"Dammed" Chinese (De)regulation

A look at liberalization failure in Sichuan water dam regulation

Around the beginning of the year, Obama made an appeal for government consolidation and to reorganize the bureaucracies in a more logical manner. At first pass, this seems like a reasonable approach. But we must beware of what Karl Smith calls "liberalization failure". While current regulation might be frustrating, badly done deregulation can result in even more finger pointing instead of actual work. Perhaps we can draw a lesson from an interesting anecdote about Sichuan river hydropower stations. 

Hydropower ventures are interesting to regulate because they do carry an externality. Besides changing the distribution of water, the dams carry a risk of collapsing. When this happens, any tunnels downstream can get flooded and, in severe situation, workers are killed as their houses are destroyed. As a result, before 2000, the construction of the dams was regulated by both a commerce agency and a water resource agency. The first would determine whether a dam could be built, while the second inspected the dams to make sure the engineering was of good quality. The collapse externality is the market failure. The inspection regime is the non-market based solution, and can be thought of as the government failure.

So where's the liberalization failure? To give you an idea of the problem, Sichuan dams are supposed to be inspected within three years of construction. Only after the inspection can they officially start producing commercial electricity. But in the past 10 years, of the over 4000 new hydropower stations constructed, a considerable number of them have never been inspected. Yet they have been "testing" their generators and selling the electricity on the market. Sichuan is one of China's largest hydropower provinces; why does it have so many regulatory problems?

A lot of the problem boils down to what the government tried to do starting in 2000 to liberalize the development of dams on the rivers. Remember the commerce and water resource agencies? In 2000's, the commerce agency took over the supervision of basic engineering from the water resource agency. But this transfer of power took place without any transfer of real resources. While the water resource department had over 150 people working on the issue of supervising construction, the commerce agency only had a few. Although their was a joint memo discussing inter-agency cooperation, was steadily ignored over the years. By 2003, the water resource agency gradually lost all of its regulatory power to the economic development agency, but still had to bear the burden of fixing engineering problems when they threatened the public safety. An official for the water resource agency summed up the problem very nicely:

"If we try to regulate, we're not the right agency. If we try to not regulate, they come and hold us responsible for the accidents on the river"

There were accidents aplenty. In 2006, because of a half-done shoddy job by a contractor, a dam broke, flooding workers houses with over a thousand cubic meters of water, killing eight people and injuring six. The manager of the dam skimped on some safeguards, jeopordizing the stability of the plant. Many of the contractors were uncertified, and there was never a third party inspector to make sure the work met standards. In 2011, large floods interrupted dam construction and flooded work tunnels, trapping thirteen workers and killing all but one of them.

And who's responsible? In the 2011 case, the government noted that better engineering would have saved the workers, but ended up putting all the blame on a "natural disaster". Even when the government takes responsibility, it is incredibly vague. A translation from a 2012 policy paper titled "Suggestions for increasing engineering and design oversight for hydropower plants of less than 25 megawatts"

After many years of hard work, hydropower plants have become a primary energy source for Sichuan's rural counties, especially for the minority and mountainous areas, and they hold the potential to support the province's economic and social development as well as its citizen's livelihoods; however, in this process of development many problems have been revealed, especially in the areas of regulatory coordination, inspection procedures, engineering oversight, environmental protection, as well as other areas that are still pending increased attention and improvement.

Note there's not a single line on who is doing this work. Agencies are hinted to later on in the paper, but not with any specificity. Merely that building safety issues should be taken up by all relevant agencies". This is especially problematic when "inspection procedures, engineering oversight, and environmental protection" are all divided over rmultiple agencies that are governed over many levels of government. Some are local, whereas others are run by the province, and even others are run by the central government.

As a result, the locus of liberalization failure centers around this problem with agency responsibility. Responsibility is never clear, and work is not delegated efficiently across the agencies. This is a key point about deregulation and attempts to make policy more "market friendly". What you may end up with is an incomplete transfer of power, thereby giving people the regulatory power but not the expertise, or vice versa. The separation of these powers may not result in check and balances; rather, it can create perverse systems of incentives in which the mistake of one agency is paid for by the work of another. In the Sichuan case, the water resource agency has to bear the burden of the commerce agency's engineering mistakes. The commerce agency could pursue their goal of economic development without too much concern, because if they went overboard it was the water resource agency's problem to solve. So in the regulation of an externality, the institutional structure actually promotes externalities within the government.

Another more philosophical note is that the government can never be truly thought of as a unified entity, but rather is better conceptualized in terms of individual agencies. These entities have their own missions, own internal incentive structures, and own responsibilities to outside agencies. As Mankiw's principles remind us, incentives matter, in both private and public life. And this is the sad truth on why the dam deregulation is likely to stay dammed. The incentive structure for change is not there, as those with the power have to shoulder none of the responsibility. 

While the above may just be a small story of a small power industry in Sichuan, the power of two "I's", institutions and incentives, should never be underestimated. Failed partial liberalization can corrupts the first; failed regulatory regimes can arise from the bad design of the second. This process is incredibly important for the design of microeconomic issues, and appears to be a fruitful investigation for the future.

Housing Equity as Price Regulation

Price ceilings with Chinese (housing) characteristics

Chinese housing prices are still very high. For as much as there's concern that the whole situation may implode, Shanghai housing prices are still in the neighborhood of 20,000 yuan per square meter. A recent high-end Beijing housing development, Ten-Thousand Willows, is shooting for about 24,000 yuan per square meter. Guangzhou just had an auction to build housing at a floor price of 32,967 yuan per square meter. In one day, an auction company sold three parcels of land, and each sale beat the previously set record. One day. Three sales. Three new records. The government response? It censured the auction firm "promoting incorrect market expectations." With this rapid growth in housing prices, the Beijing government is trying to take action to limit the price competition for the Ten-Thousand Willow land purchase. Its tool of choice? A price ceiling on the bidding prices for land, coupled with competition on the basis of housing equity.

How does this work? First, the government sets a price ceiling, which is not yet publicly disclosed, on the maximum bid that residential development companies can bid. Firms have no obligation to bid up to this price, but they can bid no more than the ceiling. Beyond this price, companies can compete in a different dimension: they can sell housing equity back to the government. Ideally, the land bids won't go that high, but the government is ready to clamp down on price growth once it hits the ceiling. At the ceiling, a company can offer to sell "repurchase housing" back to the government at about 10,000 yuan per square meter, less than half of the market price. In effect, instead of bidding more for the land, the government is forcing firms to sell equity call options to compete. The government can use these houses to provide low cost lodging to the poor, or it could even sell the houses later to fund welfare programs or state owned enterprises.This move has forced companies to re-evaluate their bids as they need to adapt to a new system that, critically, changes the way volatility and price growth affect company and government finances.

If housing prices continue to rise, repurchase housing will cut hard into company profits. The companies are losing a large part of the return on the land bid. For the government, this is also a very good deal to make sure housing prices don't rise too fast. First, the ceiling allows the government to signal their commitment to lowering prices. Then, if housing prices are still going to rise and the land is still worth more than the ceiling value, the government can capture some of the upswing through equity call options. This also arguably prevents "fragility exporting" in the system, as the companies get less of the upside risk while still bearing the downside risk. The government also gets some upside risks while still having to deal with the possible costs of future stimuli to ease a Chinese housing contraction. I still don't have faith in Chinese housing policy, and I'm concerned how this game of musical chairs will play out. However, the use of a price ceiling coupled with call options strikes me as a particularly innovative way to limit price growth. Capitalism with Chinese characteristics indeed.

