Wednesday, September 2, 2015

More Historical Fiction

Reading Paul Krugman's recent blog post reminded me of this earlier post of his, which was much in the same spirit. Krugman wants to argue that the Old Keynesians - James Tobin in particular - had it right. This is Krugman's conclusion:
So how does the decade of the 1980s end up being perceived as a defeat for Keynesians? To see it that way you have to systematically misrepresent both what happened to the economy and what people like Tobin were saying at the time. In reality, Tobinesque economics looks very good in the light of events.

So what exactly was "Tobinesque economics?" Krugman points us to Tobin's 1980 Brookings paper. Early in that paper, Tobin tells us about his view of the inflationary process - how we got where we did in the 1970s:
...when the authorities have chosen policies supportive of continued inflationary growth of MV, they have not done so from ignorance of arithmetic, indifference to inflation, or, in my opinion, political pressure. They have done so, rightly or wrongly, mainly because of the perceived consequences of nonaccommodation on the real performance of the economy. The inertia of inflation in the face of nonaccommodative policies is the big issue.
Tobin's view was that there was substantial inertia in inflation, and that it was very costly to bring it down - a widely-held view at the time. But there were other ideas at the time as I discussed here. Tom Sargent, in particular, was emphasizing the policy relevance of modern macroeconomics for disinflation. According to Sargent, central bank commitment was important, and we could reduce the inertia in inflation if we had a credible commitment from the central bank to reduce it.

The picture that Krugman shows us from Tobin's paper is this one:
Krugman says that kinda sorta looks like what actually happened. I suppose a cat looks like a horse, because it has four legs. If you read Tobin's paper, he's using that figure to illustrate how bad he thinks disinflation through monetary measures could be. Look at it! After 7 years of monetary disinflation, the unemployment rate peaks at more than 10%, and it takes more than 12 years to get back to what Tobin thinks is the natural rate of unemployment, 6%. Tobin is using what he thinks is a conventional macroeconometric model. It's got adaptive expectations and a Phillips curve with what people then would have called a "high sacrifice ratio." You have to suffer a lot of unemployment to get a small reduction in inflation. Of course, Tobin's simulation looks nothing like what happened.

In Tobin's paper, after he shows us his simulation, he goes through some arguments about other factors that may not be in his model. Then, his punchline is this:
For these reasons,I think it would be recklessly imprudent to lock the economy into a monetary disinflation without auxiliary incomes policies. The purpose of these policies would be to engineer directly a deceleration of wages and prices consistent with the gradual slowdown of dollar spending. Macroeconomic policy and wage-price guideposts or controls would be concerted. Instead of issuing a monetary threat to everyone in general and to no one in particular, the government would seek the consent and cooperation of organized labor and business in a five-to-ten-year program to eliminate inflation at minimal cost in employment, production, and investment. The most promising incomes policy is to use tax-based incentives for complying with a sequence of gradually declining guideposts.

Tobin's telling us that it would be silly to disinflate through monetary policy alone. We need wage and price controls! So, how the 1980s was a victory for "Tobinesque economics," I have no idea. The Fed did what Tobin said they should not do, inflation did not have the inertia Tobin said it would have, and wage and price controls were thrown out with the policy trash. Further, the language of modern central banking is all about inflation targeting, commitment, and looking into the future. Tobinesque economics can only look good if you're not looking.

Tuesday, September 1, 2015

Intuitive Neo-Fisherism

John Cochrane's blog post, Whither Inflation, is excellent reading. Basically, John takes a mainstream New Keynesian model and shows how it has Neo-Fisherian characteristics - if the central bank raises the nominal interest rate, inflation increases. Noah Smith seems to find this interesting, but he's got some problems with it. I'm going to attempt to answer his questions.

First, Noah says:
What about the Volcker disinflation, when Fed interest rate hikes were followed by disinflation?
Volcker was Fed Chair from August 1979 to August 1987. During that period the time series for the fed funds rate and the pce (year-over-year) headline inflation rate looks like this:
The broad story in that picture is that Volcker began his 8-year term with high nominal interest rates and high inflation, and ended it with much lower nominal interest rates and much lower inflation. The scatter plot, with points joined in temporal sequence, looks like this:
In that chart, inflation and the fed funds rate more often than not are moving in the same direction. Volcker didn't do Cochrane's experiment in reverse - the fed funds rate comes down gradually during the disinflationary period - but I don't see an inconsistency between what we see in the above 2 charts and what is coming out of Cochrane's experiments with the NK model.

