Sunday, November 30, 2008

Not in Kansas Any More

I put together a series for commodity prices as measured by various CRB indexes. Since there have been a couple of new CRB indexes introduced at certain times, and the new indexes have each eventually supplanted the earlier version, I patched together a series going back to 1950 using the "current" version of the CRB index at each point in time. (I'm looking at closing prices at the end of each month.)

Over 58 57 years, from the beginning of 1950 1951 through the end of 2007 (and through the first half of 2008), the biggest drop over any 3-month period was 20%. From August to November of 2008, it has been 37%.

UPDATE: Actually, if you use the CRB Spot Index, apparently the only one available before 1974, the contrast is even more dramatic. The biggest 3-month drop 1951 though 2007 is 14%. Over the last 3 months it has been almost 27%.

Interestingly, prior to 2008, the biggest drop in the spot index comes at a different time than the biggest drop in the futures index (even though both drops are during the period when both indexes are reported). The biggest drop in the spot index was from July to October 2001 (a time most readers will remember, especially those who were working in Lower Manhattan). The biggest drop in the futures index was from November 1974 to February 1975, where it's harder to find an obvious event to explain the drop. (The fastest part of the drop was in December 1974. The US was going deeper into what was, at the time, the worst recession since the Great Depression. Perhaps someone who is old enough to have been an adult at the time can remember something more specific, but I'm at a loss.)

Also note the corrections above. The data start in 1951, not 1950.

Saturday, November 29, 2008

Deflation Can Happen

I’m not saying it will happen, or even that it’s likely. As a matter of fact, if you offer me less than 6:1 odds, I won’t even consider a bet on deflation, even taking into account its hedge value (since deflation is likely to be associated with bad real outcomes). But what puzzles me is that James Hamilton seems unwilling to take that bet at any odds. This despite the fact that he repeatedly acknowledges the deflation that Japan was still experiencing less than a decade ago.

He makes an argument (which I will address presently) that the Fed can stop deflation, and he seems to draw from it the conclusion that the Fed will stop deflation. It seems to me he could have made essentially the same argument 15 years ago in Japan, and it would have been wrong. I guess he thinks that, since we have learned from Japan’s mistakes, we can be confident that we will avoid making the same mistakes and therefore confident that we will avoid deflation.

I expect that Japanese policymakers thought they were avoiding the mistakes the US made in the 1930s. And to some extent, they surely were. There is far from universal consensus on what exactly those mistakes were in the first place, but perhaps the single biggest mistake the US made was in using monetary policy to defend the dollar. I expect that Japanese policymakers were congratulating themselves for long ago having had the good sense to float their currency so that mistake wouldn’t happen. (In the years leading up to the deflation, they arguably made the mistake of allowing the yen to appreciate too much on its own, but that's not something they should have learned about from the 1930s.) Another commonly alleged cited mistake the US made was in not using monetary policy to offset the effect that the contraction of the banking system had on the aggregate money supply. I just pulled up some statistics on Japanese monetary aggregates, and I see that Japan definitely did not make that mistake either.

A doctrinaire Keynesian will tell you that the biggest mistake the US made in the early 1930s was in not providing an adequate fiscal stimulus. It’s clear in retrospect that Japan did make that mistake in the 1990s (and early 2000s), but at the time I expect they thought they were avoiding it. The fiscal deficits certainly looked huge enough. And in any case, during the 1990s, the preponderance of economic opinion regarding the 1930s was tending to run against the doctrinaire Keynesian explanation. Overall, avoiding the mistakes of the past is not as easy as it might sound, nor is it guaranteed to be effective, and I have less than complete confidence that US policymakers today will succeed either in doing so or in doing so effectively. Even if the Fed can stop deflation, there’s no guarantee that it will.

But can the Fed, by itself, really stop deflation? It’s a difficult question, because it depends on what policy actions the Fed is capable of taking. There are, for one thing, institutional constraints – in particular, laws – that limit the Fed’s potential actions. There also has to be some sort of “sanity constraint.” There are things that the Fed theoretically could do, but it’s impossible to imagine that it ever actually would. There are certain actions the Fed could take that would be guaranteed to stop deflation, but before the Fed would even consider such actions, it would push Congress repeatedly for more and more fiscal stimuli and accept the fact that Congress will sometimes be slow to provide those stimuli. Meanwhile, the deflation could be well underway.

Taking Professor Hamilton’s specific examples:
First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities.
Let’s consider this action in two parts. First, the Fed could buy up enough of every issue to push the market yield down to approximately zero. Then it could buy up the remainder of each issue. Would either of these actions stop deflation? The second, almost certainly not, because it just replaces one zero-return asset with another. The first, maybe, but I doubt it. If people expect deflation and have very little tolerance for risk, they will just hold on to most of the money, despite it’s zero nominal return, the same way they held on to the Treasuries. Really, zero is not all that much lower than the yields on Treasury notes today. OK,
Then buy up all the commercial paper anybody cares to issue.
This is where the sanity constraint comes in. On the one hand, the Fed can buy a large but limited amount of commercial paper from reputable issuers. They’re already doing that, and it’s not working, at least it’s not stopping the economic contraction or the talk of deflation.

