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?

What China Could Be Building

Scott recently expressed his optimism in the Chinese growth story, and sees no reason why the recent trouble with housing markets should jeopardize its growth. As a fellow traveler in China, I have to express reservations about his outlook.

One of Scott's central arguments is that Chinese people want housing. No doubt, people want somewhere to live, and recent waves of urbanization have moved more and more of demand to the cities. However, I'm not sure why this translates into an argument that the current housing situation can't be a bubble. Just because there's a need for housing does not mean that there is enough quantity demanded at current prices. There's no physical overstock, but there's a massive market overhang at current levels. If I were a homeless person who just got a job making thousands of dollars, my first priority would certainly not be moving into a sleek urban apartment whose rent would take up almost the entirety of my income. There are other, cheaper options that are not the drivers behind the current real estate rally.

This is likely because the price of houses represents more than the discounted stream of housing services, it rather represents expectations of future growth. Financial repression and low bank deposit rates force wealthy Chinese to try to grow their wealth by investing into assets such as gold, jade, or housing. Shanghai families view housing as critical to "preserving value" in a household, and the purchase of a house may reflect excessive optimism about the future price path due to other people's purchasing, instead of expectations of the value of future housing services. Printing money wouldn't solve the issue because the real cost of those items are too high, so monetary expansion would only worsen the balance sheets of the savers with bank deposits and strengthen those who had the resources to invest in housing.

The crux of the matter is inequality. Who is buying all those consumption goods you see on TV? Who is buying houses to preserve value? Yogi Berra's quote "nobody goes there, it's too crowded" does not fully apply. Nobody goes there because it's too expensive to live for the "millions of of Chinese living in tiny ramshackle homes." But the houses give just enough return for wealthy Chinese investors, who represent a small, but incredibly influential minority.

The real risk is not that the housing won't be used, but that the crash would have secondary effects. Local governments are dependent upon land sales for revenues, meaning a housing crash could have serious implications for government. In Guangdong province, some local governments are actually tearing down mountains to make new land in the ocean, all to sell the land. This, along with the recent reversal of capital flows and possible insolvency of private wealth management firms, represents a serious liquidity risk that can have disastrous consequences.

In terms of sources, I would recommend looking at Patrick Chovanec's articles on the Chinese housing market and financial system. I don't have much time to provide the direct link for each of my claims, but if there seems like something that doesn't jive right I would be happy to explain further.

So let's answer Scott's fundamental question:

So here’s my question for all of you China skeptics that insist they are building way too much housing, infrastructure, heavy industry, etc.  What precisely do you want them to build more of?  And what are the 100s of millions of Chinese living in tiny ramshackle homes to do?  Sit tight for a few more decades while resources pour into nice urban services for the pampered elite?

I want them to start building leaf blowers, so we don't have so many Chinese people in the low productivity position of sweeping streets. I want them to start building farm equipment, so we don't have so many Chinese farmers tending the fields. I want them to build more laundry machines, to free the rural Chinese from scrubbing clothes on washboards. I want them to build electric stoves, so my Grandpa can put away the coal fired outside oven. I want them to build computers that can deliver cheaper education to the masses.

Instead of just focusing on "building," I want them to invest in human capital, so productivity can be at a level that we don't need "make work" jobs. I want them to build more schools and hire better teachers, so classes aren't as large and you're not damned if you can't make it in a top elementary school. I want productivity to be high enough that high end stores don't need more clerks than actual customers.

I want these things among many others that will only be more obvious in a freer market.

That Scott can get a haircut for $4 or an ice cream cone for 50 cents shows how low productivity and wages are in China. Yet they will not grow any faster with more housing or more state directed investments. Cheap subway rides are nice, but are they not just another sign that transportation infrastructure has been built too quickly? I'm not saying China is hitting a ceiling for growth, or that vast swaths of China are condemned to poverty. But what I am saying is that we need to worry about the systemic fragility that underpins the Chinese system, and be very, very concerned about the unknown magnitude of the downside risk.

"Fed Up" With Paul Ryan

The following is an essay that I wrote for NextGen Journal, an intercollegiate journal focusing on the issues facing America's youth.
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I'm “Fed” up with Paul Ryan. No, I don't mean his regressive tax proposals, unrealistic budget projections, or his peculiar approach to health care. I am frustrated by something more serious: his call for monetary policy that would only put our economy in greater danger.

