My Climate Action Plan

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

A Class Act

A profile of Stanley Fischer.

Good News from the Marketplace

It is the beginning of a new academic year, and I am pleased to report that my favorite textbooks are still selling well.

Capital As A Social Relationship

Home Depot Sells Consumer Goods

1.0 Introduction

The lumber in the above picture may look like an immense accumulation of capital goods, where capital goods are a type of commodity. But, I argue, these commodities should properly be thought of as consumer goods.

2.0 A Keynesian Perspective

John Maynard Keynes, in The General Theory of Employment, Interest and Money, was interested in the sources of aggregate demand. Aggregate demand is demand for commodities, and an increase in this demand leads to an increase in waged labor. So, for Keynes, capital goods are goods whose use would be accompanied by labor being paid wages.

Home Depot and Loewes market to the Do-It-Yourselfer. (I assume building contractors buy in bulk, and purchase most of their stuff elsewhere.) The purchaser of products from these commercial enterprises may intend to construct a deck, erect a shed in their backyard, or remodel a kitchen or bathroom. But the work in completing this products will not be paid a wage. That is, as far as aggregate demand in a capitalist economy goes, the lumber pictured acts like a consumer good, not a capital good.

3.0 A Classical Perspective

Classical economists, such as Adam Smith, distinguished between "productive" and "unproductive" labor. Unproductive labor is that labor which is paid for out of revenue, not out of a capital fund. Unproductive labor does not earn a profit, even tendentially:

"There is one sort of labour which adds to the value of the subject upon which it is bestowed: there is another which has no such effect. The former, as it produces a value, may be called productive; the latter, unproductive labour. Thus the labour of a manufacturer adds, generally, to the value of the materials which he works upon, that of his own maintenance, and of his master's profit. The labour of a menial servant, on the contrary, adds to the value of nothing. Though the manufacturer has his wages advanced to him by his master, he, in reality, costs him no expence, the value of those wages being generally restored, together with a profit, in the improved value of the subject upon which his labour is bestowed. But the maintenance of a menial servant never is restored. A man grows rich by employing a multitude of manufacturers: he grows poor by maintaining a multitude of menial servants." -- Adam Smith, Wealth of Nations, Book II, Chapter 2.

I think of a typical example of unproductive labor as the work of a carpenter hired by a 18th or 19th century British aristocrat to build him a chest with wood that the aristocrat's estate provides. I guess such an estate would support all sorts of servants in the surrounding community. But profits would not be earned on their wages, either by these servants or by their employers.

So, even if the purchaser of the lumber products under consideration here hired some helpers or, perhaps, compensated some assistants with food or drink, these products would still not be capital goods.

4.0 A Neoclassical Perspective

A neoclassical might abstract from all these considerations of institutions, particularly for those that constitute capitalism. And the neoclassical economist might classify as capital those goods that last for many periods, providing a flow of services. (I think you can find this perspective in Leon Walras; he certainly distinguishes between a flow of services and the stock of goods.) At the highest level of abstraction, whether the owner of a capital good is a firm or a household is irrelevant. Furthermore, home improvements will increase the price that a house can fetch if you decide to sell it. If you rent it out, you will acquire what Alfred Marshall described as a quasi-rent from these home improvements.

Note, though, that this perspective abstracts from the distinction between goods, that once produced, are given in quantity at a point in time and, say, an annual cycle of (re)production of commodities needed to sustain a capitalist economy. As can be seen on the first page of the first chapter of David Ricardo's Principles of Political Economy and Taxation, classical economic theory focuses on the latter aspect.

Repression in China

A professor in China brings this story to my attention:

A renowned professor has confirmed online rumours that his peers will decide whether he will be expelled from China's most eminent university after he made a series of remarks in favour of free speech and constitutional governance. 

Economics professor Xia Yeliang of Peking University was told by his department that his fate would be decided by a faculty vote, he told the South China Morning Post on Monday. 

"They told me it's because of all the things I have said and written," Xia said. "They have threatened me before, but this is the first time they will vote on my expulsion."

My correspondent says that the vote will likely take place in September. He also reports that this is not an isolated incidence.  He writes, "Though you may not be aware, there is a quiet crack down currently under way in China with other professors being removed for similar offenses....I can tell you from my personal experience here, most Chinese faculty at PKU and other elite Chinese institutions having been educated at top schools in the US are appalled but are quite fearful to speak out."

Here are some questions to think about: If a professor at the prominent Peking University is fired for exercising free speech, how should professors in the United States respond?  For example, should American scholars refuse to attend conferences and give talks there?  Is there more we can do?

An Interview with Emily Oster

Reverse Repos and Fed Intervention

A key piece of information that I missed in the minutes from the July 30-31 FOMC meeting, is this:

In support of the Committee's longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee's ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives. The staff also identified several key issues that would require consideration in the design of such a facility, including the choice of the appropriate facility interest rate and possible additions to the range of eligible counterparties. In general, meeting participants indicated that they thought such a facility could prove helpful; they asked the staff to undertake further work to examine how it might operate and how it might affect short-term funding markets. A number of them emphasized that their interest in having the staff conduct additional research reflected an ongoing effort to improve the technical execution of policy and did not signal any change in the Committee's views about policy going forward.