On the other hand, the Fed can literally “buy up all the commercial paper anybody cares to issue.” That would stop deflation, I agree, but by a very odd mechanism. Anyone could start a thinly capitalized corporation, issue commercial paper, gamble the proceeds, default (unless they win), go bankrupt, and stick the Fed with the losses. It’s roughly equivalent to dropping money from a helicopter, since the money would be out there in the economy and the Fed would no longer have an offsetting asset. In general, such policies that actually create large amounts of new financial wealth, rather than exchanging one form of wealth (i.e. money) for another (i.e. bonds), can stop deflation. But creating financial wealth by deliberately lending to borrowers that are likely to default, this is way too far afield from what the Fed is supposed to do, and it’s not something the Fed ever will do intentionally. But OK:
In fact, you might as well buy up all the equities on the Tokyo Stock Exchange.
There are really two parts to such a policy: first, the Fed would create dollars and use them to buy yen; then the Fed would use those yen to buy equities. First of all, could buying yen stop deflation? Well, yes, if we could take Japanese monetary policy as exogenous: if you devalue your currency enough, it will eventually stop deflation. But more likely Japan would respond by buying dollars, and exchange rate wouldn’t change much.

What about buying equities? In any case it would be more effective to buy US equities instead of Japanese. That would stop deflation if done on a sufficiently large scale. Unlike bonds, stocks have no inherent price limit, so if the Fed were willing to pay a sufficiently high price, it could create enough new financial wealth to stop the deflation. But is the Fed allowed to buy equities? My guess is it’s not, but I may be wrong. And if Fed does buy equities, is that still “monetary policy”? The government taking an equity interest in private sector firms sounds like fiscal policy to me.

And if the Fed can buy direct interests in real goods and services (such as equities, which represent partial ownership of capital goods), why not have them stop the deflation directly by buying consumer goods? Let the Fed put huge amounts of gift certificates on the asset side of its balance sheet. That will do the trick. I’m not sure at what point you start to breach the sanity constraint, but to me gift certificates actually seem like a more reasonable asset for the Fed to hold than junk paper.

Anyhow, I’m sure that, between the Fed, the Treasury, the president, and Congress, they can eventually come up with a way to stop deflation. Whether it’s done by expanding the Fed’s role in previously unimaginable ways or by more traditional fiscal stimuli, it will eventually be done on a scale large enough to be effective. I’m confident of that, but I’m not entirely confident that we will reach that point before experiencing a decade of deflation.

Friday, November 28, 2008

Giving with One Hand and Taking with the Other

I admit I supported Barrack Obama in both the Democratic primaries and the general election. I still think he’ll make a better president than either John McCain or Hillary Clinton would have. And I think he’s quite an intelligent person, with a reasonable layman’s understanding of economics. But every now and then he says the dumbest-ass things.

I think the phrase “universal coverage” alone should be sufficient to substantiate my point. But the universal coverage thing was a merely semantic piece of nonsense. I doubt it interfered much with people’s ability to judge health policy proposals on their substantive merits. And after all, it had a certain entertainment value, like when the Wizard of Oz says, “Pay no attention to the man behind the screen.” It’s always fun to hear someone deny the obvious.

I’m worried, though, that the president-elect is now having one of his attacks of nonsensicality in a context that has actual policy implications, and policy implications that might be of some importance given the severity of the current economic crisis. Apparently, if I understand the press reports correctly, he is saying that he will finance part of his fiscal stimulus by cutting out wasteful and ineffective government spending.

I’m not going to push on the point that wasteful spending could be more effective than useful spending in preventing deflation, but surely wasteful spending is at least almost as effective as useful spending in stimulating the economy. If you increase useful spending while decreasing wasteful spending by the same amount, what you end up with is very little, if any, economic stimulus. (I must say, though, I’m optimistic that the incoming president will not be able to find and eradicate enough waste to pay for much of his stimulus plan. To the extent that it exists at all outside the fantasies of reformist politicians, wasteful spending is generally there because somebody wants it to be there, and usually the relevant somebodies have quite a bit of influence on Capitol Hill, which is why the spending hasn’t already been cut.)

Here’s one way to see the point. I expect that part of the stimulus plan will consist of increases in government benefits, such as unemployment benefits, and an expedited implementation of the promised middle class tax cut, perhaps with some additional temporary tax relief added in for good measure. Now, when the government sends somebody a check, does it really make any difference whether they call it, on the one hand, a paycheck, or, on the other hand, a tax refund or a benefits payment? The employees involved in wasteful government activities are getting paychecks. Is there any net economic stimulus to be had by taking away their paychecks so that you can send the money to someone else as a tax refund or an unemployment benefit?

If anything, I’d say it’s just the opposite: when someone loses a wasteful government job, their permanent income declines dramatically, and they’re likely to curtail their spending dramatically. When someone receives a larger tax refund or a larger benefits check, they’re not likely to consider it a significant increase in their permanent income (even if the tax cut is ostensibly permanent), and, under the current environment, they will likely find it prudent to save most of the money for a rainy day, especially seeing that the barometric pressure is already low and falling.

I don’t deny that the choice of where to spend stimulus money can be important, or that, in some cases, the effectiveness of a stimulus can be increased by combining the net increase in spending with a shift of spending between different categories, projects, etc. In particular, some types of government spending are likely to produce more and better jobs than are other types. But is there any reason to believe that there is a correlation (in the short run, anyhow) between spending that is wasteful and spending that creates fewer or worse jobs? Is there any reason to believe that useful spending, as such, is the type that will create more and better jobs in the short run? I can’t think of a reason.