Second, Noah says:
...are we sure we want to think about interest rate policy as a series of interest rate pegs, each of which people believe will last forever?
Typically, in analyzing monetary policy, we want to study the operating characteristics of particular policy rules. That is, we specify the feasible set of actions a central bank can take under particular contingencies, specify a policy rule as a mapping from states of the world to actions by the central bank, and then ask how the economy functions under that rule. Cochrane's clearly interested in that, but he wants to show you a simple policy experiment so you can understand what's going on: Suppose the central bank increases the policy rate at a given point in time, permanently. What happens? This can help build your intuition so that you can handle the more difficult exercise of working out the optimal policy rule.

Finally, Noah says:
But the last reason we should be a little wary of the Neo-Fisherian idea is that it goes against our basic partial-equilibrium Marshallian idea of supply and demand.
For Noah, what's going on in the NK model is not intuitive. What does he mean? We can start by consulting an online dictionary:
Intuition: the ability to understand something immediately, without the need for conscious reasoning.
That fits closely with how an economist thinks about intuition. Over time, we accumulate knowledge of economic theory - models, basically - by working with them. For a lay person, partial equilibrium Marshallian supply and demand is not intuition. He or she has no clue about supply and demand. Sometimes Marshallian intuition works - for economists. I see a piece of economics that is unfamiliar, but I can recognize elements of supply and demand in it, and then I get the idea. But Cochrane is dealing with an issue that is dynamic, it's general equilibrium, it involves how the economic agents in the model think about the future. Why would I expect that static Marshallian intution would work? And if it doesn't seem to work, why should that make me "wary" of the idea? Looks like I have the wrong intuition, and I have some learning to do.

Here's some intuition. See if this works for you. Roughly, we can separate the short-term nominal interest rate into three components at any point in time:

R = F + L + r,

where R is the observed nominal interest rate, F is the Fisher effect (or inflation premium), L is the liquidity effect - the effect of monetary policy on the real interest rate - and r is the long-run real interest rate, which is determined by non-monetary factors (we'll neglect Tobin effects and such). Next, consider Cochrane's experiment. There is a one-time, permanent increase in the nominal interest rate. In some models we would have to worry about what actual monetary policy actions (asset swaps or settings for administered interest rates) would be required to support this market interest rate, but in the NK model Cochrane works with, that's not an issue. The central bank can set the nominal interest rate, and that will induce a dynamic path for F and L. I think most economists would have intuition for the long-run effect. In the long run, the increase in L induced by the increase in R is zero, and F increases one-for-one with R. In the long run, the Fisher effect dominates.

In the short run, L moves in the same direction as R. That's the non-neutrality of money in the sticky price NK model. Consumption declines on impact, and then grows over time, at a declining rate. If you have taken a PhD macro course (or even some undergrad macro courses ) you should have some modern macro intuition. That intuition tells you how consumption smoothing relates to asset pricing. In this instance, with the representative consumer facing growing consumption, the real interest rate will be higher than it would otherwise be (the liquidity effect) because the representative consumer would like to smooth consumption over time (by borrowing against the future), but cannot. But consumption growth is falling over time, so the liquidity effect (the increase in L) declines over time. This implies that, with R constant, the Fisher effect (the increase in F) must rise over time.

So, we have the liquidity effect - the increase in L - initially positive and converging over time to zero, and the Fisher effect - the increase in F - rising over time and converging to the increase in R. But what is the Fisher effect on impact? I think the intuition of some people would tell them this impact effect should be negative. That intuition might come from thinking about Phillips curves. Maybe this Phillips curve intuition exists because people are ignoring the empirical evidence. Maybe people have some familiarity with reduced form NK models. Typically, in those formulations - essentially what Cochrane has written down - Cochrane's equation (2) is a "Phillips curve." So, you could forgive people for using their Phillips curve intuition in an attempt to understand what is going on the standard NK model. But, as it turns out, their intuition doesn't help them in this case.

It's not clear why anyone would expect the impact effect of the increase in R on F to be negative, if he or she understands what is going on in the model. And, indeed, Cochrane shows us an example in which the impact effect on F is positive, though there are other equilibria in which the impact on F is negative - in those other equilibria, the liquidity effect has to initially be that much stronger.

