Satan and the G-16: A Sacrilegious Rant and a (Modest?) Proposal

It appears now that the G-20 intend to make their compromise with the devil. That’s pretty much inevitable, since the devil is one of them. When I say the devil, I am of course referring to the nation that invented the automobile (hint, President Obama: not the US). It also happens to be the nation that invented chemical warfare and the Final Solution. (What kind of a rant would this be if I respected Godwin’s Law?) I curse Comrade Gorbachev for countenancing the demolition of the Berlin wall. It is clear now that, despite having repented, with apparent sincerity, of its earlier sins, Germany is fundamentally evil. And right now I’m imagining Angela Merkel with horns and a pitchfork.

The devil, as I said, is one of them. It might be more accurate to say that the devil is four of them. Euroland, which is counted independently as one of the G-20, is entirely under the sway of the forces of darkness. France and Italy sold their souls long ago and have little chance of redemption. If I had my way, the remainder – call them the G-16 – would redeem their own souls and let continental Europe perish in fire and brimstone.

I would have the G-16 agree on a set of fixed exchange rates against the Euro. (And if China wants a cheap Yuan, I say, so be it. Let’s see how long it takes Premier Wen to figure out that he doesn’t have luxury of mistrusting US assets.) With interest rates at or near zero, the alternative to a fixed exchange rate regime among the G-16 is a regime of pointless competitive devaluation – much like the mercantilism of olden time. Nobody wins that way. Fixed exchange rates are the way to go, and while we’re at it, we can solve the “N-th country problem” by making Euroland the N-th country. Making Euroland the N-th country on more than generous terms of exchange. Indeed, let us say more than more than generous terms.

Yes, if the Europeans want a hard currency, let them have it. Let them have a currency so hard it will break their skulls. It’s a policy once known as “beggar thy neighbor,” and our neighbors between the Mediterranean and the North Sea are begging to be beggared.

But Keynes did die for everyone’s sins, and I suggest we hold out an offer of redemption to any European country that will repent and accept John Maynard as its personal savior. Set a (temptingly ungenerous) exchange rate against the Euro for each of the individual European currencies, and agree to collectively continue defending that exchange rate for, say, 7 years, if the sinner will stop worshiping the Golden Calf.

I remember with fondness the French Franc and the Italian Lira. I remember the picturesque bills. I remember (indeed, I have preserved some relics) the varied and beautiful coins. I remember, as recently as 2002, going to a grocery store in Spain, wondering why the prices looked so high, and realizing that the prices were in pesetas rather than euro cents. I remember. I remember the Garden.

Lost. It is lost. Shall not we assert the faith that it may be regained?

Even Worse than Paul Krugman Imagines?

Reading Karl Smith’s comment on my previous entry, I started to think about the implications of rational expectations in the context of potential deflation. I’m thinking of a model like “Rational Expectations meets Calvo Pricing meets the Keynesian Multiplier meets the Mundell-Tobin Effect.” It goes something like this:

Start out imagining that prices are stable. Then introduce the expectation of an output gap (like the output gap that the CBO expects). An output gap implies that actual (sticky) prices are above equilibrium (flexible) prices. As more cohorts adjust their prices toward equilibrium levels, actual prices will fall. If you expect actual prices to fall, you have a disincentive from investing, because you have to pay today’s sticky prices for your capital goods, but you will only be able to sell your product at tomorrow’s (lower) flexible prices. So investment will be lower than it otherwise would be. And because of the multiplier effect, consumption will be lower than it otherwise would be.

So overall demand will be significantly lower than it otherwise would be. Therefore equilibrium prices will be even lower. Therefore we have to anticipate an even greater rate of deflation. Therefore we have to anticipate an even larger disincentive from investment, which implies an even lower level of investment, which implies an even lower level of consumption, which implies even less demand, which implies even lower equilibrium prices, which implies even faster deflation, which implies an even greater disincentive from investment, and so on. And all the “so on” is something that, if we have rational expectations, we will immediately anticipate.

Without actually writing down a model (which I’m not going to do), I can’t say for sure whether there will be an equilibrium, but if there is one, I’m pretty sure it is really, really, really ugly. My intuition says that, in an economy without a public sector or a foreign sector, there will normally be no equilibrium, and all production will simply cease.

