"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Friday, October 29, 2010

Really good links - Fiscal multipliers - Bond bubble - Soprano Fed - Poker face Fed - Amateur bubbles

Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh (via Tyler Cowen) - Fiscal multipliers - "Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero."

John Hussman - Bond bubble - "One might argue that while short-term interest rates are essentially zero, long-term interest rates are not, which might leave some room for a "Hicksian" effect from QE - that is, a boost to investment and economic activity in response to a further decline in long-term interest rates. The problem here is that longer-term interest rates, in an expectations sense, are already essentially at zero. The remaining yield on longer-term bonds is a risk premium that is commensurate with U.S. interest rate volatility (Japanese risk premiums are lower, but they also have nearly zero interest rate variability). So QE at this point represents little but an effort to drive risk premiums to levels that are inadequate to compensate investors for risk. This is unlikely to go well."

Patrick - Soprano Fed - "The Fed needs to take a lesson from Tony Soprano on credibility and managing expectations. Sometimes you need to back-up your threats with real muscle. Most of the time you don't have to resort to muscle if you have a reputation, but every once in a while somebody tries to call your bluff. That's when you need to remind everyone that you really are the baddest dude in town.
        The specific machinery doesn't matter all that much so long you have the ability to force people to do what you want them to do. I was only 6 years old at the time, but didn't Volcker teach us that? The Volcker Fed said "we're going to stamp out inflation". Everyone said: "That's nice. I'll believe it when wages and prices stop rising". Then the CB applied muscle; they raised interest rates to 18% (or whatever it was) and everyone started believing them. To this day, does anyone doubt a competent CB's ability to stamp out inflation at will?
        At ZIRP with high unemployment and idle capacity the CB can't call our bluff with interest rates, and all the wishy-washy talk of bending the yield curve and keeping rates low for a long time is not going to convince anyone of anything (at least not in any reasonable time frame). The Fed really needs to call our bluff and apply some muscle."

Chevelle - What do the Fed's policy and poker have in common? - "This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?"

Adam Ozimek - Amateur investors and bubbles

Wednesday, October 27, 2010

Really good links - Monetary policy and asset bubbles - Yuan and IMF - Behavioural politics

Adam Posen - Monetary policy and global rebalancing - "Japan’s extended economic stagnation since its stock market peaked on December 29, 1989, has prompted a series of investigations, recommendations, and self-examinations, both in Japan and abroad. As I have argued in several places, it takes more than a bubble to become Japan. While asset price booms and even busts are not uncommon, the persistence of Japan’s Great Recession is, and it was not the bubble and its bursting that produced this outcome. Some noted European commentators, however, have asserted that the Bundesbank’s resistance to international pressures for domestic stimulus in the mid-to late-1980s was what saved Germany from Japan’s fate. More recently, some Chinese and other East Asian commentators have picked up this claim as a reason for China not to accede to analogous requests today. All these participants in the discussion would claim that American pressure on Japan produced the bubble, and the bubble produced the subsequent disaster.

        This view is mistaken, despite its apparent political and intuitive appeal. It was not ‘excessive laxity’ of Japanese monetary policy in 1986–89 which caused the bubble in Japanese equity and real estate prices, nor was it yen appreciation against the dollar which caused the bubble’s impact, except as an induced echo of the asset price boom. As I set out last December, there is no evidence across countries over time that excessive monetary ease was a sufficient condition for the Japanese bubble (“if there is a sustained monetary ease, then a bubble occurs”), a necessary condition for the Japanese bubble (“if a bubble occurs, then there must have been prior monetary ease”), or both. <..>

       For monetary policy to be the source of a bubble, the relative price of one part of the economy (here financial and real estate assets) has to be pumped up by a blunt instrument that usually affects all prices in the economy. And it has to do so in such a way that the relative price shift either does not raise expectations of a countervailing shift in monetary policy in the near future (which relies on strange notions of what the imputed future income from increasing land and stock prices will generate), or is expected to only be affected by monetary policy on the upside but not on the down (which there is no reason to believe, if liquidity is the source of the relative price shift in the first place). Either way, this has to take place when we know both analytically and empirically that the relationship between a policy of low interest rates or high money growth and equity or real estate prices is actually indeterminate over time. <..>