Offhand, again, I would guess that it’s the other way around. If the wasteful spending didn’t involve many good jobs, then there wouldn’t be many people with good jobs to protect who would have a strong interest in maintaining that spending, and Congress would have cut it long ago. The useful spending, on the other hand, could be justified on the basis of its usefulness, and, even if there were few good jobs to protect or special interests to satisfy, Congress might have thought it more prudent to keep than to cut.

I have to acknowledge that the one actual example Mr. Obama gives of wasteful spending – subsidies to rich farmers – is one that actually does create fewer jobs than an equal expenditure from the stimulus plan would probably create. But still, the subsidies themselves are certainly a positive stimulus, and it doesn’t make a whole lot of sense to cut them at just the time when a stimulus is needed. You could make an argument that the case for cutting them in the long run is so strong that we should take advantage of any opportunity, even if it’s at the worst possible time. But that argument seems kind of lame to me.

So, Mr. President-elect, once this crisis is over and we have reversed the economic contraction, escaped safely from the threat of deflation, and set ourselves on a healthy and robust macroeconomic trajectory, I will enthusiastically support attempts to cut wasteful government spending. (After all, as everyone knows, the support of anonymous bloggers is critical to the success of any public policy initiative.) Actually, maybe not so enthusiastically, because I have some concern that the project of identifying and eradicating government waste may itself be a waste of the government’s resources. But if that’s your thing, more power to you. Just don’t do it now.

Wednesday, November 26, 2008

Are Useful Projects Really Better than Useless Ones?

In my last post I argued
...the general purpose of stimulus packages is to mobilize the economy's unused resources, and, in this particular case, to...prevent prices from plummeting. Does the presence of pork in a any way hinder the pursuit of such purposes? As far as the deflation issue is concerned, useless projects are precisely the place we should be putting our power. Useful projects will augment aggregate supply and thus push against the attempt to arrest falling prices. Instead of one bridge to Nowhere, let's have two! Just so the builders of those bridges can use up labor and make it harder for others to hire, thus halting the hemorrhage of wages and helping stabilize the price level.
An anonymous commenter replies:
I think we need useful projects. Can you explain how this works with the aggregate supply thing you mention? I don't understand why we would favor useless projects over useful ones.
All things considered, I will also tend to prefer useful projects over useless ones, but there really is a respectable case to be made for deliberately wasting the government’s money (recognizing, of course, that under the current circumstances, the government can create the money out of thin air, so the only real cost is opportunity cost).

The underlying premise is that deflation is very bad and reasonably possible, or, more precisely, that it is bad enough and possible enough to be a greater concern than productivity and, to some extent, a greater concern than employment. (I could be even more precise by talking about integrating across multidimensional probability distributions the convolution of the social welfare function with the aggregate supply function, or something like that. I’m too lazy to figure out how to say it right, and I doubt anyone cares anyhow.)

First, to justify the underlying premise: why is deflation very bad? Deflation means that money increases its purchasing power over time, which is to say, it becomes more valuable over time. Under those circumstances, people will prefer to hold their wealth in the form of money rather than investing their wealth in real capital such as computers, buildings, and research. The decreased demand for real capital goods will cause prices to fall further. Even prices for other types of goods and services will fall: workers who make capital goods (computers, buildings, &c) will be laid off, and employers in other industries will be able to hire them for lower wages, or use them to increase bargaining power over current employees, thus lowering their costs, whereupon competition from other cost-reducing firms will force them to lower prices. When prices fall, there is (by definition) more deflation, and we get a vicious circle between declining real investment and declining prices. Also, with deflation and widespread layoffs, people will choose to save as much as possible to prepare for the possibility of job loss, and consumption will decline, and with lower demand, prices will fall, and thus there is another vicious circle. Really, deflation is very bad. (As to whether deflation is reasonably possible, I think TIPS yields tell the story.)

So let’s suppose the government has a choice between two projects, a Bridge to Nowhere, which is completely useless, and a Bridge to Somewhere, which is useful. What happens if they choose to build the Bridge to Somewhere? It becomes cheaper to ship goods to Somewhere, so the people of Somewhere can get those goods for lower prices, and goods in the stores of Somewhere have lower price tags. We can quibble about the definition of deflation, but certainly we should expect the Bridge to Somewhere to result in falling prices, at least in Somewhere. If the government undertakes similarly useful projects of various types in various places, the result will be broadly declining prices. That is deflation. And deflation is very bad. Spend money on useless projects such as the Bridge to Nowhere, and we avoid that deflationary impact.

One way to think about this is in terms of the monetarist quantity equation, which I learned as



M=quantity of money
V=velocity of money
P=general price level
Q=quantity of goods and services produced

If the product of M and V is constant, then if Q goes up, P must go down. So if the government expects that product to be constant, and it wants to avoid declines in P, it should choose projects that don’t increase Q, which is to say, useless projects.