If you throw in a government, then you can presumably have an equilibrium even without any private investment, so the economy won’t grind completely to a halt, but it will sure look pretty awful. Although I wonder: if the process of selling requires holding inventories, then it requires some investment. (Technically, it requires a level of investment that may not be positive but that can still be reduced if there are incentives to reduce it.) If the disincentive to investment rises without bound, then there will be no incentive to hold inventories, and production will still cease, even with public sector demand.

I would guess that someone has already done this sort of model more rigorously, and I don’t know what the conclusions were. But I would guess that they were quite unpleasant.

What happens to the inflation when the output gap is zero?

In a blog post a couple of weeks ago, Paul Krugman presents a scatterplot of the change in the inflation rate (y) as a function of the output gap (x), with the following regression line:

y = 0.5228 x - 0.4739

I'm puzzled as to why he includes a constant term in this regression. (Maybe he was using graphics software that won't do a no-constant fit?) If you take the regression line at face value, it means that the inflation rate is predicted to fall by almost half a percentage point each year when the output gap is zero. It also means that the economy must run nearly a full percentage point above potential in order to prevent the inflation rate from falling. That doesn't make any sense.

The sensible way to do the fit is to constrain the constant term to zero (which makes the math a lot easier if you're doing the fit by hand, but some software insists on doing things the hard way even when it doesn't make sense).

It turns out it doesn't make much difference in the conclusion: the slope of the line is still approximately 0.5, and in the relevant region (with output gap above 6 percent) the intercept is not of much relative consequence. But I would have found the whole thing more convincing if the plot had displayed a reasonable regression line to begin with. When you show a line that implies that the inflation rate declines even under normal conditions, it's not that impressive when you conclude that it will decline too much under unusual conditions.


UPDATE: Paul Krugman responds. His main point is that the IMF's definition of potential output doesn't require that the inflation rate be constant when actual output equals potential (i.e. when the gap is zero). So now I understand that the IMF's construction doesn't have that property. But I'm having trouble understanding the theoretical meaning of that construction. Doesn't the IMF's filter amount to an empirical way of making a guess at a concept that still should have that property theoretically?

I suppose I can understand that you don't want to force a constraint on the guess after it has already been made. (See Prof. Kurgman's point about circular reasoning.) But the chart still doesn't look right to me. Since the CBO's potential output concept does imply stable inflation at the zero point, how can you plug the CBO's gap forecast into the IMF's gap equation and get a meaningful result? (Well, OK, the result is meaningful for our purposes, because the fitted line passes close enough to the origin to give approximately the right result, to at least the level of precision necessary for the original point about deflation risk, and because the two methods for estimating the output gap lead to reasonably similar results for the US historically -- again, given that we don't really need much precision.) Under the circumstances, since we're mixing two different concepts anyhow, it's an arbitrary decision whether to impose the zero constraint, and I think the chart would look prettier if the line went through the origin. (I suppose that's a matter of personal taste.)

I also don't like the idea of using a filter that needs to know the whole series before it can do the smoothing (which IIRC is the case with the Hodrick-Prescott filter used by the IMF). It seems to me there is still a bit of circular reasoning involved, or at least, that you're constructing a fake data series that can't necessarily be expected to have the same properties in real time as it does with benefit of hindsight. I suppose if I were doing this, and if I wanted to keep the T's crossed &c., I would avoid the CBO's gap forecasts entirely and just use raw GDP. Then I could determine historical potential output by putting the data through a one-directional filter which I could then apply to the CBO's forecasts. But it's still unclear whether the fitted line should be constrained to have a zero intercept. It seems to me, the only reason to interpret the fitted relationship as a structural one is that we have a theory wherein such a relationship exists. And in the theory, as I understand it, the line does have to pass through the origin.

Pork is Essential for Good Health

Yeah, it's not just "good for you"

Here's how things stand: the stimulus bill is way too small, it's floundering in the Senate, and we stand possibly on the edge of a deflationary abyss.

Solution: find, say, the 5 most wavering Republican senators and offer them each $100 billion worth of pork. (2 isn't enough because 1 or 2 might defect and some Democrats might defect also -- although it's kind of hard to imagine a Democrat joining a Republican filibuster under the circumstances),

That solves both problems: the stimulus bill will be big enough (if perhaps less evenly distributed in its impact than one might hope -- but multiplier effects will spread out over space), and it will survive a cloture vote.

Problem solved. No depression. Happy days are here again.

Of course, it ain't gonna happen, so I still like long Treasuries.

Time for a Price Level Target, and a Damned High One!

