must at times involve allowing the other variable to move away from its objective. In particular, reducing inflation may sometimes require a monetary tightening that will lead to a temporary rise in unemployment. And a policy that reduces unemployment may, at times, result in inflation that could temporarily rise above its target.
We know where those ideas led us.

What would Yellen's "balanced approach" imply for economic policy over the foreseeable future? She's quite specific, particularly in how she evaluates policies:
...I need to rely, as I noted, on a specific macroeconomic model, and, for this purpose, I will employ the FRB/US model, one of the economic models commonly used at the Board.
That the FRB/US model is "commonly used at the Board," and that Yellen takes its policy implications seriously, is shocking. We don't know exactly what is in the FRB/US model, but my best guess from this 1996 publication (and it's pretty poor that the latest documentation on this thing is 16 years old) is that the FRB/US model looks much like the large-scale macroeconometric models that existed in 1970. These are basically elaborate, pseudo-dynamic IS/LM models, which were debunked as policy tools by the mid-1970s.

What does the FRB/US model have to tell us?
The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016...
I should note here that, in addition to being a poor policy tool at any time, FRB/US knows absolutely nothing about quantitative easing, interest on reserves, how the world works when the Fed holds a very large stock of long-maturity Treasury bonds and mortgage-backed securities, what happens when there is a very large stock of reserves outstanding, or how a financial crisis matters. But Janet Yellen wants us to take this model seriously.

With regard to forward guidance, Yellen is all for publishing more detailed Fed forecasts, and being more explicit about the "liftoff" date.
the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.
This is a rather foolish idea. To be well understood, a liftoff rule has to be simple. It has to contain specific numerical goals, in terms of a few economic variables. But that is the liftoff rule's fatal flaw. Sensible central banking policy requires that policymakers look at everything. Unforeseen contingencies arise that would make it obvious that the liftoff rule should be abandoned, with an ensuing loss of credibility for the Fed. As well, the unemployment rate is a poor summary statistic for economic welfare, and the unemployment rate fluctuates for many reasons that the Fed should want to ignore.

To bring us down to earth, this speech by Charles Plosser, President of the Philadelphia Fed, is helpful. Janet Yellen thinks that monetary policy is a powerful tool for influencing real economic activity, but Plosser reminds us that modern economics tells us that it ain't so:
The ability of monetary policy to influence employment has long been recognized as tenuous at best. Indeed, the current workhorse models in macroeconomics rely on some form of wage or price stickiness to generate real effects of monetary policy. As wages and prices adjust, the effects of monetary policy on the real economy dissipate; in other words, the effects are transitory. In addition, the experience of the 1970s clearly demonstrated that attempts to use monetary policy to pursue an employment or unemployment target can lead to extremely poor economic outcomes, jeopardizing both employment and inflation.
People seem to forget this simple point. Outside of multiple-equilibrium models, which are not the "current workhorse models" taken seriously by central bankers, all models of short-run monetary non-neutrality involve transient real effects from monetary policy actions. Further, those real effects become smaller the more sophisticated economic agents become at seeing through central banking policy. Janet Yellen would like you to think that economic agents are so unsophisticated that they can't figure out how to adjust wages and prices in response to an announced future monetary policy, yet so sophisticated that they can predict the effects of the announced future monetary policy - for wages and prices. Further, she wants us to believe that the financial crisis - which happened in 2008 - will have lingering effects that need to be corrected by monetary policy, until 2016!

Plosser goes on in his speech to discuss the risks associated with current accommodative Fed policies. He sees those risks as associated with "moral hazard, future inflation, and loss of institutional credibility." On moral hazard, here's an interesting point:
By engaging in targeted purchases of housing-related securities, the Fed has affected expectations about what monetary policy will do in the future should the housing market take a sharp downturn. Will market participants price housing-related assets with the expectation that the Fed will protect the market from significant losses? Will investors in other markets expect similar treatment and therefore be encouraged to take excessive risk?
Those are useful points. Whether the Fed can move mortgage rates more - if at all - by purchasing mortgage-backed securities than long-maturity Treasuries, the perception is that it can. If firms and consumers take into account that the Fed will bail out their sector in the event of adverse events, this causes problems. Those firms and consumers will take on more risk than is socially desirable, and in the event that the Fed does not act as expected, the damage will be worse.