You might ask why anyone would expect the product of M and V to be constant. If Q is going up too quickly, wouldn’t the government just increase M and thus avoid declines in P? That is usually the right answer, since V doesn’t usually depend heavily on M. The late 1990s are an example. Q was rising quickly, and V was reasonably stable, so the Fed wisely chose to increase M quickly to avoid declines in P.

But things are different today, because we are in a liquidity trap. People (and, more to the point, institutions) are so eager to keep their assets safe and available that they will save any money the government can create. If all the new money is saved, it goes nowhere: it has zero velocity, so the average velocity of money goes down. Thus, with increases in the money supply, the (average) velocity of money declines in such a way as to exactly offset those increases, and the product MV remains constant. The only way to get P up is to decrease Q.

Well, OK, you could also try to increase V, which is the point of a stimulus program: the newly created money goes to the government, which spends it, so it has some positive velocity, and the increase in M is no longer entirely offset by the decrease in V. But while increasing M is easy, increasing V can be difficult, since in this case it requires an act of Congress, which may be hesitant due to concerns about government debt and the like. So it would help to try decreasing Q, or at least limiting its increase, at the same time as trying to increase V.

As I said, all things considered, I would still favor useful projects, but I don’t think this argument for useless ones is just academic sophistry. After Franklin Roosevelt was elected during the Depression, he didn’t deliberately spend government money on useless projects, but he did something with a similar effect: he spent money on useful projects, but he offset the overall macroeconomic effect of their usefulness by creating government-sponsored cartels to keep prices up. The majority of economists have now decided that cartel-sponsorship programs such as the National Recovery Act were counterproductive, but there is still a significant minority who disagree (and I should say, I’m rather sympathetic to their point of view). I have to ask that minority (and I’m serious; this is not an attempt at reductio ad absurdum): rather than going to the trouble of setting up the cartel-sponsorship apparatus, wouldn’t it be easier, and just as effective, to spend the government’s money on useless projects instead of useful ones?

Tuesday, November 25, 2008

Pork is Good for You

(My apologies to those with religious dietary restrictions...and to those who hate the letter P)

Greg Mankiw's hypothetical alliterative stimulus critic worries that the stimulus package will be "pointless, political, and pork-filled." Perhaps. But it's hard for this person to perceive how a proposal that is political and pork-filled would be probably, or even possibly, pointless. To prefigure my point, perforce, the politicians and pork-purveyors must have had a point in preparing to pass the purported pork-proliferating package. Otherwise, why, I mean, why bother?

All alliteration aside (but apparently now actively assonant), the general purpose of stimulus packages is to mobilize the economy's unused resources, and, in this particular case, to (sorry, I can't help it) prevent prices from plummeting. Does the presence of pork in a package (really, I'm sorry, but I give up) in any way hinder the pursuit of such purposes? As far as the deflation issue is concerned, useless projects are precisely the place we should be putting our power. Useful projects will augment aggregate supply and thus push against the attempt to arrest falling prices. Instead of one bridge to Nowhere, let's have two! Just so the builders of those bridges can use up labor and make it harder for others to hire, thus halting the hemorrhage of wages and helping stabilize the price level.

My other point is that, in any case, pork projects actually will be useful to someone. Somebody wants to drive to Nowhere, and that's why they want to have the bridge built. It might be pointless to divert resources toward such projects when the economy is already using most of its resources, but today (and in a few months, when there will be even more slack resources), the pointless thing would be to let those resources be wasted. Pork may not be the best use of those resources, but it's better than nothing.

And there is also the secondary effect, the Keynesian multiplier. The people hired to build bridges to Nowhere will spend some of their new wages on things that they want. When those things are produced, the resources involved are clearly being put to good use, because they create something that somebody wants and is willing to pay for.

So, to push the parlance of this passage past the point that people can put up with prior to puking, as the penultimate paragraph presages, there is plenty of point to pork-barrel politics when it comes to the passage of programs to prop up our pained pecuniary polity and positively impact its per capita product and probable performance.

Why Even Bad Bailouts are a Good Deal

Why? Because the government gets to pay with monopoly money and get paid back with real money.

Right now, with the T-bill rate at approximately zero, the Fed can effectively create an unlimited amount of money to finance the government. No matter how many T-bills the Fed buys, the rate won’t go much lower than it already is, so such purchases, even on a very large scale, won’t have much economic effect (and if they do have an economic effect, so much the better). So anything the government pays today, it can pay with free money, money that it created out of nowhere (and for some reason, people are all too willing to accept it as payment for all sorts of things).

Eventually (one should at least hope) this crisis will be over and the economy will recover, putting upward pressure on prices, causing the Fed to tighten, raising the government’s borrowing costs. Isn’t it nice that a bunch of folks are going to be owing the government a lot of money at just that time? And many of them will finally be able to pay, which means there is so much less that the government will have to borrow now that it can no longer print money with abandon.

As long as the crisis continues, the deflationary pressure will continue, T-bill rates will stay near zero, aggressively expansionary monetary policy will be warranted, and the government can continue to make payments with monopoly money. If Citicorp’s assets go sour, chances are this situation will be continuing, and the government can pay out those guarantees with monopoly money. And if the crisis continues for 5 years or 10 years, that’s so much longer that the government gets to print worthless pieces of paper (in the usual trope, though most money isn’t literally paper) and make various assetholders happy by allowing them to retrieve these worthless pieces of paper. And if the government takes some losses in the mean time, who cares? Yes, it will have to print up more worthless pieces of paper. So what?

