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June 4, 2010

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Latest Posts from Economist's View

Volcker: The Time We Have Is Growing Short

Posted: 04 Jun 2010 01:08 AM PDT

Here's part of a much longer essay by Paul Volcker on financial reform (and a few other issues):

The Time We Have Is Growing Short, by Paul Volcker, NYRB: ...The nature and depth of the financial crisis is forcing us to reconsider some of the basic tenets of financial theory. ... One basic flaw running through much of the recent financial innovation is that thinking embedded in mathematics and physics could be directly adapted to markets. A search for repetitive patterns of behavior ... are a big part of the physical sciences. However, financial markets are not driven by changes in natural forces but by human phenomena, with all their implications for herd behavior, for wide swings in emotion, and for political intervention and uncertainties.

Important questions about ... governance ... and the relationships between principals and their agents are being reexamined. Most obviously and appropriately, the role of regulation and supervision... To me, the lesson is clear. There are deep-seated structural issues that must be dealt with by legislation. Moreover, there should be common elements among nations hosting significant international financial markets and institutions. ...

The central issue with which we have been grappling is the doctrine of "too big to fail." Its corollary is so-called moral hazard: the sense that an institution—its creditors, its management, even its stockholders—will be inclined to tolerate highly aggressive risk in the expectation that it will be rescued from possible failure by official financial support. ...
Dealing with this ... moral hazard has become the largest challenge for financial reform. Central to that effort ... in the United States and in Europe has been the creation of a new "resolution authority" that could supersede conventional bankruptcy procedures when the potential failure of a "systemically important" financial institution threatens to undermine the stability of the financial system. ... Put simply, the concept is to prepare for a dignified burial—not intensive care with hopes for recovery. ...
None of these reforms will assure crisis-free financial markets in the years ahead. The point is to keep the inevitable excesses and points of strain manageable, to reduce their scale and frequency...
As we well know, the critical policy issues we face go way beyond the ... regulation of financial markets. There is growing awareness of historically large and persistent fiscal deficits in a number of well-developed economies. ... If we need any further illustration of the potential threats..., we have only to look to ... Europe. ...
In an uncertain world, our currency and credit are well established. But there are serious questions ... about the sustainability of our commitment to growing entitlement programs. Looking only a little further ahead, there are even larger questions of critical importance for those of less advanced age than I. The need ... for effective action against global warming, for energy independence, and for protecting the environment is not going to go away. Are we really prepared to meet those problems, and the related fiscal implications? If not, today's concerns may soon become tomorrow's existential crises. ...
Restoring our fiscal position..., sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We'd better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large.

Woodford: Financial Intermediation and Macroeconomic Analysis

Posted: 04 Jun 2010 12:42 AM PDT

While I'm on the topic of modern macro models, here's a recent paper (May 2010) from Michael Woodford that I came across while running down a reference for the post that follows this on. One of the missing elements in modern models -- a point I've made here often -- is the connection between financial intermediation and the real economy. So it's nice to see Woodford pushing in this direction:

Financial Intermediation and Macroeconomic Analysis, by Michael Woodford, May 2010: How will the financial crisis change the teaching of macroeconomics? While it is difficult to predict intellectual developments before they occur, one can be reasonably confident that the macroeconomic implications of developments in the financial sector will receive a great deal more attention from now on. Of course, issues relating to financial stability have always been part of the curriculum --- though perhaps presented as mainly of historical interest, or primarily of relevance to emerging markets. But recent events have made it clear that financial issues need to be integrated much more thoroughly into the basic framework for macroeconomic analysis with which students are provided.
Why has financial intermediation not played a more central role in the macroeconomic theory of the past few decades? Some suggest that fundamental theoretical or methodological commitments have made it difficult for mainstream macroeconomists to consider hypotheses under which financial conditions can be considered an independent determinant of economic outcomes. But a more straightforward explanation is that financial developments, at least in the U.S., had rendered the kinds of financial constraints previously emphasized in macroeconomic analysis less obviously important.
The Keynesian macroeconomic models of the third quarter of the twentieth century had emphasized the determinants of expenditure flows as the crucial factors behind variations in both economic activity and inflation, and the availability of credit was certainly recognized as among the important determinants of at least some key categories of spending. But the constraints on the availability of credit that were emphasized in models of the time resulted from specific institutional forms and regulatory requirements that came to be of less relevance.
For example, accounts of the "bank lending channel" of the transmission of monetary policy emphasized the indispensable role of traditional commercial banks as sources of credit for certain kinds of borrowers, without direct access to capital markets.1 Deposits were in turn held to be an indispensable source of funding for the lending of commercial banks, and these were subject to legal reserve requirements. To the extent that the latter requirements were typically a binding constraint, a reduction in the supply of reserves by the Fed would require the volume of deposits to be reduced, which would in turn require less lending by commercial banks. Yet the importance of this channel for effects of monetary policy on economic activity depended on the simultaneous validity of each of the links in the proposed mechanism: the reserve requirements a binding constraint for many banks, the lack of sources of funding for commercial banks other than deposits, the lack of sources of credit other than commercial banks for an important subset of borrowers, and the lack of opportunities for banks to substitute between other assets and the kind of lending for which they were essential.
Each of these assumptions was less obviously defensible after the financial innovations and regulatory changes of the 1980s and 1990s.2 Non-bank financial intermediaries became increasingly important as sources of credit, particularly as a result of the growing popularity of securitization. Panel (a) of Figure 1 [here] shows total net lending by the U.S. private financial sector; while commercial banks are clearly still important, they are far from the only important source of credit. More importantly, both the recent lending boom and the more recent financial crisis had more to do with changes in financial flows of several of the other types shown in the figure; for example, lending by ABS issuers surged in the period up until the summer of 2007, and then crashed.
And commercial banks themselves have increasingly turned to sources of funding other than deposits. Panel (b) of Figure 1 [here] shows the net increase in commercial-bank liabilities each quarter from each of several sources. Checkable deposits are only a small part of these institutions' financing; moreover, deposits shrank during the years of the lending boom, but have risen again during the crisis --- so that neither the growth in commercial-bank assets during the boom nor the contraction of bank assets in 2009 can be attributed to variations in the availability of deposits as a source of financing.
And finally, with the increase in vault cash holdings that has resulted from the spread of ATM machines, reserve requirements have become no longer a binding constraint for many banks (even before the massive increase in the supply of bank reserves during the financial crisis).3 As a consequence, the continuing relevance of the traditional bank lending channel is subject to considerable doubt.
Such developments have made it tempting to abstract from credit frictions in macroeconomic modeling, at least as a first approximation.4 However, the recent financial crisis has made it plain that even in economies like the U.S., with substantially market-based financial systems, significant disruptions of financial intermediation remain a possibility. Understanding such phenomena, and analysis of possible policy responses to them, requires the development of a macroeconomic framework appropriate to a market-based financial system in which credit is nonetheless not a veil.

Fortunately, work on the development of more modern approaches to the introduction of credit frictions into macroeconomic analysis is well underway.5 Here I sketch the basic elements of a modern model, at a level of detail intended to be suitable for presentation in an undergraduate course.6 I begin by explaining the basic analytical framework, and then briefly discuss some of the implications of a model of this kind for monetary policy. ...[continue reading]...

Let me relate this to the post below this one, and adopt a more critical stance toward the existing work on policy multipliers during recessions such as the one we are experiencing. First, on the empirical side, there's the problem of not having very much data to work with. In New Keynesian models, the economy behaves very differently at the zero bound, so data from ordinary times doesn't tell us much. Thus, any estimates of the multipliers that are based upon data from times when the interest rate was above zero, which is most of the evidence that we have, are highly suspect.

Second, and more to the point of this post, with respect to the theoretical models, if we don't have the connections between the financial and real sectors fully modeled -- if important elements of the transmission mechanism for financial and policy shocks are missing -- then I don't know how much faith we can put in the multipliers (or monetary and fiscal policy) that we derive from these models. That's one reason why this new work is important. We don't know for sure that the policy prescriptions that are called for in the existing models will carry over to models that incorporate an explicit role for financial intermediation in supporting real activity. I think the outcome will be much the same in terms of the overall message about stimulating aggregate demand, and that the new models will justify many of the creative steps the Fed took during the crisis. But we can't be sure until we actually build these models and look at the types of polices that work the best within the new framework.