Here are Plosser's fundamental principles:
The first principle is to be clear and explicit about the goals and objectives of policy. And in so doing, policymakers must acknowledge what policy can and cannot achieve.

The second principle is for policymakers to make a credible commitment to their goals by describing how they will conduct policy in a way that is consistent with those goals. One way to do this is for the central bank to articulate a reaction function or rule that will guide policy decisions.

The third principle is to be clear and transparent in communicating to the public the policy actions that are taken.

The fourth principle is to strive to ensure central bank independence.
It's important to note that those principles aren't so different from Yellen's. That's important. A given statement of principles can lead you in entirely different directions.

In contrast to Yellen's "balanced approach," Plosser favors a "systematic approach," which again does not differ so much from what Yellen has in mind. Plosser likes "robust rules," which includes the class of Taylor rules. The Taylor rule of course takes account of both sides of the dual mandate. I'm not sure exactly what Plosser wants. He could mean a public announcement of a specific policy rule, or he could mean simply clear statements about the reasons for Fed policy decisions, which allow the private sector to deduce what the FOMC is up to. It matters which. The former type of systematic policy seems prone to the risks that Plosser is worried about.

Finally, Plosser appears to have no sympathy for liftoff targets.
In my view, this threshold approach could cause some long-lasting confusion, especially if the thresholds are misinterpreted as the FOMC’s longer-run policy goals. But how do you decide on the right numerical values? Moreover, if numerical thresholds were provided as a way to convey forward guidance for the fed funds rate, a numerical stopping rule would also be needed to convey when QE3 asset purchases could be expected to end. This means we may have multiple thresholds associated with multiple tools. It would be difficult to describe all the various conditions necessary for this multi-faceted strategy and communicate them to the public in a comprehensible and credible fashion. I am concerned that we would create more confusion than clarity.
This is an important point. In the Fed's attempt to be more transparent about the future, it may have only sown confusion. There are now multiple facets to the Fed's forward guidance. If even the most sophisticated financial market participants have figured this out, I would be very surprised.

Sunday, November 18, 2012

The U.S. has a flat tax (in effect)

The Congressional Budget Office has a new study of effective federal marginal tax rates for low and moderate income workers (those below 450 percent of the poverty line).  The study looks at the effects of income taxes, payroll taxes, and SNAP (the program formerly known as Food Stamps).  The bottom line is that the average household now faces an effective marginal tax rate of 30 percent.  In 2014, after various temporary tax provisions have expired and the newly passed health insurance subsidies go into effect, the average effective marginal tax rate will rise to 35 percent.

What struck me is how close these marginal tax rates are to the marginal tax rates at the top of the income distribution.  This means that we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity. 

Sunday, November 11, 2012

An Interview with Eugene Fama Bob Litterman.  (A great piece to assign undergrads when teaching about financial markets and institutions.)

Saturday, November 10, 2012

How To Raise Tax Revenue From The Rich Without Increasing Tax Rates

According to the Tax Policy Center, if we cap itemized deductions at $50,000 and keep tax rates as they are today, we would raise $749 billion in tax revenue over ten years.  Moreover, according to the TPC's distribution table, 96.2 percent of the extra revenue would come from the top quintile, with 79.9 percent from the top one percent.

This may be the germ of a possible deal between President Obama and Speaker Boehner: The speaker agrees to this tax hike if the president agrees to some fundamental reform of the entitlements, such as gradually but significantly raising the age of eligibility for Social Security and Medicare.

Wednesday, November 7, 2012

No Exit

With the President reelected and the House and Senate largely unchanged in composition, the first thought that came to my mind was the classic Sartre play No Exit, with President Obama, Speaker Boehner, and Majority Leader Reid playing the three characters.

Tuesday, November 6, 2012

Lessons for University Administrators: How Not to Deal with the Media

This story is quite funny if you know the people involved.


Today is the day. If you are a reader of this blog, it is a good bet that you are better informed than average on the key economic issues of the day. So get to the polls.

BTW, for two of my three children, this is the first presidential election in which they can vote.

Monday, November 5, 2012

Managing a Liqudity Trap: Monetary and Fiscal Policy

Ivan Werning's paper on liquidity traps is getting attention in the Federal Reserve System. For example, Narayana Kocherlakota cited the paper in a recent speech. Ivan presented a version of the paper at the 2011 St. Louis Fed Policy conference, which was where I saw it.