What would happen in models where we actually include money? An example in which there are short-run nonneutralities - liquidity effects - is the class of segmented markets models. In these models, the first round effects of monetary policy affect only a segment of the population - those closely-connected to financial markets. Then, an open market operation affects people asymmetrically. One very simple model of this type is Alvarez, Lucas, and Weber (AER, 2000). In that model, there are two types of people, traders and non-traders. When an open market purchase by the central bank occurs, the traders receive a cash injection, which is a temporary increase in their wealth, so traders then consume more. This induces a liquidity effect, as it is the consumption of traders that determines the price of nominal bonds in this economy. Consumption is temporarily high for traders, so L is temporarily low, and this reduces R.

If we do Cochrane's policy experiment in Alvarez/Lucas/Weber (ALW), we can find an equilibrium in which the impulse responses look like Cochrane's. In response to a permanent increase in the nominal interest rate, the inflation rate increases over time, and ultimately the increase in F is equal to the increase in R. But in the ALW model, there is a path for money growth that is needed to support the permanent increase in the nominal interest rate. In ALW, the quantity theory of money holds in a very simply way - total output is constant, and the price level is proportional to the money stock. So, ALW tells us that, to support a permanently higher nominal interest rate, what is required is higher and rising money growth.

So, that's reassuring. Cochrane's results hold in a widely-used macro model, and they hold in other monetary models with liquidity effects. So, for people who know how those models work, the results should be intuitive.

Monday, August 24, 2015

Summers at Summer's End

Two comments on Larry Summers's piece from yesterday:

1. Summers says:
I doubt that, if rates were now 4 per cent, there would be much pressure to raise them.
I think what Summers means is that, if everything else looked the same, and if the interest rate on reserves were at 4%, then people might be drawing different policy conclusions. But of course, that's an odd counterfactual to be thinking about, as it's hard to imagine how everything else would look the same. So, consider the following counterfactual. The last time the fed funds rate was at 4% was in January of 2008. So, suppose at that time that the Fed had not reduced the fed funds rate target, but had maintained it at 4%. Suppose all other aspects of policy were the same - the interventions during the financial crisis, the Fed's balance sheet expansion etc., and that the Fed commenced paying interest on reserves at 4% in fall 2008, and maintained that until now. What would have been different? A long history of research in monetary economics - theory and empirical work - tells us that the recession would have likely been more painful and perhaps longer. But as of today, six years after the recession actually ended, on the real side of the economy things would not have looked much different. But with nominal interest rates at 4%, standard Irving Fisher economics - which is built into every monetary model that I know about - tells us that the inflation rate would be 4% higher. So in that sense, Summers is absolutely right. If rates were now at 4 per cent, and given the Fed's 2% inflation target, we would be missing the inflation target on the high side, and the pressures would be quite different.

2. Toward the end of his piece, Summers says:
Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. - See more at: http://larrysummers.com/2015/08/23/the-fed-looks-set-to-make-a-dangerous-mistake/#sthash.iJYo0wau.dpuf
As I pointed out to a commenter on this previous post, savings gluts and secular stagnation are actually quite different. Summers and Bernanke are thinking in terms of a simple model of the credit market. There is a demand for loans determined in part by the demand for investment, with demand depending negatively on the real interest rate. There is a supply of loans that depends on savings behavior, and loan supply depends positively on the real interest rate. Secular stagnation is low demand which makes the real interest rate low, savings glut is high supply that makes the real interest rate low. Entirely different. Note further, that the measurements reported here seem to put the kabosh on the secular stagnation idea.

Paul Krugman agrees with Summers:
I’m with Larry here: this attitude has the makings of a big mistake. Think Japan 2000; think ECB 2011; think Sweden. Don’t do it.
I think what he means is that Japan in 2000, the ECB in 2011, and Sweden (presumably 2011 also), did the wrong thing, saw the errors of their ways, and went back to zero or lower nominal interest rates. Currently, the overnight interest rate in Japan is 0.1%, the ECB deposit facility rate (the counterpart of the interest rate on reserves) is -0.2%, and the overnight interest rate in Sweden is -0.35%. It seems that Krugman approves of that, but the Bank of Japan, the ECB, and the Riksbank have certainly not been successful in achieving their goals. All of these central banks would like 2% inflation, but inflation in Japan is currently 0.4%, inflation in the Euro area is at 0.2%, and inflation in Sweden is at -0.1%. I'm sure Krugman (and Summers too) is thinking that a long period with very low nominal interest rates makes the inflation rate go up, but the last 20 years in Japan and this recent experience in other countries might make him want to think twice.

Sunday, August 23, 2015

Gomme, Ravikumar, and Rupert on the Rate of Return to Capital

Paul Gomme, Ravikumar, and Peter Rupert would like to respond to comments on their 2011 RED paper, and St. Louis Fed Economic Synopsis, in blog posts by Noah Smith and Robert Waldmann. Here, I've put in my own words the results of some email conversations with them.