        Another way to see this inconsistency is that supposedly loose Federal Reserve monetary policy in the early 2000s built the US real estate bubble, and now supposedly loose Fed policy is fuelling capital outflows from the US to emerging markets. <..>

        Surely, if it were clear that the BOJ were violating its normal policy priorities due to obvious international pressure, the idea that such low rates would be sustainable without any effect on inflation or medium-term growth would have been discounted. The fault for the asset price increases seems to lie in the unrealistic expectations of participants in a bubble, not in Japanese monetary ease itself. <..>

        This is consistent with my view (Posen (2009)) that regulatory rather than monetary factors are the source of most real estate bubbles."

John Cochrane - Yuan and IMF - "He [Geithner] argues for a brave new system, coordinated by the IMF, of international discretionary currency interventions: "G-20 advanced countries will work to ensure against excessive volatility and disorderly movements in exchange rates." <..>

        This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find "imbalances," properly diagnose "overvalued" exchange rates, then "coordinate" structural, fiscal and exchange rate policies to "facilitate an orderly rebalancing of global demand," especially using "medium-term targets" rather than concrete actions. The German economics minister, Rainer Brüderle, called this "planned economy thinking." He was being generous. Planners have a clearer idea of what they are doing."

Matt Ridley - Behavioral politics - "But while there is a lot of interest in the psychology and neuroscience of markets, there is much less in the psychology and neuroscience of government.<..>

        The issue of action bias is better known in England as the "dangerous dogs act," after a previous government, confronted with a couple of cases in which dogs injured or killed people, felt the need to bring in a major piece of clumsy and bureaucratic legislation that worked poorly. Undoubtedly the rash of legislation following the current financial crisis will include some equivalents of dangerous dogs acts. It takes unusual courage for a regulator to stand up and say "something must not be done," lest "something" makes the problem worse.<..>

        "Affect heuristic" is a fancy name for a pretty obvious concept, namely that we discount the drawbacks of things we are emotionally in favor of. For example, the Deepwater Horizon oil spill certainly killed about 1,300 birds, maybe a few more. Wind turbines in America kill between 75,000 and 275,000 birds every year, generally of rarer species, such as eagles. Yet wind companies receive neither the enforcement, nor the opprobrium, that oil companies do."

Monday, October 25, 2010

Really good links - Milton Friedman - Tax cuts - Backloaded deficit reduction - Wen's put - Higher expected inflation

David Beckworth and William Ruger - What would Milton Friedman say? - "Had he been alive, Friedman would have been shocked to see the Fed in late 2008 and early 2009 allow nominal income, as measured by nominal GDP, to experience its sharpest downturn since the Great Depression. He would also be amazed to learn that nominal GDP forecasts are once more headed down.
        Given these developments, Friedman would likely be calling on the Fed again to do a better job stabilizing nominal income."

Karl Smith - Please endorse tax cuts as an option - "Tax cuts. I know for many of my liberal readers this is increasingly becoming a bad term. However, the point is not whether we concede to a so called “republican” idea, the point is whether we reduce unemployment for those in need.
        I have argued and will continue to argue if that for some reason, that I don’t completely understand, the markets fail to take the Fed seriously we still have the option of injecting large amounts of liquidity quickly through tax cuts.
        Please, lets not get hung up on whether tax cuts are an excuse to hand out money to the rich. We can cut payroll taxes. We can even provide a payroll tax credit where you get back the first 5000 your family paid in payroll taxes."

Christina Romer - Backloaded deficit reduction - "While immediate fiscal tightening isn’t wise for the United States, we do need to address the deficit. The best thing would be for Congress to pass a plan now that will reduce deficits when the economy is back to normal. France’s recent plan to gradually raise its retirement age to 62 from 60 is a classic example of such “backloaded” reduction.<..>
        Such backloaded deficit reduction would not hurt growth in the short run — and could raise it. If uncertainty about future budget policy is harming confidence, as some business leaders suggest, spelling out future spending and tax changes could be helpful."