If you believe in a NAIRU, or anything remotely like a NAIRU or an accelerationist Phillips curve, the prognosis for prices is looking increasingly ugly. For those who believe confidently in such a Phillips curve and accept historical estimates of the parameters, deflation is now a certainty, and severe deflation is a strong possibility. Even among those who don't believe in a Phillips curve, deflation should be considered at least a serious possibility, and the danger of a deflationary spiral should not be ignored.

It's time to stop worrying about policies that "may cause inflation in the long run" and to embrace such policies specifically because they may -- and hopefully will -- cause inflation. Markets are desperately in need of "shock and awe," and the Fed can provide that shock by setting a long-run price level target much higher than anything previously considered reasonable. I would recommend a target representing an average rate of inflation of 6% over the next 5 years and 5% over the subsequent 5 years. The Fed could also set longer range price targets that represent lower inflation rates thereafter (assuming the earlier targets are achieved): say 4% from 2019 to 2024 and 3% thereafter. (Experience has now made clear that 2% was too low -- too close to zero -- for a long-run target during normal times.)

The point of using price level targets is that, the worse things get, the more inflation the Fed will promise for the future. And the more inflation it promises for the future (assuming markets believe those promises), the lower will be longer term real interest rates at any give level of nominal rates. If the Fed can induce such an expectation, it will then be able to provide a more dramatic stimulus at just the right time by setting real rates that are significantly negative. (If necessary, the Fed can set longer-term real rates by buying sufficient quantities of longer term securities, or by having the Treasury retire such securities.)

Again, "dangerous policies" that "may be highly inflationary in the long run" are just the policies that our leaders should be embracing at this moment, precisely because those policies may -- and hopefully will -- be inflationary in the long run. So if the Fed buys lower quality securities on which it risks having to take losses, let it say, "It is our great hope, in the event that economic weakness prevents the price level from approaching our target, that we may have the opportunity to take large losses on these securities and to make up those losses by creating more base money. Only by taking such losses can we implement the 'helicopter drop' that may be necessary." And if the Fed should expand the monetary base dramatically in the hope of encouraging bank lending, and detractors should argue that this policy is reckless because the Fed will need to withdraw that money later to prevent inflation and may not be willing to do so, let the Fed respond, "It is not our intention to withdraw that money later, unless the price level should threaten to rise significantly above our target. Should the inflation rate over the next few years prove too low, it is our intention to resist steadfastly any pressure to avoid the very high inflation rates that will then be necessary to achieve our target."

Let's be quite clear about the arithmetic here. If the average inflation rate over the next 5 years should be zero -- which in the absence of policies such as those I advocate above, would be a very reasonable forecast, and in the presence of such policies would still not be an unreasonable one -- the Fed will of course miss its 5-year target by a dramatic margin. But the 10-year target will remain. The arithmetic would then require an 11% inflation rate over those next 5 years, in order to meet that target. That is the promise that the Fed must make for the future in order to achieve the vital goal of producing very low real interest rates today. And as for those who say that 11% is too much, even if they be 99% of the population, to my mind they are all traitors, enemies of the United States and of the world, and if I had my way, they would all be hanged!

Their intentions are good, perhaps, but we must not let such foolishness lead us down the road to Hell.

Irrational Policy

Following up on my last post concerning Nick Rowe's application of rational expectations to public policy: it occurs to me that the way to look for evidence of policy effectiveness is to find cases where policy was, in retrospect, irrational. In other words, look for cases where policymakers were trying to achieve objectives that, in the light of later economic thought, were bad ideas in the first place. Then look at whether they succeeded in achieving those objectives.

How exactly one would go about this econometrically I have no idea, but there is at least one obvious case study, which (if you're a macroeconomist) you have probably already thought of. According to the popular story (which I'm not entirely sure is true), the boom of the late 1960's was partly a deliberate result of policy. Today's economists tend to see such booms as a bad idea, because booms (so today's theory teaches) ratchet up inflation expectations. But the concept of ratcheting up inflation expectations was virtually unknown in the 1960's. So by today's standards, the policies of the 1960's were irrational. If you believe that story, then it is at least one data point in support of the hypothesis that policy is effective.

Rational Policy

Why is it that so many economists assume that private agents are rational but policymakers are irrational?

Breaking with that rather silly custom, Nick Rowe (hat tip: Mark Thoma) applies the rational expectations concept to policymakers and reaches the conclusion that we will never be able to find evidence of policy effectiveness, even if policies are actually quite effective.