The Federal Reserve controls U.S. monetary policy by controlling the growth of the money supply in accordance with its dual mandates of “maximum employment” and “price stability.” Traditionally this has meant unemployment below 5% and inflation around 2%. According to Paul Ryan, recent Fed actions have caused massive inflation and have debased the dollar. Therefore, the Fed should abandon the “maximum employment” part of its mandate and focus on targeting headline inflation. However, a look at the data suggests this would be the wrong way to go.

Ever since July of 2008, annual inflation has been at about 1.1%, far below the 2% target traditionally set by the Fed. Long-run expectations of future inflation are also below target, at 1.26%. Moreover, the dollar is actually stronger now than it was at the beginning of 2008. The value of the dollar last peaked at the height of the financial crisis, showing that, in recent times, a strong dollar is not a sign that markets are doing well, but rather that they are breaking down.

So if inflation is low, and the dollar is strong, why has the Great Recession been so great? The biggest reason is that nominal gross domestic product (NGDP), a measure of the total dollar value of goods produced by the U.S. Economy, has collapsed. During the worst quarter of the crisis, NGDP fell at an annualized rate of 8.4% and has not returned to the previous trend, something unheard of for any other recession in the past century. The fall in NGDP has harmed the economy in many ways, most importantly by making it harder for families to meet mortgage payments and for business to justify further expansion.

To change this, the Federal Reserve should announce a policy of restoring NGDP to its pre-crisis 5% trend, and take all necessary steps to reach the goal. This policy enjoys a wide range of support from conservative and liberal economists alike. Changing the Fed's mandate to targeting the level of NGDP would change market expectations and work to stimulate growth now.

Representative Ryan might argue that this shift would be just another form of discretionary monetary policy that jeopardizes the stability of the economy. In his 2010 op-ed with John Taylor, Ryan demanded that the new monetary regime have “greater simplicity; a description of interest-rate responses to economic developments including how the Fed will achieve those responses through money growth; and greater attention to commodity prices, including food and energy, as opposed to a myopic overemphasis on core inflation.” Fortunately, NGDP targeting addresses the root of those concerns just as well, if not better, than Ryan's version of inflation targeting.

First, unlike the current vague balance between “maximum employment” and “price stability”, an NGDP mandate only targets NGDP, making it a simple rule based regime. On the other hand, inflation is not so simple. To properly measure it, you need to pick which prices to check, and then adjust for quality increases. If a car's quality and price both improve, how do you know the real value? Moreover, which inflation – CPI, PCE, or PPI – should the Fed target? This confusion only complicates matters and increases policy uncertainty.

Second, a simple mandate translates into self-evident money supply responses to economic conditions. If NGDP growth is above the 5% trend, the money supply should contract. If NGDP growth is, as in the current situation, below the 5% trend, the money supply should expand. I choose not to talk about interest rates because, as Milton Friedman once wrote, they are misleading guides to monetary policy. Low interest rates can be the result of easy money that pushes down the market interest rate, or the result of tight money that leaves nobody wanting to borrow.

Third, an NGDP target shifts away from a myopic focus on core inflation and can effectively deal with asset bubbles. Even if focusing on core inflation led the Fed to hold interest rates “too low for too long” during the housing bubble, the inclusion of commodity prices in inflation indicies doesn't solve the issue. During the 90's and the early 2000's, the computer revolution increased productivity growth, driving down all measures of inflation, including those that took commodity prices into account. In response, the Fed eased monetary conditions and lowered interest rates to hit its inflation target. On the other hand, NGDP targeting would have actually tightened money in response to the 7% NGDP growth, thus popping the bubble before it grew large enough to hurt the broader economy.

Yet in spite of all this, Ryan wants to limit the mandate of the Fed to only inflation. On one issue, I agree with Paul Ryan, “we are on an unsustainable path” and “it doesn't have to be this way.” But to embark on a new path, we need an NGDP target, not inflation mongering. The first is an enlightened path forward, the second is but a dangerous step back that compounds our economic stagnation.