Monetary Policy and Inequality

The recent Stiglitz commentary on monetary policy and inequality has provoked several responses from Karl Smith and Tyler Cowen. I find their responses to be broadly correct, and get to the fact that monetary policy is not supposed to be a panacea; rather, it helps restabilize conditions to allow other adjustments to be implemented with less pain. Given Evan Soltas' recent post on monetary policy and poverty, it seems dubious that monetary policy, in and of itself, is the root cause of inequality and the skyboxing of society.

Funnily enough, as I was flipping through new NBER working papers, there was a paper testing the empirics of the monetary policy-inequality hypothesis. What do the authors find?

We study the effects and historical contribution of monetary policy shocks to consumption and income inequality in the United States since 1980. Contractionary monetary policy actions systematically increase inequality in labor earnings, total income, consumption and total expenditures. Furthermore, monetary shocks can account for a significant component of the historical cyclical variation in income and consumption inequality. Using detailed micro-level data on income and consumption, we document the different channels via which monetary policy shocks affect inequality, as well as how these channels depend on the nature of the change in monetary policy.

Et tu, Stiglitz?

A Currency Union by any Other Name

...still suffers from the same adjustment problems

Recently there's been a spurt of discussion on the part of Simon Johnson and Paul Krugman on Optimum Currency Areas and productivity growth, and Nick Rowe is still a bit confused. Why should productivity growth differentials matter? Nick lists out a variety of thought experiments and finds no satisfactory answer. As he says, "There must be something else. Some other hidden (to me) assumption they are making. What is it?" With some thought, I believe the "something hidden" is something that market monetarists (including Nick Rowe) have written extensively about: nominal GDP.

Why nominal GDP? Because it's the "something" that can link "productivity differentials, current account deficits, and exchange rate regimes".

First, let's talk about the relationship between higher productivity growth and higher nominal GDP. At least within the United States, productivity growth has a strong correlation with nominal GDP growth. A 1 percentage point in YoY multifactor productivity predicts about a 0.66 percentage point increase in nominal GDP growth. This observation is likely compounded by the Balassa-Samuelson effect, which would imply higher inflation in the regions with higher productivity growth. In terms of the AS/AD model, if the AD curve has a price elasticity of greater than 1, positive AS shocks boost nominal GDP. Fiscal policy is not an answer, as politicians are rarely going to pull back during a boom. And if monetary policy intervenes to cool down the growth, this puts the brakes on nominal GDP growth for the rest of Europe, thus compounding the asymmetric shock problem. Either way, a permanent productivity differential can lead to permanent nominal GDP growth differentials, even if the central bank targets mean nominal GDP growth.

Nominal GDP also can help explain exchange rate regimes and current account deficits. As Scott often reminds us, "You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level." And what measures aggregate demand? Nominal GDP. Consequently, if we shift discussion to nominal GDP growth rate differentials, we can talk more intelligently about exchange rate issues. The rate of nominal depreciation of one country's currency vis-a-vis another should equal the difference between the first country's NGDP growth rate and the second country's NGDP growth rate. Thus, if one country has lower NGDP growth than the second, the currency of the first should also depreciate. However, this cannot be the case in the present environment. As Evan Soltas has noted, the Euro has recreated the world of the gold standard. The Euro prevents currency depreciation. Instead of depreciating currencies, we have falling nominal GDP. Countries like Spain and Greece are forced to grind through internal devaluations, imposing massive costs on their citizens.

By refocusing on nominal GDP, a lot of the questions Nick and others are asking become much clearer. Why does a permanent differential in productivity growth matter? Because it implies a permanent differential in NGDP growth, which causes pressures for an exchange rate to change. But because the euro pegs the exchange rates all together, the pressure manifests itself as internal devaluation, which carries very severe negative consequences on count of sticky wages/prices and safe asset shortages. Why does a permanent differential in productivity levels not matter as much? Because if productivity growth rates are the same, there is no differential in nominal GDP. Therefore there's no pressure for currency adjustment. Productivity growth may not force trade deficits, but it can still cause nominal GDP differentials.

Why do fiscal transfers matter? Because in a gold standard world, fiscal transfers between regions (countries) can affect regional NGDP growth. Fiscal transfers are a crude way of "taking" aggregate demand in one region and putting it in another. Fiscal transfers do what domestic central banks can not; stabilize country level NGDP growth. This is politically justifiable if shocks are temporary and distributed among the countries. But when one country has permanently higher real growth and nominal GDP growth, that country will be permanently paying transfers to the others. This is the political problem to which Krugman and Johnosn refer. These permanent NGDP differentials necessitate a one-sided transfer union, which we do not have. As a result, we see the painful process of internal devaluation in periphery countries.

A narrative in terms of nominal GDP also subsumes discussions about unit labor costs. By the New Keynesian business cycle model, lower nominal GDP growth rates arise because of higher real wages or labor costs. So the lower nominal GDP growth in the periphery raises the real wage, rendering the periphery uncompetitive. This is then a more concrete reason why internal devaluation is the only option in a world without transfers or national currencies. Unit labor (and capital) costs need to adjust.

We can now try to answer Nick's thought experiment on a country filled with both low-productivity "Greeks" and high-productivity "Germans", If you separated them, you would observe that the Greeks would have lower growth in nominal production relative to the Germans. This would manifest itself in a growing income gap over time. But what keeps countries together? First, there's "labor mobility". There's no reason  why the Greeks have to stay Greek; maybe they can intermarry and become high-productivity Germans. Second, there's "transfer payments", along the lines of social welfare. High productivity Germans are taxed to pay transfers to the low productivity Greeks. And as in the currency union, the Germans will likely complain about having to subsidize the laziness of the Greeks. If the Greeks can't fight for these policies in the sober halls of Parliament, they can threaten an "exit".This is the basic story behind nationalist secession.

Eurozone Breakup Probabilities

Quick, look at the prediction markets!

The Intrade prediction markets currently predict a 30% chance that one country will leave the Euro by the end of 2012, a 59% chance that one country will leave by the end of 2013, and 60% chance that breakup will happen by the end of 2014. Looking at the graphs for the period since June 10, one can see that the June 17th election results brought down the two nearer term probabilities by a substantial amount, while the longer term 2014 probability barely moved.

It's also helpful to look at the spreads between the 2013 and 2012 prices and between the 2014 and 2012 prices.

From the graph of the spreads, it's very obvious that the markets perceived the recent election as just "kicking the can down the road". Longer term probabilities diverged from the near term ones, but the longer term probabilities converged to each other. From this data, it seems that the markets perceive the probability of a breakup by 2014 is almost equal to the probability of a breakup by 2013. Either way, things look bleak for the Eurozone.

Friday Roundup

Some more bond vigilante-unsustainable debt commentary for the UK. The analysis is peculiar because the question is why so many people are willing to invest in UK bonds now. If expectations for the future are dour, why would investors have faith now? This may be linked to the story on a possible bubble in US government bonds. Current demand for safe assets is because of collateral needs; once the economy recovers borrowing costs are going to skyrocket.

Koo takes a close look at Eurozone fiscal and monetary union dynamics, and concludes that neither system deals with balance sheet recessions effectively, especially as they are often asymmetric shocks. An interesting point is that monetary policy, when it tries to ease the impact of these shocks for certain states (ie Germany), the cheap credit causes new problems in other countries. For as much as the ECB pursues "Deutschland über alles", there may be nothing left to be over if the monetary union doesn't develop a system of interstate transfers.