When investment expenditure takes place, the economic measure of the cost of investment is resources foregone, which we measure in the national income accounts as the real value (units of real GDP) of investment expenditure. Then, for example, if there is one unit of investment expenditure, in units of real GDP today, and that unit of investment expenditure becomes usable capital in the future and yields to the owner of the capital a payoff of r in units of real GDP, net of depreciation, we would say that the capital has a rate of return r and, if we've measured depreciation properly, we know how many units of capital we have left, in units of real GDP.

So, note that in defining the rate of return on capital, we don't have to think about market interest rates, discounting, or how the investment is financed. Those things are relevant for the investment decision, but not for calculating the rate of return on investment, or for determining the economic cost of investment. This is just accounting - not corporate finance.

In the 2011 paper by Gomme et al., the idea is to measure average r at a point in time. In this chart, from their Economic Synopsis, they show us before-tax and after tax rates of return on all capital, and on business capital:
For those calcuations, Gomme et al. work with the measurements the Bureau of Economic Analysis (our national income accountants) provide. In particular, from the flow national income accounts - income side - they take the flow income that can be attributed as factor payments to the owners of the relevant component of the capital stock, then divide by the relevant capital stock, which is also measured by the BEA. So, that is an average rate of return on capital, net of depreciation, measured as a ratio of income (in units of real GDP) to capital (in units of real GDP).

Note that the Gomme et al. measure is net of depreciation. On page 2-9 of the BEA manual the BEA shows us how they calculate gross domestic income. The profits measure is net of depreciation, and then the BEA adds depreciation back in to get gross domestic income (that's what "gross" means - GDP and GDI do not net out depreciation). So the Gomme et al. rate of return is not too high because they fail to net out depreciation.

Another complaint (from Waldmann) relates to the fact that, for investment decisions, what we care about is capital's marginal rate of return, not average. Of course, if the production function is Cobb-Douglass, then the marginal product of capital is proportional to the average product of capital, so in that case it does not make any difference whether we're looking at average or marginal. By continuity, anything close to Cobb-Douglass will work as well. In any case, it's hard to imagine why the average return on existing capital would increase as observed without a commensurate increase in the marginal product of capital, or why investment would have increased as it did post-recession unless the marginal product of capital had increased in line with average product.

The main thrust of the Economic Synopsis related to "secular stagnation." Larry Summers holds the view that investment expenditures are stagnant because the rate of return on capital is low. Gomme et al. say that no, as measured, the rate of return on capital is not low and, by the way, investment does not appear to be stagnating. "Stagnation" seems an odd characterization given the data, as Gomme et al. point out. That's not saying that the behavior of of investment is not somehow puzzling, i.e. that we don't have to work hard to explain how it is behaving. Just to repeat, here are Figures 3 and 4 from Gomme et al., which certainly don't look like stagnation in investment spending:

In his post, Noah Smith does in fact express puzzlement that the rates of return in the first chart above are so high currently, while the corporate bond rate is so low. That is, he thinks that investment should be even higher than it is, given those observations, which leads him to conclude:
I suspect that either 1) Gomme et al. have measured the return on capital incorrectly, or 2) basic corporate finance theory doesn't capture what's going on in our economy, or 3) both.
If the recent behavior of investment puzzles Noah, he should also be puzzled as to why there was an investment boom in the 1990s when corporate bonds rates were so high. And if he's worried about the measurement that Gomme et al. report, he should take that up with the Bureau of Economic Analysis.

Friday, August 21, 2015

Krugman Comes Around

I opened up my New York Times (literally - I still retrieve the physical NYT from the curb, the bushes, the mud puddle) and was pleased as could be to see that Paul Krugman has finally picked up on what I think is a key idea for understanding macroeconomic behavior post-financial crisis. The essence of the idea is:
When the housing bubble burst, all that AAA-rated paper turned into sludge. So investors scurried back into the haven provided by the debt of the United States and a few other major economies. In the process they drove interest rates on that debt way down.
I could also add that sovereign debt problems in the world contribute to shortages of safe assets, as do new banking regulations, for example the liquidity coverage ratio requirements in Basel III.