When the recovery finally comes, everyone to whom the government has lent these worthless pieces of paper (all the ones that are still solvent, anyhow), and whose loans it has rolled over and over as the crisis continued, will have to pay up. It’s like a huge, temporary tax increase, just when it’s needed, only without having to actually raise taxes.

Monday, November 24, 2008

Gurantee the Liabilities

Here's my Monday evening quarterbacking. They should have guaranteed Citigroup's liabilities (in other words, extending deposit protection to other types of creditors and to large depositors) rather than its assets. (Perhaps nobody had the authority, but Congress should give them that authority now in case the same thing happens again.) The liabilities are effectively guaranteed anyhow, because officials know better than to let Citi ever actually default. But as long as the liabilities are not explicitly guaranteed, the company essentially has the financial system as a hostage. They won't threaten to kill the hostage intentionally, but when they bargain with the government, they can threaten to take the risk (i.e. to refuse a bailout on the government's terms, thus putting the hostage in peril). This gives them a bargaining chip. If their liabilities were explicitly guaranteed, they would lose that bargaining chip, because the government guarantees would insulate the rest of the financial system. Then the government could bargain thusly: "Accept our bailout that wipes out 98% of your equity, or else we'll force you to write down your assets and recognize your off-balance-sheet liabilities until you have no equity left, and then we'll take over, and believe me, that won't be pleasant for the current management."

Sunday, November 23, 2008

Memo to Tim Geithner: Retire the TIPS

Before the Treasury decided to start issuing TIPS, I was a strong advocate for inflation-adjusted bonds. At the time, I felt that people were overly concerned with inflation. (That was the mid-90’s, and I think subsequent experience bore out that opinion.) I thought that the government should issue indexed bonds to, as it were, take inflation off the table – to give people worried about inflation the opportunity to hedge, and to reassure markets that inflation was not the government’s intention. This, I thought, would give macro policymakers the opportunity to experiment more, having effectively given assurances that, if their policies were lead to a bout of excessive inflation, they had every intention of nipping that in the bud.

But times have changed. A few economists may still be worried about the possibility of inflation at a long horizon, but the consensus of the bond market seems to be more concerned about deflation, particularly at a short-to-intermediate horizon. In fact, some TIPS appear to be trading at yields higher than the corresponding nominal Treasuries. That doesn’t make any sense to me, because, as I understand it, TIPS principal cannot be adjusted downward in nominal terms, which, if my logic is correct, means that, when you buy a TIPS at a yield higher than the corresponding nominal, you are guaranteed a higher return when you hold it to maturity.

I don’t feel like working out the algebra right now, but I’m pretty sure that kind of thing isn’t supposed to happen in a market with rational agents -- unless of course the agents don't realize that one another are rational. (I can see how it might happen in a CAPM-type model in which the agents don’t care about higher moments, since nominal Treasury returns might be negatively correlated with other asset returns; but this is a case where the higher moments obviously matter: whatever the means and variances might be, if portfolio A outperforms portfolio B under every possible outcome, then portfolio A is obviously better.) It’s certainly true that there is a liquidity premium in TIPS yields. But it’s hard for me to believe that the bid-ask spread on TIPS is large enough, or expected to become large enough, to justify the kind of yield spreads we’re seeing. Perhaps there is some other technical reason that I don’t understand.

Anyhow, rational or not, TIPS are obviously cheap today. Moreover, this is not a time when the government should want to reassure people of its intention to avoid excessive inflation. There is an overwhelming demand for safe assets, and the way to get people to invest in other assets is to take away the opportunity for safety. The US government should be happy to do anything that will make people worry that real Treasury returns are vulnerable to inflation. Not that I’m advocating intentionally high inflation: I’m just saying don’t make any promises.

Moreover, the government, which can issue its own Treasury bills whenever it needs access to cash, doesn’t have to worry about liquidity. The government should be happy to provide more liquidity to the market and to earn the liquidity premium in return. And if market agents are being irrational (as they apparently are), it’s in the public interest for the government to set them straight and to make a profit in the process, while also reducing its long term risks. So it is both good macro policy and good financial policy for the government to be on the buy side in the TIPS market.

I therefore recommend that the Treasury stop auctioning TIPS until further notice and begin bidding for TIPS in the open market with the intention of retiring them and issuing nominal securities in their place. When times change again, when inflation becomes a big concern in the market, when inflation protection is once again something that people are willing to pay for, then it may be a good time to start issuing TIPS again. Sell high, when you have the opportunity, but right now it’s time to buy low.

UPDATE: Foster_Boondoggle points out in a comment that my argument about irrational valuation doesn't apply to outstanding TIPS for which the principal has already been substantially adjusted for past inflation, since subsequent deflation will still reduce the value of the TIPS. So I was wrong to suggest that the market was necessarily irrational and that the government would be taking a sure bet by retiring TIPS.

However, I do think the government would be taking a pretty good bet, especially since deflation would give the government the ability to do virtually unlimited seignorage (thus more than compensating taxpayers for losing the inflation bet), whereas if there is greater-than-expected inflation, the government's borrowing costs will likely go up. In other words, if the TIPS-to-nominals spread is actuarially fair, then the government is getting a costless hedge by retiring TIPS. Also, my argument about the effects on expectations becomes stronger: by retiring TIPS, the government is explicitly betting against deflation, which should increase the market's confidence that it will try harder to avoid deflation.