One way to think about it, perhaps, is that all we observe in the data are the effects of policy mistakes. We cannot observe policy successes because they are negative events -- non-recession, non-inflation, etc. Only if policymakers were irrational would their "successes" -- the success of perverse policies at producing perverse effects -- correspond to positive events like recessions and inflation, so that we could find correlations between policy measures and outcomes.

To be more precise, any unusual events (recessions, inflations, etc.) that we see in the data must have been unpredictable; otherwise policymakers would have predicted and avoided them. But if they were unpredictable, that means they couldn't have been correlated with any variable that is supposed to measure policy; otherwise policymakers could have observed that variable and predicted and avoided the unusual event.

I made a similar point a couple of years ago: the inability of economists to forecast recessions is actually a point in favor of the economics profession, because it means that economists who guide public policy are doing their job well and avoiding all the predictable recessions.

Snarking Bloomberg

A headline on Bloomberg:

Fed Loans Guided by Raters Grading Subprime Debt AAA

Oh, my God! You mean the Fed is actually relying on ratings provided by major ratings agencies? Can you imagine such a thing? And did you know there are homosexuals in Iran? Shocking, isn't it? Hard to believe, but it's true.

Seriously, dude, this is not news! It would be fine if you labeled it as commentary and called it something like, "Why is the Fed Relying on Raters Who Graded Subprime Debt AAA?" There is a good case to be made that the Fed should be doing its own credit research rather than relying on agencies that have both conflicts of interest and abysmal recent records. And someone else can perhaps counterargue about the dangers of allowing public institutions to pick private sector winners. Whatever. It's all very interesting, but it's not news.

Krugman on Steinbrueck

If I were a currency trader, I'd be selling Euros.

Phillips Curve Presages Deflation

Back of the envelope analysis:


UE rate is now 6.7%.
Almost certain to rise over next couple of months.
Probably at 7% early in '09.

The most optimistic estimates have recession ending about halfway thru '09.
Stimulus program heavy on public works will be slow to implement.

In recent recessions, UE has continued to rise for at least a year afterward.
So a fairly optimistic scenario would have UE rising to 8% by YE '09 and staying there for a year.
That would give average UE around 7.5% for '09 and 8.0% for '10.

Typical estimates put NAIRU at 5%.
So UE gap is 2.5% for '09, 3% for '10.

Typical Phillips curve coefficient is around 0.5
which implies inflation rate will fall by 1.25% in '09
and an additional 1.5% in '10
and continue to fall.

Current inflation rate is around 2%


You do the math

I’m with Mephistopheles

Paul Krugman makes the case for deliberately providing too much of an economic stimulus. Here I want to examine the counter-case, for which I think there is a valid argument, although it doesn’t seem to be the argument that anyone is actually making. In the end, though, I agree with Professor Krugman: too much is better than too little.

Here’s the thing, though: there is one big advantage in doing too little economic stimulus. I mean, doing some, doing a significant amount, but not quite enough. The advantage (as I have argued in many of my recent posts) is that it doesn’t cost anything, because it can be financed with seignorage.

Professor Krugman makes the case that, from the point of view of the condition of the economy – the tradeoff between output and inflation, which is what macroeconomists usually care about – it is better to do too much, because, if you do too much, the Fed has the power to undo the excess by raising interest rates (whereas, if you do too little, there is nothing the Fed can do about it, since we’re in a liquidity trap). But as most people writing for the public acknowledge (or insist), there is more to care about than the condition of the economy. There is also the condition of the government’s finances.

As far as the government’s finances are concerned, it is not just a bad idea to do too much; it is a bad idea to do enough. As long as you don’t do enough, standard textbook macroeconomic theory (at least the Keynesian kind, which is the one most influential among economic forecasters) says that there will be disinflationary, and ultimately deflationary, pressure. It’s a pretty simple point of logic. “Doing enough” is defined as getting the economy on a track where the unemployment rate will go down to the NAIRU (or possibly lower, if deflation takes hold and we are trying to reverse it). What other definition could there be? Then by definition of the NAIRU (the “non-accelerating inflation rate of unemployment,” which, if looked at from the other direction, is the non-decelerating inflation rate of unemployment, or eventually the non-accelerating deflation rate of unemployment), the inflation rate will tend to keep falling. Therefore, the Fed can keep creating money, financing the Treasury, and there will be no inflation (or any other deleterious effects that I can think of).