What's the paper about, and why would the FOMC be interested in it? The basic model Werning uses is a well-worked-over linearized New Keynesian sticky price model, much like what can be found, for example, in Clarida, Gali, and Gertler's survey paper. The key differences here are that Werning works in continuous time with no aggregate uncertainty, which is going to lend tractability to the problem. Further, he's going to solve an optimal policy problem. Perhaps surprisingly, New Keynesians do not often do that. The typical approach is to assume a Taylor rule for monetary policy, and go from there.

Here's the basic model(changing notation a bit):

(1) dx/dt = a[i(t)-r(t)-p(t)]
(2) dp/dt = bp(t)-kx(t)
(3) i(t) >= 0

x is the output gap, i is the nominal interest rate, r is the natural real rate of interest, and p is the inflation rate. a, b, and k are positive parameters. Equation (1) is an inverted Euler equation, equation (2) is a Phillips curve, and (3) imposes the zero lower bound on the nominal interest rate. Given an exogenous path r(t), the central bank determines i(t), and this determines a solution p(t) and x(t). Werning assumes a typical quadratic loss function, where bliss is taken to be a zero output gap and zero inflation.

What is an optimal monetary policy in this environment? If r(t)>=0 for all t, then the answer is easy. Bliss is attainable for all t. An optimal monetary policy is i(t)=r(t), which implies x(t)=p(t)=0.

The interesting question is what happens if r(t)<0 for some t. A simple example is r(t)=r1 for t<=T and r(t)=r2 for t>T, where r1<0 and r2>0. This will imply that bliss is not feasible for all t, and the zero lower bound (3) must bind at some dates. This is intended to look like the type of monetary policy problem that the Fed is currently faced with, as we'll see.

It will make a big difference whether or not the central bank is able to commit to a policy. With no commitment, we know that the central bank chooses i(t)=r(t) from date T on, with x(t)=p(t)=0 for t>T. Then we can work back to find the dynamic path up to time T. Before time T, we are in a liquidity trap, with i(t)=0, and things can be very bad. The output gap and the inflation rate are increasing, but until the time of liftoff there is a negative output gap and deflation. The problem gets worse the larger is T, i.e. the longer the liquidity trap scenario lasts.

Basically, the problem is that the real rate of interest is too high, and there is nothing the central bank can do about it, being constrained by the zero lower bound on the nominal interest rate. Further, the problem is compounded because of deflation during the liquidity trap period.

But, the central bank can do better if it can commit to a policy different from i(t)=r(t) after date T. After date T, the optimal policy with commitment is for the central bank to generate inflation above zero and an output boom (i.e. a positive output gap) after date T, which feeds back to the liquidity trap period, increasing inflation and output before period T.

You can see why people looking for a rationale for the FOMC's recent policy decisions like this paper. If you buy Werning's results, you might write something like the following in an FOMC statement:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
The Fed is under a lot of pressure to "do something" about the weak labor market, and that pressure has been fed (no wordplay intended) by the Fed's confident statements about the efficacy of its policies. Apparently they are looking for serious research that will support what they are doing.

But how seriously do we want to take Werning's paper? Is this a basis for sound monetary policy in the circumstances we find ourselves in? I don't think so.

What's the shock that is driving the policy? As in much recent Keynesian analysis, the reason for being in a prolonged state with a binding zero lower bound on the nominal interest interest rate is that the "natural real rate of interest" is low (negative, in the model). In the underlying model, the natural interest rate is the real rate of interest under flexible prices. What would cause the real rate to be low? The underlying model is a standard neoclassical growth model, in which the natural rate of interest depends (with a constant relative risk aversion utility function) on the discount factor (from preferences) and consumption growth. The natural real rate goes down if the discount factor rises (people care more about the future) or if efficient consumption growth falls. We're supposed to think that the financial crisis was about everyone simultaneously taking a greater interest in the future? At the optimum, this would make them want to save more. Or maybe the financial crisis shock - whatever it was - should have resulted in lower than average consumption growth coming out of the recession? These things are inconsistent with the Keynesian ideas about intervention that I have been hearing.