Thursday, November 20, 2008


The bad news is that the headaches and fatigue you’ve been experiencing aren’t just stress. According to our tests, you have a serious illness, and if it’s not treated soon, you could be dead within a year or two.

The good news is that the treatment is 100% covered by your health insurance, and with a good, aggressive treatment plan, you should be virtually symptom-free within a few months.

Some patients do experience side effects, but those are generally quite mild except at extremely high doses. In rare cases, where patients had doses far above the therapeutic range, some of the side effects have persisted after the treatment was finished, but those side effects can also be treated, so that’s not something you should be worrying about.

I have to warn you, doctors have had a tendency to be too conservative in treating this illness, and some patients have remained very sick for years – not because they couldn’t be cured but because doctors were uncertain about the right dosage. Given the balance of risks, it’s always better to prescribe too much than too little, and the therapeutic range is actually fairly wide, so with appropriate treatment, you should never have to experience the more painful symptoms that people in advanced stages of the disease go through.

There isn’t really much good news or bad news right now with respect to the possibility of deflation. Yes, there was a record drop in consumer prices in October, but that was mostly due to rapidly falling energy prices, which are unlikely to fall much further (although they have continued to fall in November, so we should expect one more large drop in the CPI next month). The core CPI also fell, but by only one tenth of a percentage point, which should not be alarming. (The last time the core CPI fell was in 1982, but such drops were not uncommon during the early 1960s – a time of some economic weakness but hardly a depression.) So the tests are inconclusive at worst, but it would be reasonable to begin some prophylactic treatment.

If there does turn out to be deflation, will that necessarily be a bad thing? It will be quite bad if it’s allowed to persist for years, but if it’s handled appropriately, it has a good side too. Basically deflation means that the Fed can create huge amounts of money without having much of any ill effect. (What would you be worried about? Inflation?) Those huge amounts of money can be used to finance huge federal deficits for a while without having to borrow additional funds from the public. So even a shockingly large fiscal stimulus could be more or less free – paid for by seignorage in an economy where people are only too eager to accept intrinsically worthless fiat money as payment for real goods and services. (That’s essentially the definition of deflation. Money has no intrinsic value, but in a deflation, producers offer greater and greater quantities of goods and services in exchange for a given amount of money.)

So if the headaches and fatigue that the US economy is beginning to experience turn out to be symptoms of the serious illness known as deflation, the treatment will be 100% covered. And with a good, aggressive treatment plan, we should be virtually symptom free within a few months. Not that that’s likely to happen, but I’m more afraid of the timid doctors in the US Congress than I am of deflation per se.

Wednesday, November 12, 2008

Deficit Hawks are Like Protectionists

Everybody knows that, in the aggregate, trade increases welfare. We can quibble about how to aggregate welfare across individuals, but at least in a Kaldor-Hicks sense, trade increases welfare. In that aggregate welfare sense, trade is a free lunch, and that lunch is wasted if nobody eats it. But protectionists argue that the redistributive effects of trade can often be bad enough to outweigh the aggregate advantage. Trade can hurt certain parties that one may wish not to hurt. The overall pie is larger, but someone’s share may be smaller.

When an economy has slack resources, as the US economy – as well as the world economy – clearly does now and likely will even more in the immediate future, there is no aggregate welfare cost to using up those resources, so any benefit society receives is, in the aggregate, free. In an aggregate welfare sense, slack resources are a free lunch, and that lunch is wasted if nobody eats it. Deficit hawks talk about the cost to taxpayers and the cost to future generations and all that. But let it be noted that fiscal stimuli during times of slack resource use make the overall pie larger, and any objections must rest on the premise that the new division of the pie leaves some particular party with a smaller slice despite the larger pie. It’s pretty much analogous to the argument for protectionism.

You can argue about whether resources are truly slack. There is a labor/leisure tradeoff, you might say, so there is always a cost to employing those supposedly slack resources. I warn you not to make that argument, because I will counterattack by taking a more extreme position than I took originally: not only are the resources slack; they are more than slack. In an aggregate welfare sense, you actually get a bonus for using up those resources, even if they don’t produce anything. It seems obvious to me that the emotional pain involved in unemployment typically outweighs the value of the additional leisure. (I know you’ll give the counterexample of your cousin who had always wanted to learn to play the guitar and he finally got the chance when he lost his job: but your cousin is not typical.) Add in the search costs, and it’s a slam-dunk. At this point I might be willing to compromise and say that the resources are just plain slack, not “hyperslack,” if you agree to abandon once and for all the labor/leisure argument.

Now I also hear echoes in my head saying, “There is a cost to using those resources, because, even if they are in some sense slack, the additional demand will shift the Phillips curve and raise the expected inflation rate.” Dude, that’s not a cost! Have you noticed that the nominal 10-year Treasury yield is trading less than 100 basis points above the comparable TIPS? How you noticed that the price of oil has fallen by more than 50% over the space of a few months, and that other commodity prices have fallen dramatically too? Have you studied what happened in the US in the early 1930s, and in Japan in the late 1990s? Gimme that expected inflation, Baby, and give it to me hard!