Once you do enough, not only does the government have to start doing real borrowing to finance its deficit; it also has to pay real interest on the outstanding debt. The government is like a monopolist facing a kinked demand curve. As long as you stay below the kink, the more you produce, the better. But as soon as you get to the kink, all Hell breaks loose. Not only are you unable to sell your marginal “new” products for a profitable price; the price of your inframarginal “old” products starts to go down too.

This puts us in a position rather like Goethe’s Faust. (I’ve only read selected passages, and those in very loose translation, so I’m relying on someone else’s analysis here, and probably an inaccurate memory even of that.) Faust is granted unlimited knowledge, until the point where he can say it is finally enough, that he has reached the culmination of human experience. At that point his soul belongs to the Devil. Similarly we are granted unlimited economic stimulus, until the point where we can say it is finally enough. At that point we are damned to Eternal Debt.

But as I argued in an earlier post, even with a debt-financed stimulus, we have a net free lunch, in the same sense that Ricardians argue that international trade provides a net free lunch. With the stimulus, there is more produced today than there would otherwise be, and at no point in the future will production have to be reduced in order to pay for the increased production today. There is unambiguously more. There may be issues about distribution, as there are with trade, but overall there is unambiguously more. Perhaps the current generation benefits at the expense of future generations, but the current generation gains more than the future generation loses.

I want to say one other thing. Even with the biggest fiscal stimulus anyone can imagine, our debt-to-GDP ratio will still end up lower than it was at the end of World War II. As I recall, that situation didn’t work out too badly. In fact, as a representative of the Future Generations that were affected by that debt – a representative who has a self-defrosting refrigerator-freezer, an automatic washing machine and dryer, a dishwasher, an air conditioner, a flat-screen color television set, a VCR/DVD player, several personal computers, an air-conditioned car with automatic transmission and power brakes that gets 35 MPG on unleaded gasoline, a blackberry, wireless internet access, immunity to polio, the ability to make a living without putting my pants on, and the opportunity to go to sleep after dusk in New York and wake up before sunrise in London despite the time difference – I would like to thank our grandparents for choosing damnation. Hell doesn’t really seem all that bad.

And in Goethe’s version, doesn’t Faust end up going to Heaven?

My Fantasy

As a postscript to my last two blog entries, I want to imagine a possibility.

Suppose that the Treasury were to retire all its outstanding long-term debt, and suppose that the Fed were to buy enough of its short-term debt to keep the interest rate at zero. And suppose this were all done without causing inflation. I realize, for institutional reasons, this is all highly unlikely to happen, and it is also somewhat unlikely for economic reasons. But it isn’t inconceivable. In fact, leaving aside the institutional issues, I’d give maybe a 25% chance that it’s economically possible today, provided that the fiscal stimulus is not large enough (which is likely to be true in any case). You can disagree, but anyhow, this is only a fantasy, and I’m pretty sure I can get quite a few reputable economists to agree that my suppositions are far from inconceivable, economically speaking.

So here’s my fantasy:

Federal Budget, FY 2010

National Defense and Homeland Security  $730,213,476,219.56
Domestic Discretionary Spending         $773,154,217,326.40
Social Security                         $653,207,125,217.23
Medicare                                $417,316,224,327.01
Other Entitlements                      $615,222,143,177.03
Interest on the National Debt                         $0.00

OK, it’s only a fantasy. But as fantasies go, I think I’ve got a better shot at this than at dating Angelina Jolie. Or Isobel Wren, for that matter.

Behold the Power of Seignorage

For Sepetmber 2008, the monetary base was reported at $903.5 billion. For October, it was reported at $1.1285 trillion. That's an increase of $225 billion. That's how much money the Fed created directly in one month. A couple of months of that would be enough to finance last year's federal deficit. Three or four months would be enough to finance this year's likely deficit, including the first half of the TARP.

Granted, not all the money was actually used to finance the federal deficit. Much of it was used for even more "inflationary" purposes, such as emergency lending to banks. But the money was created, and it could have been used to finance the federal deficit. And if the Fed keeps creating money at anywhere near that rate, chances are that the portion created by buying T-bills and other Treasury securities will be enough to finance the current deficit, even if that deficit is larger than we expect.

And yet not many people seem to be worried about inflation. TIPS are selling at historically high yields relative to nominal Treasuries. Commodity prices are crashing. And the great debate of the time is about whether we will experience deflation.

Yes, Virginia, there is...