Eyes on the Prize

A look to the final frontier and then back to energy

Picture from The Guardian

While evidence in favor of global warming piles up by the day, there seems little political motivation to try to address the issue. Both cap and trade and a carbon tax would be politically impossible in such a low growth environment, and subsidies for more clean energy research would be shouted down with cries of "Solyndra!" Moreover, these policies are likely to have little substantive effect either. Without an international governing body, trade would nullify cap and trade or carbon taxes, and research subsidies tend to increase the price of research without raising the quantity. With this in mind, Evan proposes an alternative funding mechanism: research prizes. Instead of having the government subsidize firms or directly do basic research, the Federal government could sponsor research competitions, allowing innovators from all over the world to pool their collective wisdom to solve the energy crisis. To get a better idea of this would mean, we should look at a current example in which prizes played a large role: NASA's development of private, low earth orbit vehicles.

First, some history. What is often left out of the public memory of the push into space is what happened after we made it to the moon. Optimism about U.S. space policy led people to make "conservative" predictions of Mars landings by 1988, with a Mars base by the end of the century. Pan-Am even started taking reservations for flights to the moon, as it was forecasted that trips to the moon would be a quickly realized affair. So what happened? As the geopolitical impetus for the space program started to fade, so did the funding. Instead of going back to the Moon and beyond, we settled with the Space Shuttle program, which functioned as a space taxi that would ferry astronauts from Earth to Low Earth Orbit (LEO) and the International Space Station.

In theory, the Space Shuttle was supposed to be a temporary affair, replaced by a vehicle capable of going to the moon and beyond. However, cost overruns and budget problems eventually ended the program, resulting in a problem: after the retirement of the Space Shuttle in 2011, there was no way for U.S. astronauts to get back to space. Instead, we had to buy seats on Russian Soyuz shuttles at a price of $51 million, round-trip. 

Enter Commercial Orbital Transportation Services (COTS), a program designed to spur private sector solutions to the space transport program. It was implemented through special arrangements known as Space Act Agreements (SAA) coordinating development between NASA and private sector firms. Firms submitted proposals, NASA gave initial approval, and as the firms met certain milestones NASA gave them more funding. The funding was capped though, so no matter how much the companies spent, NASA would not pay them extra. This forced the competing firms to cut costs and streamline projects. NASA promised to purchase resupply and crew transport services from the final successful companies.

The program has been a resounding success. About 26 companies submitted proposals for the first stage, CCdev-1. Another 11 propsals were submitted for the second stage, CCdev-2. Space-X, the private space company that docked with the ISS just a few months ago, was actually denied funding for CCdev-1, but was later granted funded for CCdev-2. This showcases the resiliency of the SAA funding structure. Even though SpaceX was passed over, it still pulled through and is now the front runner in the COTS race. There is even discussion on how SpaceX's Dragon and Dragon Heavy rockets may make a trip to Mars by 2017, nearly 15 years before the same projection for the NASA planned Space Launch Vehicle at less than one hundredth of the cost. Of course some of it is hype and overoptimism, but it nonetheless stands testament to how far SpaceX and commercial space ventures have come since the era of Apollo.

The development of commercial crew highlights a few lessons about prizes and innovation. First, prizes often save money. There are stories of Elon Musk, the founder of SpaceX, being so unsatisfied with the market price for a certain injector that goes into the Dragon rocket that he decides to build it in-house at less than half the price. This is a particular issues as politicians like to see results for their billions of dollars spent. Lower costs equal happier politicians, which is a plus for a research program.

Well, except if the politicians are hungry for the pork offered by the traditional Space program. In the commercial transition, Senator Hutchinson of Texas has been a notable offender, fighting hard for the traditional government programs such as the Space Launch System as their budgets are cut in favor of commercial crew. This is the second lesson on why prizes are useful; they guard against rent-seeking, as if a firm meets the requirements, they are eligible for funds. No backdoor deals are needed.

A third lesson is that when you give the private sector the chance to directly work with the technology in the hope of generating disruptive innovations, they are in a better position to develop the technology into further disruptive innovations. In the vocabulary of growth economics, prizes promote "learning-by-doing", and have domino effects in promoting further development down the line. The fact that many firms are all trying their own ideas means that the market learns at a much faster rate once the knowledge gained from the innovations diffuses outwards. You have decentralized tinkering, instead of a top-down solution, vastly increasing the probability that someone thinks of the golden idea.

