Distributional Politics of the Ice Cream Parable

Tyler Cowen is thinking out loud:

This parable assumes that [monetary] injection effects are important, namely where the new money goes first. This Austrian-like view is unfashionable, has weak theoretical foundations, and violates the Modigliani-Miller theorem, but at the moment markets seem to believe it. Should we believe it too?

Yes we should. Or at least we shouldn't let Modigliani-Miller stop us. In his 2011 Presidential Address to the American Finance Association, John Cochrane said the following:

Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we face amount to discount-rate variation we do not understand. Our theoretical controversies are about how discount rates are formed. We need to recognize and incorporate discount-rate variation in applied procedures.

If discount rates are varying a lot -- across time, space, and actors -- then a representative agent model such as Modigliani-Miller is not going to perform very well. And, as it turns out, it doesn't. I have paper, while I'll be sending out for review soon, which drills down at banks' activities (at the firm level) across countries and time. It turns out that there is all kinds of variation being driven by a whole host of variables at multiple levels of analysis. Which, you know, we all know intuitively... but it's not what our models expect. So let's ditch Modigliani-Miller. Capital structure is clearly not irrelevant in the real world.

Going back to Cowen, here's something with which we might be concerned. Central banks act by trading debt instruments for others at price. In normal times the swap is either short-term sovereign debt for cash or present dollars for future dollars plus interest. In our current environment, it's practically anything for cash. Who benefits from this situation? Those who can create debt that can be sold to the central bank for cash. In normal times this has primarily been governments, but governments are doing everything they can to stop creating debt. So who does that leave? Banks.

Because central banks want to be active they have been broadening the range of debt instruments that they will conduct business in. So here's a worrisome dynamic: governments are trying to reduce debt, while banks are being encouraged by central banks to create debt instruments which they can trade for cash. Karl Whelan may be correct that traditional solvency concerns don't apply to central banks, but that doesn't mean that there aren't knock-on effects from this.

The upshot is that expansionist central bank policy requires somebody to lever up. If governments won't do it and households can't do it then banks and large corporations pretty much have to. The more activist the central bank wants to be and the less indebted the government wants to be, the more banks have to create debt instruments however they can. Possibly that could mean loans to individuals and smaller firms, which could be stimulative, but households and firms are deleveraging. Meanwhile, bank regulators are telling banks to stop lending to risky groups. So where's the debt going to come from?

Banks and big credit-worthy firms are going to do very well. They're getting debt finance for free, so their equity can be deployed elsewhere or held in reserve. This is why stock markets are up so much. This is why Apple and other corporations are taking out loans when they don't even need the cash and have no real plans to do much of anything with it in the short run. Everyone else is not going to do very well, because the traditional mechanisms for distributing from central banks to the citizenry -- fiscal policy plus bank loans to individuals and small firms -- is being cut out of the story. In one sense that might be okay if the future costs of debt servicing are higher than the expected return folks would get from borrowing. But the distributional implications of this are clear: the economy is going to become more unequal and less efficient. Credit is not being allocated to facilitate productive investment -- there might not be many -- but to create debt instruments to sell to central banks for cash. The policy mix we have right now practically requires inequality to go up, which is a sign that the economy is seriously imbalanced.

One alternative is to let risk back into the system but I don't hear anybody calling for that right now.

At some point central banks will be pressured to tighten. It looks very likely that this will be under conditions of steady but slowish growth. This is where the Big Unknown comes in. When that day comes will banks (and corporations) start using their cash productively or keep hoarding it? Given the experience of the past decade or so, will there be many people who even want to borrow in order to build a McMansion or buy a luxury car or MBA? If they did, will regulators let banks lend to them? Will the originate-securities-and-distribute-to-surplus-countries market come back as strong as before?

There Is No Technocracy: Stop Worrying About Aggregate Demand

Is "aggregate demand" really what anyone cares about? I don't think so. We care about the quality of peoples' lives. And new research is starting to look at what sorts of fiscal policies matter for improving well-being whatever the macroeconomic aggregates say. Evan Soltas describes some of this work and interviews the authors:

Tax revenues fall automatically in recessions, and governments back that up with lower tax rates and/ or new credits and deductions. On the spending side, extra outlays on unemployment benefits and other transfers greatly exceed extra outlays on infrastructure and other purchases. This modern kind of fiscal stimulus is supposed to work by stabilizing disposable income. Stabilize that, the thinking goes, and you stabilize output and employment. 

But is that right? In a new working paper, Ricardo Reis of Columbia University and Alisdair McKay of Boston University say no. They find that stabilizing aggregate disposable income plays a “negligible role” in stabilizing the economy as a whole. Transfer payments can indeed stabilize output, they find, but mainly through a different channel -- not by changing disposable income in the aggregate, but by changing its distribution. Fiscal policy, in other words, is all about inequality.

“It’s the redistribution that has a lot of kick,” Reis said in an interview. “The usual argument for transfers is basically Keynesian. We find that has very low impact in our model.”

More on the fiscal side here. What about the monetary side? Marc Chandler, a Wall Street manager writing in the Jacobin, describes the relationship between monetary policy and distribution.

Central bank independence was never what it was cracked up to be. During “normal” times, central banks protected the interests of the owners of capital. Paul Volcker is often cited as the epitome of the independent central banker, but surely his tight monetary policy, justified in terms of some technocratic money supply target created winners and losers. The owners of capital were among the winners, while those who did not own capital were losers (through such things as higher unemployment and downward pressure on real wages). ... 

The setting of monetary policy was never simply a technocratic exercise as the [central bank independence theory] pretends. There were always those interests that benefited and those who did less well. Few cried of a loss of central bank independence, for example, when the Bundesbank would threaten tighter monetary policy in reaction to unions seeking a sharp increase in wages.

Much more here. Both the commentariat and academia have focused too long on the supposed technocratic features of policy: whether unemployment is at its "natural" rate, whether output is at "potential", whether central banks are "independent", whether inflation is "low and stable". None of these concepts exist in nature. None of them are even definable quantitatively, although they may be described quantitatively. Hence, they are not scientific concepts but terms of art with important distributional ramifications.
 
I have a paper forthcoming which looks at how banks respond to monetary arrangements. It turns out that monetary politics goes well beyond central bank independence. I'll post a link when it's available.

There Is No Technocracy, Bank of Japan Edition

Scott Sumner:

My view (and that of many other market monetarists) is that the Bank of Japan acted as if it didn’t want inflation, tightening policy in 2000 and 2006, despite no inflation. In my view the press and many economists were somewhat naive in accepting the BOJ’s claim that there was little they could do to end deflation. After all, the yen is a floating fiat currency. ... 

I used to wonder why the BOJ tightened so much in late 2006, raising interest rates and reducing the monetary base by 20%. Another Financial Times story gives us the answer: 

In recent years, the bank has tended to shrug off overt political pressure. A 1998 revision of the BoJ law strengthened its operational autonomy by removing the government’s authority to dismiss the governor and deputy chiefs.  

Only under prime ministers with very solid popular support, such as Junichiro Koizumi between 2001 and 2006, has the BoJ appeared to bend to the government’s will. It has put up a particularly strong defence of its independence under Mr Shirakawa, promoted from deputy governor in 2008.

This is a common theme on this blog. Hopefully others are starting to internalize it. For some reason this particular post and discussion reminded me of this old article (pdf) of Oatley's on the politics of central banks. For my money the best articles on the politics of "technocratic" institutions have yet to be written. There's a good bit of fruit still to be harvested from there.

Will the Dollar Remain the Global Reserve Currency?

Jeffrey Frankel summarizes some of his recent research on how some currencies become internationalized, and speculates on the implications of his work (and that of others like Eichengreen) for the rise of the renminbi as an international currency. He highlights two previous occasions change in reserve currencies: the shift from the pound sterling to the dollar in the 1930s-1940s, and the rise of the yen and German mark during the 1970s-1980s. (He mentions the rise of the euro since 1999, but the euro mostly just replaced the mark.) Frankel suggests that shifts in global reserve currencies come about when the following conditions are met:

1. A large volume of trade in the rising country.

2. Creditor status for the rising country.

3. Perceptions that the currency of the rising country will maintain its value.

4. Deep, liquid, open financial markets in the rising country.

China definitely meets the first two criteria, probably meets the third, and definitely does not yet meet the fourth although it has taken some baby steps in that direction over the past few years. But I'd add another criterion to the four above: a reserve currency becomes a reserve currency when it's already a reserve currency. In other words, the attractiveness of a currency is partly about the national characteristics that Frankel describes and partly about network externalities. The usefulness of a reserve currency is largely a function of who else uses it as a medium of exchange. If lots of other folks use it, it makes sense for you to use it too. If few others use it, there's not much point in your using it. Therefore, currency usage is determined by a preferential attachment decision rule: currencies that attract a lot of usage by foreign entities tend to attract even more usage; currencies that attract little usage tend to continue to attract little usage.*

For this reason, the reserve status of a currency tends to be pretty durable. As long as the currency network remains intact, central nodes tend to remain central nodes and peripheral nodes tend to remain peripheral nodes. It generally takes a major crisis for the network to disintegrate, thus it generally takes a major crisis for a displacement to take place even if Frankel's four conditions are otherwise met. The shift from the pound sterling (under the gold standard) to the dollar required several world wars and a global depression. These extreme events obliterated the network that had emerged during the "first age of globalization"(large pdf), and allowed the formation of the post-war reserve system based on the dollar.

In other words, I believe Frankel's criteria are necessary for a shift in global reserve currency, but are not sufficient. Previous systemic changes required major crises. There have been few of these; in the past half-century perhaps only a partial one: the dollar's status weakened a bit with the collapse of the Bretton Woods system of exchange rates pegged to the dollar, which was in turn pegged to gold. This led to the emergence of the German mark and Japanese yen as important currencies, though clearly still subordinate to the dollar. The dollar's centrality remained through the "Bretton Woods II" system, in which industrializing economies exported capital to industrialized countries (particularly the United States) to facilitate growth and employment through exportation.

This monetary system actually reinforced the central role of the dollar in the international monetary system, but eventually culminated in the subprime crisis. Was this shock large enough to further the process of reserve diversification by disrupting the currency network? There are reasons to think so. The initial financial shock was probably the largest in history, and it emanated from the country at the center of the system: the United States. In hierarchal complex networks, major systemic change generally requires a large attack on the central nodes. For these reasons many expected -- and some hoped -- that the subprime crisis would lead to a reorganization of the international monetary system and the rise of a new reserve currency. Some hoped that the Chinese yuan would increase in global importance, others that special drawing rights at the IMF -- which are comprised of a basket of currencies -- would emerge as a central international reserve asset. Still others anticipated a greater role for the euro; while the European debt crisis now makes this look exceedingly unlikely, it never had much of a chance as Kathleen McNamara wrote in a 2008 article in RIPE.

So there are also reasons to be skeptical about a shift away from dollar dominance. Unlike the British in the interwar period, the US has proactively worked to stabilize the international monetary system. The Fed opened currency swap lines with almost every important central bank in the world from 2008-2010, ensuring that the financial system had ample liquidity. For the most part these actions have been successful, and as of year-end 2010 the dollar was as central to the international exchange network as it had been in 1998.** In other words, the US's actions prevented the network from unraveling the way it did during the interwar years.

In addition, there is no other country that is well-positioned to take over. The Chinese yuan is not yet convertible. The Japanese and Swiss economies are not large or dynamic enough. The euro is not stable enough. And that's... about it. So despite major upheavals in recent years, I do not expect major shifts in the international monetary system any time in the near future.

*Credit to Thomas for first making this point to me.


**I took a look at the data in a previous post, from which the picture at the top of this post is taken.  

Elementary Questions About Keynesianism

I think I asked this question back in '09 or early '10, but I didn't get a satisfactory answer so I'll ask it again. I am certain that there is a simple answer to it, but I haven't yet seen it. I know some Keynesian economists occasionally read this blog, so I'm hoping they'll set me straight.

As far as I can tell, the whole Keynesian framework depends on the existence of a liquidity trap. Without it, as Krugman keeps repeating, normal rules of macroeconomics apply: trade is good, monetary policy is effective, etc. But in Depression Economics all that is turned upside down. The rules of the game change because of the constraint imposed by the liquidity trap. Normal macroeconomics doesn't work.

In the Keynesian framework monetary policy is ineffective at the zero lower bound because people (banks, businesses, households) hoard cash. Thus there is a decrease in aggregate demand, economic activity slows, unemployment increases, etc. I get all of that. Here's the leap that I can't make: why isn't that true of fiscal policy as well? If I use monetary policy to give people money and they hoard it, why would they not hoard money if I use fiscal policy to give them cash?* The whole idea of Depression Economics depends on a psychological model of mass peoples -- what Keynes called "Animal Spirits"** --  that would seemingly apply universally to all public policy intended to stimulate demand. I see no reason why businesses or households would respond to cheap/free money from the monetary authorities by not hiring, but respond to cheap/free money from the fiscal authorities by hiring.

In other words, if the monetary multiplier is small because of the hoarding impulse derived from animal spirits, then the fiscal multipler should be no greater and probably smaller, for a few reasons. Cash transfers on the fiscal side only moves the money once, and then it should be hoarded in the same way as cash from monetary policy (which is also moved once). But fiscal policy also incurs new debt, which must be serviced. That imposes real future costs in the form of interest -- which is admittedly quite small or even negative in the present environment -- and fiscal drag from future taxation, both of which can be anticipated. Tack on some waste/corruption/deadweight loss and it's hard to see how fiscal policy would be more effective than monetary policy at the zero lower bound or anywhere else. Even at a high discount rate monetary policy can always be cheaper than fiscal policy, so it should seemingly have a higher multiplier.

I freely admit my ignorance and stupidity in this matter. I understand that economics often makes no sense until someone explains it to you, and my economics education effectively ended with my undergrad major. So I'm asking someone to explain it to me: why do animal spirits negate monetary policy at the zero lower bound but not fiscal policy? I'm guessing it has something to do with financial intermediaries, but then doesn't that require an additional, separate assumption about psychology?

*The closing scene in the HBO adaptation of Sorkin's Too Big to Fail has Poulson muttering to one of his deputies something like "We gave the banks the cash; now they better spend it and get the economy moving". I'm sure that's apocryphal, but the whole point is that they didn't. They hoarded it, as a Keynesian would expect from monetary policy, but not from fiscal policy. Poulson, of course, was most concerned with the fiscal intervention.

**While I'm here, there's something else I don't understand: Why is it that Keynesians smirk at assertions that businesses aren't hiring between of "uncertainty" when their entire underlying model depends on precisely that claim? Partisans on the right surely miss part of the story when they attribute this uncertainty only to Obama's policies -- I agree with Summers when he said that the biggest uncertainty is over the entries on the order books, i.e. aggregate demand --  but the uncertainty that matters is over expected profits. One part of that equation is revenue, the other part is costs including regulatory and tax costs. Decreasing uncertainty over the former (in a positive direction) increases confidence and thus investment, but so does decreasing uncertainty over the latter (in a positive direction). Both sides seem to be right and wrong. Or, rather, incomplete without the other.

A Few Links in Lieu of Actual Post

-- Phil Arena has a great post on selectorate theory as applied by Bueno de Mesquita and Smith in this Foreign Policy article. Gist: if selectorate theory generates useful advice for leaders like Obama, then it isn't much good as theory.

-- John Quiggin on China.

-- Erik Voeten on the UN and a potential General Assembly vote on Palestinian statehood.

-- Hayek: *Monetary Nationalism and International Stability*, from 1937. Haven't finished this yet. Hoping it provides some impetus for a research project or at least a substantive blog post or two.

-- Michael Pettis is a must-read on balance of payments dynamics and currency issues, especially related to China. I've started a post on this, which I hope to finish soon.

Links

Probably won't get to blog these properly, but they deserve attention.

-- Sad that this is necessary, but Barry Eichengreen discusses why a return to the gold standard is probably impossible, and not at all desirable anyway.

-- "The network of global corporate control", a very interesting research paper.

-- "The Convulsions of Political Economy", an application of Marx to the current environment from an unlikely source: a Senior Economic Advisor at UBS.

The BIS Misses Monetary Moral Hazard

That's the "Bank for International Settlements", the group comprised of central bankers from the leading world economies. Here's what they're saying:

However on one key issue the Bank of England’s FPC [Financial Policy Committee] appears to fall short. The potential trade-offs between monetary policy and financial stability are not addressed. In an opinion piece today, the former Bank of England Monetary Policy Committee [MPC] member Sushi Wadwhani has highlighted the dilemma.

For example, suppose we have an emerging house price bubble and the FPC increases capital requirements which, through widening lending margins, slow the economy, and this leads the MPC to expect inflation to undershoot the target over the next two years. Under the proposed structure, it is envisaged that the MPC would lower interest rates in order to keep inflation at target. If so, would this not largely offset the actions of the FPC and keep the house price boom going?

The BIS report concedes that the short-term interests of monetary policy and financial stability policy may occasionally diverge. Mr Wadwhani argues this means a single committee should be responsible for both monetary policy and financial stability. While BIS accepts that would facilitate coordination and force policy makers to confront the trade-offs at stake, it concludes that responsibility for the two policies can be separated, as long as it is clear which takes priority.

What does this mean? In England, the the Monetary Policy Committee is tasked with conducting a monetary policy that will keep the economy on a path of steady growth with low and stable inflation. The Financial Policy Committee is tasked with maintaining financial stability. But there is an important tradeoff between monetary policy goals, which are counter-cyclical, and financial regulatory goals, which are pro-cyclical. Having two separate institutions pursuing opposite goals can be self-defeating, which is why Sushi Wadwhani suggests having a single institution responsible for both. And the BIS seems to agree:

The logic for central bank involvement is well established. The financial crisis showed that central banks are ultimately lenders of last resort to the financial system, and so should pay proper attention to its overall health. Moreover central banks’ primary policy mandate, monetary policy, has a strong influence on financial stability; think quantitative easing today, or the consistently low interest rates in America that encouraged a bubble in real estate prices in the 2000s.

The BIS wants all central banks to be given legal responsibility for financial stability, arguing that macroprudential regulation requires the same autonomy as monetary policy. ...

For now though, the direction of travel is clearly towards legally defined responsibilities for financial stability and the centralisation of power within central banks. Unusually that points towards emerging market structures, rather than American or European ones.

So the BIS wants a single institution -- the central bank -- to be responsible for both monetary policy and financial stability. It acknowledges the tradeoff between the two, but does not specify how that tradeoff is likely to be resolved. Note the bolded portions above. But what are appropriate ways to resolve the tradeoff? How do we make it "clear which [goal] takes priority"? Which goal should take priority?

I've argued in my research (currently under review and previously discussed here), building off of prior work by Copelovitch and Singer, that the tradeoff is resolved by central banks that also regulate in a way that the BIS might find perverse: by privileging banks' interest. Copelovitch and Singer find that regulatory central banks allow higher inflation -- i.e. more access for banks to cheap funds, which then fuels economic expansions -- than nonregulatory central banks. I extend that by arguing that banks respond to this policy dynamic by acting more riskily when regulated by central banks, because they believe that they'll have access to those funds in times of need. I call this "monetary moral hazard", distinct from the fiscal bailout moral hazard involved with TBTF firms, and support for such a relationship shows up in the data.

In other words, the BIS (and Bank of England) are correct that there is an important tradeoff between macroeconomic management and financial stability. But resolving that tradeoff by locating regulatory authority in central banks resolves the tradeoff in a way that may not promote financial stability, instead creating monetary moral hazard. One possible way to get around this dynamic (that I do not explore in the paper) is via much stricter statutory regulations by removing discretion from regulators, which is more or less the opposite of what the BIS is proposing. Many in England and elsewhere have called for stricter laws along these lines, and while the international Basel III agreement has taken a step in that direction, it's not a very large one.

FOTD

But despite its best efforts, the Fed has only succeeded in raising America’s broad money supply (as measured by seasonally-adjusted M2) to about $8.8 trillion. China’s central bankers, on the other hand, have increased China’s M2 to almost 70 trillion yuan, or $10.5 trillion. As Mr Kroeber points out, China has a greater quantity of money circulating in an economy a third of the size. Who is calling whom easy?

Via.

Emmanuel's Gonna Love This

Via the whole internet.

The Effect of the Unholy Trilemma on the International System

McMegan can't find anything wrong with Drezner's post about international politics and the unholy trilemma. Let me try to help her. Drezner's is a decent post, but it reads like he might have been a bit short of time because it's a bit under-developed. First, his claim:

The unholy trinity in open economy macroeconomics is pretty simple. It's impossible for a country to do the following three things at the same time:

1) Maintain a fixed exchange rate

2) Maintain an open capital market

3) Run an independent monetary policy

One of the issues with macroeconomic policy coordination right now is that different countries have chosen different options to sacrifice. China, for example, has never opened its capital account. The United States, in pursuing quantitative easing, has basically chucked fixed exchange rates under the bus, no matter how many times Tim Geithner utters he "strong dollar" mantra in his sleep to reporters.

So far so good -- although I'd emphasize more than him that it is possible to do any two of those three, so the choice is which one to neglect, not which one to pursue -- and he's honing in on an important dimension of IPE right now: what happens when the major economies disagree about which two to prioritize? Bretton Woods I emphasized #s 1 and 3; Bretton Woods II emphasized #s 2 and 3 (see graph above). Right now there doesn't appear to be a consensus.

As Drezner notes, right now the U.S. is letting the exchange rate float (which is nothing new; it has been official policy since the early 1970s), China maintains a closed capital account, Brazil is trending towards that direction, the E.U. has sacrificed independent monetary policy within its borders and fixed exchange rates beyond them, the U.K. is allowing sterling to float, Japan is also eschewing a fixed exchange rate, while open exporting economies like S. Korea and Switzerland have worked to protect their exchange rates. Right now nobody is stressing too much about maintaining capital account openness, but this is a relatively new development.

The interesting part of this, to me, is that divergent policies could put states, especially major trading partners, at cross-purposes. This could under-cut the effectiveness of states' domestic policy goals, which could lead to confrontation and instability. Unfortunately Drezner ultimately neglects the question of why different countries will prioritize different policies, and what the implications of those choices are for the macro system. Instead, he argues that we'll see "a lot more capital controls". That's true, but we'll also probably see a lot more central bank activity and a lot more exchange rate manipulation, depending on the domestic political incentives of states. We've already seen increased management along all of these dimensions recently. In other words, I think we should expect a more active role overall for states in managing their economies in the coming decade that in the past one, but different states will prioritize different goals.

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms.

My money is on the former response, however.

Or they could revert to their default position: the Washington Consensus. The major criticism from the advanced economies of emerging economies prior to the Asian financial crisis was the persistence of capital controls. The major IPE controversy from 1973-2000 or so was the use of the IMF to break those controls down. It's definitely possible that that debate flares up again in the coming years, precisely because capital owners in emerging countries benefit from a more-closed financial system while capital owners in developed countries benefit from a more-open financial system.

We'll have to wait and see, but the longer it takes the global economy to rebound, the stronger these pressures will become.

The Decline

Consider the never-ending narrative of American decline. My historical knowledge isn't super-deep, but I know for certain that that drum has been kicked at least since Sputnik ('50s), continuing through the Vietnam War ('60s), the closing of the gold window and the oil embargo/stagflation ('70s), the rise of Japan ('80s), European integration ('90s), and now the rise of the BRICs, especially China. During this entire period critics of the U.S. have focused on its sclerotic political system and messy "laissez-faire" capitalism (ha!), which was clearly inferior to the svelte technocratic industrial policies of the USSR OPEC Japan NICs E.U. China. The U.S. is becoming more and more irrelevant, I keep hearing. The quick rebound of China, Brazil, and Germany is proof that the world is decoupling from the U.S. The world is becoming more multipolar, the U.S. needs to learn how to shift into obsolescence and be just another state among states.

And yet when the U.S. announces that it is going to reduce some of the maturity of its sovereign debt in order to boost domestic demand -- an equivalent action to normal monetary policy operations, except on 5-year T-bills rather than shorter maturities, at a time when markets expect deflation (see graph above) -- the world goes ballistic. Huh? If the U.S. was as vulnerable as folks make it out to be, and the rest as powerful and resilient, this shouldn't even register. Instead the Chinese complain about "currency manipulation" as if QE2 wasn't a demand-side domestic monetary policy. Brazil complains about capital inflows creating bubbles, and institutes capital controls to counteract them, as if protecting local capital owners and commodity exporters in one of the most inegalitarian countries on earth had nothing to do with it. Japan enacts its own QE, and South Korea is pushing for, er, something to deal with exchange rates at the upcoming G20 meeting it hosts. The entire industrialized world is concerned that a relatively small program in the U.S. is going to threaten their entire economies.

(Either that or they're using it as cover to justify policies that they wish to enact anyway. I actually think this is more likely, since they can always continue to devalue against the dollar without retribution if they wish, and anything that boosts American demand is good for Chinese, Japanese, Brazilian, and South Korean exporters. But I don't know that for certain; maybe these leaders really are freaked out.)

Of course all of this follows a financial crisis that originated in the U.S. but was not contained within it. Forgive me for thinking that at this point the importance of the U.S. to the global economy almost cannot be overstated. At this point I wouldn't be terribly surprised if the replacement of Bretton Woods II is a variant of Bretton Woods I. The U.S. needs to recognize its place in the world, and act like a hegemon should. There's not chance the G-20 is capable of doing it.

So far I think we've done a reasonably good job -- the trading system has remained intact, warnings of competitive currency depreciations have been all smoke and no fire, countercyclical lending has gotten to states (like Greece) that have needed it, international institutions have held together remarkably well -- but we can do even better. Now is the time to finish the Korea FTA and give fast-track negotiating authority to Obama. Doha isn't going anywhere right now, but in a few years time there could be a window for movement, and it would be good to have the tracks laid ahead of time. Now is the time to let other countries devalue against the dollar if they need to, while still pursuing policies that will boost domestic demand, including demand for imports. Yes that hurt employment in tradable sectors, but mostly in the sort of less-skilled manufacturing that will not yield new jobs anyway. In the meantime, it will boost employment in importing sectors, and provide low-cost goods for struggling households. I wish it were possible to push for immigration reform too, since it's the time for that as well, but I'm pretty sure the sort of immigration reform we'd be likely to see right now isn't the sort I'd support.

Now is emphatically not the time to "get tough" with other countries that also pursue policies in their domestic interest, even if they have some short-run negative consequences for the U.S. There is a lot of low-hanging positive-sum fruit hanging out there. There's no need to take an axe to the trunk.

After all, if the Federal Reserve can't get the U.S. economy moving, the Bank of Japan won't be able to either.

The U.S. should not set policy out of fear of decline.

Fiscal Stimulus and The Unholy Trilemma

A new NBER working paper (earlier ungated version here) presents a more nuanced view of the effectiveness of fiscal stimulus:

How Big (Small?) are Fiscal Multipliers?

Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh

We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. 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.

In other words, maintaining an open economy with flexible exchange rates prevents a country from using fiscal policy to stimulate during downturns. Note that under their definition (total trade = 60% of GDP), the U.S. is far from being an open economy. As such, the authors find that the post-1980 multiplier in the U.S. is 0.3 - 0.4. Additionally, when debt-to-GDP is greater than 50%, fiscal multipliers are nil or negative.

It appears that, once again, governments face a tradeoff between maintaining an open economy and being able to effectively moderate downturns using countercyclical policy tools. More specifically, the effect of monetary vs. fiscal stimulus appears to be moderated by exchange rate policy. Under fixed exchange rates, either capital mobility or monetary independence must be sacrificed. Under floating exchange rates monetary independence may be kept, but there's less room to maneuver on the fiscal side. That can leave a country in trouble if it runs up against the zero lower bound.

We may have to further complicate the Unholy Trilemma. In any case, this is a reminder that policy choices can have far-reaching effects.

Hegemony and Currency Wars

Apologies for the lack of posts lately. Real work has gotten in the way.

Over the past few weeks I've been thinking about the Fed's actions over the past few years. At the height of the crisis the Fed moved to shore up the integrity of the banking sector and immediately lowered the funds rate to practically 0%. It also engaged in a first round of quantitative easing -- by increasing the size of its balance sheet -- and qualitative easing -- by increasing the riskiness of its balance sheet. Most observers agree that these actions prevented the Great Decession from becoming another Great Depression.

Since early-2009, the recession has worsened but the Fed has mostly kept policy stable. This has led to complaints from many ideological corners; Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. After all, he famously said of the Fed's role in abetting the Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

So why has he let the U.S. economy stagnate? Why has he let other countries devalue their currencies with no U.S. response? Why hasn't he learned from history?

Perhaps he has. I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets:

"As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Faced with that scenario, perhaps Bernanke has opted instead to try to stabilize markets and defuse an explosive global political economy by allowing other countries to beggar the U.S. some in the short run. Again, I don't know if this is the case, but it seems more persuasive to me than "Bernanke doesn't understand the monetarist lessons from the Depression".

It should be noted that Barry Eichengreen disagrees with Kindleberger about devaluations. Eichengreen argues that while competitive devaluations in the 1930s did beggar neighbors in the short run, they also constituted a large international monetary stimulus that helped pull the global economy out of the depression (after several years). More recently, Eichengreen has argued that this process is best done through multilateral policy coordination so as to avoid swings in exchange rates. Unfortunately this sort of coordination is basically impossible right now. The Prisoner's Dilemma that incentivizes beggar-thy-neighbor devaluations also incentivizes defection from a coordinated monetary policy.

Given that, perhaps Bernanke has chosen to follow Kindleberger's advice: provide as much liquidity as he can, work to maintain an open trading system and relatively-stable exchange rates, and allow other countries to devalue without U.S. reprisal. Perhaps that will cost the U.S. in the short run, but it can benefit the global economy over the longer run.

The IMF Doesn't Like Inflation Any More than the Finance Ministers Who Run It

Some IPE bloggers seem to be reading a lot into a recently-released IMF Staff Position Note. In this note, IMF chief economist Oliver Blanchard and his co-authors consider the lessons we might draw from the recent crisis about the pre-crisis consensus on macroeconomic policy. One lesson he suggests is that a slightly higher inflation target (4 rather than 2 percent) might make it easier to cut rates in the face of large negative shocks. Let me quote the relevant section at length:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

Achieving low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering this question implies carefully revisiting the list of benefits and costs of inflation (page 11).

Maybe I am missing subtlety (subtlety has never been my strong suit), but I don't see how one gets from these paragraphs to Erik Voeten's assertion that the IMF's "Chief Economist calls for countries to raise their inflation target to 4 percent."

Nor do I see how James Vreeland (welcome to the blogosphere, James) can assert that Blanchard has called for monetary authorities to raise their inflation target and cite (I can only infer approvingly) the Financial Times' claim that this "represents a dramatic shift away from the standard policy advice of the IMF." (Though I highly recommend the rest of Vreeland's post on the evolution of IMF conditionality).

Nor, even if this interpretation is correct, do I see why this is hypocritical. What I see is exactly what one hopes to see. Reflective people drawing lessons from major historical events. Lord Keynes' ideas for the IMF emerged from his reflections on the lessons of the Great Depression. In that context, it made sense to prioritize the fight against deflation. Central bankers embraced a two-percent inflation target based on lessons of the Great Inflation. In this context, it made sense to prioritize the fight against inflation. The world throws new challenges at us, and we reflect and adapt. And then the world throws new challenges at us. Shouldn't we welcome indications that policymakers are reflecting and possibly adapting?

Multipliers and Rational Expectations

Back in March I wrote this:

Presumably, Krugman thinks we are in a liquidity trap because the Fed can't credibly commit to boost future inflation. In other words, expectations of (low) future inflation prevent monetary policy from taking hold in the present circumstances, thus reducing the monetary "multiplier" (i.e. velocity of money). In Krugman's mind, this is so self-evident that he doesn't even need to consider things like quantitative easing or eliminating interest payments for excess bank reserves. Banks (and investors) have expectations of [low] future inflation, which makes monetary policy ineffective in a liquidity trap, full stop.

Why, then, are Krugman and his minions so dismissive of the "Treasury View" that the fiscal multiplier is greatly diminished by crowding out private spending because of expectations of future tax increases? Why are one set of expectations enough to make monetary policy completely ineffective, but not have any effect on fiscal policy? For this view to be coherent, there must be some fundamental difference between expectations over future inflation and future taxes, but I can't see what it is. Both expectations come from beliefs about future real net income.

Especially since, as Krugman himself noted earlier today, both banks and consumers are hoarding cash right now. I would expect Krugman to say that we need to government to spend precisely because banks and consumers are hoarding cash. But that only moves the money once: after the government spend the cash, whoever receives it will just hoard it and there is no stimulative effect. In order to get the money moving on a more sustained basis, there has be a story about how consumer expectations improve when faced with fiscal stimulus but remain unchanged when faced with monetary stimulus.

Today, Tyler Cowen said the same thing:

It is frequently suggested that the multiplier today is best estimated at 1.5 or 1.6. My point today is this: if you postulate a potent multiplier you cannot easily also postulate a liquidity trap. The whole point of the multiplier is that if the government buys cement from my company (say for a road) I as the company owner take those cash receipts and spend them elsewhere. Maybe so but that means people are willing to spend cash when they receive it. It means that a helicopter drop (and maybe other forms of monetary policy as well) would stimulate AD quite readily and for free. You don't need exotic or balance sheet-distorting QE here, a simple injection of cash will do.

Indeed, the Christiano, Eichenbaum, and Rebelo model of fiscal policy in a liquidity trap, no matter what you think of it both implies and states that monetary policy will work too. And if that monetary policy is truly a free lunch in terms of gdp, it should be quite credible (if it's not credible in the real world maybe the problem wasn't AD in the first place).

This in response to Robert Barro's recent research (see this op-ed for a summary) and the chatter it has inspired. Just to be clear here: Krugman's position is incoherent. That doesn't mean that Barro's argument is empirically true. But if there is a way that fiscal money multiplies while monetary money does not multiply then Krugman or one of his fellow-travelers has to show how that happens.

Brad DeLong Wrote Something Important in 2005

And it remains important today. I'll quote the conclusion, but it has no power unless you read the whole thing. Please do.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

Politics =/= Magic

Alex Tabarrok muses on the "political" part of "political economy":

Furthermore, the petition says that central bank decisions should not be "politicized." Again, this is disingenuous. Why are more independent central banks better at fighting inflation than less independent central banks? There is nothing magical about independence that makes for low-inflation. Suppose we pick someone at random and give them complete power over monetary policy. Such a central banker would be very independent but I wouldn't count on this policy resulting in much in the way of systematically lower inflation.

The primary reason that independent central banks are better at controlling inflation is that absent direct political control the default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.

Thus, independence is a political decision that favors lenders in the decisions of monetary policy. Now, depending on the alternatives, there may be good reasons for making this choice but we should not fool ourselves into thinking that we have depoliticized money. We should not be surprised, for example, that "independent" central banks tend to make lender of last resort decisions that protect banks and bankers.

[bold added]

This isn't the first time I have been disappointed in Tabarrok's (lack of a) grasp of simple political economic theory. Fortunately for the world, there are a few people who think about the "political" part of "political economy", and they might even have something to say on the topic. For instance, Rosenbluth and Schaap found that electoral rules (i.e. single-member districts vs. proportional representation) play a major role in what types of banking regulations are chosen by governments. In proportional systems governments tend to choose "profit-padding" regulations that are intended to reduce risk-taking by limiting competition, thus guaranteeing higher profits for domestic banks. In other words, political variables can have major effects on banking policy.

Nor is it clear that bankers prefer lower inflation. If the higher inflation comes from lax monetary policy, then banks may prefer easy access to cheap credit over a lower price level*. In fact, Copelovitch and Singer found [pdf] that central banks that have multiple mandates -- i.e. to regulate banks and fight inflation -- choose different policies than those have a single mandate to fight inflation. Interestingly (and contra Tabarrok), Copelovitch and Singer found that central banks that regulate domestic banking sectors have higher inflation rates than those with a single mandate, but that central bank independence has no statistically significant effect on inflation rates. If bankers prefer low inflation, as Tabarrok states, then independent central banks are not acting in the interests of bankers**.

All to say that central banks may be "politicized" in many different ways, and the potential outcomes of that politicization is not predetermined or unidirectional. If these studies are to be believed, a less-independent Fed should lead to higher inflation and more prudential regulation of banks.

More distressing than Tabarrok's specific empirical claims is his attitude. Perhaps there is nothing "magical about independence that makes for low-inflation," but there could be something political about independence that makes for low inflation. In fact, there is a broad and deep literature in both the economic and political science disciplines showing that central bank independence is positively associated with lower rates of inflation. This is unsurprising for students of political economy, since we understand that short-run political incentives often diverge from longer-run economic incentives. "De-politicizing" monetary policy prevents politicians from damaging the macroeconomy in the longer-run in exchange for short-run political gains (at least, it prevents them from using monetary policy as such a tool; fiscal policy is another matter).

In short, there is nothing "magic" about politics, and we don't need "magical" reasons for expecting a link between central bank independence and lower rates of inflation: we have political explanations for these phenomena.

[UPDATE]: McMegan adds comment, and basically gets it right (she's got the story right but loses a few points for saying "magic" rather than "politics"):

Central bank independence works, not because the bankers aren't accountable to Congress (they are, after all, reappointed every so often), but because Congress is only weakly accountable for the actions of the central bank. If Congress were held to account for the actions of the central bank, Congress would appoint bankers who would do populist things that would make us all worse off. Most of the financial policy journalists I know have the sense that Congress actually supported most of what Paulson/Bernanke/Geithner did, but knew they did not dare enact it. They don't want a more accountable central bank.

*In a rational expectations framework lenders shouldn't much care about levels of inflation since they can adjust the interest rates they charge to compensate. In the long-run equilibrium, real profits should be the same no matter what the inflation rate is, so long as the inflation level is mostly stable.

**Or the Copelovitch/Singer results are spurious. For example, they did not test potential interactions between central bank independence and a central bank's mandate, or indeed any interactions including central bank independence. I have a lot of problems with their article, but so far it has not been challenged empirically.

Monetary Policy as Counter-Insurgency Strategy

Via Blattman, here's the abstract of a new NBER working paper [pdf]:

Between 2004 and 2009, Iraq’s currency experienced a massive real appreciation, driven by both nominal exchange rate appreciation and high inflation. The forces driving this appreciation include the end of economic sanctions, the rally in oil prices, and the influx of US aid. During the same period, a number of insurgent groups confronted the Iraqi government. While once posing a formidable threat to Allied forces, the insurgents now seem to be in a terminal decline.

In this essay, we argue that the real appreciation of Iraq’s currency may have played an important role in weakening the various insurgent movements. Many of these organizations were heavily dependent on foreign funding, and the appreciation eroded the purchasing power of their foreign funds. This may have forced insurgents to turn to forms of domestic financing that are inherently inferior for two reasons. The first is that the collection of local “taxes” by insurgents would reduce their popularity. The second is that local collection of revenue increases the autonomy of local insurgent commanders at the expense of central command authorities.

Correlation doesn't equal causation, of course, but it's certainly an interesting thesis.

Who is to Blame?

Who should we blame for our current economic difficulties? I have been thinking about this question for the past week. Not because I wonder who we should blame, but because I am puzzled by the quest to find the person or persons who are responsible. The consensus places primary responsibility on Alan Greenspan. A few, such as Fred Bergsten, blame the IMF as well (for what, exactly, remains unclear). There appears also to be a consensus that Bernanke is to blame for failing to respond correctly to financial weakness (whatever that means) in order to make things better.

I find the search for a culprit puzzling for two reasons. First, the blame game rests on faulty reasoning. Those who assign blame implicitly compare what did happen with a utopian counter-factual of what would have happened had a different policy been followed. Greenspan is to blame because he cut rates too much and fueled the housing bubble. Asserting that these rate cuts were mistaken (and thus G is to blame) requires one to believe that not cutting rates would have produced a much better outcome. Yet, what would have happened had G not cut rates? We might have had a severe rather than a mild recession in the early 2000s. Then we would blame him for not cutting rates (fully unaware, of course, that cutting rates would have produced a housing bubble). So, when we assign blame we assume that the path not taken was a better path without having any good reason to believe this.

Second, when we assign blame we assume that individuals can control highly complex systems. Yet, our understanding of the relationship between monetary policy instruments and economic activity has not yet reached the status of Newtonian mechanics. There is considerable uncertainty about how financial markets work, and how they respond to changes in monetary policy. Whatever imperfect understanding does exist is constantly in flux as financial markets innovate. Is it reasonable to expect the Fed to anticipate the emergence of the new and highly complex financial instruments that drove the sub-prime lending boom? How reasonable is it then to argue that the housing bubble was foreseeable (and foreseen) by Greenspan? This is, of course, the inverse of the first flaw in reasoning; we assume that the future consequences of our current decisions are knowable and we can therefore avoid bad futures.

So why do we insist on assigning blame? I don't know, maybe it reflects our discomfort with the uncertainty that pervades all of the decisions we make and our inability to accept how little direct control we have over the broader forces that shape our lives. Or, perhaps it reflects the exigencies of democratic politics. In a world in which we expect so much from our government, we have lost the capacity to distinguish between those things that a government can be reasonably expected to do and those things we think it should be able to do. As a consequence, we expect unreasonable things from our government, and these expectations create opportunities that those seeking office can exploit to their electoral advantage.