Arthur Kroeber (via FT Alphaville) - Wen’s put - "For the last two months we have unkindly compared Chinese premier Wen Jiabao to the later Alan Greenspan, who helped inflate the US housing policy with his ultra-low interest rate policy which financial markets dubbed “the Greenspan put.” Premier Wen’s put option was his government’s implicit guarantee that GDP growth would never be permitted to fall below 8%. This guarantee destroyed the credibility of all government commitments to structural reform (whose cost is likely to be lower growth), and stoked fears that Beijing simply wanted to buy short-term growth through an endless expansion of credit, and was oblivious to the risk of asset bubbles in the short term and a structurally dysfunctional Japan-style economy in the long term.
        We believe that the official and unofficial statements emanating from last weekend’s annual Communist Party plenary meeting ended the Wen Jiabao put option and signaled that structural reformers are in the saddle (although not with unbridled power). Tuesday night’s surprise interest rate hike, coming immediately after the meeting’s close, strongly amplified this signal. While we do not expect dramatic policy shifts, we do anticipate that the pace of reform measures will visibly accelerate over the next 6-12 months, and that the pace of GDP growth will gradually slow from the current 9% clip to a more sustainable rate of 7-8% over the next two years."

Bill Woolsey - Higher expected inflation - "Only from the point of view of central bankers, with their irrational attatchment to targeting short term and safe nominal interest rates, does higher (expected) inflation provide “benefits.” Their approach to policy, combined with their policy of issuing zero nominal interest currency on demand, has left them stuck. Higher expected inflation would pull them out of this trap of their own construction.
        Well, I guess higher inflation makes the real yield on zero nominal interest hand to hand currency more negative, and so provides more income to the central bankers who borrow by issuing it immediately, and their government owners indiredtly."

Thursday, October 21, 2010

Really good links - Price level targeting - International Yuan - China - Mankiw - Social discount rate - Bailouts and AD

Dave Altig, senior vice president and research director at the Atlanta Fed - Benefits of sticking with a simple price level target - "Some potential benefits of simply sticking with a price-level target is that it (a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behavior (as attested to by the second chart above); (b) avoids a potentially confusing impression that the central bank is jumping from one framework to another to serve whatever is convenient at the moment; and (c) gives the public a clearer way to monitor if and when the long-term price-level objective is being compromised (as can be seen by comparing the implied tolerance bounds in the two charts above)"

Karl Smith - Paul Krugman and Yuan - "It should mean that when the Fed loosens policy, that China responds by loosening the International Yuan which in turn gets shunted towards commodities. Thus rather than boosting the consumer price level as we hope, Fed easing actually winds up boosting commodities.
        This is because China is offsetting the total increase in worldwide consumer demand by tightening the Yuan at home, and boosting the total increase in commodity demand by loosening the Yuan abroad.
        Thus this Yuan policy does all the wrong things."

Paul Krugman - China raises rates - "So, the United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it’s pursuing a contractionary domestic monetary policy, reducing overall world demand."

Greg Mankiw - Marginal tax rates - "Mike [Kinsley] says, "If Mankiw’s marginal tax rate has actually been 80 percent for all these years, it doesn’t seem to have affected his incentives very much, and 90 percent won’t, either."
        Mike might recall that he has, as an editor, several times tried to recruit me to write something for him. I turned him down every time. If he had offered me a reasonable fee, and somehow could have promised that this income and all the investment returns it subsequently generated would be free of all taxes, I might well have accepted the jobs."

Brad DeLong - Compound interest and social discount rate - "If long-term real interest rates are as Mankiw describes them, then either the future must be so filthy rich and so satiated with wealth that there is no point in saving, or it is profoundly irrational to consume more than bare subsistence today because the opportunity cost in terms of how much you are impoverishing the future is so large."