The Credibility of Monetary and Fiscal Policy

Posted: 04 Jun 2010 12:24 AM PDT

Scott Sumner, responding to a post by Tyler Cowen, says:

Expectations traps: They're even more applicable to fiscal policy, by Scott Sumner: Tyler Cowen links to this post from Mark Thoma:

As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Paul Krugman developed the idea of an expectations trap as a way of explaining the dilemma faced by the Bank of Japan.  Except there is just one problem.  Almost everyone agrees that Japan does not face an expectations trap.  They can devalue the yen whenever they wish, as much as they wish. ...

But here's the bigger flaw with the whole expectations trap argument.  People think it applies to monetary policy, but they forget it applies equally to fiscal policy.  (Indeed I never realized this until today.)  Here's why.  Krugman's model relies on rational expectations, indeed you can't get the expectations trap without ratex.  But if you have ratex in your model, then no policy can work unless it is expected to work.  ...

This is relatively easy to dispense with. First, those of us who pushed for fiscal policy were told we were basing this on old-fashioned models, IS-LM at best, maybe even more outdated than that. So the New Keynesian theorists went to work and showed that within the modern models used for policy analysis, fiscal policy does, in fact, find support.

The model I've been using in particular is Eggertsson's and to some extent Woodford's. The difference is that Eggertsson looks at how multipliers vary across various tax and government spending policies, while Woodford is more concerned with the determinants of the size of the government spending multiplier. For example, Woodford says:

Much public discussion of this issue has been based on old-fashioned models (both Keynesian and anti-Keynesian) that take little account of the role of intertemporal optimization and expectations in the determination of aggregate economic activity. Yet discussions of monetary stabilization policy over the past several decades have been transformed by the development of a new generation of macroeconomic models that simultaneously consider the dynamic implications of intertemporal optimization on the one hand, and delays in the adjustment of wages and prices on the other. The implications of these models for fiscal stabilization policy have been much less fully developed than their implications for monetary policy. But this is not because the models do not have implications for fiscal policy. The present paper reviews some of these implications for one specific question of current interest: the determinants of the size of the effect on aggregate output of an increase in government purchases, or what has been known since Keynes (1936) as the government expenditure "multiplier."

Going back to the creditability issue raised by Scott Sumner, one of the points that Eggertsson makes is that government spending does not have the credibility problem that plagues monetary policy. He says:

As shown by several authors, such as Eggertsson and Woodford (2003) and Auerbach and Obstfeld (2005), it is only the expectation about future money supply (once the zero bound is no longer binding) that matters ... when the interest rate is zero. ... Expansionary monetary policy can be difficult if the central bank cannot commit to future policy. The problem is that an inflation promise is not credible for a discretionary policy maker. ...
This credibility problem is what Eggertsson (2006) calls the "deflation bias" of discretionary monetary policy at zero interest rates. Government spending does not have this problem. ... The intuition is that fiscal policy not only requires promises about what the government will do in the future, but also involves direct actions today. And those actions are fully consistent with those the government promises in the future (namely, increasing government spending throughout the recession period). ...

Even so, monetary policy might still work, it's a matter of being able to credibly commit to future inflation:

It seems quite likely that, in practice, a central bank with a high degree of credibility, can make credible announcements about its future policy and thereby have considerable effect on expectations. Moreover, many authors have analyzed explicit steps, such as expanding the central bank balance sheet through purchases of various assets such as foreign exchange, mortgage-backed securities, or equities, that can help make an inflationary pledge more credible (see, e.g., Eggertsson (2006), who shows this in the context of an optimizing government, and Jeanne and Svensson (2004), who extend the analysis to show formally that an independent central bank that cares about its balance sheet can also use real asset purchases as a commitment device). Finally, if the government accumulates large amounts of nominal debt, this, too, can be helpful in making an inflation pledge credible. However, the assumption of no credible commitment by the central bank, as implied by the benchmark policy rule here, is a useful benchmark for studying the usefulness of fiscal policy.

I think the assumption that the Fed cannot credibly commit to future inflation is a relevant benchmark in the present case since I am not sure that people believe that the government will actually create inflation in the future even if they promise to do so now. As I said in the original post, I think the inflation fighting credential the Fed has worked so hard to earn work against them in this instance. My point was that I didn't want to put all of my faith in one policy instrument -- monetary policy -- when theory and experience says that fiscal policy is the superior policy tool at the zero bound. Monetary policy alone might work, but again, if fiscal policy is available and these uncertainties exist, why take a chance? Why not use fiscal policy as well?

More generally, if people want to go back and use older or different models to make their arguments, that is fine, but it doesn't have a lot to do with the argument I was making. Perhaps they believe these models are superior to the models that Woodford and Eggertsson are using, that's certainly their prerogative, but which model provides better answers to the questions we are asking is a completely different argument. For the most part, the issues being raised about credibility have been considered and addressed within the New Keynesian framework.

Update: See Paul Krugman's comments, Policy And The Tinkerbell Principle.

links for 2010-06-03

Posted: 03 Jun 2010 11:05 PM PDT

"The Mankiw Rule Today"

Posted: 03 Jun 2010 03:33 PM PDT

Andy Harless says the Mankiw rule for monetary policy indicates is will be quite awhile before the Fed starts increasing the target interest rate:

US Monetary Policy in the 2010's: The Mankiw Rule Today, by Andrew Harless: To make a short story even shorter, the Mankiw Rule suggests that the Zero Interest Rate Policy will continue for quite some time, barring dramatic changes in the inflation and/or unemployment rates.

"The Mankiw Rule" is what I call Greg Mankiw's version of the Taylor Rule. "Taylor Rule" is now the general term for a rule that sets a monetary policy interest rate (usually the federal funds rate in the US case) as a linear function of an inflation rate and a measure of economic slack. ... Unfortunately, there are now many different versions of the Taylor Rule, which all lead to different conclusions. Not only are there many different measures of both slack and inflation; there are also an infinite number of possible coefficients that could be used to relate them to the policy interest rate. ...

Parsimony suggests that a good Taylor rule should have 3 characteristics: it should be as simple as possible; it should use robust, easily defined, and well-known measures of slack and inflation; and it should fit reasonably well to past monetary policy. Also, to have credibility, such a rule should have "stood the test of time" to some extent: it should fit reasonably well to some subsequent monetary policy experience after it was first proposed. The Mankiw Rule has all these characteristics. It uses the unemployment rate and the core CPI inflation rate as its measures, and it applies the same coefficient to both. This setup leaves it with only two free parameters, which Greg set in a 2001 paper (pdf) so as to fit the results to actual 1990's monetary policy. As you can see from the chart below, the rule fits subsequent monetary policy rather well, although policy has tended to be slightly more easy (until 2008) than the rule would imply.

You will notice a substantial divergence, however, after 2008, between the Mankiw Rule and the actual federal funds rate. If the reason for this divergence isn't immediately clear, you need to take a closer look at the vertical axis. ...

If we wanted to make a guess as to when the Fed will (or should) raise its target for the federal funds rate, a reasonable guess would be "when the Mankiw Rule rate rises above zero." When will that happen? (Will it ever happen?) Nobody knows, of course, but the algebra is straightforward as to what will need to happen to inflation and unemployment. If the core inflation rate remains near 1%, the unemployment rate will have to fall to 7%. If the core inflation rate rises to 2%, the unemployment rate will still have to fall to 8%. Do you expect either of these things to happen soon? I don't.

I don't either, but that doesn't mean the Fed can't deviate from its past pattern. Let's hope that the members of the FOMC are smart enough not to begin raising interest rates too soon. However, the hawkish statements coming from the Fed recently, particularly from presidents of the regional Federal Reserve banks, do make me wonder if the Fed will begin raising rates while unemployment remains substantially elevated. For example (and this relatively dovish overall compared to, say, this):

The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I'm very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.

The ADP Says There Were 55,000 New Private Sector Jobs in May, But That's Far Short of What's Needed

Posted: 03 Jun 2010 11:52 AM PDT

I have a short comment at MoneyWatch responding to today's ADP report on private sector job growth,and on how to interpret tomorrow's jobs report from the government :

The ADP Says There Were 55,000 New Private Sector Jobs in May, But That's Far Short of What's Needed

The ADP figures, and those expected tomorrow in the jobs report, may not be as good as some reports are indicating.

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