OK, sorry for the vulgarity, but back to the original point: just like the protectionists, the deficit hawks must be concerned about the redistributive effects of deficits, since the aggregate effect is to increase welfare. But while the protectionists actually have a pretty good argument (at least at the national level, in developed countries) as to why the redistributive effects are bad and might be expected to outweigh the aggregate effects in terms of importance, the deficit hawks’ arguments seem pretty lame to me.

The main issue would seem to be redistribution from future generations to the current generation. Here’s a point I made a couple of years ago, but I’ll repeat it: in the history of capitalism, there has been a consistent long-term trend of increasing welfare, by pretty much any reasonable measurement. You can complain about some of the things that have gotten worse, but the fact is, the19th century really sucked for most people, and the 18th century sucked even worse. And compared to the 1990s, the 1920s sucked, too. Unless we expect the trend to suddenly reverse itself, the likelihood is that future generations will be, in the relevant sense, richer than the current generation. So the deficit is a transfer from relatively rich future generations to the relatively poor current generation. I would hope that those future generations could spare a few extra pennies for such miserable folk as we. Especially since it is our blood, sweat, and tears that will have made them so rich. It is through no merit or toil of their own that they will come of age using microprocessors that run 1000 times faster than the ones we use today.

There are other arguments, but they’re even lamer. There is the idea that we will be paying interest to the Chinese for decades, as if that constituted a transfer of wealth from the US to China. It’s actually just the opposite. We are paying chicken shit interest to the Chinese, because they are so eager to keep their currency weak that they willingly overpay for US assets. Meanwhile, any reasonable capital investment by the US government will produce higher returns. Maybe we use the money for consumption rather than capital investment, but that the just brings us back to the “future generations” argument.

Tuesday, November 11, 2008

The Chinese Fiscal Stimulus, correction

Damn, this gets so complicated when you try to do it rigorously. In my earlier post, my mind had scrambled together 3 or 4 different models, thrown in some extra stuff to try to make the result realistic, and ended up with a high-cholesterol omelet. Now that I have separated the yolk from the white and the white from the cheese, and taken out the bacon that was supposed to make it realistic, the result is much tighter theoretically but difficult to explain in a single blog post. The bottom line is that, according to standard Keynesian-style models with (usually assumed but obviously not realistic in China’s case) perfect capital mobility and perfect asset substitutability, the Chinese stimulus has an unambiguously positive (well, non-negative, anyhow) effect on non-dollar countries and an ambiguous effect on dollar countries (particularly the US).

The two critical elements of the reasoning are
  1. that the stimulus causes Chinese to import more (possibly indirectly) from the US (likely, since China is not self-sufficient, and some of the additional things the Chinese will want to buy will be things that are made in the US – certain kinds of business services, for example).

  2. that the stimulus causes the value of the dollar to rise against floating currencies such as the euro (usually considered likely for the reason I gave in my previous post – that the financing of the stimulus will put pressure on credit markets, thus raising dollar interest rates and making dollars more attractive relative to the floating currencies)
Contrary to what I said in my earlier post, the first of these effects should dominate the direct effect of rising interest rates rather than the other way around, and if it weren’t for the floating currencies, the stimulus would be at worst neutral, and more likely positive, for the US. However, the indirect effect of rising interest rates – namely the strengthening of the dollar – is negative for the US, since it makes US goods less attractive relative to goods from floating-rate countries. The direction of the net effect on the US is ambiguous. One should note also, though, that the stimulus will have an unambiguously positive (well, again, non-negative) impact on the floating rate countries, because (among other things) it will weaken their currencies and make their goods more attractive.

I started out writing a post that tried to explain all this in more rigorous detail, but it got hopelessly long and complicated. I might put the explanation in the next post, but I’m trying to keep this one reasonably user-friendly

When you introduce imperfect capital mobility and imperfect asset substitutability, the story becomes even more complicated, and I haven’t even thought through the implications. Imperfect capital mobility and imperfect asset substitutability essentially represent the idea that China’s monetary policy doesn’t have to depend on its exchange rate policy. In other words, China can affect the exchange rate by, in effect, swapping huge quantities of Chinese bonds for huge quantities of US bonds. Institutionally speaking, China issues renminbi bonds, uses the proceeds to buy dollars, and invests the dollars in dollar bonds (really in Treasury notes, mostly). Ordinarily the effect of such intervention would be offset by the actions of private investors, but China can do it on such a massive scale that it overwhelms the actions of private investors. Moreover, China can restrict the actions of investors.

To the extent that imperfect asset substitutability is important here, I got things completely backwards (sort of) when I said
...given China’s de facto currency peg, [the stimulus] will have to be financed by reducing purchases of foreign assets (particularly US government securities).
Wrong! Actually, if China operates fiscal policy, monetary policy, and exchange rate policy independently from one another, it will have to buy more US government securities, not less. The fiscal stimulus will raise Chinese interest rates (and also probably make investment activities in China more profitable in general), thus making renminbi more attractive to investors. The Chinese authorities will have to offset the incipient increase in the value of renminbi by absorbing all the new dollars which investors want to exchange for renmibni that they can use for investment in China. Then the authorities will invest these dollars largely in US Treasury securities.