Karl Smith - Bailouts and Aggregate Demand

Monday, October 18, 2010

Really good links - Price level targeting - Optimal inflation rate - Interest on bank reserves - Unemployment puzzles - Government sector - QE 2

Charles Evans, President, Chicago FED - Developing a State-Contingent Price-Level Target - " I would like to use this opportunity to expand the discussion about additional communications tools available to central banks in a low-inflation environment. In a nutshell, I think there are special circumstances when price-level targeting would be a helpful complement to our current and prospective strategies in the U.S. Clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.
        There are quite a number of academic studies of liquidity trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies; and yet, central bankers and the public generally loathe the idea that even a temporarily higher inflation rate could be beneficial or be consistent with price stability over the longer term.
        Nevertheless, with potentially beneficial policies so well grounded in rigorous economic analysis, I cannot stare at our current projections for high unemployment and low inflation and think that these projections are consistent with the best monetary policies to address the Fed’s dual mandate responsibilities." - The implied inflation rates for a 2 percent P* path where the current price gap is closed by the end of 2012 (pdf). - A more aggressive P* policy that is assumed to close by the end of 2013 (pdf)

Joe Gagnon - Friedman rule and optimal inflation rate - "Another argument for a positive inflation rate has to do with a fundamental asymmetry built into the Friedman rule that, to my knowledge, has not been explored in the academic literature. Friedman was concerned about the “shoe-leather” cost of minimizing cash holdings when inflation is positive. What gets almost no attention, however, are the much larger costs to society in lower capital and output arising from deflation. Why would anyone hold risky capital with an expected real return of 5 percent during a steady deflation of 6 percent? In that case, the riskless returns to holding cash exceed the risky returns on productive capital. As the rate of deflation increases, the entire economy shrinks as the capital-output ratio contracts. This cost is many orders of magnitude greater than the “shoe-leather” cost associated with positive inflation of 6 percent. The Friedman-optimal rate of inflation may be -1 or -2 percent, but the costs of deviating below that are sky-high whereas the costs of deviating above it are small."

Stephen Williamson - Liquidity, Financial Intermediation, and Monetary Policy in a New Monetarist Model (pdf) - "One source of much confusion concerning current monetary policy in the United States concerns how policy works when the central bank pays interest on bank reserves, in circumstances where the quantity of excess reserves held overnight is greater than zero. The Fed has now been paying interest, at 0.25%, on overnight reserves since October 2008. In our model, it is a straightforward exercise to include interest bearing reserves. What the model shows is that, if excess reserves are held in equilibrium, then open market operations are irrelevant at the margin, much like in the liquidity trap equilibrium, but with a positive nominal interest rate. Monetary policy works in this regime through changes in the interest rate on reserves, which essentially determines all short-term market interest rates. <..>
        An increase in risk can make liquidity more scarce in general, and this acts to reduce the real interest rate, and to increase the marginal social cost of inflation. An optimal policy response is for the central bank to sell interest-bearing assets and reduce the inflation rate. The real interest rate rises due to the policy action. This is quite different from typical Keynesian financial crisis analysis, where a problem arises because of the zero lower bound on the nominal interest rate, and the real interest rate is viewed as being too high. Here, the real rate is too low in the absence of intervention, due to the shortage of liquid assets. The optimal policy
response in our model is consistent, in a sense, with what the Fed actually did during the financial crisis. After the Lehman Brothers collapse in fall 2008, the Fed sold a large portion of its portfolio of Treasury securities."

Alex Tabarrok - Unemployment puzzles - "The first puzzle about unemployment when thought about from within the search-matching framework is that unemployment rates are highest among the least skilled and most homogeneous skills, i.e. among those worker/jobs with the easiest matches. It's hard to believe that it takes a year to match a construction worker to a job. <..>
        The second puzzle is that uncertainty should matter most when hiring and firing costs are high and once again these costs are lowest for those workers with the greatest unemployment rates."

Menzie Chinn - Government sector (USA) - "The following four figures highlight: (1) normalized Federal outlays are not much higher than in 1986; (2) government consumption to GDP is back up to 1991 levels (and not yet back to 1987 levels; (3) the cyclically adjusted budget deficit is only 2 ppts larger than that recorded in 1987; and (4) Federal consumption remains far below the previous peak in 2007."

Scott Sumner - QE II is arriving right on schedule

CNBC Video - Discussing whether QE2 will work, with James Hamilton, professor of economics at University of California at San Diego.

Thursday, October 14, 2010

Really good links - Money expenditures - Why is Paul Krugman angry? - Bretton Woods 2 - Correlation bubble

Bill Woolsey - Money expenditures - "The problem isn’t that inflation changes and this disrupts output. The problem is that money expenditures change and inflation fails to change enough to avoid disruption of output.
        If some prices change and others don’t (say wages), then the problem isn’t that some prices changed or that everything would be fine if those prices didn’t change. The more fundamental problem is money expenditures changing, and the secondary problem is that some prices failed to change enough.
        In other words, the “too little inflation” approach is wrong, wrong, wrong."

Angry Bear (spencer) - Why is Paul Krugman angry? - "Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $).
        That mean that the increase in imports was 87.5% of the increase in domestic demand. That mean[s] that the increase in imports was 87.5% of the increase in domestic demand.
To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%."

Tim Duy - Bretton Woods 2 - "Bretton Woods 2 simply morphed forms. Rather than a reliance on US financial institutions to intermediate the channel between foreign savers and US households, a modified Bretton Woods 2 - Bretton Woods 2.1 - relied on the US government to step into the void created by the financial mess and become the intermediary, either by propping up mortgage markets via the takeover of Freddie and Fannie, or the fiscal stimulus, or a dozen of other programs initiated during the financial crisis.
        In essence, a nasty surprise awaited US policymakers - after two years of scrambling to find the right mix of policies, including an all out effort to prevent a devastating collapse of financial markets and a what Administration officials believed to be a substantial fiscal stimulus, the US economy remains mired at a suboptimal level as stimulus flows out beyond US borders. The opportunity for a smooth transition out of Bretton Woods 2 was lost. <..>
        Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2. November 3, 2010. Mark it on your calendars."

Marko Kolanovic (via FT Alphaville) - Correlation bubble - "We conclude that both the realized correlation of stock prices and option implied correlation are in a ‘bubble’ regime and forecast a significant decline of correlation over a one- to two-year time horizon."

Monday, October 11, 2010

Really good links - Nobel in Economics - Money expenditures - Richard Thaler and EMH - Taxes - China

Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences - Scientific Background on the Economics Nobel 2010 - "Along similar lines, Diamond argued that a search and matching environment can lead to macroeconomic unemployment problems as a result of the difficulties in coordinating trade. This argument was introduced in a highly influential paper, Diamond (1982b), where a model featuring multiple steady-state equilibria is developed. The analysis provides a rationale for “aggregate demand management” so as to steer the economy towards the best equilibrium. The key underlying this result is a search externality, whereby a searching worker does not internalize all the benefits and costs to other searchers. The model Diamond developed in this context has also become a starting point for strands of literature in applied areas such as monetary economics and housing, which feature specific kinds of exchange that are usefully studied with Diamond’s search and matching model." - See also Tyler Cowen's take

Bill Woolsey - Money expenditures - "If there were a commitment to get the quantity of money high enough and market rates low enough to get money expenditures back to the growth path of the great moderation, then the demand to hold money would fall and the natural interest rate would rise. It is entirely possible, if not likely, that the actual quantity of money would need to fall and market interest rates would need to rise."

Richard Thaler - EMH (via FT Alphaville) - "The bad news for EMH lovers is that the price is right component is in more trouble than ever. Fischer Black (of Black-Scholes fame) once defined a market as efficient if its prices were “within a factor of two of value” and he opined that by this (rather loose) definition “almost all markets are efficient almost all the time”. Sadly Black died in 1996 but had he lived to see the technology bubble and the bubbles in housing and mortgages he might have amended his standard to a factor of three. Of course, no one can prove that any of these markets were bubbles. But the price of real estate in places such as Phoenix and Las Vegas seemed like bubbles at the time. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble."

Greg Mankiw - Bush tax cuts - "Suppose that some editor offered me $1,000 to write an article. <..> Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000 [30yrs from now]. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?
By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working."

Brad DeLong - China (written in 2006) - "At some point China's State Council will tell the People's Bank of China to stop buying dollar-denominated securities. What happens then? Bad things. And if I listen to my inner Friedrich Hayek about how the cost of unwinding a fundamental resource-allocation and investment disequilibrium rises more than one-for-one with the magnitude times the duration of the disequilibrium, I can get very worried indeed. Dollar crashes, financial crises, large-scale housing defaults, deep recessions, panics, revulsions, discredits--and at the very least the movement of 8 million workers in the U.S. out of construction, consumer services, and supporting occupations and into export and import-competing manufacturing, and the movement of 40 million workers in Asia out of export manufacturing and supporting occupations and into... what?"

Thursday, October 7, 2010

Really good links - Monetary imbalances vs. financial stability - Stock market returns (Bill Hester) - Old monetarism - Brad DeLong

Jürgen Stark, Member of the Executive Board of the ECB - Monetary imbalances vs. financial stability - "Not all historical episodes of private sector money and credit balances going off track have been followed by threats to financial stability. But, every major economic crisis in the 20th century was preceded by the emergence of monetary imbalances. <..>
        The Great Depression is another case in point. It is certainly true that the banking crisis brought about by the failure of central banks to understand their role as a lender of last resort under the gold standard was detrimental. But equally detrimental was the sheer unavailability of monetary data that could have signalled the need, given the collapse in money and credit, for monetary policy to be accommodative much earlier on, to a higher degree and for much longer."

Bill Hester - Do Past 10-Year Returns Forecast Future 10-Year Returns? - "Can the process of forecasting long-term stock market returns be simplified to include just one step – calculating the prior decade's return? This is one of the arguments that analysts are currently using to convince investors that the coming decade will offer above-average returns. It's important to take a closer look at the argument because it's become widely discussed and reported. A strategist at a major investment bank argued recently that poor 10-year trailing returns is reason enough to expect lofty returns over the next decade. A similar argument was recently made in Barron's, and by various mutual fund companies. <..>
        The argument that above-average long-term returns typically follow periods of poor past long-term returns is not wrong, it's just incomplete. The more complete argument is above-average long-term returns can be expected to follow long periods of low or negative, provided that they end with low P/E multiples on smoothed earnings and precede a period where the economy can be expected to enjoy robust growth. Today, valuations are at levels that have normally been followed by 10-year returns that are well below average. At the same time, based on a template from more than a dozen prior credit crises, the argument that the economy will grow strongly over the coming decade finds little support."

Nick Rowe - Was Milton Friedman right after all??? - "Suppose you were a monetary economist in the US in the 1930's. And suppose you knew that currency was a medium of exchange, but you didn't know that demand deposits at fractional reserve banks were also media of exchange. You would have noticed the runs on banks, and bank closures, but you wouldn't think that these had anything to do with the supply of money. As far as you knew, the money supply, which you thought of as currency, would have seemed OK. You would completely miss the fall in the money supply.
        Maybe we are like that now. Maybe a large part of the money supply is dark matter. We didn't see it fall. We saw the runs on the shadow banking system, but didn't see how it affected the money supply.
        I have no idea if this is right. It probably isn't. But I'm not as confident as I used to be..."

Brad DeLong - Standard open market operations - "And it is the exact shape of the financial excess demand--which will always be, empirically, a mixed matter--that determines which strategic governmental interventions will be most effective. Printing up more government bonds will fail when the root problem is excess demand for money and money demand is not very interest-elastic. Standard open market operations in short Treasuries will fail when the root problem is excess demand for bonds-as-savings-vehicles or for high-quality assets and money demand is very interest-elastic."