So does this mean this kind of fixed-cost research prize system is always superior to government sponsored direct subsidies and research funds? If anything, just the opposite. SpaceX, United Launch Alliance, Sierra Nevada, and all the other commercial space companies would not have gotten off the ground without the initial investment from NASA. Imagine Kennedy delcaring "We choose to pay the private sector to bring us to the moon in this decade and do the other things, not because they are easy, but because they are hard" There would have been no gravitas, no national pride, and importantly, no technology. At that point, the technology had not been developed. Somebody needed to go do the basic science to get us up there. 

To give an example of the wide range of science involved, think about the "simple" task of linking two orbiting objects together. It requires a firm understanding of the science of orbital rendezvous to build the correct equipment and to pilot correctly. Buzz Aldrin actually wrote a dissertation on this issue, and although it seemed useless at the time it was critical in the development of the space program. Buzz also spent time solving other physics problems such as the differential effects of gravity on large objects in space and the implications for navigation. If that science seems like something the private sector would be willing to fund, recall that the initial analyses of rocketry were conducted by a German Nazi* that was working on military rockets. None of this was easy; this was part of the reason why there were so many failures. Without the military impetus and government support, there would have been no space program. If the SpaceX Falcon rockets are able to fly so far now, it is because they launch off of the shoulders of giants. This is true figuratively as well as literally. The Falcon rockets launch from Cape Canaveral, the former launch site of the rocket that took us to the moon: the Saturn V.

In short, government directed research and prizes are complements. First, government R+D and subsidies are best for discovering fundamental disruptive technologies and sciences, whereas prizes are an effective way to further organize and commercialize that existing knowledge. Without DARPA, there would have been no Internet. But without subsequent innovations from companies such as Google or Facebook, the Internet would not be as vibrant as it is today. Second, it is important the government is to be a consumer, or an anchor tenant, of the innovation. For commercial space, NASA has committed to buy launches from whichever company that ends up developing the rocket. For energy, this would mean a guarantee from the government to purchase the electricity or fuel cells produced by a revolutionary firm. Third, private sector innovations from prizes can be used by the government. Government investments that fed into the private sector may feed back to the government again. NASA may end up using the improved rockets from COTS instead of the current United Launch Alliance Atlas V rocket for future Mars missions. The military may extensively deploy improved private sector solar panels to increase readiness in times of energy price volatility. So by all means, use prizes to spur innovation. But don't neglect the foundational role of the government in other dimensions.

*The rocket scientist in question was Wernher von Braun, and Tom Leher once wrote the following poem making fun of his political history:

Once the rockets are up,
Who cares where they come down?
'That's not my department',
Says Wernher von Braun.

Food (Price Shocks) For Thought

Global food prices and inflatable BRICs

While Shanghai recovers from the aftershocks of the Haikui typhoon, many other areas in the world are dealing with record droughts and rising food prices. The bad weather has hit U.S. farmers hard, with corn futures last week surging 59% from mid-June and soybeans jumping 21%. This may soon have international spillovers as U.S. crops count for more than half of the export market in corn and soybeans, both important inputs for the food industry, especially meat markets.

Although the recent food price spike has been significant, global food reserves and good harvests in other crops will likely prevent it from causing mass starvation. Nonetheless, food inflation is now putting the heat on global central banks as they consider whether they need to tighten monetary policy to maintain inflation credibility, or whether they should stick to maintaining short term growth instead. The BRIC countries stand on a dangerous precipice, as their real growth in recent months has slowed dramatically. The Brazilian Central bank is dealing with inflation on its doorsteps as its own employees are striking and demanding a 23% wage hike to compensate for higher cost of living. India's growth engine is also losing its spark and global food prices coupled with an already poor monsoon season could push inflation further beyond the central bank's comfort levels.  China is barely holding on, and monetary tightening at this juncture would have serious implications for both broad growth and the stability of the shadow banking sector. Russia is dealing with its own drought and its central bank is also under pressure from IMF officials calling for a monetary tightening. These food inflation problems are compounded by a rise in the value of the dollar, making purchases of U.S. corn, whose futures are 6% more expensive than their 2008 peak, even more costly.

No doubt, the current situation is quite severe, but what can history tell us about how food price affect inflation in the BRIC countries? Econometric evidence suggests that world food prices are a key driver, more so than oil, of global inflation, but can we generalize to the BRIC countries in the current situation? The first thing to note is that global food prices, as measured by the IMF food price index, have been on a secular rise since 2000, but that in June, the last measured month, food prices were still below where they were during the 2008 or 2011 food price crises.

