Voter and Consumer Irrationality: An Extension

Questioning rational choice is not a sufficient basis for arguing for government intervention. But my past few posts questioning standard market propositions in the case of health care are not meant to promote every single government regulation. Rather, I wonder if we can try to further the study of economics and public policy by reversing the typical way public choice economics is applied.

When I think of public choice economics, I think of papers about how the marginal costs and benefits of lobbying lead to poor government policies or how decentralizing the functions of governments leads to a competitive equilibrium with better governmental policies. At its core, I interpret this line of analysis as using the success of markets to explain why governments fail. Markets succeed because marginal costs line up with marginal benefits, and thus governments fail because these costs and benefits are distorted. Markets succeed because there is competition between firms, and thus governments fail because there is no competition. What I want to propose is that we change the direction of this line of thought, and start from the vast literature on why governments fail, and see if that can teach us about why certain markets fail. 

This is why I think behavioral economics is so important. By reducing biases down to core psychological first principles, it highlights the connection between government and market failure. But we should also make sure to avoid thinking that policy makers themselves are perfectly rational. As John Papula pithily points out:

Why in the world do behavioral economists who study our flaws and irrational quirks advocate centralized power in the hands of a small group of flawed overlords? If people are irrational, so are government regulators, only they have corrupting monopoly power.

As such, I agree that it is important that behavioral economists grasp the concept of public choice, but also for public choice to grasp the concept of behavioral economics. There exist reasons for why the market often overcomes behavioral biases, but then there also exist markets in which those mechanisms don't function well. And most likely, we can trace these mechanism failures to arguments past public choice economists have made about the failure of government. That is my conjecture, and I hope to be able to pursue further analysis of health care under this framework.

Voter and Consumer Irrationality: Two Sides of the Same Coin

One strong argument against the government provision of services is that democracy is a very imperfect substitute for markets. As noted by Bryan Caplan, voters have a hard time rationally evaluating policy options, and thus the public choice economy may be a very bad one. The natural conclusion of this argument is that, to the greatest extent possible, the provision of goods should be pulled away from government and the responsibility should instead be allocated to the market. Yet this line of logic contains its own contradiction: if voters cannot rationally choose the right public policy, how can they be expected to make the right private choice?

Now, I don't mean to say markets never work. I am very happy with the way capitalism has treated me, both in terms of the large historic liberalizations that brought me to this country as well as in the small conveniences that improve my everyday life. I don't mean to reject this. But what I want to suggest is that the acceptance of the irrational voter hypothesis suggests that we should take a closer look at our acceptance of the perfect market equilibrium in many different sectors, in particular health care.

Bryan Caplan, in his work on voter irrationality, outlines four main biases: the anti-market bias, anti-foreign bias, make-work bias, and pessimistic bias. 

Anti-market bias refers to the public's systematic bias towards policies that interfere with prices and profits, such as farm subsidies or rent control. I like to think of it as the public's bias against simple supply and demand explanations of the market. 

Anti-foreign bias refers to the way the public tends to see people from other countries as fundamentally different from itself, and thus the bias causes people to under-estimate the benefit of free trade and immigration. People focus on the auto jobs outsourced by free trade and the native fast food restaurant replaced by immigrants, while paying little attention to the new opportunities and technologies granted by interaction with foreigners.

Make-work bias refers to the way the public confuses productivity with having a job. As Caplan cleverly states, "For an individual to prosper, he only needs to have a job. But society can prosper only if individuals  do a job, if they create goods and services that someone else wants." People tend to make the classic luddite fallacy, that new technology destroys more jobs than it creates, and that, as a result, technological growth actually worsens the standard of living.

The fourth and final bias, pessimistic bias, refers to the way the public tends to overemphasize the things the get worse over time, and forget the ways that life improves. Recession is confused for regression, and the massive technological advances of the markets, such as improvements in information technology and energy infrastructure, are forgotten.

Yet when I think about these biases, I would argue that they all are manifestations of a more fundamental psychological bias: a bias towards salience.

Salience refers to the way certain effects or phenomenon are more apparent and more obvious. We should be familiar with this idea of salience in our everyday lives. It's easy for me to enjoy the concentrated fun of watching old episodes of scrubs, it takes more effort to remind myself of the dispersed benefits of working hard on math homework. It's easy for me to catch up on the extra hour of sleep, it takes more effort to remind myself of the long-term benefits of exercising in the morning. As Katherine Baicker, Sendhil Mullainathan, and Joshua Schwartzstein like to joke, "Our research has definitively determined that running is unpleasant and donuts are tasty," and as such, people tend to choose the salient joy of tasty donuts and the immediate avoidance of hard running instead of the long term benefits of consistent exercise. Or as Thaler and Sunstein put it in their book Nudge, very rarely do people ever make new years resolutions to smoke more cigarettes or drink more alcohol.

I would argue that salience forms the basis of Caplan's irrational voter biases. Salience means that people tend to see the direct negative impacts of market liberalization, and neglect the role of the fallacy of composition in hiding the harms that arise from government intervention. In the case of the anti-market bias, the benefit from paying farmers is salient, whereas the cost of higher food prices are dispersed and not as apparent. In the case of the anti-foreign bias, the closed steel mills down the street are immediately visible, whereas the newly created jobs in the software industry and management consulting are not as visible. In the case of the make-work bias, people directly observe the seamstresses fired and don't see the new women, who on count of greater general prosperity, are then given the chance to go to college for a better life. And finally, in the context of the pessimistic bias, people tend to worry about the bad changes more than the good. People complain more about the rising price of gas and food, which they buy everyday, and not the fall in computer prices, which they rarely have the chance to purchase.

Re-framing the issue in terms of fundamental psychological first principles adds to the way we should interpret the irrational voter hypothesis. Rather than seeing the phenomenon of the irrational voter as an isolated problem that makes government policy ineffectual, we should see the irrational voter as a more general irrational person. As such, there may be certain (not all) markets, such as health care, that do not liberalize in the way other markets do. In the case of health care, because certain differences between doctors, such as bedside manner, are more salient than others, such as improved recovery times, a simple market liberalization may not always promote the best health outcomes. We need to think again, again, about why we need reform. Promoting price disclosure makes the costs consumers pay more salient. Moving away from an employer provided health care system towards individual insurance with an individual mandate makes the costs of choosing bad insurance more salient. But just kicking back and "letting the market (not) work", and treating healthcare just like "consumer electronics, telecommunications, computers" or cars is not a sufficient answer. And if we can move away from fiery rhetoric about socialism and capitalism and towards a grounded and pragmatic analysis of psychology and behavioral economics, only then can a meaningful dialogue on healthcare can occur.

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Update 11/18: I extended some of my thoughts on public choice and health care here.

Healthcare and Cars are Not Isomorphic

I've recently been doing some thinking about health care, and my thoughts aren't yet complete. However, when reading many of the conservative commentaries on health care, I was very peeved by their treatment of the market for health care just like the market for any other good or service, and this was aggravated by the fact that I agreed with most of their other arguments. As a result, I wrote the following NextGen article to collect my thoughts on this issue before I move on to more substantive analyses of some recent posts.

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"Healthcare and Cars: Why They're Not the Same"


How is the market for health care different from that for cars? And how does this difference change our understanding of health care policy?

Let us start from the basics: health care is a service, while a car is a good. While this does not prevent market competition from improving society's welfare on the margin, it does mean that there are fundamental limits to how far the market can improve. In particular, it means that one productive hospital cannot simply “export” its health care services across the country. And as we know from the car industry and international trade theory, that lack of export markets and distant competitors can impede the creative destruction that makes markets work.

But this is an incomplete justification. Haircuts are also services, but few people think barbershops require regulation. Yet, they differ in one key respect. While it is easy for me  to determine the quality of my haircut, it is much more difficult for me to determine what counts as “good” health care. A large part of this is linked to the uncertainty inherent in any kind of biological process. How does one determine if one is receiving sufficient care? Of course, if there is any gross negligence, it can be detected. Yet if the care is just slightly worse than it should be, there's no real way for the consumer to know. The problem is compounded by the fact that most people rarely get sick. If you go to get a haircut every month, you can quickly determine which barbershop is the best. Unfortunately for neoclassical economists but fortunately for society as a whole, people need catastrophic care substantially less often than they need haircuts, thereby impeding the market from finding the most efficient solution.

Chronic care does change the calculation, but it introduces other factors that again prevent the market for health care from functioning like the market for cars. To take a concrete example, consider the 40 million elderly individuals who suffer from arthritis. Does it make sense to ask them to “shop around” to find the perfect hospital? Does it make sense to ask them to trust in an online service like Yelp to decide where to get care? And when they are fatigued by chronic pain, does it make sense to think they can make the “optimal” choice, and not just the most convenient?

Other problems make it difficult for the market for health care insurance to function like a regular competitive market. Again, a parallel to the market for cars, in particular used cars, is helpful. A problem with used car markets is that it's not entirely clear whether the car you wish to purchase is good or bad. This depresses the market value of used cars, both good and bad. But then producers of the more expensive good cars exit the market, further lowering the average quality of a used car until the market spirals out of existence. The market for health care is subject to similar pressures, but in the opposite direction. For insurers, they cannot easily tell whether an applicant is healthy or not. As a result, they charge the same premium to all individuals, which leads to healthy individuals dropping out of the market because they value the insurance less. This process repeats itself until premiums spiral upwards and no market for health care insurance exists.

This describes what economists call adverse selection, and although it is a market failure, it doesn't mean the government always needs to step in. However, understanding how the market circumvents the problem helps us understand why a simple solution for the health insurance does not exist. For example, markets for used cars can exist because the salesmen can offer warranties, so that if the car does break down you can “turn back the clock” on the purchase and return the car. This reduces the incentive for used car salesmen to trick you into buying lemons, because if the car does turn out to be a lemon you can always return it.

But what would a similar system mean for health care insurance? In that market, it's the consumer who has the private knowledge, therefore it falls to the consumer to make the “warranty”. This would mean the consumer would have to be able to guarantee that he or she won't become more unhealthy in the future – an impossible task. Alternatively, insurance companies can “turn back the clock” and refuse to pay for the consumer on the ground that the consumer was unhealthier than was expected. This hardly seems like an efficient or moral outcome, and is precisely the reason why the protections for preexisting conditions is so popular in the ACA.

With these stylized facts, it should be abundantly clear that the markets for health care and insurance are very different from what the standard competitive model predicts. Hence, we need to be very cautious when we draw glib analogies from health care to cars. However, the implications for policy are mixed. On one hand, certain regulatory reforms such as cutting the employer health care deduction, reducing occupational licensing barriers, and relaxing privacy laws can result in substantial advances towards improving health care. Yet the presence of these government failures does not mean that there is no role for the government to ameliorate the market pathologies that I have listed above.

A notable example of this is the individual mandate. The individual mandate, by forcing people to purchase insurance, massively expands the market for health care. In doing so, this increases the incentive for firms to pursue innovative new projects to increase productivity. And even though consumers still rarely need catastrophic care, the larger market allows transparency and reputation to have an effect as hospitals are at greater risk to lose customers. For the insurance market, an individual mandate can help pull us away from the adverse selection death spiral by preventing self selection and thereby keeping most of the population insured.

In other words, the government is not perfect, but neither is the market. By noting that the market for health care is fundamentally different from that for other goods such as cars, we can recognize why the standard assumptions for regular markets may not apply in the case for health care. As such, we must move forward with caution, with an understanding that true reform lies not with complete liberalization or complete regulation, but rather with a judicious mix of the two.
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Update 10/24/12 -- I was pleasantly surprised to find that this post was heavily discussed in Reddit. I just wanted to put a few points to defend myself from a series of very informative critiques.

• I never oppose market reforms like HSA's or cutting the employer healthcare tax deduction. That's not in my post at all.
• The point of the post is to highlight some frictions in the healthcare market that justify some sort of intervention -- market based (preferably) or command and control (not ideal).

Nominal GDP Targeting: An Introduction with Market Applications

A few weeks ago, I joined Michigan Interactive Investments, the premier finance club at the University of Michigan. Every week during our meetings, we have a market update during which we sound off our opinions on recent market events. And, as readers know, I take a great interest in monetary policy and have been very vocal about the positives behind the Federal Reserve's recent moves in terms of QE3 and conditional forward guidance.

However, I find that there's a disconnect between my understanding and perception of monetary policy and that of my fellow peers at MII. My suspicion is that it has something to deal with the differences between practitioners and academics, but I am still unsure of the specific difference. As a result, I prepared a presentation on this issue and wanted to share it with the rest of the blogosphere. I consider this different from Evan's excellent post on the layman's guide to NGDP targeting for two key reasons. First, this is targeted for those who are already financially literate -- ie they know what treasury bonds and other financial indicators are. Second, it's meant to be more visual to drive the point home in a presentation.

Considering I used quite a few graphs that have been inspired by debates I've encountered through blogging, I thought it would be apropos to present it here first. I hope it is useful for explaining nominal GDP targeting to a more technical financial crowd or undergraduate economics students. As always, comments are encouraged, and I'm happy to revise the presentation if I missed something.

Notes on a Healthcare Talk

Yesterday at the Ross School of Business, there was a panel discussion on health care in the United States. Jonathan Gruber and  Katherine Baicker, two well known health economists, in addition to David Leonhardt, a New York Times reporter who has reported extensively the health care debate, gave their perspectives on health care in the United States.

What I found was quite interesting was how much of a consensus there was among health care economists. Yes, the health care market fails for the 46 million uninsured Americans. No, providing more health care for people doesn't reduce spending on health care. But yes, there are major tax and market reforms that the government can do to increase the value of health care delivered in the United States.

Gruber was the first speaker, and I found his defense of the ACA quite witty. He characterized health care reform as a three legged stool that depends on three parts -- coverage expansion, individual mandate, and subsidies -- to fully function. Because pre-existing conditions can cause people to be kicked off the rolls when they need it most, it's important to reform coverage laws to allow more people to buy insurance. But then if there's no individual mandate, the market is subject to adverse selection. It is, as Gruber joked, "like forcing sports bookies to take bets at half-time". And to make sure that people can afford to purchase insurance, the government has to provide subsidies to increase affordability.

Something else that Gruber emphasized during the talk was that the health care debate is highly nuanced, and that talk of reform shouldn't be on partisan lines. The Affordable Care Act is not a government takeover of health care -- it merely creates a new market in which private insurers can innovate and thrive. Nor is it a federal takeover of health care delivery -- states are allowed large levels of discretion in how they implement their health care exchanges. Something that both Gruber and Baicker seemed excited about was the possible policy innovations the ACA may stimulate. The ACA, while it is certain in the coverage expansion, is much less certain on how to control costs. It is hoped that the variety of reforms -- capping the employer tax deduction, pilot programs for alternative health care delivery, and comparative effectiveness research -- can eventually discover something that the market will find valuable and later deploy.

We already see some of this innovation in the reform of fee-for-service payments. For two years, Blue Cross and Blue Shield of Massachusetts has already been trying out an alternative payment structure that focuses on patient wellness rather than the number of office visits. And then in the past week, Medicare took its first step away from fee-for-service by penalizing readmission and rewarding hospitals that deliver better care with higher payments. Later during the Q and A session, Baicker mentioned other possibilities, such as integrated health care units or even simple emails from your doctor, in order to improve health care effectiveness.

Gruber and Baicker were both optimistic that these kinds of reforms would be critical in bringing costs down. Baicker often mentioned that increasing coverage is easy -- the question is how to control costs. Yet, for both Gruber and Baicker, this ignorance about cost control was just a better reason to expand coverage first. We know how to expand coverage, we don't know how to expand costs. So, as Leonhardt noted, let's expand coverage to save lives now, and use what we learn from the new practices in the health care market to try to reduce costs on a national level.

I find this approach eminently sensible. As mentioned above, reform is critical to creating a larger market for health care, and it seems to be a natural result that the resulting market will have a greater variety of business models and payment structure innovations. Given that ideas can quickly spread, the efficiency of the system will ultimately be determined by the efficiency of the best, not the average. As such, increasing the number of health care consumers seems to be the first step towards discovering a solution to rising health care costs. Gruber also argued that this would help solve the primary care doctor shortage by changing the incentives for medical students. By changing the way insurers reimburse for services, this would reduce the demand for specialty medicine, and thus push more doctors out of specialty disciplines and into primary care.

Baicker made a statement that I feel is very important in framing discussions in health economics: "Health ≠ Health Care ≠ Health Insurance". From all the above analysis, we know this to be true. Just because something is a health care service, such as proton beam therapy, doesn't mean it improves health. And just because something improves health, such as phone calls from a physician, doesn't mean we think of it as "health care". And to properly fund all of this, we need a robust system of insurance that requires incentives and cost structures that are not directly related to a person's biological condition, but nonetheless change the way health care is delivered. The fact that this is true means that when we move forward with the health care system, we need to consider each of those three related, but distinct, parts.

The Fed Should be a Day Trader

According to  Philadelphia Federal Reserve President Charles Plosser, the economy is "immune" to the Fed's stimulus efforts. Therefore we shouldn't even try to ease. I think Matt Yglesias does a very good job with responding to this argument, so in this post I want to draw attention to another fallacy Plosser makes that, as a result, makes the shift to a forward looking monetary regime even more important.

From a Thursday morning interview, the WSJ represents Plosser's views as:

“Monetary policy shouldn’t be a day trader,” Plosser said Thursday morning in an interview with Dow Jones Newswires and The Wall Street Journal. “I don’t think that’s a healthy focus for central banks…Policy making is too focused on short-term and not long-term views.”

On face, it seems sensible. Of course the Federal Reserve shouldn't act in an erratic manner like a day trader, and of course it should focus on long-term views. But does one imply the other? I would say no -- to focus on long-term views, it makes sense to act like a day traders and look at real time market expectations of the long term.

Specifically, it should make sense for the Federal Reserve to worry about long-term inflation expectations, as they, by definition, represent the long-term views of the market. Given that the 5-year breakeven is barely above 2%, this means that, given what the market perceives of the economy and policy interventions, annual inflation is forecasted to be around 2% for 5 years. Given that inflation since the 2008 peak has been around 1.1%, a period of higher than average inflation should not be problematic. By the premise of efficient markets, the relatively low breakeven suggests that the Fed should take additional action. Perhaps there is some argument for why the breakeven is skewed, but traditional deviations from efficient markets, such as momentum trading, does not seems to form the basis of any of Plosser's arguments.

Plosser's comments also point out a more glaring hole: if the Federal Reserve isn't going to use indicies looking forward to guide monetary policy, what should it do instead? If we aren't allowed to forecast using the knowledge of the market, then the Fed is left to waiting for the data to come in and then to adjust economic policy many quarters after the original shock. This is actually worse for long-term views, as it opens the possibilities for downside for the financial market that isn't controlled for with policy.

To improve on the current situation, we could subsidize and construct an NGDP futures market in order to measure market expectations of future NGDP growth, and then the Federal Reserve can use those futures as a leading indicator on whether they should ease or tighten. These futures can even help in the unwinding process, as it lets the Fed know when the money supply has increased too quickly even before the actual numbers come in. Acting like a day trader is not inconsistent with an appreciation for long term fundamentals - the trick is to find a day-to-day measure and then use it to put the economy on stable, long run foundation.

Never Reason from a Price Change: Commodity Price Edition

The Federal Reserve's historic announcement of open ended QE3 has sent the stock markets soaring, both at home and abroad. However, there's a persistent concern that QE3 will hurt the economy through higher commodity prices. However, this view is misplaced and violates a fundamental rule of macroeconomic analysis: never reason from a price change.

Consider the following news article:

WASHINGTON (AP) — Higher gas prices are crimping consumer spending and slowing the already-weak U.S. economy. And they could get worse in the coming months. 

The Federal Reserve this week took steps to boost economic growth. But those stimulus measures are also pushing oil prices up. If gas prices follow, consumers will have less money to spend elsewhere. 

The impact of the Fed's actions "is likely to weigh on the value of the U.S. dollar and lift commodity prices," said Joseph Carson, U.S. economist at AllianceBernstein. "We would not be surprised if (it) fueled more inflation in coming months, squeezing the real income of U.S. workers."

Given that the argument is that more spending on fuel causes less spending on other goods, purchases of durable goods should go down in response to an oil price spike. However, a quick look at the time series suggests otherwise.

As noted by Ritwik, we need to look at durable goods spending in contrast to the amount fuel inflation exceeded regular inflation. So in the graph, blue is the real level of PCE on durable goods, while red is the fuel/oil component of the CPI divided by the part of the CPI less food and energy. From this we do see that although there are some times where oil prices go in the opposite direction of real purchases of durable goods, in general they move together. We can get a more precise image of this by looking at year over year growth rates:

As well as a running correlation of the two graphs. The correlation at any given time looks at the 12 months before the given month including the given month as well as the twelve months after. The thick lines are the thresholds for statistical significance.

This suggests that while rising oil prices sometimes hurt the economy, such as in early 2004 or early 2008, rising oil prices can also be a sign of a recovery, such as in 2009 and 2010.

The mistake the news article makes is that it starts from the price change in oil and then tries to figure out what happens to demand in other goods. Instead, one should proceed from demand and derive the change in price. If the factor pushing up fuel prices is a general increase in income and aggregate demand, that means the gas price rise is a part of a general rise in the price level, meaning purchases of other goods actually increases with the rise in gas prices. However, if the reason gas prices rise is because oil refineries in the Middle East are shut down, crimping aggregate supply, then the rise in the relative gas price would reduce demand for other goods, lowering the overall standard of living in the economy.

This kind of analysis is also powerful in microeconomics when answering the classic question of "what happens to consumer expenditure on other goods if the price of gas rises?" To give a full answer, we have to know what causes the price increase. If the reason gas prices rise is because supply contracts and lowers the equilibrium quantity transacted, then people will buy fewer other consumer goods. But if the reason gas prices rise is because higher incomes push up demand, then we should expect people to buy more consumer goods.

In Econ 101, one could possibly get around the problem by pointing out that a rise in income would cause a general rise in the price level, not the relative rise that is important in microeconomics. However, this does not mean we can reason from a price change in microeconomics.

First, sticky prices for durable goods means that a rise in income will directly increase the relative price of fuel, but this change will still predict an increase in durable goods purchases.

Second, a change in preferences towards something that requires large amounts of gas, such as roadtrips, would increase the relative value of gas while also increasing demand for restaurant food and hotel rooms.

The problem is that price changes are not exogenous; they happen as the result of changes in supply and demand. Outside of corner cases*, there is no such thing as "ceteris paribus, the gas becomes relatively more expensive." Quantity changes always accompany price changes, and supply and demand determine the two. In the case of monetary policy, we should look towards the recent rise in commodity prices with approval, as it is a sign that policy is working by increasing demand and stabilizing nominal GDP.

Never Reason from a Price Change

In introductory microeconomics, professors introduce the concepts of substitute and complement goods. In my Econ 101 class at the University of Michigan, the professor stated the concept as:

If two goods are substitute goods, an increase in the price of one increases the demand of the other.

If two goods are complementary goods, an increase in the price of one decreases the demand of the other.

This might make sense in most situations, but my Sumnerian senses are tingling -- why are we reasoning from a price change? What is causing the price of one good to increase, and how does this change whether the demand of the other good to increase or decrease?

Let us first consider the case of substitute goods. If two goods are substitutes for each other, it seems logical to consider that if supply in the second good contracted, pushing prices up, then people would substitute out of that second good and increase demand for the first good. If cars become harder to produce and become more expensive, it's logical that the demand for bicycles will increase. However, does this hold up if the price change was because of a demand shock? If cars became more expensive because demand increased, it seems peculiar to think that the demand for bicycles also increases. Just because it's a price change doesn't mean it's the price change you were looking for.

A similar scenario plays out in the case of complement goods. If two goods are complements, it seems logical to consider that if the supply for one good increases, then the price decrease would increase the demand for the second good. If tortilla chips become easier to make, we can expect the demand for salsa to increase. But does the same hold true if it was a demand shock that caused the price change? If people start demanding more potato chips, pushing up the price, what do we expect will happen to the demand for chip dip?  We would expect it to increase -- directly contrary to what the definition suggests.

Reasoning from a price change fails because it neglects whether the price change in one good is from a change in production technologies or from a change in preferences. If it's a change in technology, the standard analysis applies. However, if it's a change in preferences, we need a more nuanced view that encompasses both modes of analysis.

If two goods are substitute goods, an increase in the equilibrium quantity of one decreases the demand of the other.

If two goods are complementary goods, an increase in the equilibrium quantity of one increases the demand of the other.

So in the market for cars and bicycles, if the equilibrium quantity of cars increases, whether from a supply expansion or a demand contraction, then the demand for bicycles will decrease. This is true regardless of what happens to the price of cars. Similarly, if the equilibrium quantity of potato chips increases, then the demand for chip dip increases -- regardless of where the price for potato chips go. This makes sense because it encompasses the lay person view of substitutes and complements. If I ride my bike more, I drive less. If I eat more chips, I buy more salsa.

The fact that this isn't taught on the first pass around is understandable -- you don't want to confuse the auditorium of 300+ students with a model of both supply and demand when you're introducing the demand curve. But it does pose a problem when there are exam questions such as "Does an increase in price of a complement good raise the demand of the original good?" To which I have to say, "it might". A possible solution is to ask "Holding the demand of a complement good constant, does raising its price raise the demand of the original good?" This would be more comprehensive, and those who understand can better answer the question, while those who don't understand can forget about the first clause and just answer the second question.

Cochrane: "Woodford Needs to Fight Harder!"

When reading John Cochrane's critique of Woodford's call for NGDP targeting, I felt it was actually a great justification for why Woodford needed to write that paper, and for why the market monetarist project is something that we need to continue to fight for.

Cochrane's largest argument rests on a credibility argument -- that there's no way for the Federal Reserve to credibly commit to a permanent expansion of the monetary base, because the market expects that the Fed will tighten to reach 2% inflation in the future. As a result, because there's no way to effectively change expectations of the future monetary base, there's no way to change the level of present NGDP.  In the words of Cochrane:

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?

Cochrane must know that hose are two very different questions! When we call for a 5% NGDP target, we're not calling for the path of the 1970's -- to say so is a complete straw man. Thus, the real question is how do we convince people that the Fed won't tighten in response to mild inflation. And to me, the answer is simple: declare that the Fed is targeting NGDP.

Why? Because all of the current analysis on credibility and promises implicitly assumes that the Fed is targeting inflation! Of course, an inflation targeting Fed's promise to hold rates low until an NGDP target is hit is not credible because everybody knows the Fed will tighten in response to the higher level of inflation. If, on the other hand, if people know that the Fed is willing to tolerate higher levels of inflation because it is in their mandate, the credibility problem will go away.

The problem is that everybody is looking at the standard loss function for inflation and arguing that NGDP targeting doesn't minimize the function. If you're just trying to minimize the squared deviations from 2% inflation, of course an NGDP target is nonsensical; an NGDP target actively encourages deviations from 2% inflation to correct for past mistakes. However, if the loss function is seen as the squared deviation of actual NGDP from trend NGDP, then the promise to target NGDP is much more logical.

Formally, if the Fed's optimal policy is described by minimizing this:

(π - 2)²

Of course the Fed won't manage to minimize this:

(Y-Ytrend)²

This is why Woodford's paper is so important. It's the first step towards convincing economists and market participants that the Fed's loss function is changing. Given that Woodford presented the paper at Jackson Hole, the premier meeting on monetary policy, the paper is a key step in signalling that NGDP targeting is gaining legitimacy.  If successful, people will realize that the Fed's new policy will tolerate a temporary inflation increase in order to bring NGDP back to trend. No longer does the Fed have to "credibly promise to be irresponsible", it can just change the definition of responsibility. 

So when Cochrane argues that NGDP targeting is flawed because the Fed can just go back to inflation targeting, what he's actually saying is that academics should fight extremely hard to legitimize NGDP targeting. When a monetary policy that targets NGDP becomes as self-evident as one that targets inflation, it will be no difficulty to credibly commit to a new monetary regime.

Chinese Housing: A Reply

This post is meant to be a reply to Scott Sumner and Matt Yglesias' thoughtful points on the Chinese housing market and what China could be building besides housing. Reading their responses, it seems that a large part of the debate is about whether China needs more housing right now, and if the current explosion in housing construction is in-line with long term fundamentals.

Yet this debate about fundamentals seems to neglect the most important part about housing in China: the role of housing as a savings vehicle. What I think is sometimes forgotten is that Chinese citizens face a severe shortage of effective ways to save money to 保值, or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don't necessarily rise. There are securities companies, but it's very difficult for the people to trust them. Moreover, given the recent explosion in these companies, it's not hard to imagine that any risk-adjusted excess returns on securities should quickly go to zero. The stock market is seen as a capricious creature, and given past stock crazes involving nannies and farmers, people are right to be suspicious of investing in stocks as a way to secure wealth.

Therefore, housing is special because it is much more concrete than other investments. It depreciates relatively slowly and is easy to verify; this is unlike many other investment opportunities such as equities or securities. It is useful, because you can immediately start to live in it or rent it out. Also, because of rising incomes across China, it seems very reasonable that demand for housing will increase and therefore building a house will have a high return. Urbanization and demographics are sometimes used by Shanghai residents to justify that housing prices “will never fall,” or that if they do, the drop will be minor. As a result, Shanghai residents view houses as an incredibly important way to save money. This past summer, I had the opportunity to work with a Chinese instructor on my language skills. She was a middle-class Chinese citizen and often mentioned that, although housing wealth was rising, she and her family didn't feel much richer. This was because, for them, the houses were seen as a savings vehicle, much too important to be sold on a whim.

Under such conditions, large scale housing investment is not necessarily a neutral “revealed preference”. Rather it can be a dangerous “constrained preference”. Given the option between negative real rates in a bank account or housing, Chinese citizens choose housing. But if they had the option of higher deposit rates, we might have seen a shift away from housing towards regular bank deposits. This is very similar to the problem developmental economists face when discussing whether people in poor countries have too many children. While parents might prefer to take care of fewer children, they choose to have more children so that enough of them survive to take care of their elderly parents. So similarly, poor people choose to have a lot of children given their constraints, but with enough financial innovation they would consider having fewer children.

Applied back to housing, these dynamics result in a world where the statements “there are too many houses” and “housing prices are too high” can both be true. Chinese people want housing, but they would prefer an alternative savings mechanism. Therefore, houses are built because there is the demand for the savings vehicle. But there are “too many” houses because the demand doesn't have to be this high. The high demand pushes up prices, pushing those who need the a roof over their heads into cold or other cramped conditions.

From an empirical standpoint, this story should manifest itself in a rising price to rent ratio as well as a lower housing yield. This is because if the house is seen mostly as a savings vehicle, those who own houses would be willing to take a lower rental rate, as their income growth is not dependent upon the flow of rental fees but rather on the growth in the value of the underlying asset. And as seen on page 12 of a 2010 IMF working paper, housing markets in cities such as Shanghai, Beijing, and Senzhen were “overvalued” in 2010 by this metric. More recent data on rental yields also supports this hypothesis, as rental yields in Beijing have fallen to around 2.2% while yields in Shanghai are around 2.8%, much reduced from above 9% and around 6% when the data was first collected.

This has serious implications for policy. First, housing controls such as one-house per family or severe taxes against house-flipping may not be very effective in stanching the speculative demand. The speculative demand is not from, as it was in the US, large banks trying to manufacture subprime mortgages to sell CDS. Rather, Chinese housing demand is from everyday people desperately trying to stretch their savings so that they have something solid to own many years from now. These “mom and pop” speculators are sometimes even willing to go through sham divorces to get around housing restrictions to make this saving method work. As the ant colonies of everyday workers get richer, they too will try to invest in housing for the purpose of saving money, only compounding this problem. This is all a natural outgrowth, and not some nefarious plot by one financial firm. In some ways, larger scale speculation may even be beneficial as it would encourage firms with enough capital to point out the lack of fundamentals in certain areas and help moderate prices.

Second, the question of housing investment is intimately related to efficient resource allocation. Because state-owned enterprises depend on low deposit yields to make a profit, they are a critical structural driver of continued housing price growth. We can't just write off billions of dollars of malinvestments and non-performing loans just because China is quickly growing. The continued support of enterprises that make those kinds of investments is a large reason why there is such excessive growth in housing. Moreover, these malinvestments prevent the necessary structural adjustment that Matt talks about. So unless we can address the problem of providing average Chinese citizens with more savings vehicles, we're not going to be able to address excessive growth in housing construction.

This is the reason why I believe that, besides housing, there are many things China could be building right now. I don't mean to deny the fundamentals story advocated by Scott and Matt, but while China does need a lot of housing to keep up with rapid urbanization, it does not mean that all the housing investment that is occurring at the margin is beneficial. In fact, the same IMF paper does point out that a change in the interest rate would have dramatic effect on price to rent ratios, highlighting the point that the Chinese could be pouring their resources into a lot of other places. Yet, if these places are not immediately obvious to us, it does not mean the market cannot use the higher price of credit to create more productive enterprise.

Third, demand for housing can be highly capricious, creating a dangerous situation for private companies and government alike. To play with expectations is to play with fire, and warning flags are popping up that investment demand for housingis running out. The worst case scenario would be some massive loss of confidence as people pull out of housing as it suddenly has lower yield than other wealth-preserving investments such as gold or jade. Such a drop in prices could shift expectations, driving yields lower. While the probability is uncertain, the fragility is certainly there. When I read stories about entire credit chains dependent on house sales, I have to wonder how severe the problem is. The fear is not about demographics or the fundamentals, it's the possibility of a market that, all of a sudden, falls apart. Perhaps this is yet another reason why there's too much housing; it fragilizes society to be dependent on houses for credit, revenue, and cash flow. And when the music finally stops, we all fall down.

Interest on Excess Reserves: An Illustrated Investigation

The Federal Reserve's policy response to the latest financial crisis can be summed up in one word: unconventional. Between interest on excess reserves (IOER), quantitative easing (QE), and purchases of mortgage backed securities (MBS), the Fed has deployed a wide range of instruments to avoid deflation while preserving financial stability. However, although it is clear the Fed has acted in many ways, what is still unclear is how these policies impact the financial sector and the economy at large. Is interest on excess reserves expansionary or contractionary? Are large scale asset purchases expansionary or contractionary? A rapidly growing and evolving shadow banking sector has only worsened this confusion, and this post is an attempt to make some sense of these arguments in an illustrated form.

First, an introduction to the major players. Interest on Excess Reserves (IOER) originally was a policy implemented by the Federal Reserve in the depths of the financial crisis to expand the Fed's balance sheet to ease liquidity needs. It authorized the Federal Reserve to pay banks interest on their reserves that were in excess of the required amount, and thus gave all commercial banks a risk free return of 0.25% on any extra available cash. However, as a side effect, it meant that banks were unwilling to invest in any security that had a nominal yield of less than 0.25%, as they could just plow that money into excess reserves instead. 

IOER was especially important in limiting the inflationary effects of the Fed's Large Scale Asset Purchases. In these programs, the Fed massively expanded its balance sheet by purchasing either long-term treasuries (QEI, QEII), or mortgage backed securities. These purchases have more than tripled the Fed's stock of treasuries from about $480 billion in August of 2008 to $1.64 trillion in August of 2012, raising the monetary base from $884 billion to about $2.61 trillion in the same time period.

These purchases of treasuries have been problematic for the shadow banking sector, notably the oft maligned money market funds, as the purchases have drained the financial system of safe collateral. Money market funds offer a liquid, yet interest bearing fund for large deposits by taking the deposited cash and entering into repurchase agreements, or repos. Repo is a sort of rental arrangement in which the money market fund "rents" out its cash to firms who need liquidity but who do not want to sell their assets. A typical repo involves the money market fund giving another investor cash in exchange for an asset, then after a certain period of time, the investor repurchases the asset and the money market fund gets its cash back with an interest payment. However, the lower the yield on the underlying asset, the smaller the interest rate payment. As a result of the financial crisis' effect on the perceived riskiness of "unsafe" assets, treasuries have become the asset of choice for repos. However, the shortage of safe collateral has pushed down yields on treasuries. As a result, money market funds are surviving on smaller and smaller spreads, putting them in a precarious position and threatening a contraction of collateral chains. The fear is that if this continues, money market funds will collapse and a (shadow) bank run will cause a liquidity and solvency crisis.

This new element of shadow banking makes evaluating monetary policy a headache. Traditionally, expansionary monetary policy in the form of asset purchases works like in the diagram below. When the Fed buys assets, the money that it injects into the market goes to commercial banks who can then lend out the money and make a yield. Also, the market for treasuries doesn't shift that much as banks can also sell their holdings of treasuries, preserving the model of the shadow banks as they can still make some yield off the repo agreement.

However, in the current crisis position, the situation is very different. Because of the safe asset shortage, commercial banks pile into treasuries as a way of getting some yield for their depositors. This is happening at the same time as the central bank buys large stocks of treasuries, thereby contracting the supply of treasuries even further. As a result of high treasury prices, shadow banks struggle as they can no longer provide a sufficient yield. Commercial banks are in a better position than shadow banks because commercial banks can still park their excess reserves at the Fed and earn IOER. They can limit their purchases of treasuries, thus maintaining what is left of the treasury market.

The key question that David Beckworth and Cardiff Garcia are trying to settle is what would removing IOER from the system do? David Beckworth focuses on the money side, and argues that a removal of IOER would be seen as a permanent expansion of the monetary base, thereby rapidly boosting inflation expectations. In response, banks sell off treasuries and invest in riskier assets which keeps shadow banks safe. His world looks much like the following picture:

On the other hand, Garcia focuses on credit, and argues that IOER is the only thing keeping treasury interest rates positive. Therefore a removal of IOER would lead to massive expansion of commercial bank purchases of treasuries in search of yield, thereby collapsing the shadow banking sector as the system is drained of safe collateral. His world looks much like the picture below:

The critical difference between the two scenarios is how IOER affects commercial bank purchases of treasuries. Beckworth seems to believe a removal of IOER would push banks into riskier assets, thus causing banks to sell treasuries and keep shadow banks safe. On the other hand, Garcia seems to believe a removal of IOER would not be enough to compensate for the perceived riskiness of non-treasury assets, so banks would purchase treasuries in response to a cut in IOER. This would contract the supply of treasuries, destroying the shadow banking sector.

So which one is correct? To be honest, I don't know for sure, and I'm not sure if either Garcia or Beckworth can be certain about the whole story. But Dan Carrol mentions an interesting option that would perform well in spite of this model uncertainty: sterilized lowering of IOER. In this case, the Fed removes IOER, but then partially compensates for the treasuries bought by commercial banks by selling its own stock of treasuries. The drawing looks something like this:

This might seem counter intuitive as the central bank appears to be doing two actions that seem to contradict each other. Yet if we consider the role of expectations, such a policy becomes much more logical. Given that the monetary base has more than tripled since 2008, it should be clear that the market does not expect that expansion to be permanent. According to Krugman, a fully credible expansion of the monetary base in this period and all future periods should directly lead to inflation. Therefore, since prices have not tripled in response to the change in the base, markets must be pricing in the fact that the base expansion will be sterilized by the Fed in the future. 

To raise inflation expectations, the Fed must credibly commit to a future base expansion, and, paradoxically, it cannot do so if the monetary base is too large. Therefore, if sterilized IOER reduction is seen as a move to hitting a nominal target, such as higher NGDP, it can still be part of a credible package that restores the nominal target while preserving the shadow banking sector. In the case of NGDP, a rough estimate of pre-crisis trend growth puts desired NGDP at about $17.3 trillion, about $1.7 trillion dollars above where we are now. Because the average NGDP to Monetary Base ratio over the Great Moderation was about 16.3, a reasonable monetary base would be about $1.06 trillion, $1.59 trillion less than the current monetary base. This means as long as the Fed can credibly commit to permanently expanding the monetary base to around $1.06 trillion, the Fed has room to unwind about $1.59 trillion of treasuries. This would expand the supply of safe collateral and address Garcia's concerns. In addition, giving up on IOER and credibly committing to a permanent base expansion would address Beckworth's call for a regime shift that would restore trend NGDP growth.

A sterilized reduction in IOER would have other advantages as well. First, because its mechanism is not dependent on central bank treasury purchases, there's no risk that shadow banking troubles would lower NGDP growth. Since there's uncertainty about which of Garcia's or Beckworth's scenario would play out, an unsterilized reduction in IOER would translate into uncertainty about whether future NGDP growth should go up or down. Markets would still be uncertain on the status of the shadow banking sector, thus holding back growth.

Second, sterilized cuts in IOER directly commit to a modest increase in the monetary base instead of relying on small monetary frictions. One argument for LSAP's effects on expectations is that an increase in the Fed's balance sheet increases the fraction of its balance sheet expansion that markets expect to be permanent. In other words, the expected future monetary base is convex with respect to the current monetary base. But this approach is fraught with uncertainty and a lack of precision, which may be an issue holding back further monetary easing. If the set of possible inflation rates are {1, 1,2, 1.4, 1.8, 2, 10, 100}, this may change whether the central bank is willing to ease or not. Unwinding the balance sheet while cutting IOER would increase the Fed's precision, improving monetary credibility.

Another framework in which sterilized IOER makes sense is DeLong's law, a modification of Say's law and Walras' law. Say's Law originally said that excess demands for all goods must add up to zero, so there cannot be a general glut. 

(equations from Mark Thoma)

However, Walras pointed out that we needed to include money in this model, therefore there can be a general glut in goods if there is excess demand for money. This opens up a role for monetary policy to reduce that excess demand.

DeLong then argues that another factor we need to be aware of in the recent recession is excess demand for safe assets. So Walras' Law should be expanded further:

This framework clearly delineates between what Beckworth, Garcia, and Carrol are proposing. Beckworth argues that lowering IOER directly solves excess demand for money, and therefore goes on to solve excess demand for safe assets. But Garcia argues lowering IOER directly increases excess demand for safe assets to such an extent that it overwhelms any reduction in excess demand for money. So while directly cutting IOER reduces excess demand for money, it's ambiguous whether it reduces the general glut for goods. Carrol's proposal then comes in the middle, as cutting IOER reduces excess demand in money while sterilization reduces excess demand for safe assets.

In the end, this debate shows not only why the market monetarist focus on expectations is important, but also why an analysis of mechanisms cannot be ignored. All of these arguments for sterilized IOER depend on a credible commitment to expand the monetary base, so if the market expects the Fed to maintain a 2% inflation ceiling the policy change would still be useless. However, changing the target without being aware of the collateralized world we live in would also be a failure, as we would be twisting the dials in all the wrong directions, endangering monetary credibility.

Chinese House Buying Negotiations

Today I went with my family to go look at houses in some Shanghai suburbs an hour from the city. The houses were what we call "别墅", or multi-story mansions at around 320 square meters (~3000 square feet). What struck me as very humorous was how Victorian the sellers would adorn the showcase houses. The curtains were very gaudy, and the walls were often covered with old fashioned paintings of people from 18th century England. Photos were strictly of Europeans and Americans, adding to the western image.

Yet beneath the facade of grandeur, there seemed to be signs of something more pernicious. When we sat down to discuss prices, the agents asked for us to, on the spot, give them ¥100,000 RMB (~$16,000 USD) for a voucher. The voucher would reimburse us for ¥100,000 RMB if we decided to buy the house and would also  guarantee us the opportunity to buy one of the "few" houses that were still selling at about ¥3.5 million RMB (~$550,000 USD). We were a bit taken back, but they explained to us how it would be an almost zero-risk transaction, as the fee wouldn't commit us to actually purchasing the house -- it would just be an indication that we attended their showing and were interested in buying. If we decided not to purchase, we could withdraw our money a month later without any fee. The conversation went something like this:

"Is there some contract or paperwork for this agreement?" my mother asked.

"No, it's just this voucher -- see here. After you swipe your card, then we give you this voucher that clearly says that you are entitled ¥100,000 RMB towards buying a house. And your money will be safe if you don't want to buy, you can get your money back after a month," one agent said.

"Well, I don't have ¥100,000 available to me today. I plan on taking out a loan to buy a house."

Another agent introduced himself as the deputy-manager and said, "If you don't have it all today, that's fine. You can pay ¥20, ¥30 thousand today and pay the rest tomorrow."

"I don't know. Isn't there some kind of something that I can get signed?"

Yet another agent, lanky and with a pen twirling in his hand, replied, "How about this, I can write out a note saying that you have a right to the ¥100,000, and I'll sign it."

I perked up and asked, "Why do you need the ¥100,000 anyways if it doesn't commit us to buying the house?"

"Well, we need the cash flow. We can't keep the bosses always waiting, and they won't be happy if we don't bring in some near term revenue," the first agent replied.

In the end, we didn't give them the money. But the discussion along with other observations seemed to confirm several running hypotheses about China right now.

First, there seems to be a serious liquidity, if not solvency, problem among Chinese housing companies. The housing complex that we were looking at has had difficulty selling in the past two months, and they actually had just cut prices by about a million RMB to boost sales. While they tried to project an image that people were scrambling to buy the houses, there were still three agents aggressively trying to get us to sign. Admittedly, there were quite a few other families looking at houses, yet the agents' ploy for ¥100,000 still seemed like a desperate attempt for liquidity to meet payroll or something more fundamental. This anecdote seems to confirm Patrick Chovanec's analysis that many loans are coming due during this second half of the year, making it difficult for property developers to stay afloat.

Second, Chinese finance is highly uncertain. What did we have to guarantee that the company would actually pay back our ¥100,000? In truth, nothing. There was no hard contract that we could take to the courts, and if the company took a hit from collateral calls as their loans came due, we would be dead in the water. They would be playing with, as Karl Smith likes to say, "other people's money". Once we think about this precarious credit situation in the context of rapidly slowing manufacturing and fragile credit guarantee companies, things are not looking good at all.

NBER Macrohistory: A Few Interesting Results

As I was browsing the FRED database for data, I noticed the front page posting of academic historical data that covers various time series that cover the time between the mid 1800's to the mid 1900's. It's quite amazing the wealth of data available, and I thought I would corroborate some conclusions that fellow bloggers and I have regarding the impact of certain economic policies and phenomena.

First exhibit: Openness to Trade

While the Bretton Woods period after the Gold Standard is typically characterized as a dark era for international trade, in reality trade grew at a steady clip. From 1870 to 1944, trade grew an average of 4.0% every year, whereas during the Bretton Woods period, from 1944 to 1971, trade grew at about 6.6% per year. However, after the breakup of Bretton Woods, trade boomed, with yearly growth in trade averaging 9.6%. This corroborates Evan's analysis that trade went parabolic in the 1970's as global trade barriers steadily went down. I've graphed the data below in terms of log of the index, so the distance between two vertical values is actually a measure of percent change, making historical comparisons much simpler.

Looking at the data, we can also see that, among the post war recessions, trade has fallen the most in percentage terms in the Great Recession than in any other recession. A close inspection indicates that it still has not caught up with the pre-recession trend, but an even closer inspection indicates that the lack of catch-up growth should not be too surprising, as in the last two recessions, trade never caught up to the pre-crisis trend.

Second exhibit: Price Stability

Prices were incredibly stable during the Gold Standard era, to the point of bordering on pathology. The prospect of decades of deflation is unthinkable now, but it was something that Americans had to deal with during the time period from 1880 to 1900. It's amazing to think that the price level was fundamentally controlled by gold discoveries, as the mid 1860's boom in the price level can be directly traced to the gold rush during that time period. Yet as production rose, the price level fell, the natural result of a commodity price regime in which the supply of the commodity is severely limited.

The behavior of prices during the interwar period is also interesting, as prices doubled with the beginning of World War I, and then collapsed 40% with the onset of the Great Depression. And during the Great Depression, although FDR's dollar debasement strategy did work to significantly raise the price level, it was not enough to return it to its pre-war trend before he cut it off with his policy reversals in 1937.

Third Exhibit: Turn of the Century Wage Levels

This provides an interesting complement to the price stability graph because it seems to show that the rise and fall in the price level were the ultimate drivers of the wage rate, and not so much other factors such as the extremely large flows of immigrants in the late 1800's and early 1900's. By looking at the graph, it would be impossible to try to pin down when immigration was at its highest or when restrictions on immigrants were put into place. This goes down as a historical point to explain in debates about unskilled immigration and wage rates, a some of the most prosperous periods of American history took place side by side with large immigration flows. On the other hand, hard money seems to be a serious issue holding back wage growth, so this graph should help in showing how problematic the Gold Standard truly was and how a similar commodity standard today would be seriously detrimental to necessary growth in nominal GDP.

The Fed's Balance Sheet, Interest on Reserves, and the Zero Lower Bound

A look at some time series evidence and conclusions for IOER and NGDP

Is the Fed powerless at the zero lower bound? Most market monetarists would say no, the Fed always has a wide range of unconventional policies that affect expectations and can boost nominal spending growth. As long as it can boost the monetary base, there can be an effect on expectations and NGDP. Miles Kimball argues that QE is effective because it takes advantage of small monetary frictions to achieve large real effects. Karl Smith suggests that QE is effective because the central bank will unwind QE before it raises short term interest rates, making QE a commitment mechanism for forward guidance.

However, some detractors argue that, because of interest on excess reserves, policies such as quantitative easing are useless. Because banks can just hoard the money and get interest payments from the Fed, QE doesn't spur any additional lending. Others argue that QE just takes collateral out from the financial system, thereby shortening collateral chains and contracting the economy.

So what does the data say?

Not surprisingly, expansions of the monetary base, even at the zero lower bound, have a powerful effect on both current inflation and expectations of future inflation. The graphs below are changes in inflation and inflation expectations with respect to changes in the monetary base.

The first two growth spurts of the monetary base in the two graphs are QE I, QE II, respectively. The fact that inflation moved with the monetary base is important. In the time periods for both graphs, IOER was at 0.25% and the fed funds rate was at 0-0.25%. However, this did not nullify the effects of a monetary base expansion on inflation or the expectations thereof.

Therefore, these graphs provide a tentative answer to the debate over negative rates, nominal GDP targeting, QE, IOER, and collateralization. First, expanding the monetary base boosts inflation and nominal GDP. This happens in spite of the removal of safe collateral from the repo market. Additionally, IOER has not proven to be a barrier to QE or other expansions of the monetary base. Under such conditions, why not maintain IOER? Money market funds can reap the benefits of a guaranteed income stream AND higher nominal GDP growth. The debate on negative rates and IOER becomes a moot point. Given IOER is not a barrier to monetary expansion, the Fed can leave it untouched and pursue a transition to a nominal GDP target in different ways.

As a result, I stand by my original policy suggestion of continued interest rate guidance combined with more QE while leaving IOER untouched. Quantitative easing fundamentally changes what forward guidance means. Because low interest rates are not reliable indicators of monetary policy, a policy that only commits to a long period of low interest rates may be perceived as a Delphian prediction that nominal GDP growth will be slow. On the other hand, if QE provides the pressure for rising inflation and nominal GDP growth, forward guidance turns into an Odyssean commitment to low interest rates in spite of higher nominal GDP growth. With IOER still around to guard against any uncertain effects of negative rates, this policy would maintain financial stability while guarantee robust nominal GDP growth.

What firms See and not See

Matt Yglesias replies to Brian Caplan on why right-wing economists tend to like Bastiat much more than left-wing economists do. I think Matt is correct in saying that those who quote Bastiat often already assume government intervention is undesirable, but I wonder why those who support limited government intervention don't employ Bastiat as well.

Most reasoned arguments for government intervention happen on welfare-theoretic grounds, so why not use those types of "unseen" costs or benefits as reasons for government intervention? When a people pay for immunizations, what they see is the cost in both time and money to get the shot, while what stays "unseen" is the population of other people who are not going to contract the disease. When an oil rig is opened, what is seen is the growth in economic activity and jobs, while what stays unseen is the pollution that contaminates other towns. When Wall Street firms overleverage, what they see is the higher return when times are good, what remains unseen is the systemic risk that devastates the system when times are bad.

In these situations, government policy can allow the market to see what was previously unseen. Subsidized immunizations show parents that immunizing their children can save the lives of others. Carbon taxes show companies that their oil consumption hurts the health of others. Higher capital requirements show banks that their higher return can lead to the fragility of others. Often times, transaction costs are too high for the Coase theorem to internalize these externalities, and it becomes necessary for the government to try to reveal the true costs of actions to the market.

Of course, perhaps there's a government failure, perhaps the government does not have the necessary information to intervene. But at this point, Bastiat stops becoming a sufficient argument, therefore we need to look at the empirical data. For this reason, I read Bastiat and am left with "meh"; it is much too general to strike at truth.

Nominal and Real GDP: A Barrier to a Statistical Approach

Scott Sumner regularly talks about how almost all discussions of inflation become much clearer in terms of NGDP. This is because people have a hard time differentiating between inflation as a result of more aggregate demand (demand-push) and inflation as a result of less aggregate supply (cost-pull). The difference is summarized in the textbook aggregate demand/aggregate supply diagrams below:

Aggregate demand expansion = Inflation

Aggregate supply contraction = inflation

The first kind of inflation changes NGDP, while the second has minimal impact. This way, when we are in a recession and demand more inflation, what we really mean is that we need more of the first kind of inflation because we need more NGDP. If we were in the second situation, we wouldn't be demanding more or less NGDP because the supply shock would have had minimal impact.

Another example in which NGDP makes explanations easier is in discussions of whether deflation is bad in an economy. Often times, liberal economists will point to the recent recession and say deflation is bad, while libertarians might point to the late 19th century, early 20th century and say that deflation is good. The more correct answer is that stable NGDP is best. So because the first kind of deflation reduced NGDP, it was bad, while the second type of deflation kept NGDP steady, and therefore was good.

While NGDP is simple, it makes it hard to statistically show NGDP boosts RGDP. You can't look at a graph and point to any correlation; a skeptic could just say that it's the RGDP that's driving the movements in NGDP, and not the other way around. In the end, to explain the relationship between nominal and real output in AD shocks, I have to find specific channels, such as nominal debt. On the other hand, inflation and output make much more sense in terms of trying to find statistical relationships. These concepts are far enough in people's minds that a relationship doesn't seem like a tautology. However, when you start directly talking about NGDP and RGDP, it's too easy for people to think the observed relationship between NGDP and RGDP is just because the second is a component of the first.

How Does Paul Ryan Want to Target Inflation?

He would have to use Quantitative Easing anyways

While my previous post talked about the variety of ways Paul Ryan should prefer an NGDP target over an inflation target, I realized that a lot of the Fed's policies that Paul opposes would still be necessary in a world of inflation targeting. In his 2010 Op-Ed with John Taylor, he called the quantitative easing programs  "departures from rules-based monetary policy" that have "increased economic instability and endangered the central bank's independence." But would strict inflation targeting really solve the problem?

Below I've created a graph plotting quarterly annualized headline CPI inflation which includes commodity prices, the 2% inflation target, along with zones indicating when the two quantitative easing programs were hinted at and then executed. The dates for the QE announcements were taken from a conference paper, and they are used to show how policy and inflation were related.


As you can see, for much of the past four years, headline inflation was significantly below the 2% target traditionally set for the Fed. In response, the Fed hinted at the quantitative easing programs and drove up inflation. Yet Paul Ryan opposes these policy interventions. The question that I pose to Paul Ryan and his supporters is "what would you have had the Fed do during those time periods?" The short term interest rate was already at zero, so what would Ryan have suggested to fulfill the mandate? Paul would have been forced into unconventional monetary policy such as QE or Operation Twist just to fulfill his proposed mandate!

Under these conditions, there's no reason for Paul Ryan to not opt for an NGDP target instead. If you're going to be using unconventional monetary policy tools, you might as well use them to target a metric that is critical for stable, robust growth. An NGDP regime would be simple, rule based, and verifiable. So when choosing a monetary policy regime, why not NGDP level targeting?