Demand for safe assets doesn't necessarily lead to a shortfall in aggregate demand...only if monetary policy can function as an offset. Is the German current account surplus sucking up your country's growth? Not if your central bank holds tight to a nominal aggregate and keeps growth on track. Just as Scott Sumner says, if your central bank is doing a good job, there are no "depression economics"; fiscal policy doesn't boost output, and current account deficits don't hurt growth. The article does outline a pretty scary chain of events for why demand shocks matter

If demand still fails to materialise, economies go on to restructure via the supply-side.
A vicious circle ensues as capacity is reduced at the expense of the least efficient businesses. Unemployment rises. The economy contracts.
All the while those who still have wealth are encouraged to hoard even more, a fact which only exentuates the contraction in broad money supply, preventing liquidity from reaching those who would most likely be prepared to spend.

Is there really that much regulation holding back the natural gas energy boom? It doesn't look like it. If anything, regulation looks to be too lax, with large scale environmental concerns just shoved under the rug. The NYT piece does bring up an interesting point. Companies, at this point, have an incentive to just get the gas out as fast as possible, before the regulations start coming into effect. Sounds like a dangerous starting point with massive first mover advantages.

Greater transparency in European repo markets would be helpful, but to what extent would it actually solve anything? No doubt more aggregate statistics would help with systemic regulation, but there's still concern that unknown unknowns could crop up. Especially since there's no legal way to force every piece of data from firms, there could always be off-sheet risks building up. And when individual transactions can lose billions of dollars, these unknown risks could break the bank.

Also on the transparency front, European governments are resisting shifts to more transparent accounting standards. It looks like many European states, especially Germany, are concerned about hidden pension debts that may rise to the surface. This does not bode well for the Eurozone in the medium-term, even if national leaders can't wade through the politics to an agreeable solution.

On the topic of the Eurozone, there's an interesting new VoxEU article on the tragedy of the commons problem with regard to the ECB and the peripheral central banks. In a nutshell, the authors argue that since national banks could determine what collateral was considered "safe", they would have an incentive to be too lenient on their own banks in order to gain an advantage in lending costs in the Eurozone. In effect, each national bank's action had a negative risk externality that would be born by the entire Eurozone. This means that fiscal solutions to the crisis are not sufficient. The problem goes deeper, starting with the conflicting incentives of sovereign central banks and the European central bank.

Chinese Labor (and Fried Chicken) Shortage

A story of China, fried chicken, and labor shortages

There's a labor shortage in China. Yes, in the land of over 1.3 billion, companies cannot find enough workers. Well, at least this is true for certain companies. While browsing a Chinese newspaper yesterday, I read an article with startling reports on labor market conditions in Guangdong, or the Hong Kong area, that talks about the exact same points as the linked article. In short, inland China is getting richer and more developed, putting upwards pressure on coastal city wages. And when those wages start becoming uncompetitive, there's growing pains as increasing amounts of migrant workers stay near their inland home provinces, working for newly constructed factories there.

Another interesting manifestation of the coastal city labor shortage in Shanghai, where I currently am, is that KFC is attempting to actively recruit workers. Yes, the fast food service industry, what is often considered to be an employer of last resort in the United States, is advertising its job offers. Below is a picture of one of these posters:

Note the happy, young, restaurant workers, who are looking forwards to a bright future. There were also other posters that declared it was time to get trained, time to get down to business, and learn the ways of working at the Chinese KFC equivalent of a West Point. On every table in the restaurant, there were little stickers listing the restaurant shifts, and of when workers would be able to get free food during their shifts.

Yet in contrast to this apparent worker "shortage", I still observe people working in extremely low productivity positions. Streets are still manually swept by workers in blue jumpsuits wielding long brooms made from thick straw. Streetside vendors pedal mobile kitchens around to serve day workers lunch and dinner. It is as if they are part of a broader labor mismatch problem in China. In the case of Shanghai, there aren't enough workers into official jobs such as fast food service, even as a large proportion of the labor force is in extremely low productivity or shadow economy jobs that they've held for a long time. I see this as another way state managed investment booms fail to effectively promote welfare. Although airplanes and train stations are fancy, there's a lot more low hanging fruit if the government could build the capital to obviate repetitive manual tasks (Street sweeping? Really?). This could allow a shift into more manufacturing or just higher end (think KFC) service work.

The fact that coastal cities are dealing with labor shortage while inland factories are blossoming strikes me as funnily ironic. While we in the U.S. complain of offshoring and outsourcing to lower wage areas, coastal China is dealing with "inshoring" as factory jobs move inland. This really strikes at the heart of why labor reallocation happens. Once the standard of living rises, it's no longer sustainable to keep people in low wage jobs. And when those wages start rising, there start to be competitiveness issues as productivity doesn't keep pace. I imagine this productivity competition is even stronger between inland and coastal China than it is between the United States and China, as the gap between production technologies employed within China is likely less than the gap between the production technologies employed by the United States and coastal China. China really is, as Chovanec says, nine nations governed under one flag. It is not a monolith, but rather a collection of subregions, each with their own markets and attending problems.

Drachmatic Monetary Policy

The trauma of drachmatazation and how monetary policy could be conducted

A recent blog post from Evan mentioned some of the problems in drachmazation, and as my list of thoughts steadily grew longer, I thought I would explicate them more fully in a blog post.

In his post, Evan mentioned that:

To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive  -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma. 

I find this to be an interesting point, but I think his arguments about the legal status of the Euro are a bit more important. Without a legal mandate that the Euro can't be used in the future, there would truly be no incentive for people to go exchange their euros in the transition. If the conversion rate did not offer enough drachmas for every Euro, then not enough people would go. If too many drachmas were offered, then there would be additional inflationary pressures. Moreover, if the borders controlling capital inflow were porous, foreigners could go in and exchange their euros for drachma at the favorable rate. However, if capital controls are tight enough and the legal mandate for the use of the Euro certain, then domestic Greeks would have an incentive to exchange Euro for drachma, while foreigners would have no incentive to do so.

Evan concludes his post on possibilities for the future of Greek monetary policy. As a market monetarist is wont to do, he floats the idea of an NGDP target to limit the inflation expectations when the Greek government becomes dependent on the central bank for financing. While it sounds good in theory, this is an important example of where NGDP targeting fails in stabilizing crises. If the Greek government is going to be in such bad shape after the exit, what guarantee do we have that any of the data will be reliable? If it's not even certain who's withdrawing money and what currencies are being spent, how does one measure the net value of all the transactions to get an NGDP number? Given the turmoil, it's also unlikely that a deep NGDP futures market would be established, so there would be no way to evaluate whether NGDP is on trend or not. Once it becomes logistically impossible to maintain a credible NGDP targeting, all of the expectations-based arguments used to support NGDP level targeting start to buckle. If the public suspects that the central bank may overshoot, they can go with the momentum and send NGDP off its trend. The same would be true if there were expectations that NGDP was falling and the central bank wouldn't respond quickly enough. Although, in the end, the level target would function, the lack of true credibility would make for wild short term gyrations. In this situation, a composite inflation and rate change of employment target might function better, as quick statistical surveys could get a snapshot of these statistics. This data consideration is a very important point once NGDP targeting starts to spread to other countries. If financial markets aren't deep enough for NGDP futures targeting, and quarterly NGDP statistics are hard to verify, it may be better to work with what we have with regards to inflation and unemployment data.

Rate and Level Targeting

Evan Soltas always offers plenty of interesting topics to talk about, and his recent post on level and rate targeting is no different. Evan strikes as the fundamental problem with looking at unemployment and the rate of price growth (ie inflation) to determine monetary policy: the Fed has the rates and levels mixed up. From his post:

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.

This another example of a pragmatic near-term policy that the Fed could pursue. Instead of creating new NGDP futures markets or shifting the focus on to market forecasts, the Fed could just focus on rate changes in employment and the level of prices.

Evan, in his posts, points out an interesting mathematical discrepancy with unemployment-inflation targeting: unemployment is a level, while inflation is a rate of growth. The units don't even match up, the classic problem of physicists everywhere! His adjustment to focus on changes in employment and the level of prices has support from another empirical "rule of thumb": Okun's law. Okun's law relates the rate change in unemployment with the real GDP growth in that period. Historically, the economy needs about 3% real growth every year to maintain the unemployment rate, and every 1% increase in real growth every year can reduce the unemployment rate in that year by about 1%.

Thus, the rate change in unemployment could be used as a quick flash estimate of NGDP growth. This could then be wrapped up in a new targeting regime, as policy makers may pursue higher inflation rates or faster falls in unemployment to reach some hybrid index, which the Fed could target as if in an NGDP level tareting regime. Now that you mention it, it smells suspiciously like Evan's old H-Value proposal, just implemented with a different data source, with unemployment as a proxy for GDP growth. The data frequency argument is a pretty important one against NGDP targeting, so any alternatives for more intermediate data are always important.

1970's Sumner-time Stagnation

Recently, Scott Sumner and Karl Smith have debated to what extent was the 1970's an era characterized by "stagnation" (AS shock), or just overexpansionary monetary policy. For Scott, much this debate seemed to be about retelling the stories that we learned in introductory economics. Scott reframes the issue in terms of above trend nominal GDP growth, and, along with other data about the labor markets, argues that the decade of inflation came about not because of stagflation or supply shocks, but rather because of overly loose monetary policy.

From the most basic AS/AD perspective, robust real growth in the 1970's is no indication that there was no stagnation. Given the accelerated NGDP growth, real GDP growth should have been higher, for reasons ranging from money illusion to sticky wages to sticky prices. In other words, the higher rates of nominal change meant that a short run equilibrium with higher real growth could be maintained. Had NGDP growth been slower, then we would not have been able to squeeze 3.2% RGDP growth out of the economy. In short, I disagree with the statement that:

I think Karl and I would both agree that (whether or not there was stagflation during the 1970s) under 5% NGDP targeting there definitely would not have been any stagflation."

Is there any reason for this? Scott's argument presupposes that you can decouple nominal growth from real growth. So when he says:

Growth was normal, and inflation was very high.  Rapid growth in AD explains roughly 100% of the inflation during the 1970s.  There was no stagflation, just inflation.

He presupposes the high real growth was not explained by the higher inflation. While, in the long run, higher inflation does not lead to a permanently higher level of growth, there is still a positive relationship between inflation and output in the short run. In introductory terms, this trade-off is the aggregate supply curve, and the correlation arises from increases in aggregate demand. If the high level of aggregate demand is the reason why inflation is high, the high level of AD is also the reason output is high. I don't see how they can be separated.

There are also many places one can look for data to support this hypothesis. The first is the classic shifting of the Philips curve. If the Philips curve moved outwards in the 1970's era, that meant you needed a higher level of inflation to reach any given unemployment rate. If the unemployment rate is a proxy for real growth, then this directly leads to the conclusion that higher levels of inflation allowed higher levels of real growth.

However, Scott prefers to focus on real GDP ("I had thought the word ‘stagflation’ meant high inflation plus slow output growth (due to slow growth in AS.)"), and on this issue the data still suggests that the higher NGDP growth could not be disentangled from the higher RGDP growth. The first graph is a scatterplot of 1960's data, with NGDP YoY growth on the x-axis, and RGDP YoY growth on the y-axis.


The following grpah is a scatterplot of 1970's data, with the same x and y axis data.

Looking at these two graphs, one can see that the relationship between NGDP and RDGP was very tight in both periods. While correlation does not prove causation, it's hard to think of any theoretical mechanism that could have decoupled NGDP from RGDP in either period.. Another interesting note is that the x-intercept of the 1970's data is much larger than the 1960's data. This suggests that you needed a higher level of nominal growth to hold RGDP steady in the 1970's than you needed in the 1960's. the 1970's was suffering from an overall supply shock relative to the 1960's.

As an interesting corollary to all of this, given the lack of a long-run relationship between higher nominal and real growth, you need accelerating nominal growth to prevent real growth from falling down. In a sense, in addition to the positive relationship between the first derivatives of NGDP and RGDP, there should also be a  positive relationship between the second derivatives of NGDP and RGDP.

Notably, these correlations are even stronger than the first two graphs. This lends more evidence to the argument that, had the Fed decided to decrease YoY NGDP growth, RGDP would have taken a hit. For all the power that lies within expectations, they can't take away all of the pain away from a NGDP disinflation.

What seems unexplained is why the 1970's slope is higher (with greater than 95 confidence) than the 1960's slope. If agents adapt, the same increase in NGDP growth should result in a lower increase in RGDP growth. By that theory, the 1970's slope should be less than the 1960's slope. This will be an interesting topic for future investigation.

Over the Great Firewall

From the 17th of June until the 30th of August, I will be on the other side of the Great Firewall of China for summer vacation and language studies. While Blogger is blocked in China, I will still be able to post with the help of email and a good friend in the United States. However, this process is not perfect; I will not be able to read many important blogs (Evan Soltas, David Beckworth), research will become substantially more difficult, and the formatting through the email system may not be perfect. I just wanted to make clear why my posts may start becoming more sparse.

Friday Roundup

Niall Ferguson takes a break from his usual Newsweek hackery and takes a look at the political constraints surrounding the Eurozone. The narrative is rather similar to previous ones regarding the decentralization of economic and political power, and all the attendant problems that arise with coordination. Killer paragraph from the article:

Imagine that the United States had never ratified the Constitution and was still working with the 1781 Articles of Confederation. Imagine a tiny federal government with almost no revenue. Only the states get to tax and borrow. Now imagine that Nevada has a debt in excess of 150 percent of the state’s gross domestic product. Imagine, too, the beginning of a massive bank run in California. And imagine that unemployment in these states is above 20 percent, with youth unemployment twice as high. Picture riots in Las Vegas and a general strike in Los Angeles.

Now imagine that the only way to deal with these problems is for Nevada and California to go cap in hand to Virginia or Texas—where unemployment today really is half what it is in Nevada. Imagine negotiations between the governors of all 50 states about the terms and conditions of the bailout. Imagine the International Monetary Fund arriving in Sacramento to negotiate an austerity program.

Capital control regimes look to be an interesting field of analysis for the future. The authors do make an important note: control over the capital account, to a certain extent, implies a control over the balance of trade. this is an important point for future negotiations, as it is a reason why capital controls should be used sparingly.

Apparently Bernanke doesn't shy away from strong language when the financial system is on the line. Although he's been relatively lukewarm about further easing to lower unemployment, he seems totally on board to do "whatever necessary" to stop the Eurozone contagion from spreading to the United States. One wonders what's the consideration preventing him from doing something similar to solve the US employment crisis.

The political argument about Glass-Steagall is quite interesting. The thesis goes that, after the merging of commercial and investing institutions, bank lobbies became much more unified, thereby warping the government towards helping the banks. This seems like an issue that would be interesting to study in a political business cycle or political DSGE model. It would make banking regulation endogenous, and the results could be quite unpredictable.

While I do think the broad enets of the efficient market hypothesis are true, I think the new concern with systemic risk is well deserved. I think viewing the EMH as a limitation on information, and not a limitation on the presence of crises is very important. Otherwise it leads to a dangerous bias, as described in the article:

There may be a deeper bias at work. In business and investing, choices under conditions of uncertainty are made all the time, and mistakes are routine. By contrast, developed country policymakers’ default stance seems to be that proactive or preemptive measures require a high degree of certainty, owing to a deep-seated belief that financial markets are stable and self-regulating. 

If one believes that market instability is rare, then it is reasonable to refuse to act unless there is a compelling case to do so. In light of experience, the view that the financial system is only exceptionally unstable or on an unsustainable path seems at least questionable.  

Unsurprisingly, the article is short on specifics on how to regulate systemic risk, but it is certainly one of the biggest issues for financial stability.

Finance is incredibly complicated, making it hard for anyone to regulate it. This is one of the issues that makes me skeptical of the argument that markets can regulate themselves when it comes to complex financial products. The payoffs are too volatile and uncertain for the market to truly know. Of course, it's unlikely that regulators know any better. However, this is no excuse for government to throw up its hands; rather, it's an opportunity to craft simpler rules that are robust to errors.

What are the systemic risks associated with money market funds? They played a large role in the liquidity crisis and financial turmoil in 2008, and thus their systemic role will be important for future analysis.

An insightful look into the failure of the Gaussian model and the real reasons why it was so destructive. Modelers never truly believed in it, and rating agencies never got around to implementing them. However, due to the demand for AAA rated assets, financial engineers gamed the system to satisfy the demand and earn hefty bonuses. It seems that the story is much more about individual incentives and corporate governance, and much less about an "equation that destroyed finance" or the financial conspiracy.

Swiss Fragility

Swiss watches aren't fragile; but can the same be said for the currency floor?

Evan recently had a post looking back on the Switzerland issue, which made me look back at our previous discussion.  In the spirit of Evan's proposition reflection, I'm also going to elaborate on a few of my arguments and look at where they're still true (often in different ways) as well as proven wrong (no surprises).

As I noted in my addition to the previous post, a lot of my previous arguments about the instabilities of a currency peg are not as relevant to the Swiss situation. The Swiss intervention is a floor on the exchange rate, and not a fixed peg. The SNB policy is to intervene on foreign exchange markets so that the Franc/Euro exchange rate can not go below 1.20. In effect, the 1.20 Franc/EUR exchange rate is the strongest the SNB will allow the Franc to be. As a result, the Swiss are not dealing with inflationary pressures as a result of the currency floor, and there's no tension between the domestic monetary policy goal of stabilizing NGDP and the external goal of limiting real appreciation.

Moreover, I do agree with Evan's broad argument that the power of expectations substantially reduces, but does not eliminate, the need for the SNB's forex interventions. However, I'm not quite as optimistic as Evan on the longer term effects of the exchange rate floor. I can't deny that the economic indicators look good: 2.8% annualized GDP growth, 3.2 percent unemployment, etc. But in spite of these positive signs, I want to make a general comment about discussions about expectations and cautionary notes on the fragility of such an arrangement.

First is that expectations cannot work in every instance. My arguments on the instability of currency pegs are a perfect example. Pegs can't function on expectations because speculators can push the bank off the edge because there's not an infinite supply of foreign reserves to defend the peg. While the SNB's policy is not a peg, this comparison leads to an important theorem for expectations arguments. Expectations can only be used as an argument if the policy would work even without expectations. In the case of the currency floor, the forex intervention would stop appreciation even if speculators didn't have expectations of future policies. The SNB could just keep on printing francs and depreciate the currency. If the speculators didn't take into account that they were overpaying for francs, they would be naturally selected out of the market by speculators who would bet that the SNB's floor will hold. Thus, if the SNB commits, they can hold the exchange rate greater than or equal to the 1.2 floor. Speculators, knowing this, would then stop speculating. In the case of unconventional monetary policy, asset purchases and lower IOR in and of itself can raise growth through portfolio balance and hot potato effects. Expectations can help augment these policies because the market would do the work for the central bank, increasing monetary policy's effectiveness. In each of these circumstances, expectations make the policy more powerful, but in and of themselves cannot make impossible policies possible. Expectations are powerful, but we need to make sure to use a rigorous set of criteria before we start applying the argument everywhere.

Second, such large scale asset purchases on the part of the SNB to maintain the peg represent an important form of instability. While I was not prescient enough to make the argument in full, I did comment on the danger of such a large balance sheet filled with foreign currency denominated assets. As Evan notes, a lot of forex intervention from the SNB is the result of absorbing demand for a safe haven currency. Thus, unless policy changes, we should expect the balance sheet to get larger and larger.

As the size of the balance sheet increases, we have to start worrying about fragility, or any ripple effects across international financial markets. To illustrate the problem, imagine a "fundamental" rate path that charts the value of the franc in the absence of a floor from the SNB. This fundamental value would also take into account the demand for a safe haven asset. Given the power of the floor, we can safely assume, currently, the fundamental value is below the floor.


However, if, for whatever reason, the fundamental value shoots above the floor (when the orange part goes above the blue), we can anticipate a sudden large amount of selling and revaluing of assets. All of a sudden, what was once at a fixed exchange rate is now moving. Because the SNB's balance sheet is so large, this shift could have massive implications for the balance sheets of other governments.

The most pernicious part of this shift would be that, given the suppressed volatility from the floor, there would be no way for the SNB to tell when we should start to get worried. Even if the fluctuation was pure static, like that shown in the graph, there would be a massive signal confusion problem. Policy makers could guess, but prediction is often quite difficult. It would also be unlikely that other indicators, such as unemployment or inflation, would be update quickly enough to keep up with changes in forex flows. This represents a key form of fragility that we need to worry about in all expectations regimes. If, for some reason, the regime changes, many arrangements that depended on the previous regimes have to be recreated, with sometimes drastic consequences.

To get around such issues, the exchange rate needs to be less about maintaining some floor and more about maintaining a favorite target, such as forecasts of NGDP growth. This way, the market is allowed a natural level of volatility, and policymakers can use this volatility to gauge the state of demand for the currency. Additionally, this natural, day to day volatility would caution those who hold the Franc from depending too much on its 1.2 floor. Alternatively, increasingly draconian capital controls could be used to change the fundamentals of holding currency in Switzerland, thereby limiting capital inflows while allowing volatility in the exchange rate. However, such an approach is subject to leaks, and given the manual smuggling of currency, is likely to fail.

Third, and as a corollary to the second point, the question we need to ask whenever we talk about regimes that fix certain values is "what are the costs?" As Miles Kimball noted, central banks can do a lot of things, so our attention needs to shift to the collateral effects of such actions. And as Bastiat reminds us, we need to look at that which is hidden in addition to the more obvious effects. While a lot of the more mainstream discussions focus on welfare costs of volatility, I worry more about fragilities in the spirit of Taleb or fault lines in the spirit of Rajan. I've commented on this line of thought in the context of NGDP targeting (here and here), and I think it has an important role in any kind of system that suppresses volatility, such as the exchange rate peg.

I can't quibble about the SNB's effective block of the Franc's appreciation, but we must qualify its success. Beware manufactured stability, especially when it creates fragilities and uncertainties that we aren't prepared for.

Can You Tell Me How to Get, How to Get to NGDPLT?

How quickly can bank reserves unravel?

Why are we always focused on the equilibrium, but not the disequilibrium dynamics that get us to that point? Noah Smith made this point in an old post about DSGE models, but it seems like there's a similar problem when it comes to an NGDP target. No doubt, in the end, an NGDP targeting regime would have incredible benefits, but how do we first get there? Specifically, how does the Fed adjust its balance sheet so that it doesn't trip on the "concrete steppes"?

Given the large expansion of the monetary base through excess reserves and IOR, the Fed cannot simply let all of the expansion become permanent. If the expansion were permanent, one would expect prices to be about four times higher than they were in the beginning of 2000. While I certainly support higher levels of inflation to support real growth in recessions, even I find that much inflation a bit unpalatable. It would certainly go beyond the 5% NGDP target that most market monetarists advocate and would result in massive political backlash. Most tragically, this would discredit the entire market monetarist enterprise, jeopardizing one of the most important revolutions in stabilization policy.

Thus, how do we control this unwinding? The typical market monetarist response is that a credible NGDP target establishes a bound on the expansion. The target can anchor market expectations to prevent inflation from getting out of control. But what happens when the policy is not fully credible? Again, I don't mean to say the central bank can not inflate. My concern is with the other side of the target and the possibility of above trend NGDP growth. When you're dealing with such a large expansion of reserves, you need to be cautious with how much is unwound as well as how quickly it takes place.

Ala Eggertsson-Woodford, we know the permanence of the monetary expansion is the critical determinant of the path of NGDP. This is confirmed in some private email correspondences, which brought up the possibility of banks paying higher dividends, or perhaps even venture capital as outlets for bank reserves. However, those options are not viable if the reserves aren't seen as permanent. A particularly striking line was:

The standard Keynesian story has been that in a zero interest-rate economy, it makes perfect sense for government to borrow a ton and invest now, because low rates don't last forever; well, guess what, it makes sense for the private sector too. Both the government and the private sector can think of ways to use more money, and if it wouldn't hurt for government to borrow and spend more, it won't hurt for business to borrow and spend more either.

While this means a credible expectations based regime can easily inflate, it should also remind us that controlling inflation and NGDP growth can be a non-linear task, subject to type-2 extremistan variation. We're not playing with bank balance sheets as much as we're playing with bank's beliefs. Beliefs can change on a whim. Once a certain threshold of expectations or interest rates are passed, banks will rapidly unwind their excess reserves and put their money to use. There is a critical level that we cannot observe, but once we pass it the monetary effects will be significant.

A possible argument out of this problem is that, if the banks knew what fraction of the reserves would be taken out of the system, they could plan ahead so that they don't expand by too much. However, the market is not a platonic game. There is no social planner that will only take a fraction from each bank; the banks have to reach a decentralized solution. Assuming each bank's reserves are small relative to the total stock of excess reserves, it would be in the interest of each bank to spend all of their excess reserves into higher yield assets or dividends so that they can take advantage of the limited permanent expansion of the base. It would be incredibly difficult on the part of the banks to coordinate, because how would they know the level of NGDP? Moreover, if the NGDP level overshot, why should private agents expect the Fed to step in? If central banks are inertial, the credibility of the NGDP target could be compromised. The FOMC only meets eight times a year, how could policy direct the path of NGDP well enough?

Fundamentally, there's two uncertainties that NGDPLT has to deal with. First is a band on the rate of NGDP growth. It can vary around the 5% goal. Second is the band on the timing of when the target is hit. If central banks are slow on adjusting policy, the market may see a bubble opportunity and jump in to make money. Timing is especially problematic because it's something that can cause bubbles even when market participants are rational about fundamentals.

To get around these problems, NGDPLT has to be implemented in a very careful fashion with strong forward guidance on what market participants should expect in terms of NGDP. Scott Sumner often discusses proposals for NGDP futures to help guide policy, but given these disequilibrium dynamics in the transition to NGDPLT, the futures markets are actually a prerequisite. Importantly, these NGDP futures should give information over a variety of time horizons, so banks, both central and private, can know more and plan for the future. With all this information, the central bank would need to be much more active in tuning the rates. While the instability of the rates might seem problematic, they would be instrumental in proving the credibility of the central bank in maintaining a smooth transition. This transition should also be slow, so that the return to trend growth is not too sudden. Thus, NGDP growth does not need to speed up too quickly before it's identified as "overshooting" the path that the Fed plans. It's not a simple act of "shooting for it". The Fed's balance sheet is incredibly large, so we need to be careful so that the easing process does not cause too many problems.

There is little doubt that a credible NGDP target regime with a small monetary base will yield incredible benefits for stabilization policy. But we can't let the perfect be the enemy of the good, and such a regime shift will require great caution.

The Whole is Greater than the Sum of its Parts: Forward Guidance and QE

Maybe interest rates aren't so useless after all

In a recent post from Stephen Williamson, he derides Christina Romer's proposal to tie new monetary expansion to objectives such as unemployment or inflation

First, I'm not sure how you announce a policy without saying what it is. Second, the last sentence in the above quote is interesting. The Fed claims that, for example, purchases of long-maturity Treasuries will lower long bond yields. If they were confident about that, the FOMC would announce targets for long bond yields rather than quantitative goals. They don't announce the targets, therefore they must not be confident that QE does what they claim.

My first reaction is the classic Market Monetarist/Friedman/Bernanke retort: interest rates aren't an indicator for the stance of monetary policy. Perhaps the Fed lowering the interest rate could be an example of loosening policy, but it would hardly qualify as loose policy. In a sense, the derivative of the interest rate time path could give information about the derivative of the policy tightness function, but the level of the interest rate tells you nothing about the tightness of policy. Low interest rates could reflect low NGDP expectation or they could reflect substantial levels of monetary easing. There's no way to actually tell.

However, some recent econometric evidence has shown the forward guidance on interest rates has some effect. In the conference paper "Macroeconomic Effects of FOMC Forward Guidance," the authors categorized two kinds of forward guidance: Odyssean and Delphic.

In Odyssean forward guidance, the interest rate path is a path that will take place in spite of elevated inflation or NGDP. The declared interest rate path is a deviation from the policy rule and is designed to "catch up" to trend growth. On the other hand, Delphic forward guidance is simply a prediction. The interest rate path is simply following the policy rule and will not make any exceptional effort to catch up growth. Thus, if the Fed's commitment to low interest rates until at least mid-2013 is Odyssean, it means that the Fed sees NGDP growth rising but it will still commit to low rates. If the guidance is merely Delphic, the guidance is merely a forecast of low NGDP growth until at least mid-2013.

(Note:  Odyssean references the scene in the Odyssey, when Odysseus commands his sailors to tie him to the mast of the boat when they travel through the land of the sirens. Odysseus committed, beforehand and contrary to what he would want at the time, to stay tied to the boat. Delphic refers to the oracle of Delphi that could tell the future.)

In the period of time before the financial crisis, research showed that the markets were listening to the Fed's declarations for a future policy path. As summarized in the Brookings paper (note, GSS is the name of the study that analyzed the data, my emphasis)

By performing a suitable rotation of the two unobserved factors, GSS show that they can be given a structural interpretation. One is a “target” factor, corresponding to surprise changes in the current federal funds target. The other is a “future path of policy,” or simply “path,” factor, corresponding to changes in futures rates that are independent of changes in the current funds rate target. The “path” factor is shown to be associated with significant changes in FOMC statement language. For example, its largest realization in absolute value occurs on January 28, 2004 when the federal funds target was not changed, but the phrase “policy accommodation can be maintained for a considerable period” was replaced with “the Committee believes it can be patient in removing its policy accommodation.” This change in language was interpreted by markets as indicating the FOMC would begin tightening policy sooner than previously expected. 

Using ordinary least squares regressions of changes in interest rates before and after the windows of time surrounding FOMC statements on the target and path factors they find that 75 to 90 percent of the explainable variation in five- and ten-year Treasury yields is due to the path factor rather than to changes in the federal funds rate target itself. Information in the statement about the future funds path that differs from prior market expectations or revelations about the FOMC’s outlook for the economy that changes private expectations of that outlook both should affect anticipated future federal funds rates. Therefore their evidence strongly suggests that forward guidance, broadly conceived, has had an impact on asset prices prior to the financial crisis.

The zero-lower bound has called into question whether interest rate guidance can still stay effective. The current literature on QE1 and QE2 both use this "future path of policy" argument. As per the paper:

This evidence is suggestive for the current situation, but not conclusive, since it covers a period before the financial crisis and the attainment of the ZLB robbed the FOMC of its principal policy tool. Research on monetary policy announcements since the onset of the crisis has focused almost exclusively on the impact of announcing large scale asset purchases (LSAPs).7There is significant evidence that LSAP policies can alter long-term interest rates. For example, Gagnon, Raskin, Remache, and Sack (2010) present an event study of QE1 that documents large reductions in interest rates on dates associated with announcements of LSAPs. Also using an event-study methodology, Krishnamurthy and Vissing-Jorgensen (2011) evaluate the impact on interest rates of announcements associated with both QE1 and QE2. They uncover several channels through which these announcements have had an impact on asset prices. With QE2 a major role is ascribed to a “signalling” channel whereby financial markets interpreted LSAPs as signalling lower federal funds rates going forward. This suggests that one feature of LSAPs resembles forward guidance and so the findings of Krishnamurthy and Vissing-Jorgensen (2011) can be interpreted as supporting the view that forward guidance has had a significant impact in the recent period. However, the impact of “pure” forward guidance, where the policy action is solely reflected in statement language, in the recent period remains unclear.

More rigorous statistical analysis finds that the path factor still exerts a large amount of impact. 

When the target and path factors are calculated using all the announcements in Table 1 except the one associated with QE1 they explain 96 percent of the total variation in the seven futures contracts we employ for their estimation. The target factor alone explains 79 percent of the variation. Table 2 reports the fraction of variation in each of the seven futures contracts explained by each of the two factors. The target factor dominates the variation in the current quarter futures rate and the one-, two- and three-quarter ahead rates, while the path factor explains the majority of variation in the three longer rates and negligible share of the two shortest contracts after the current quarter one. This pattern is broadly similar to the one obtained by GSS. The main differences are that in our case the target factor accounts for a somewhat larger share of variation at the short end, while the path factor’s explanatory power is more concentrated toward the long end. Still, the overall impression is that the impact of FOMC statements in the recent period is not very different from prior to the financial crisis. Given the disparity in the associated economic conditions this is a striking finding.

So, to quibble with Nick Rowe, the impact of the future path of interest rates is probably not 99%, but the effect is still very high.

There is also some interesting information on the safe-assets story in the paper. The authors find that expansionary forward guidance can lower corporate bond yields. Specifically:

In contrast, a one-standard deviation positive path factor realization raises the Aaa yield by 54 basis points and the Baa yield by 48 basis points.

This provides evidence of a portfolio balance effect that QE does stimulate easier credit conditions for firms. Yet this effect comes not so much from the actual asset purchases but rather from the information on the path of future policy that it yields.

As a result of this forward guidance analysis, the paper finds the Evans 7% unemployment/3% inflation joint target useful to restore aggregate demand without destabilizing inflation expectations:

Evans (2011) has proposed conditioning the FOMC's forward guidance on outcomes of un-employment and inflation expectations. His proposal involves the FOMC announcing specific conditions under which it will begin lifting its policy rate above zero: either unemployment falling below 7 percent or expected inflation over the medium term rising above 3 percent. We refer to this as the 7/3 threshold rule. It is designed to maintain low rates even as the economy begins expanding on its own (as prescribed by Eggertsson and Woodford(2003)), while providing safeguards against unexpected developments that may put the FOMCs price stability mandate in jeopardy. Our policy analysis suggests that such conditioning, if credible, could be helpful in limiting the inflationary consequences of a surge in aggregate demand arising from an early end to the post-crisis deleveraging.

Thus, the econometric evidence comes somewhere in the middle. Yes, interest rate guidance can have an effect, but asset purchases have a large impact as well on a wide variety of interest rates because the purchases substantively change the expected future path of policy. This suggests that the two policies together would have a much stronger effect than either of them apart. I see this playing out in the following manner: 

Limiting policy to a near-term interest rate commitment raises the possibility that the forward guidance describes the Fed passively tightening and keeping growth down. This forward guidance may be seen as Delphian. However, with asset purchases like QE, the Fed signals that it is committed to expansionary policy, which has first order effects on corporate bond yields and other asset prices. This additional policy action changes the original forward guidance from being Delphian to Odyssean. The Fed will be effectively saying, "We will pursue asset purchases that will push up inflation, but in spite of this inflation we will be keeping interest rates low". This would break out of the indeterminacy on whether low interest rates are expansionary or contractionary. Quantitative easing might be normally seen as just a temporary injection of money, but forward guidance cements that injection in as permanent.

This interaction effect would offer the Fed much more ammunition with its current policies. It could help alleviate the concerns of the "concrete steppes" by using not-so-unconventional policies to shape expectations. Once the expectations are settled and we escape the zero-lower-bound, forward looking monetary policy shouldn't be too difficult at all. This would be an example of the pragmatic monetary policy that could eventually transition to the end of history stabilization policy: a NGDP targeting regime.

(International Trade) Walking on Sunshine

Unleashing the power of the sun international trade in clean energy production

(Photo credit: http://seidmaninstitute.com/wp-content/uploads/2011/01/solar-panels.jpg)

International trade has been one of the most powerful forces in promoting technology development and diffusion. Why should this be any different for the clean energy industry? Without a doubt, one of the largest crises modern economies face in the medium-term is that of energy. Modern production depends on high-density energy sources; without them, many cornerstones of society, such as transportation, manufacturing, and agriculture would be impossible.

To begin the discussion, it's useful to describe some stylized facts about clean energy production. On a whole, it's an industry that exhibits increasing returns to scale. While current costs are relatively high, it's hoped that by increasing the scale of production, costs will be lowered in the future. I can think of at least three mechanisms that make this the case.

First: research and development. Much of the current knowledge about clean energy is quite limited and is not enough to create sources of energy competitive with fossil fuels. Thus, small amounts of investment are unlikely to create enough of a critical mass to make clean energy competitive. Instead, large increases in investment may result in a breakthrough which can then diffuse through the market. As firms compete with each other, this may result in more knowledge spillovers, creating ever more efficient sources of energy.

Second: scale of production. The average businessman can't produce solar panels; large scale production requires at least a year of developing infrastructure, and the complex chemical knowledge behind creating the solar panels entails a large amount of fixed costs as well. Panel production only becomes profitable at a certain critical threshold of demand, making the industry subject to strong increasing returns.

Third: scale of distribution. A major problem with popular clean energy sources such as solar or wind is that they can be intermittent. Solar cells can't power a house when the sun doesn't shine; windmills can't power factories if the wind doesn't blow. Smart grids offer a solution by allowing utilities to dynamically allocate these volatile sources of energy. However, the service provided by smart grids is a public good. Companies can not opt out of using the grid, making the good non-excludable. Companies can use the information utilities offered by the grid without excluding other firms, making the good non-rivalrous. It's the classic example of a public good that a perfectly competitive market can't provide. Thus, if the panels are produced at a larger scale, this allows more efficient distribution of the energy through a smart grid: a critical component of clean energy development.