Given that average food expenditure as a percentage of income for Brazil, Russia, India, and China all hover around 25 to 35%, we should expect that increases in food price growth should quickly show up in each country's inflation rates . However, by looking at the time series for each CPI and the IMF food price index, we see that the time series do not match up well and that the real story is a bit more complex. In each graph, CPI year over year growth rates are plotted on the left axis, while food index year over year growth rates are plotted on the right axis.

I split the countries in the above two groups for more than aesthetic reasons. If you look carefully at the time series, you can see that in the first group, China and Russia, food price growth and inflation rates seem to move together at all levels of food price growth. Over the entire period, China's inflation rate and food price growth had a correlation value of 0.7, which is enough at the 99% confidence level. Russia's correlation is more limited, as inflation only starts to move in sync with food prices after 2007. But in the period of time since 2007, the correlation value is 0.18, which is enough at about the 90% confidence level. I call this the unconditional inflation group, as the correlation between food prices and inflation is not conditional on the rate of food price growth.

On the other hand, if you look at the second graph, there's less of a discernible pattern for India or Brazil. Food prices spike in 2004 and 2008, but neither of the magnitudes of the two countries' change in inflation match the large swing in food price. However, the time series do start to line up in times of crisis, such as in 2009. This is especially evident for India, as from 2009 on, its inflation rate seemed to move in tandem with the food price growth rate. I call this group the conditional inflation group, as the correlation between food prices and inflation seems to be conditional on whether food price growth is sufficiently high.

To test this hypothesis, we can generate 2-year backwards looking rolling correlations and see how they evolve through time. These price correlations are plotted below, with the value of the 2-year rolling price correlation plotted on the left axis and year over year change in the IMF food index on the right.

China and Russia:

India:

Brazil:

In these graphs, we see the difference between the groups in a different light. The value of the food correlation for China and Russia seem quite uncorrelated with food prices, whereas for India and Brazil the correlation between food prices and inflation is higher when food prices are higher. With further analysis, it can be shown that we can reject the null hypothesis that food prices don't affect the value of the food correlation for Brazil and India, but we fail to reject the same null hypothesis for China and Russia. This is the reason why Brazil and India are grouped together as conditional inflation countries. Food price changes affect their inflation rate only if food prices are growing quickly enough. On the other hand, Russia and China are unconditional inflation countries, as food prices strongly affect their inflation rates at all levels of food price growth. The scatter plots of correlation versus food price growth for India and Russia are particularly illustrative of this difference. First, India:

Second, Russia:

While India's food correlation values look to be affected by food price growth, Russia's food correlations seem to just cluster horizontally around values of y=-0.75 and y=0.5. With more detailed regression analysis of India's results, we obtain a 95% confidence interval of (-0.25, -0.05) for the intercept and a 95% confidence interval of (0.0053, 0.0156) for the slope. A similar regression for Brazil returns a 95% confidence interval of (-0.35, -0.18) for the intercept and a 95% confidence interval of (0.0022, 0.0141) for the slope. Both these numbers suggest that the effect is real: higher food price inflation is associated with a tighter positive relationship between food prices and inflation. Food prices are a convex predictor: little effect when prices are low, much stronger effect when they are high.

What implications does this have for food inflation and the BRIC countries? First, we should expect China's and Russia's inflation rates to be hit the hardest by any food price growth. They unconditionally inflate, which means that the historical relationships suggest that a rise in food prices will directly translate into higher inflation rates for those two countries. On the other hand, India and Brazil only conditionally inflate. Statistically significant relationships are unlikely to form at current food price growth levels, and we need to be looking at at least 10% year over year growth in food prices before we should expect each country's inflation to becomes statistically linked to global food prices. Therefore, their inflation rates will likely only rise after China and Russia's inflation rates rise. However, this analysis does not say anything about welfare costs to these countries. Given that India and Brazil have higher inflation rates than China or Russia, convex costs to inflation may end up leading to more damage in the conditional inflators than in the conditional inflators. Nonetheless, it shows that the relationship between food prices and broad inflation is not so clear cut, and that some statistical manipulation can be invaluable in teasing out the connection.

NGDP Autoregressions and the Lucas Critique

Is NGDP growth sticky? In other words, does above NGDP growth in one period affect GDP growth in the next? