Saturday, September 22, 2012

Europe's payroll taxes

The Wall Street Journal made this nice graph on Saturday.

Forget "who bears," it's the totals here that are mind-boggling. In most countries, if you add up the "employer" and "employee" contributions, you get between 30 and 40%. So, if a worker produces 100 euros worth of output, 30-40 euros immediately go to the government. And there is an additional 20%+  VAT when the worker goes to buy something. So, right out of the gate, we have a 50-60% wedge between working and the fruits of labor. Income taxes, corporate taxes and property, excise, and other taxes are all on top of that! It's a wonder anyone in Europe bothers to work at all.

(I haven't looked in to the numbers, but I presume the European numbers include financing of their health systems, and the US number does not. Don't feel so cheeky.) 

The story was about a proposal to shift "employer contribution" to "employee contribution" in Portugal, as "the title" who bears the burden" suggests.

Economists will quickly tell you that who pays the tax doesn't matter. Gas stations pay the gas tax, but everyone can see that it is all passed on as higher gas prices; we're not "socking it to the rich oil companies" with gas taxes.

But if wages are "sticky," especially if fixed by union contract or law forbidding cuts, then this argument fails, and the Portugese transfer is an interesting way to lower wages without devaluing the currency, changing the overall tax wedge, or repealing laws forbidding wage cuts. 

Apparently the protesters in the streets figured that one out. If they figure out that nominal wage increases offset the whole thing, then we're back to the standard theorem.


Casey Mulligan and one commenter noticed that I oversimplified.
It's not huge but not rounding error either: you cannot just add the employer and employee rates in order to quantify the combined distortion, unless wages are held fixed, because the employer contribution is omitted from the payroll tax base. The formula typically used by tax economists is:


Eg a 100% employer tax is very different, and much less damaging, than a 100 percent employee tax. Your error is largest when the employer rate is far from zero, which it is in Europe.
Good point, and in retrospect it's better to use the right formula than simplify too much, even here. However, for everyone else, keep in mind that this is not a serious attempt to measure the overall total marginal disincentive in tax and transfer systems. The point is that this rather large social insurance wedge is at the beginning; we add income taxes, means-tested transfers, phaseouts, wealth taxes, etc to this rather large base. We keep talking about income taxes as if they existed in a vacum.

On the quesiton whether it's a tax because you get benefits: What counts is the margin. A forced savings plan has very little disincentive. If you have to save 10% of income, you get the results eventually. The wedge is only how much you'd really rather have the income today. US social security has a bit of you get more if you pay more, but not that much. And my impression is that european social insurance systems give much less marginal benefit for marginal contributions. (Commenters, I'm curious to hear facts on that)

Thursday, September 20, 2012

Two views of debt and stagnation

Two new papers on economic stagnation in periods of high government debt (i.e. now) are making a splash: 

Public Debt Overhangs by Carmen  Reinhart,Vincent Reinhart and Ken Rogoff
The Output Effect of Fiscal Consolidations by Alberto Alesina, Carlo Favero and Francesco Giavazzi

This review is mostly about the former, with a little mention of the latter (maybe I'll get back to that later)

The Reinharts and Rogoff look at episodes in which government debt crossed 90% of GDP. They have two big conclusions: the episodes lasted  a long time, "...among the 26 episodes we identify, 20 lasted more than a decade," and those episodes are associated with slow growth: "the vast majority of high debt episodes—23 of the 26— coincide with substantially slower growth."

They want very much to conclude that high debt causes the slow growth, referring to "growth-reducing effects of high public debt." But as always in economics, correlation is not causation, which they recognize:
But obvious concerns arise here about cause and effect. Is the public debt overhang causing the slower growth? Or is an exogenous shock that causes slower growth either helping to generate the public debt overhang or else prolonging the escape from that debt overhang?
Evidence? Well, the debt episodes last a long time
The long length of typical public debt overhang episodes suggests that even if such episodes are originally caused by a traumatic event such as a war or financial crisis, they can take on a self-propelling character...
 The long duration belies the view that the correlation [high debt with low growth] is caused mainly by debt buildups during business cycle recessions. ...
No, alas. This makes a pretty good first-year exam question: write down a model in which income is completely exogenous (unrelated to debt levels) yet once a country crosses 90% debt/GDP it takes decades to repay, and growth is slower conditional on high debt. (Hint: Use the permanent income model. Countries get in debt when they have bad income shocks. Debt has a unit root in that model, so debt excursions are never expected to revert.  It does take "growth fluctuations" that are beyond "cyclical," but those do exist, even without high debt.)

Ok, well,
This endogeneity conundrum has not been fully resolved. However, a number of recent studies have tackled the problem. .... [they] have concluded that the relationship cannot be entirely from low growth to high debt, and that very high debt likely does weigh on growth.
Oh, great. "Studies." Yet, as I read the review of the "studies," they are the usual sort of growth regressions or instruments, hardly decisive of causality.

I shouldn't be too hard, because I agree with the conclusion (high debt is likely to cause low growth). I'm just picky about the logic. But for a reason.

What's missing? A mechanism. To discuss cause and effect sensibly we have think about the plausible mechanism is. Regressions can too easily conclude that since rich guys drive BMWs, all you need to do is drive a BMW and you'll get rich.

And clearly, debt by itself doesn't matter -- it's how debt leads to other economic events that matters.

This is to me a frustrating feature of Reinhart and Rogoff's earlier work. Recessions after financial crises are typically longer (usually misquoted as "always.") Ok, but why? Because governments follow policies after financial crises that screw up economies for a long time (distorting taxes, wealth transfers, propping up zombie financial institutions)? Because of "private debt overhang" that would be cured by a massive transfer from savers to borrowers? (Not my favorite theory, but popular around the lunchroom so I'll mention it.)  Because the destruction of property rights in bailouts freezes new investment?  Their work is quoted as a mysterious fact of nature about which nothing can be done.

Here, Reinharts and Rogoff do mention some mechanisms
The first channel operates through a quantity effect on private sector investment and savings. When public debt is very high, it will tend to soak up the available investment funds and thus to crowd out private investment. If the government at the same time is imposing policies that attempt to reduce its debt burden with higher taxes, a burst of unexpected inflation, or various types of financial repression, then investment may well be discouraged further.
The first mechanism seems to me to confuse debt with deficits. The second one rings true: high debts correspond to high taxes (really high tax rates), wealth expropriation, and other big drags on investment. Financial repression is an under-reported issue:
In addition, governments in the second half of the twentieth century often used policies of “financial repression” to reduce the cost of the public debt, by limiting capital flows and regulating financial institutions in such a way that alternative investments were blocked and financing for government debt would flow more cheaply.
See Banks, comma, European. And given the detailed control that Dodd-Frank gives to US regulators, I can see "gee, we didn't see you at the Treasury Auction. Should we send some inspectors down to look at the books?" coming to a bank near you soon.
The second channel involves a rising risk premium on the interest rates for government debt. Sufficiently high levels of public debt call into question whether the debt will be repaid in full, and can thus lead to a higher risk premia and its associated higher long-term real interest rates, which in turn has negative implications for investment as well as for consumption of durables and other interest-sensitive sectors, such as housing. 
This makes less sense by itself. Why should a risk premium on government debt matter to private investment?  Well, because we can all see that an indebted government is going to tax away private businesses... but we already talked about that.

A mechanism could let us sort out cause and effect. We can see distorting taxation, financial repression, property rights destruction in defaults, inflation, and see which paths following high debt make growth better or worse.  (Many PhD theses here!)

And, more importantly, the correlation is really pretty useless until we figure out which mechanism is at work.

RRR's Conclusions:
This paper should not be interpreted as a manifesto for rapid public debt deleveraging
exclusively via fiscal austerity in an environment of high unemployment.
OK, but I find this annoyingly misleading. Why sign on to the deliberately obfuscation induced by current political use of the word "austerity"? Cutting spending is a lot different from raising marginal tax rates. "Unemployment" sounds like an endorsement of short-term Keynesian stimulus, which must be the one thing that clearly doesn't work in their data once debt gets to 90% of GDP.

Alesina and company make this clear:
Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions. 
Here we have in a nutshell my frustration with the Reinhart-Rogoff paper. There is a causal mechanism staring us in the face -- high taxes, prospective wealth confiscation (and financial repression) kill growth. Yet, they want to make "debt" the culprit, not really looking at the causal mechanisms in any detail. Why are they not just a big data set for Alesina and co's conclusions?  Back to RRR:
Our review of historical experience also highlights that, apart from outcomes of full or selective default on public debt, there are other strategies to address public debt overhang including debt restructuring and a plethora of debt conversions (voluntary and otherwise). 
Now you get the agenda and weak discussion of causal mechanisms. If "debt" is the problem, the answer is obvious: default or inflate it away. "Restructuring" and "conversions" are nice words for default.

But the case for default is not, in fact, made anywhere in the "review of historical experience" in this paper. Serial defaulters in their data do not have higher growth rates. Paying it back worked out OK for Alexander Hamilton. The Soviet Union was inaugurated the opposite way with a big default. If washing your hands of debts is such a good idea, it's interesting that so many governments go to such lengths to avoid it.

Where is the option, liberalize your economy, and grow out of it? They dismiss the one great data point that goes against the trend, the UK paying off Napoleonic war debt, thus,
there were substantial transfers from the colonies to finance debts and facilitate debt reduction...With the exception of the United Kingdom at the height of its colonial powers in the nineteenth century,

So forget  free markets, industrial revolution, railroads and all that -- England just taxed colonies like ancient Rome?

Speaking of the 19th century
In those days before fiat currency, inflation was not as prevalent as it would later become. Thus, the “liquidation” of government debt via a steady stream of negative real interest rates was not as easily accomplished in the days of the gold standard and relatively free international capital mobility as in the decades after World War II.
This sounds like a bad thing!

Yeah, default sounds great ex-post. But it is the precommitment against default ex-post that lets you borrow ex-ante. To say nothing of the chaos a large-scale sovereign default or inflation in the US and Europe would cause. Not so easy.

I don't mean to sound one-sided on this. I've been advocating Greek default for a while, at least while the original bond holders still held some of the debt. (Too late now). I'd still rather see us all  liberalize, grow, and pay it off. I'd rather see governments cut spending, as I see that paying it off by confiscatory wealth taxes will lead to a big no growth data point. Default is only a little better than that option. But let's face up to the costs of default, not just how nice it will be to wipe out the debt.
However, the evidence, as we read it, casts doubt on the view that soaring government debt does not matter when markets (and official players, notably central banks) seem willing to absorb it at low interest rates—as is the case for now.

I'm glad to end on a note of total agreement. "As is the case for now" only applies to some countries -- ask a Greek friend!

Sunday, September 16, 2012

Sargent and interest-rate options

By now, you've probably seen Tom Sargent's great Ally Bank TV spot.

But, were I to needle Tom just a bit, I might ask, "Tom, the Ally Bank CD allows you the option of raising your CD rate once over its two-year life. Can you explain when to optimally exercise that option?''  Or (second beer), "Tom, to what portfolio optimization question is the answer, combine a two-year CD with an American option to raise the rate once?  You must have some great robust-control result here about parameter uncertainty in dynamic interest-rate models."

Tuesday, September 11, 2012

Unraveling the Mysteries of Money

Harald Uhlig and I did a fun interview run by Gideon Magnus (Chicago PhD) at Morningstar. We talk about the foundations of money, fiscal theory, monetary policy, European debt problems, etc. Gideon framed it well, and Harald is really sharp. Somebody combed my hair. A cleaned up version of the interview appeared in the Morningstar Advisor Magazine (html) (A prettier pdf)

A link in case the video doesn't work or doesn't embed well (if you see "server application unavailable" the link usually still works), or if you want the original source.

The video starts a little abruptly, as it left out Gideon's thoughtful introduction (it's in the Magazine) and framing question:
Gideon Magnus: I want to discuss the value of money and the idea that money is valued similarly to any other asset. Are there really assets backing money? If so, what are they? John, please explain.

Monday, September 10, 2012

How not to blow it with phase-outs

Today's Wall Street Journal article, How Not to Blow It With Financial Aid, appparently about financing college education, has important lessons for the ongoing grand fiscal debate.

The article is about college financial aid, especially federally funded, and unwittingly exposes the atrocious incentives of the system.
"Every $10,000 reduction in income is going to improve your aid eligibility by [about] $3,000" if you have one child in college..

Every dollar a child has in assets—that includes bank accounts or trust funds—cuts their possible award by 20 cents. Every dollar a child makes in income above $6,130 (the limit for 2013-14 aid) cuts their possible award by 50 cents...

Every dollar a student gets from a 529 plan owned by other relatives is considered income to the student and reduces potential financial aid by 50 cents if the student is above the income threshold
So, we're looking at 30, 20, and 50 percent additional marginal tax rates on income or savings -- how much you lose if you make or save an extra dollar. The journal is full of useful tips to game the system.

Now, to the larger question. What matters for economics is the total, marginal tax rate. If you earn one extra dollar, and then spend it, how much stuff or services do you actually get -- after all taxes are included, including payroll, federal income, estate, excise, state income and excise, local, sales or property (if a good) or a second round of income and social insurance taxes (if a service). Ideally, we'd add in the burden of taxation incorporated in product prices too -- if the government taxes a business and that raises the price of what you pay, that's just like taxing you for buying the good.

And phaseouts. Phaseouts of deductions and eligibility for benefits count the same as taxes. If earning an extra dollar lowers your eligibility for college financial aid by 30 cents, that that is exactly the same thing as a 30 cent additional marginal tax rate.

In our grand national discussion about taxes, I seldom see any attempt to add this up -- to addess the total marginal rate, including all sources of taxation and deduction and benefit phaseouts. (And all questions of margins and distributions should include benefits in the same breath with taxes. If the tax system were flat and the government writes checks to people with lower income, that's the same progressivity as if the tax system were progressive and spending were not.) The debate over Federal taxes focuses on the headline federal income tax rate, 35 vs. 39%. But that is basically meaningless. The extra 30% marginal rate for people sending kids to college has not been mentioned once. Or the effects on the economy if people follow the Journal's advice to intentional impoverishment.

I wish I got to ask a question at the Presidential debate, of both candidates: Sir, what do you believe is the highest total marginal tax rate any American should pay, including all sources, phaseouts, and means-tested benefits? What do you think that rate is now? What steps will you take to ensure that no American pays a  higher rate?  Just asking the first question should send the fact-checkers on a field day and we'd start talking about how high marginal tax rates are now.

Even the Journal gets this wrong on occasion. Here's a graphic, from today's Hollande-Arnault story

No, dear Journal, this is not even close to the "top marginal rate." To start with, the US has state and local taxes, which Europe does not. And Europe has fewer phaseouts.

And now the conundrum of tax policy: As you can imagine, I'm a big fan of lowering rates and paying for it by eliminating deductions and tax expenditures. If I were in charge, the mortgage-interest and charitable contribution deductions would be gone, as would the deductibility of employer-provided group health plans. Now you know why I'm not in charge.

In this weekend's Meet The Press interview, Gov. Romney said he wanted to "limit deductions and exemptions for people at the high end" only.   Well, phasing out deductions is the same as a marginal tax rate.  If earning an extra dollar lowers, say, the deductions you can take on your existing income by 50 cents, that counts as a 50% marginal tax rate every bit as much as  if we just take the money.

I haven't done the numbers, but that's going to make it  harder to lower the economically meaningful marginal rates. It would seem far better to give the lower-rate-and-no-deductions offer to everyone.

The extraordinary complexity of the tax system is also curious. Perhaps the hope is that, since no economist seems to be able to calculate the true marginal rate, and people seem not to talk about it much, that nobody notices and so ignore the disincentives. Alas, there is an army of tax lawyers who are very good at this sort of thing, and even Wall Street Journal articles can advise that the year before your kid goes to college might be a good one to take that round the world tour rather than make any money.


Casey Mulligan wrote to let me know his upcoming book "The redistribution recession (cover at left, link to Amazon) undertakes a lot of marginal tax rate calculations, finding a maximum over 400 percent,  "over a pretty wide range of income, although applicable to a small percentage of the population." It will be on top of my stack as soon as it comes out.

A physician wrote with a comment, on my statement that economists don't calculate total marginal rates often enough:

..I certainly did. As a solo general surgeon in private practice, in 2004, with a gross business income before taxes of roughly $500K, I figured that the 39.6% Federal + 9.98% state top income tax rates + 6% [state] sales + Medicare which no longer peaked out, + property taxes, medical license fees, malpractice fees which were already at $100K for me and headed higher, and no scholarship help for the 4 out of 10 kids in college at the time, my marginal rate was somewhere north of 70%. Once I 'retired' from surgery and became a biology professor, making around $50K, my gross income was one tenth as much, but now one of my kids got a full-ride scholarship at [University], another got a half-ride scholarship, and another got a couple thousand that would not have been given under my earlier circumstances. By my 'going Galt', I figure that the .gov took at least a $200K hit (I remember previously paying $161K in fed. income taxes alone), whereas my disposable income was only about half of what it had been before. So you can bet that we non-economists, with all the individually detailed information at our disposal do indeed make these kinds of calculations, even if they're tough for economists to do in aggregate. At least for me, the argument that a simple 36% federal income tax is below the Laffer curve hump is lame, given other factors

SEC Sues Investment Advisor for Failure to Disclose

Before anyone thinks that the SEC is not monitoring investment advisors, last week the Commission announced that it instituted a settled administrative proceeding against two Portland, Oregon-based investment advisory firms and their owner regarding the failure to disclose a revenue-sharing agreement and other potential conflicts of interest to clients.
The SEC alleged violations in three areas of the advisory business run. Most notably, the firm did not disclose to customers that it was receiving revenue-sharing payments from a brokerage firm that managed a particular category of mutual funds being recommended to the firm's clients. Because the firm received a percentage of every dollar that its clients invested in these mutual funds, there was an incentive to recommend these funds over other investment opportunities in order to generate additional revenue for the firm.
Without admitting or denying the SEC’s charges, the owner and the two advisory firms agreed to pay a combined $1.1 million to settle the case.
If you are not sure if you are in compliance, with SEC or state regulations, hire an experienced securities attorney to represent you and to provide you with the appropriate guidance. The time and energy in preventing a compliance screw-up is a whole lot less than defending an SEC action and paying a significant fine, for the same screw-up. Need help? Email us.

Wednesday, September 5, 2012

Bad Hair Day

A short interview by Betty Liu on Bloomberg TV: (if that doesn't work a link). The ECB's big bond buying program, how "sterilizing" won't solve everything, and discussion of the WSJ Oped on the future of the Fed

Cetera Rebrands Its Independent B-Ds

Cetera Financial Group i has announced a rebranding each ofits four broker-dealers with new names that all begin with Cetera.

  • Genworth Financial Investment Services, acquired earlier this year from insurer Genworth Financial, largely comprises advisors with expertise in tax and accounting. It will become Cetera Financial Specialists, eliminating confusion about any continued association with its former owner.
  • Multi-Financial Securities, consisting of entrepreneurially minded advisors who, according to Brown, prefer a direct connection to the home office, is being renamed Cetera Advisors.
  • PrimeVest, with advisors in banks, credits unions and other financial institutions, will become Cetera Financial Institutions.
  • Financial Network, composed of advisors grouped into regional networks, will retain its regional orientation, becoming Cetera Advisor Networks.

Financial Planning has more details at their site.

    SEC Charges Poker Players with Insider Trading

    The SEC announced charges against a California man for with illegally tipping a hedge fund manager with inside information about Nvidia Corporation’s quarterly earnings that he learned from his friend who worked at the company.
    The SEC alleges that Hyung Lim of Los Altos, Calif., received $15,000 and stock tips about a pending corporate acquisition for regularly providing a fellow poker player, Danny Kuo, with nonpublic details ahead of Nvidia’s quarterly earnings announcements.  Kuo, a hedge fund manager, illegally traded on the information and passed it on to multi-billion dollar hedge fund advisory firms Diamondback Capital Management LLC and Level Global Investors LP.
    The SEC charged Kuo and the firms among others earlier this year as part of its widespread investigation into the trading activities of hedge funds. “These hedge fund traders were eager to find an edge in an otherwise competitive marketplace, and Lim provided them that edge for a price,” said Sanjay Wadhwa, Associate Director of the SEC’s New York Regional Office and Deputy Chief of the SEC Enforcement Division’s Market Abuse Unit.  “Now one more participant in this sprawling scheme is being held accountable for his illegal transgressions.”
    In a parallel action, the U.S. Attorney for the Southern District of New York today announced criminal charges against Lim. According to the SEC’s complaint filed in federal court in Manhattan, Kuo and the hedge funds made nearly $16 million trading in Nvidia securities based on Lim’s inside information.
    More detail is available at the SEC web site in its press release.
    We represent professionals and investors in insider trading investigations and proceedings, and have been doing so for decades. If you have a question regarding an insider trading investigation, or any SEC, FINRA or State investigation, send us an email at

    Tuesday, September 4, 2012

    Woodford at Jackson Hole

    Mike Woodford's Jackson Hole paper is making a big buzz, and for good reasons. Readers of this blog may be surprised to learn that I agree with about 99% of it. (Right up to the "and hence this is what we should do" part, basically!)

    Any student of economics should read this paper. Mike lays out in clear if not always concise prose, and remarkably few equations, the central ideas of modern monetary economics, on all sides, along with important evidence.

    Mike's central question is this: how can the Fed "stimulate," now that interest rates are effectively zero, and given that (as Mike reviews), "quantiative easing" seems extremely weak if not completely powerless? He comes up with two answers: (Hint: starting with the conclusions on p. 82 is a good way to read this paper!)

    First, the Fed can make promises to keep interest rates low in the future, past the time when normally the Fed would start to raise rates. He hopes that such promises would lower long-term interest rates, through the usual expectations hypothesis mechanism that long rates are expected future short rates. He is sympathetic to "nominal GDP targeting" as a way to commit to those promises.

    Second, drop money from helicopters, i.e. "coordinated monetary-fiscal policy." Basically, the Treasury borrows money, writes checks to voters ("helicpoters"), and the Fed buys the debt. I certainly agree the latter policy can create inflation (I wrote as much in "Understanding Policy"), though both Mike and I  emphasize that policy needs some expectations and commitments asterisks too.

    Why monetary stimulus?

    One reason I disagree so little with the analysis of this paper is because of the part that Mike left out (rightly, it's already 98 pages): Mike didn't explain why he thinks more monetary "stimulus" is a good thing right now.

    Treasury rates are at 50 year lows. The 10 year Treasury rate is 1.5%. At 2% inflation, that's a negative 0.5% real rate. Yes, the economy is in the toilet, but surely too-high Treasury interest rates are not the crucial economic problem right now.

    So the case for "stimulus" must be that some other, unstated lack of "demand" is the problem, and that all "demand" is the same so that monetary "stimulus" will cure that problem. I disagree on that one.

    Mike's enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word "stimulus," never differentiating between real and nominal stimulus. Surely, we don't want to cook up some inflation just for its own sake -- we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here -- promising to keep rates low even once inflation rises, adopting "nominal GDP targets," helicopter drops, or similar policies such as raising the inflation target.

    I don't put much faith in Phillips curves to start with  -- the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.

    But it's a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment.

    So, in my view, the problem isn't overly tight monetary policy. The economy's problems lie elsewhere. Monetary policy is basically impotent. And it's hard to see that deliberate monetary "stimulus" via expected inflation will help the real economy. We should be telling the Fed to stop pretending to be so all important. You've done what you can. Thanks. You'll do best now by sitting on your hands and letting others cure the real problems.  But that kind of advice doesn't get you (me!) invited to Jackson Hole! The Fed wants to "do more."

    So, let's leave alone the question whether a bit of deliberate inflation is a good thing -- I think not, but that's where we disagree -- and analyze Mike's proposals for  how the Fed can create some inflation. Here I mostly agree, with a few asterisks.

    Open mouth operations 

    So, interest rates are stuck at zero. Can the Fed do anything about it? Many economists have advocated promising that rates will stay at zero further in the future. I've been a bit sceptical of this advice, for example in" Understanding Policy"
    I read this move as sign of desperation. Teddy Roosevelt said to speak softly but carry a big stick. These steps are speaking loudly because you have no stick. What will the Fed do if it announces a higher target but inflation does not change? [Announce a larger one still?] We are here in the first place because the Fed is out of actions it can take. Talking is the ‘‘WIN’’ (Whip Inflation Now) strategy that failed in the 1970s. 
    More generally, I'm skeptical of the idea that wise governance consists of "managing expectations" by government official's promises.

    Mike starts with a review of the literature that studies whether announcements -- "open mouth operations" have had effects in the past. Here's a good example.

    These are "Intraday OIS rates in Canada on April 21, 2009. The dotted vertical line indicates the time of release of the Bank of Canada’s announcement of its “conditional commitment” to maintain its policy rate target at 25 basis points through the end of the second quarter of 2010."

    On many occasions Fed announcements, coupled with no actions, do move markets. Monika Piazzesi and I once looked at high-frequency data and came to the same conclusion.

    But these what do we make of this fact? They certainly do not mean that the Fed can talk down rates at its pleasure. Mike briefly acknowledges one possibility: Markets do not interpret these announcements as changes in policy, or "intentions" but instead simply inform the markets of the Fed's deteriorating economic forecasts.   If the Fed gets news, or forms an opinion, that the economy will be weak, then future interest rates will be lower even if the bank follows the same old Taylor rule.  We can see this reaction even if the central bank has no influence at all over market interest rates (as in Gene Fama's latest) but has a decent forecasting shop. A coming recession means that interest rates will fall no matter what the Fed does about it, so long term rates fall now. Mike has a long section on open mouth operations that don't work, or go the wrong way, and pages of advice for central bankers on how to move markets the way they want.

    Mike makes an excellent point though. Overnight rates last overnight. If the Fed has any influence at all on long-term rates, it is entirely through expectations. Talk may not matter, but expectations are everything.

    Promises, Promises

    Assuming that the Fed does have total control over short term rates, the answer to my Teddy Roosevelt quip is this: Yes, the Fed is powerless to do anything now. But the time will come that the economy recovers or inflation breaks out, and the Fed will want to raise rates. Those 1.5% 10 year rates reflect expectations over some paths in which short rates rise. If the Fed can credibly promise not to raise short rates, even in circumstances in which it would normally be expected to do so, then by expectations hypothesis logic today's 1.5% ten-year rate will decline, as will the implied 10 year real rate (we're assuming the Fed can hold short rates at zero in the future despite the outbreak of significant inflation.)

    The deep, intractable problem with this idea is commitment. This occupies the bulk of Mike's analysis, but I don't think he, or others advocating these policies, successfully solves it.

    Every day I promise that tomorrow I'm not going to have dessert. Every tomorrow I change my mind. Because I can. Tomorrow, if inflation breaks out, the Fed will want to raise rates sharply.

    How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

    Here (p. 42, 44) Mike comes out in favor of a nominal GDP targets. In his view, they're not as good as the optimal policies he and Gauti Eggertsson have calculated, but clarity and communication are important, and Mike can see that nobody but he and Gauti understands the optimal policy.

    Nothing communicates like a graph. Here's Mike's, which will help me to explain the view:

    The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.)

    Now, let's be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying "see, if the Fed had kept nominal GDP on trend, we wouldn't have had  such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession." This is NOT what Mike is talking about.

    Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could. The trend line was not achievable.

    The point of a nominal GDP target to Mike is this: When and if inflation breaks out (which raises nominal GDP) or (let's hope) real GDP starts growing again, the Fed, following the usual Taylor rule linking interest rates to GDP growth or inflation, would normally raise rates. If the Fed instead changes to a nominal GDP target, then the Fed will not raise rates, until the cumulative inflation or real growth brings us back to the dashed line. Then, and only then, will the Fed raise rates.

    And, it will (supposedly) use all its hard-won anti-inflationary toughness to keep nominal GDP (inflation at that point) from growing faster than the trend line. In fact, it will become super-tough. In the past, with an inflation target, the Fed swallowed inflation shocks. With a nominal GDP target, the future Fed will supposedly commit to a slow deflation after a 1% surprise inflation shock, to bring the level of nominal GDP back, just as now it is committing to a substantial inflation to bring up the nominal GDP level.

    In sum, this nominal GDP target discussion is not about what the Fed does now, or what it should have done in 2008. It is not about whether over the long run a nominal GDP target is better or worse than a Taylor rule (roughly, its first difference), which is a good topic for another day. It is a proposal to manage expectations about what the Fed will do in the future, and its hope is to lower long-term rates now.

    Sounds good? Not so fast. Odysseus had himself tied to the mast so he could not change his mind. The Fed is changing rules now, in response to extreme conditions. What stops the Fed from "changing rules" again, the minute inflation does break out? True precommitment means setting things up so you can't change your mind, or at least so there are substantial costs to changing your mind. When Woodford 2016 comes back to Jackson Hole saying, "to fight this galloping inflation we need to change to the Gold standard rule" what stops that?

    "Rules" without costs are no better than promises. I don't just promise each day not to have dessert. I change each day to the "no dessert" rule. Each night, I change back to the "no dessert, starting tomorrow" rule.

    Furthermore, people might be less worried about the tough anti-inflation Fed than the new we-want inflation Fed. The second promise of the nominal GDP target is to contain expectations that once inflation breaks out it explodes. One inflation breaks out, and the Fed isn't responding, will people really say "oh, that's the new nominal GDP target Fed, they'll get really tough once we get to the 2007 nominal GDP trend?" Or will people think "oh-oh, we've got the 1970s Fed on our hands again"!

    Suppose it's 2016, inflation has brought nominal GDP to trend, but real growth is still stagnant, unemployment is still high, the eurozone mess is worse, and candidate Hilary Clinton's poll numbers are tanking. Will Mike--and maybe more importantly, Christina Romer, Paul Krugman, Brad Delong, and the rest of the dovish punditry  recently converted to nominal GDP targeting -- really stand up and say, "we're on the nominal GDP target. We have to keep our promises. Raise rates and open the bar early."? More importantly still, do people now believe that will happen?

    (There is also a larger question here, why do we that people will believe fine-tuned promises from the Fed about some brand new, never-tried rule, about how it will behave 5 years from now. To the public, how are the Fed's promises different from annual rosy scenario budget forecasts out of every Administration? How many average Jay-Walking voters even know who Ben Bernanke is or what nominal GDP is?)

    I think the lesson of all precommitment economics is, that if you want people actually to believe the commitment, it must have substantial costs to change. Making the target a legal restriction might do. But the Fed adamantly doesn't want any restrictions on its power.

    If you cannot limit your power ex post, you cannot commit to anything ex ante. If you cannot commit ex ante to do things you will not want to do ex post, your promises are empty. Even if they are "rules" not "actions."

    Mike beautifully sums up what we're looking for on p. 82,
    Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions...
    That criterion dooms a nominal GDP target or any other promise that is not "forward-looking" or "discretionary."  

    Especially the Fed. Institutions work from historical perspective, and the Fed regards itself as fresh from the great success of "unconventional" policy experimentation in the great crash of 2008. What, tie ourselves to some rule that might keep us from saving the world again with our innovative discretionary policy? Not a chance.

    (And even a legal restriction, writing nominal GDP targets into the law, is no guarantee. The ECB has a legal restriction against buying sovereign debt. Ha Ha Ha.)

    The Fed was an alcoholic in the 1970s. It went on a 12 step program, reformed in the 1980s, and not it's a teetotaler on inflation. It wants to promise to go back to being a social drinker -- just three drinks until my nominal alcohol target is fulfilled for the night. And it doesn't want to let its spouse pour the drinks.

    Quantitative easing

    Mike moves on to quantitative easing. Here, the Fed buys short term treasuries, long term treasuries or other securities, issuing money in the process. Does this "stimulate?"

    Mike starts (p. 49) by masterfully destroying the theoretical idea that QE should work. Yes, monetarists think the quantity of "money" matters, even at zero interest rates. They believe that because they think velocity is stable. The historical experience behind that conclusion does not have long periods of zero rates. When interest rates hit zero,
    the demand for reserves should become infinitely elastic, so that variations in the precise quantity of excess reserves (as opposed to other short-term, essentially riskless assets) that banks must hold will have no consequences for equilibrium determination. ...once that lower bound is reached, further expansion of the supply of reserves should not have any consequences for aggregate expenditure or the general level of prices (or for that matter, for broad monetary aggregates).
    Mike goes on to skewer long term bond purchaes -- they are the same as ineffective QE plus a rearrangement of the maturity structure of debt, which at least should not involve the Treasury doing the opposite.

    Starting on p. 60, he points out that no asset market purchases should have any effect. If the Fed buys mortgages or long term bonds, yes, the private sector seems to hold less risk. But the Fed is ultimately holding risk that is guaranteed by the Treasury and hence by your taxes -- The  Modigliani-Miller theorem of Fed impotence. The starting place should be that purchases have no effects.

    Of course there are frictions, liquidity effects, and so on. But with this theorem, all monetary theory must be about really understanding the frictions. (I did say this is a great review of monetary theory! Students, pay attention to these sections) For example, the monetarist position that only the issuance of money matters, but what assets the Fed buys do not matter, comes from recognizing one and only one friction, the necessity of money for making transactions. Mike reviews all the currently hypothesized frictions underlying asset purchases. Go read.

    Though Mike goes for frictions a lot more than I do, we end up at the same place: a logical conundrum. If the Fed can affect, say long-term treasuries because that market is segmented, cut off from, say, mortgage markets, practically ipso facto changing long term treasuries won't spill over into markets you care about such as mortgages
    Second, the existence of market segmentation makes it possible for central-bank purchases to affect the price of an asset, but at the same time limits the generality of the effects of a change in that particular asset price on the rest of the economy. In order for the policy to be judged effective, it is necessary that influencing that particular asset price can be expected to achieve an important aim. In the case of the CPFF, this presumably was the case — only the financing costs of a particular narrow class of borrowers were affected, rather than financial conditions more generally, but the program achieved a specific goal that motivated its creation. One cannot, however, point to such a program as evidence that purchasing any kind of assets eases financial conditions generally. Instead, to the extent that market segmentation is relied upon as the basis for a policy’s effectiveness, one should expect the effects to be relatively local, and the composition of the asset purchases needs to be tailored to the desired effect.
    Well, if it makes no theoretical sense, maybe it works anyway? Mike's graph here
    is better art than the graphs I made in a QE oped here. QE is supposed to lower interest rates. You have to tie yourself in knots to get this graph to say that interest rates are lower in the grey periods when the Fed is buying lots of stuff.

    The Fed and its defenders do: they point to the declines in rates just before QE episodes as evidence for QE's power, then point to the rise in rates as verifying that the economy got better.  Mike explodes this view deliciously (p.71). The view that only the announcement-day decline measures the effects of QE relies on efficient markets. And if markets are efficient, then QE doesn't work, because it relies on segmented markets.

    Mike concludes with an interesting observation: the only way that it makes sense for QE to have any effect is not directly, but because it signals to markets just how desperate the Fed thinks the situation is, and therefore communicates that interest rates will be zero for a long time.

    But that makes no sense (p.84 of the conclusion is quietly devastating on this widespread view.) QE has the same commitment problem. The only hope for it to work is for people to think the money will stay out there once interest rates rise above zero. But the Fed has loudly told us how easy it will be to soak up all this money the minute it needs to do it, which is reassuring for inflation. But the point was to stoke inflation!

    Helicopter drops

    So, in conclusion (p. 82 -- hey, at least the blog post is shorter than the paper!) Suppose the Fed wants some inflation, what should it do? The only thing that can create some inflation, if the Fed wants to do that is helicopter drops, which are really fiscal policy: (p. 87):
    the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus—whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS.. At the same time, commitment to a nominal GDP target path by the central bank would increase the bang for the buck from fiscal stimulus, by assuring people that premature interest-rate increases in response to rising economic activity and prices would not crowd out other types of spending than those directly affected by fiscal policy. And the existence of the central bank’s declared nominal GDP target path should also limit the degree of alarm that might arise about risks of unbridled inflation when special fiscal stimulus measures are introduced.
    The Treasury borrows and, with Congress, spends the money. The Fed buys the debt and issues money. That's how we do helicopters today.

    Even helicopter drops aren't easy however.  If people think that the government will raise taxes tomorrow to pay back the debt, and the Fed will unwind the purchase, even helicopter drops don't cause inflation. There really is no escape from "expectations." Helicopters -- or boondoggle stimulus projects -- are thus a communication mechanism for the government to say, "no, we are not raising taxes to soak up this debt. We really are leaving the money outstanding so it will inflate. You'd better spend it fast." And that's just what Mike wants, more "spending." (See "Understanding Policy" for more).

    But Mike is being inconsistent here. He told us how impossible it is to commit to a nominal GDP target. And he told us how irrelevant the maturity structure of goverment debt is. Not raising taxes is really a fiscal commitment not a monetary one. Why is Mike back to a costlessly chageable promise to target nominal GDP? I think he recognizes that the commitment not to undo the helicopter drop is crucial to his proposal, and so he has to rescue that somehow.

    So, in the end, I find Mike and I in strong agreement on mechanics. IF the Fed wants to inflate, a helicopter drop is the only way to do it. Even that is about expectations. And it's essentially fiscal policy. And, of course, we have now arrived at a point that completely contradicts the intial search: A policy of announcements, open mouth operations, that the Fed can follow alone.

    The question, which Mike does not address, is this: Why in the world would such a deliberate inflation -- which in this case is a deliberately-induced flight from US government debt, exactly what Europe is so desperately trying to avoid -- be a good idea right now?

    The rest of p.82 is chilling really. It is a lovely statement of the Fed's problem:
    Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking 
    We saw how (i) dooms open mouth operations, and conversely dooms the chance the Fed can affect the economy by announcing any new rules and targets.

    Yet the Fed wants to be powerful. That leaves (ii). "Allocation of credit" means lending to particular favored markets and institutions.  The Fed understands the huge danger of going here. Lending to cronies is how central banks operate in all the basket cases of the world. But, if the Fed is unwilling to say "Inflation 2%. Banks steady. Interest rates zero. We've done our job," and wants to stay powerful, direct lending (which is really fiscal policy) or direct intervention in the policies of the TBTF banks under its control is going to be increasingly attractive.

    Monday, September 3, 2012

    CBO and fiscal cliff, again

    I turned last week's CBO post into an Op-Ed for Bloomberg. This version is better.

    Last month, the Congressional Budget Office released a report warning that the “fiscal cliff” would cause a new recession. It came to the right conclusion for all the wrong reasons.

    Reasons matter. A policy response crafted to satisfy the CBO’s analysis would hurt the economy. Reports such as this one would be much more useful if the agencies that publish them were more transparent about the calculations, and explained the logic of their models.

    This is the cliff: Unless Congress acts, the Bush-era income-tax cuts will expire, Social Security payroll taxes will increase, and capital-gains and dividend tax rates will rise sharply. Also, the estate tax will come back with a roar, “mandatory” spending cuts will take effect, the extension of unemployment insurance to 99 weeks will expire, and Medicare payment rates to physicians are supposed to be slashed.

    The CBO projects that “such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.”

    Keynesian Projections

    How does the CBO come up with these numbers? Its projections are Keynesian. If the government borrows $1 billion and spends it, the CBO will project that this action raises gross domestic product by $1.5 billion. Government workers are counted as “producing” what they cost, so borrowing money to keep them employed generates the same GDP as building a bridge. If the government just gives the money to people, this also raises the CBO’s GDP estimate. Reducing government spending and transfers has the opposite effect.

    If, like me, you think that spending less money on useless projects is good for the economy, or that taking money from A and giving it to B has little overall effect, you would come to much different conclusions from the CBO’s.

    Similarly, the CBO says raising tax rates hurts the economy because taxpayers will consume less, lowering “aggregate demand.” If, like me, you think that taxes hurt the economy not so much because of how much people have to pay rather than lend to the government, but because higher (marginal) rates discourage work, saving, investment, business formation and growth, then the CBO’s numbers are meaningless to you.

    The central distinction between Keynesian and regular economics is the assumption that people don’t respond to incentives. In regular economics, prices and taxes first and foremost change incentives. Transfers, though important to the people who pay and get them, have much smaller effects on the overall economy. Keynesian economics and the CBO’s analysis take the opposite view: Transfers matter, incentives don’t.

    A good example: What will be the effect of curtailing 99 weeks of unemployment insurance? To the CBO, it will reduce GDP because would-be beneficiaries will consume less. A standard economic analysis predicts that it will have the opposite effect, increasing GDP and bringing down unemployment. That’s because unemployment insurance means some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move.

    (Remember that the CBO and I aren’t opining on what’s good or bad. The point is only to project whether GDP and unemployment will go up or down. Some unemployment insurance can be a good thing even though it hurts GDP and raises unemployment.)

    Tax Increases

    To the CBO, tax increases and spending cuts have about the same effect. In my analysis, higher tax rates are more damaging than spending cuts. To me, a revenue-neutral tax reform that took in the same amount of money at much lower marginal rates would be a boon. It would have little effect at all in the CBO’s analysis.

    In my view, the bigger problem with the fiscal cliff is the utter chaos it reflects. What serious country decides its tax laws year by year, in one big crisis during the first few weeks of the year? The CBO’s model doesn’t assess chaos.

    Moreover, this crisis atmosphere is a fiesta for lobbyists, tax lawyers and crony capitalists of all stripes. The CBO’s list of expiring tax provisions gives a taste:
    “Cellulosic Biofuel Credit, Credit for Past Minimum Tax Liability, Depreciation of Certain Ethanol Plant Property, Election to Accelerate AMT and R&E Credits in Lieu of Electricity Production Credit for Wind Facilities, Exclusion of Mortgage Debt Forgiveness, Indian Coal Production Credit....”
    The list goes on. Lobbyists will fight for each one in the middle of the night.

    So, in my view, most of the CBO’s analysis is wrong.

    This matters most as we consider alternative policies. CBO- style analysis will encourage more ineffective “stimulus” spending. It won’t lead to the all-important tax reform that stabilizes and simplifies the code and lowers marginal rates. It won’t help reduce the vast amount of useless government spending.

    (To the CBO’s credit, it has been warning that skyrocketing debt poses a long-run threat. But higher long-term interest rates seem a distant worry to a still-struggling economy.)

    Its analysis isn’t logically wrong. If you accept its Keynesian logic and the absence of incentive effects, the CBO’s assessment makes sense. It’s those ifs that are wrong.

    The deeper problem is that we really don’t know how the CBO gets its numbers. You can search its website without finding a reproducible description of the calculation, or the computer program that produces numbers. My characterization comes only from talking to CBO staff.

    Logical Pathways

    This obscurity pervades government and its think-tank satellites. A report opines with great precision on the effects of policies. There is a model. But you can’t find what’s in the model or reproduce the numbers. Even where documentation exists, it’s buried. Most of all, the report never explains the logical pathways, the necessary but controversial “ifs” needed to arrive at the numbers.

    Economic models aren’t engineering models. If you ask several aeronautical engineers to project how adding flaps affects an airplane’s takeoff speed, their models will be complex, but they will come up with about the same, and reliable, answers. You don’t need to know why.

    But good economic models are quantitative parables, not authoritative black boxes. They only are trustworthy if they illustrate clearly understandable and explicitly stated pathways.

    Numbers and models are important. The CBO needed to add up all the complex provisions of the law, and it is very good at doing this. If we retreat from numbers and models altogether, we cannot know, for example, that reversing the Bush-era income-tax cuts for “the rich” won’t make a dent in the deficit, let alone provide revenue for new programs.

    But economic numbers cannot stand without the logic that produces them. Clarity and transparency are far more important to a good quantitative parable than the illusion of authoritative precision.

    (John H. Cochrane, is a professor of finance at the University of Chicago Booth School of Business, an adjunct scholar of the Cato Institute and a senior fellow of the Hoover Institution. He blogs as the “Grumpy Economist.” The opinions expressed are his own.)

    Saturday, September 1, 2012


    This has nothing to do with economics or finance, but it's way cooler...If you or your teenage children are into young-adult fiction.

    My wife  Beth's young adult novel, Monstrous Beauty, published by Farrar, Straus and Giroux, will be released September 4.

    Fierce, seductive mermaid Syrenka falls in love with Ezra, a young naturalist. When she abandons her life underwater for a chance at happiness on land, she is unaware that this decision comes with horrific and deadly consequences. Almost one hundred forty years later, seventeen-year-old Hester meets a mysterious stranger named Ezra and feels overwhelmingly, inexplicably drawn to him. For generations, love has resulted in death for the women in her family. Is it an undiagnosed genetic defect . . . or a curse? With Ezra’s help, Hester investigates her family’s strange, sad history. The answers she seeks are waiting in the graveyard, the crypt, and at the bottom of the ocean—but powerful forces will do anything to keep her from uncovering her connection to Syrenka and to the tragedy of so long ago.

    There will be a launch party at 57th street books in Chicago, Tues. Sept. 4, at 6 PM. A second larger coming out will happen at the Plimoth Plantation, Plymouth MA (the book is set in Plymouth, and partly on the plantation) Sept. 7, at 5 pm, information here.

    Then Beth will be off on Macmillan's Fierce Reads Tour with three other YA authors.
    • September 18: Changing Hands Bookstore, Pheonix
    • September 19: Tattered Cover, Denver
    • September 20: Left Bank Books, St. Louis
    • September 21: Joseph-Beth Booksellers, Cincinatti
    • September 22: Next Chapter Bookshop, Milwaukee
    • September 23: Malaprop’s Bookstore, Asheville 
    For a taste of Beth's mermaid lore, try the extra short story "Men Who Wish to Drown" on, (cover art to the left).

    Monstrous beauty at Amazon and the publisher's website 
    Visit Beth at her blog and on Twitter

    (My plot suggestion, "Syrenka, Libertarian Mermaid" went nowhere. I guess I'd better keep my day job!)