I've written extensively about safe asset shortages, particularly their consequences for monetary policy. You can find that stuff in my blog archive, working papers, and forthcoming and published work, for example:

Scarcity of Safe Assets, Inflation, and the Policy Trap, with David Andolfatto
Scarce Collateral, the Term Premium, and Quantitative Easing
Central Bank Purchases of Private Assets

A safe asset shortage is actually a property of Krugman's own model, though I'm not sure he ever picked up on this. Krugman used his work with Gauti Eggertsson to back up with formal analysis the kinds of things he was saying in blog posts. So, the Eggertsson/Krugman paper focused on a situation in which the nominal interest rate is at the zero lower bound because of tight borrowing constraints, in which case you can get some welfare benefits from increasing government spending. What fixes the problem in his model, in a clean way, is actually an increase in government debt, which serves to relax borrowing constraints and to raise the real interest rate. That is, because of the safe asset shortage the real interest rate is inefficiently low, and fixing the problem raises the real rate.

Recognizing the existence of a safe asset shortage can help explain a lot of things. For example, you might think that inflation is puzzlingly high. In most models we work with, a long period of zero nominal interest rates would produce a deflation. But, at the zero lower bound on the nominal interest rate, the tighter are the liquidity constraints that bind because of the safe asset shortage, the higher will be the inflation rate. To see how that works, see the papers I listed above.

Safe asset shortages also have a bearing on how we might think about "secular stagnation," which Larry Summers has been talking about. Eggertsson and Mehrotra's "A Model of Secular Stagnation," is, like Eggertsson/Krugman, actually a model of a safe asset shortage. E-M write down a fairly conventional overlapping generations model with some borrowing and lending and a binding borrowing constraint. This economy wants an outside asset badly - both to permit intergenerational trade and to bypass the borrowing constraint. But that's not something the authors consider.

In any case, there's hope for Paul Krugman. Maybe soon he'll be a committed neo-Fisherite.

Wednesday, August 19, 2015

Tuesday, August 18, 2015

Some Real Interest Rates Are Low, But Some Others Are Not

Observed real interest rates on U.S. government debt are, by any measure, low. For example, here's the 30-day T-bill rate minus the inflation rate:
And this is the yield on 10-year TIPS:
John Cochrane has a post which references a recent Council of Economic Advisors survey on low real interest rates, which contains a useful summary of what is known about this. As well, Ben Bernanke discussed this phenomenon in his blog, and Bernanke and Larry Summers discussed what this might have to do with so-called "secular stagnation."

Some of this discussion seems to work from the assumption that the rate of return on government debt and the rate of return on capital are the same thing. For example, Bernanke shows a chart of the 5-year TIPS yield and then, in addressing what this might have to do with secular stagnation, makes this statement:
First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period.
So, Bernanke appears to think that low real Treasury yields are associated with low rates of return on capital. As well, Summers's arguments concerning secular stagnation seem to rely on a loanable funds theory of the real interest rate - the demand for investment (i.e. the demand for loanable funds) is low, which makes the real interest rate low. It seems clear that the real interest rate that Summers has in mind is the real rate of return on capital.

John Cochrane also discusses an idea related to low real bond yields, which he attributes to Summers:
One hypothesis that I learned from Larry Summers is that today's production function needs a lot less physical capital to produce the same productivity. A 1930s steel mill is a lot of accumulated savings. Facebook has nothing but a basketball court sized building full of 20-somethings coding while wearing headphones, and a really cool food court. The company is worth billions but it took comparatively little accumulated savings to start it up. If technology moves so that human, rather than physical capital is the heart of the K in F(K,L), productivity growth may determine interest rates in the long run, but there are lower interest rates on the transition path.
Again, this is an explanation for why the real rate of return on capital might be low.

But what if we actually go out and measure rates of return on capital? This work by Paul Gomme, B. Ravikumar, and Peter Rupert, reported in the St. Louis Fed's Economic Synopses, does that exercise. Here's their Figure 2:
So, by any of those measures, the rate of return on capital (this is average, not marginal) is as high or higher than it was before the recession. Conclusion: According to conventional measures, the rate of return on government debt is low, but the rate of return on capital is not.

In many standard economic models, there is no difference between the real interest rate faced by consumers and the marginal product of capital. But that will not be the case in models in which, for example, government debt plays some special role, for example as collateral, and therefore bears a liquidity premium. There is work by Kiyotaki and Moore that studies this type of effect, and I've worked on models in which government debt can bear liquidity premia, for example in this paper with David Andolfatto, and this paper of mine on QE. The ideas in those papers are related to Caballero's ideas on "safe asset shortages."

I think that the measurements in the work by Gomme/Ravkumar/Rupert are key to thinking about issues related to low real interest rates, so this deserves attention.