Tuesday, October 5, 2010

Really good links - Zero bound - Bad news and stocks - Labor market - Countercyclical protectionism - Currency wars

William Dudley - Zero bound and inflation expectations - "Clear communication on the part of a central bank is important at all times, but it is even more critical when the federal funds rate is at or near its effective lower bound. In this environment, a decline in inflation expectations that drives up the real interest rate and thereby increases the real cost of credit cannot be offset by simply lowering the federal funds rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate is at the zero bound represents a de facto tightening of monetary policy and of financial conditions. Such a tightening would clearly be highly undesirable at a moment when unemployment is too high, inflation is too low and the economy has only moderate forward momentum. <..>
        If we judged it desirable, we could go still further and provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years."

Nick Rowe - Bad news and stocks - "With a consistent inflation targeting central bank, it used to make sense that weak data causes stock prices to rise. Weak data is news that the natural rate of interest is lower than we thought it was. The central bank will adjust monetary policy to keep AD and earnings on target, but the lower natural rate means a higher PV of those earnings."

Eric S. Rosengren - Dislocations in the Labor Market? - "In fact, in each of the three previous recessions there was a decline of 5 percent or more in no more than two industry categories – as the figure shows – with many industries experiencing little or no net job loss over the course of the recession. Structural shifts across industries are not uncommon in recessions – and also, some structural dislocation seems inevitable as it will always take some time for capital and labor to flow to those industries with the greatest opportunities.
        In rather stark contrast, the most recent recession is far less a reflection of dislocation in a few industries but rather reflects a general decline in almost all industries. As the chart on the far right shows, in this recession there has been a peak to trough loss of employment of 5 percent or greater in construction, manufacturing, retail trade, wholesale trade, transportation, information technology, financial activities, and professional and business services. To me, this does not suggest that the driver is structural change in the economy increasing job mismatches – although no doubt some of that exists – but instead I see here a widespread decline in demand across most industries."

Stephen Gordon - Some implications of thinking of trade as a form of technology - "One issue where I wish I had remembered this story was when it was suggested that protectionism could be used as a counter-cyclical policy instrument. Yes, I would have replied, in much the same way that forbidding the use of excavators and backhoes would be a counter-cyclical policy instrument: construction firms would have been forced to hire any number of extra workers to dig by hand. Both measures would have put people to work doing tasks that had not been hitherto performed by Canadian workers. And in both cases, it's not at all clear what the exit strategy would have been."

Paul Krugman - Currency wars - " ...rates are pretty much at zero. And in that case, it’s hard to see what mutual intervention accomplishes. Suppose the Fed buys a bunch of euros, and the ECB a bunch of dollars. Suppose also that they do the usual thing and hold the newly acquired reserves in short-term debt — Treasury bills. Then the net effect is just as if each central bank had done a conventional open-market operation in its own T-bills.
        And the whole point of the liquidity trap literature is that such conventional open-market operations have no effect — they just swap one zero-rate asset, monetary base, for another, short-term government debt. So the currency interventions accomplish nothing.
        It would be different if the central banks acquired long-term assets instead; then we’re talking about quantitative easing through the back door."

Saturday, October 2, 2010

Brad DeLong and flight to safety

Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:

"Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds--which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange."

The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, "it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money". You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.

It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called "The largest arbitrage ever documented", as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.

While the root cause of the crisis might have changed since the Lehman panic, the low prices of Treasury securities give us no indication what it is. We might have the lack of safe assets, or we might have the lack of liquid assets. Policy responses that expand both are to be preferred at this point. One good option is credit easing - expansion of central bank lending collateralized by a diversified mix of medium quality private sector assets. Replacing 3-month T-Bills with reserves achieves nothing, as 3-month T-Bills have greater utility as medium of exchange than reserves, we know this because 3-month bills often yield less than the effective fund rate.

When the Minsky moment arrived in September 2008, we had a flight to liquidity that was not fully accommodated by the Fed. Investors who thought that we had a flight to safety underperformed after Lehman as they purchased safe but less liquid assets such as TIPS, off-the-run Treasuries and gold mining stocks.

The Money Demand