In terms of the logic of the model, and what we know about the recent recession, the negative natural real rate shock does not make any sense. More fundamentally, this is a model which does not incorporate any financial factors. There is no credit, no banks, and in fact no money. Monetary policy is about setting a market nominal interest rate, and that's it. The model has nothing to say about quantitative easing, why it may or may not work, and how that policy fits into the forward guidance policy that Werning's paper is about. It seems particularly bizarre to be attempting to address monetary policy in the wake of the financial crisis in a model that can exhibit nothing that looks like a financial crisis.

Approximations. There are at least a couple of papers in which it is argued that nonlinearities are important at the zero lower bound, one by Villaverde and coauthors, the other by Braun and coauthors. Sometimes accounting properly for the nonlinearities doesn't just change the results quantitatively, but gives you qualitatively different results. It's a big deal. Werning uses the standard approach of linearizing around zero inflation, and then using a quadratic loss function to approximate welfare loss. I think the latter is suspect as well. As evidence that approximation may be leading Werning astray, look at his results on the effects of allowing for more price flexibility. Monetary policy in this model is all about correcting the price distortions that arise from price stickiness. Thus, one would expect that any monetary policy problems become less foreboding as prices get less sticky. That's not true in Werning's linearized model. In fact, in the economy without commitment, the output gap goes to minus infinity as price stickiness goes away in the limit. Something wrong there, I'm afraid.

Basic New Keynesian problems. I've come to think of the standard New Keynesian framework as a model of fiscal policy. The basic sticky price (or sticky wage) inefficiency comes from relative price distortions. Particularly given the zero lower bound on the nominal interest rate, monetary policy is the wrong vehicle for addressing the problem. Indeed, in Werning's model we can always get an efficient allocation with appropriately-set consumption taxes (see Correia et al., for example). I don't think the New Keynesians have captured what monetary policy is about.

Commitment. The original idea about monetary policy and commitment came from an example in Kydland and Prescott's paper. In that model, in the absence of commitment the central bank is always tempted to use inflation to increase the output gap. The result is a bad equilibrium with high inflation. That model was used to justify commitment to policy rules that would lower long-run inflation with no cost in terms of output. The Werning paper, and related work, is being used to turn that argument on its head. Now, we are supposed to think that committing to high inflation in the future, when the central bank would otherwise choose low inflation, will be a good thing. Whether Kydland and Prescott's monetary policy model was any good (it has its problems), the idea certainly played out well in the policy realm, beginning with the Volcker disinflation.

The forward guidance idea in FOMC policy, backed up by Werning's work (and Woodford's), may prove to be harmless. But maybe not. Some FOMC members, particularly Evans and Kocherlakota, seem bent on writing down explicit numerical criteria for future policy tightening. I hope they run up against resistance.

Friday, November 2, 2012

Dave Altig: Has Fed Behavior Changed?

I never thought I would be reporting regression results in public, let alone having people comment on those results. Life is full of surprises. Dave Altig has written a response to this blog post.

1. Dave points out that, given my crappy model, the current fed funds rate is well within a standard error of a predicted value of 1.1%. I am of course no Taylor rule fanatic, and am willing to blame Taylor for any shortcomings of his rule. Dave could also have pointed out that the relevant policy rate is the interest rate on reserves, which is the overnight nominal rate of return faced by most of the financial institutions in the system. The current fed funds rate is only relevant to the GSEs, who now do most of the lending in the fed funds market. 0.25% is even closer to 1.1% than the current fed funds rate, which makes Altig's case stronger. But hold on. Given past behavior, the FOMC should at least be considering that they will be increasing the policy rate soon. But they are promising to keep it where it is until mid-2015. Seems like a break with previous behavior, don't you think?

2. Here's Dave's dual mandate analogy:
Consider a homeowner with the dual mandate of keeping both the roof of the house and the driveway in good repair. If the roof isn't leaking but there are cracks in the driveway, I think you would expect to see the owner out on the weekend patching the concrete. I don't think you would conclude as a result that he or she had ceased caring as much about the condition of the roof. I do think you would conclude that attention is being focused where the problem exists.
I see it more like this. Suppose the homeowner has a husband. The dual mandate is: Keep the roof in good repair, and make sure the husband behaves well. Keeping the roof in good repair is a task with a well-defined goal, and the homeowner knows how to do it. Getting the husband to behave well is ill-defined, and at best the homeowner knows that she can only move him temporarily toward what she might see as well-behaved. She would be foolish to think otherwise.