So, what does that mean? If you check the state of the Fed's balance sheet, you'll see that the current size of the Fed's balance sheet is about $3.6 trillion. On the liabilities side, the Fed has reserve balances outstanding of about $2.2 trillion, and the Fed's assets include about $1.3 trillion in mortgage-backed securities and about $2 trillion in long-maturity Treasury notes and bonds. The Fed currently holds no Treasury bills. Thus, relative to pre-financial crisis times, the Fed has issued a very large stock of reserves in order to expand its asset portfolio. Further, that portfolio, which used to have a composition that looked roughly like the composition of the federal government debt outstanding, now is tilted heavily toward the long-maturity end of the spectrum, and includes assets which, though passed through public hands, are essentially private. For a very long time, the Fed is likely to have a balance sheet that is very large relative to what it has been historically, and it is not likely to be selling off assets or if it does sell assets, to sell them at a high rate.

Thus, the Fed is likely to be operating under a "floor system" for a long time. Under a floor system, there are excess reserves outstanding in financial markets each night, and the interest rate on reserves plays a key role in determining short-term interest rates. But, given the complications of the law governing payment of interest on reserves, GSEs (Fannie Mae and Freddie Mac) hold reserve accounts but cannot be paid interest on reserve balances by the Fed. Indeed, it seems that most of the current activity on the fed funds market consists of GSEs lending reserves overnight to financial institutions that receive interest on reserve balances. Arbitrage would seem to dictate that fed funds would trade at 0.25%, the interest rate on reserves (IROR), but that's not what happens, as you can see in the chart. There is something inhibiting arbitrage - the GSEs are poor bargainers, fed funds borrowing has implications for deposit insurance premia, for example.

And it's not like the friction in the market is going away. Currently the margin between the IROR and the fed funds rate is about as large as at any time since the Fed started paying interest on reserves.

So, what happens when the Fed reaches the "liftoff point," when it decides that the IROR should go up? Possibly the margin between the IROR and the fed funds rate stays at about 5 to 15 basis points. Maybe that margin increases. We might make some predictions based on what we think is determining the spread, but those predictions could be wrong, which could be embarrassing for the people running the Fed. For most of the financial system, the relevant opportunity cost of overnight funds is the IROR, not the fed funds rate. But, the Fed sticks to the fiction that the policy rate it cares about is the fed funds rate. The key wrinkle is that, officially, the IROR is set by the Board of Governors, not by the FOMC.

Suppose that the Fed, two years from now, announces that it intends to tighten. Suppose further that this tightening takes the form of an increase from 0.25% to 0.50% in the IROR. But what does the FOMC tell us about its target is for the fed funds rate in these circumstances? Currently the IROR is 0.25%, and the FOMC claims the "target" for the fed funds rate is 0-0.25%, which is obviously pretty safe, as 0 and 0.25% bound the possible outcomes. When tightening happens, suppose that the FOMC says its fed funds target is 0.25%-0.50%. Obviously that doesn't look like pre-financial crisis policy - it's not "normal" for the FOMC to be giving a range for the fed funds target. How does the Fed explain that? Alternatively, suppose the FOMC says the fed funds target is 0.30%, but it can't get the fed funds rate to go that high? What then? And what happens at higher levels for the IROR? Given the importance people attach to the policy rate, how is the Fed going to explain itself?

When the Fed first broached the idea of using reverse repurchase agreements (reverse repos) and term deposits, they sold the idea as "introducing reserve-draining tools." Initially, I thought this either represented a misconception about what causes inflation on the part of the Fed. Maybe they didn't understand that this change in the composition of the Fed's liabilities through the use of these tools would have little or no effect on inflation. Or maybe the idea was to reassure people who thought that reserves are money waiting to bust loose and cause a hyperinflation - if you give the reserves another name maybe those people won't be so bothered. Now I'm thinking this might be the brightest idea the Fed has come up with in a long time - at least the reverse repo part.

What's a reverse repo, in this instance? The New York Fed has experimented with small volumes of these transactions, in order to get some practice. As the excerpt above, from the FOMC minutes, indicates, the Fed reverse repo intervention will proceed as follows. The Fed will set a rate at which it will borrow in the overnight repo market, using the government bonds and mortgage-backed securities in its portfolio as collateral. The effect of such a reverse repo transaction is to change the composition of the Fed's liabilities - reserves outstanding are reduced, replaced by a collateralized loan to the Fed from the private sector. You might ask why a loan to the Fed needs to be collateralized. Surely the Fed is going to be good for it. But the Fed already has unsecured liabilties - those are called reserve accounts.

But what could this possibly accomplish? First, take a look at the newly-expanded list of reverse-repo counterparties, from the New York Fed's web site. This list includes the GSEs - Fannie Mae and Freddie Mac. Thus, reverse repos are a roundabout way of paying interest on reserves held by the GSEs, while staying within the bounds of the law. Further, the repo market potentially has a wider list of participants than the fed funds market does, and the fact that the lending is secured (fed funds lending is unsecured) makes the overnight repo rate a potentially better policy rate from the Fed's point of view.

It's possible then, that engaging in reverse repos allows the Fed to tighten up its control over short-term interest rates, while giving the public a better read on the effects of Fed's policies, and on Fed intentions. But, presumably what will happen post-liftoff is that the balances in GSE reserve accounts will disappear overnight into reverse repos with the Fed. There will then essentially be no activity on the fed funds market, and the fed funds rate will become meaningless. Maybe the fed has plans to supply data on overnight repo rates. Maybe such data exist (if so, please let me know). Of course, if the Fed reverse repos enough of its portfolio, it can reduce reserves to pre-crisis levels, which would presumably produce an active fed funds market. Maybe that's what the Fed wants. I know next to nothing about the practicalities of financial market trading, but wouldn't rolling over more than $2 trillion in reverse repos every day be a costly endeavor?

In any case, I think there is more to the reverse repo idea than might meet the eye. I think the Fed should tell us more about it.