Scale economies make trade very important because the large international market provides the necessary demand for companies. However, scale economies can also justify industrial policy, Governments may want to promote domestic clean tech companies to carve out a larger share of the global market. Clean tech is an especially lucrative field for industrial policy as it also represents one of the "advanced manufacturing sectors with high technological and skills requirements"" that the US has dominated in the past. A recent Brookings report comments on the importance of manufacturing for the United States:

Manufacturing accounts for 12 percent of U.S. gross domestic product and less than 10 percent of national employment; alone, it cannot power the economic recovery. Yet manufacturing accounts for 70 percent of private-sector research and development in the United States. High levels of investment in R&D, the potential to reduce the trade deficit and the ability to produce good jobs for middle-skilled workers merit the increased attention the sector is receiving after decades of policy drift. The administration, for example, has included a manufacturing initiative of roughly $1 billion in its fiscal 2013 budget, and notable plans have been proposed in Massachusetts and in Chicago.

As a result, the government has implemented various production tax credits, direct loan guarantees (link to Solyndra), and, most recently, tariffs against solar panels produced in China.

This is where I depart from the stylized description and proceed to get incredibly angry at the tariff on solar panels.

While most of the other subsidies are based on solar power production, the tariff is unique in that it taxes international solar panel production to bolster domestic panel production, not domestic power production. It is as if the policy loses sight of the end-goal of power production in the pursuit of component production. But, in the end, we shouldn't care who's producing the nuts and bolts. Who harvests the energy is much more important. What we consume matters much more than what we produce. To provide an example, if one country, say "China", produces solar panels, while another country, say the "U.S.", consumes the solar panels, which country ends up producing more of its electricity from clean energy sources? Although "China" goes through all of the hard work of production, it is the "U.S" that reaps the benefits of solar power consumption.

Recent experience has shown us that cheap Chinese solar panels facilitated the low-cost installation of many rooftop panels, thereby strengthening the solar power industry in the United States. We need to face the fact that the Chinese can produce solar panels at a comparative advantage. They are willing to jeopardize their own environment to produce the panels; this is a cost that we refuse to bear.

US manufacturers of solar-grade silicon would never be able to replicate the actions of the Chinese. Porges stresses that “production in the United States is a highly, highly, highly regulated process” and McCue misses no opportunity to emphasize the extensive waste management efforts of his company. Shi categorically contrasts the US market with Chinese manufacturers, claiming that if silicon tetrachloride poisoning “happened in the United States, you'd probably be arrested."

The fact that solar panels can be produced so easily in China should actually be a good omen for solar power advocates. The technology has been developed and has diffused to such a degree that even a low productivity country such as China can produce them competitively.

Another argument for liberalizing solar panel production follows Richard Baldwin's recent works on "Globalization's Second Unbundling" and the role of supply chains in industrial policy. The old trick with using tariffs to create an entire domestic infant industry has lost its effectiveness. Nowadays, countries tend to integrate themselves into supply chains. Instead of mastering the entire production process, countries can now specialize in one component, and then gain a comparative advantage in producing that one component. Thus, the United States really should worry less about the production of solar panels and start worrying more about other high value-added activities involved in the development of clean energy.

On this topic, I'm thinking specifically of the development of smart grid technologies. This is something that Europe has been trying to develop as well, so the returns from an effective development of a smart grid would be massive. It would facilitate greater clean energy production in all countries, and would also allow us to reap the gains of cheaper clean energy components, no matter if they come from China or are produced domestically. The smart grid also has an uncertain right tail. From the UCLA Smart Grid Energy Research Center:

While every major media source today is talking about the Smart Grid due to its importance to the national energy policy agenda, it is still unclear to many as to what this grid of the future will look like. In-fact, it is like trying to predict what an iPhone would have looked like in the year 1984 (25 years ago), when a cell phone was simply a mobile telephone. There is tremendous opportunity for creativity, experimentation and research in the defining of the Future Smart Grid. Throwing open this opportunity to students in universities or entrepreneurs in industry could result in new and currently unimaginable possibilities for the grid of the future. Therefore, while the utility community is trying to determine this singular vision of the grid of the future, the eventual outcome is impossible to predict, but the community at large needs to ensure that those who want to experiment with meritorious ideas get the appropriate resources, opportunities and incentives to do so.

Industrial policy, by its virtues, tries to change comparative advantage. But it should be designed to create new comparative advantages in new fields, not to fight old comparative advantages in old fields. It should be used to find new value-add technologies, like smart grids, and not mess with old vanilla components, such as polysilicon solar panels. Global warming is, indeed, global, and well designed international trade policy will be an important component in that fight.

P.S. While the following is pure speculation, an extended version of Baldwin's "rebundling" of globalization and regional comparative advantage would seem to justify the U.S. working with Latin American countries to help promote component production for a smart grid. This would help cement the Western Hemisphere's regional comparative advantage in a critical technology for the future. Ideas like these would constitute a form of industrial policy that goes beyond one's borders in order to secure a domestic advantage. This seems like an exciting route for future policy.

P.P.S. Funny quote from the NYT article on the solar tariff, can you figure out why?

“This is really a surprise,” he said in a telephone interview. “It’s really dangerous.” Mr. Li said that Chinese companies would “certainly” retaliate by filing a trade case at China’s commerce ministry accusing big American chemical companies of dumping polysilicon, the main ingredient in solar panels, on the Chinese market.

Friday Roundup

China is not much of a global economic leader. China doesn't see financially protecting Europe as critical for its own economy; it feels that is is segmented enough to protect itself. This also shows how China is not willing to provide global public goods (ie stable finance). It is no economic hegemon, and therefore doesn't act in a way conducive to global economic coordination.

There's been a series of good posts from FT alphaville on the issues facing European finance. Given the meteoric rise and fall of finance in Europe, one has to wonder why the markets didn't price in the risk. The most plausible answer? There was too much that they could never have known; markets were too opaque. This should be a lesson for people who think they can "calculate" the optimal level of risk. You know too little about probabilities to make a surefire judgment; you should resort to looking at fragilities instead.

Banking union? Not likely. International economic coordination is hard, and Europe isn't quite up to it. There's just too many different interests at play for a banking union to work; who would we hold responsible to pay? Banking is a market that extends beyond governance, which makes it almost impossible to solve the problems with capital flight and get the Euro on solid footing.

China is slowing down further: steel edition It's really quite staggering how many different factors are converging at the same time: China bleeding into Australia, India slowing down, and then the Eurozone is falling apart. We have no idea how bad it's going to get, which makes the fragility of all financial systems particularly worrisome.

Global equities fall on the announcements of one Federal reserve chair. Asia was counting on further easing, and the fact that Bernanke didn't come out clearly in support of it is not good news. The announcement really marks how the United States truly is a monetary superpower; a tentative decision on QEIII is enough to send markets roiling. These are the kinds of problems that make me really wish that monetary policy was done in a more rule-based fashion that took into account the gigantic output gap. Perhaps something like NGDP targeting...

More on the safe assets story and the fiscal cliff. This shadow banking dimension is something I want to investigate going forward because it seems to be a new channel for traditional fiscal and monetary policies. Shadow banking seems to make fiscal policy more powerful as it improves the stock of collateral, whereas it makes monetary policy more problematic as stocks of collateral are bought up.

An interesting look at the linkages between Europe and the United States. I think the finance data coupling indicates that the relationship really goes beyond simple export statistics. This is an interesting problem from the concepts of "opacity", because we really don't know the extent of the connection. All that we know is that there are hints of financial coupling, which might make the Eurozone contagion problematic for the United States.