But here’s where the “sort of” part comes in: the increased demand for US Treasury securities, while indeed it doesn’t increase overall stress on US asset markets, doesn’t actually reduce such stress either. The whole point of buying the dollars to be invested in US Treasury securities was to offset what private investors were doing: taking dollars out of US assets and putting them in Chinese assets. All things considered, the effect China’s attempt to maintain its exchange rate will indeed be bad, because it will shift demand out of US private assets into US public assets, when the big problem in the US now is that everybody wants Treasury bills and nobody wants anything else. We want people to keep their risk capital in the US, not move it to China. So, the reasons are much more complicated than I thought, but we can still expect that the Chinese stimulus might have a detrimental effect in the US.

Monday, November 10, 2008

GM is not Lehman

I’m generally in favor of bailing out the US auto industry, mostly because such a bailout would be a relatively inexpensive form of fiscal stimulus. Compare the cost of bailing out the auto industry to the cost of trying to replace the lost jobs by means of government hiring. (There will be multiplier effects on both sides of the equation, which should roughly balance out.) Bailing out the auto makers, by just lending to them at below-market interest rates, is clearly cheaper. In fact, the interest rates should still represent a positive, or at least neutral, spread to Treasury rates, so there need not be any cost at all to the bailout unless the bailees eventually do default.

However, comparisons between GM and Lehman Bros. are overblown. The lost jobs at GM could be replaced by means of a fiscal stimulus, albeit an expensive one; the financial impact of the Lehman bankruptcy cannot be undone, though the government is doing its best to mitigate that impact.

An industrial company is simply not the same as a financial company. Yes, the auto companies do have creditors, and those creditors will lose out if the auto companies go bankrupt, and this may have significant adverse indirect effects. And yes, such bankruptcies will somewhat reduce confidence in US industrial companies in general and make it a bit harder (though probably not a lot harder) for them to obtain financing.

But a financial company doesn’t just have creditors, it’s in the business of having creditors. The indirect impact of a major failure – by forcing creditors, and creditors of creditors, and so on, to deleverage themselves – is huge. And a loss of confidence in financial companies doesn’t just make it harder for them to find financing; it instigates a chain reaction of additional deleveraging on a grand scale. And as we have seen, this can make it impossible for many companies (and households) to find financing at all, and such tightening of credit can result in many more job losses than the collapse of a few large industrial companies.

So, yes, I do support an auto industry bailout. But let’s not allow the auto companies to bamboozle us by claiming that their failure would be as disastrous as the Lehman failure. The public should not consider itself to be in a terribly bad negotiating position with respect to the auto industry. Bail them out, but bail them out on our terms, not theirs.

The Chinese Fiscal Stimulus

[EDIT: OK, I take it all back. Well, not all of it, but some of it. With the benefit of some perspicacious comments, 50 minutes of jogging, and 200 mg of modafinil, I see that I was mixing up several different models in my mind (an inherent hazard when you try to use two-country models to analyze a world where some exchange rates are fixed and others float). In standard Keynesian-style models, the Chinese stimulus is unambiguously good for non-dollar countries, and the effect on the US is ambiguous. I don't have time to explain now or to do the appropriate overstrikes, but I will get to it later and probably add a new post on the subject.]

There’s no question in my mind that the Chinese fiscal stimulus is a good idea – from China’s own point of view, as well as from the point of view of general balance and long-term stability in the world. But I wouldn’t jump to the conclusion that the policy will be good for the rest of the world (or particularly the US) in the short run.

The fiscal stimulus has to be financed, and given China’s de facto currency peg, it will have to be financed by reducing purchases of foreign assets (particularly US government securities). Reduced demand from China will put downward pressure on asset prices in general at a time when falling asset prices (though not specifically US government securities, of course) are already a problem. It will also complicate any US fiscal stimulus by making it more difficult to finance. Moreover, the portion of US deficits that China no longer finances will instead have to be financed elsewhere, and the higher interest rates necessary to attract such financing will tend strengthen the dollar, making US goods and services less attractive. All three of these effects would tend to exacerbate economic weakness in the US.

On the other hand, the fiscal stimulus will also mean increased demand for imports by the Chinese. It’s not clear which effect will predominate. In textbook theoretical Keynesian-style open economy macromodels, the former effects are more likely to predominate, which would mean the stimulus is bad for the US economy. In the real world, it’s not clear that this would be the case, but it’s also not clear that it wouldn’t.

Friday, November 07, 2008

To Hell with the Long Run

For Christ's sake stop worrying about the long run and whether long run US fiscal policies will be sustainable. We should be trying as hard as possible to undermine confidence in the creditworthiness of the US government, and especially in the soundness of the US currency. We should be doing everything we can to discourage investors from holding their assets in US Treasury securities. We should be following a policy explicitly designed to bankrupt the US Treasury. Some time later (possibly much later) it will be necessary to change this policy, but let's try not to give away the secret that we intend to change it.
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It pisses me off that that the EU is taking acton against Ireland for violating the deficit rules. As we face the prospect of a possible worldwide depression, we should be encouraging deficits as large as possible. I think the US should retaliate by pursuing an explicit weak dollar policy, until we break the EU and force them to run large deficits just to avoid becoming the world's economic wasteland.

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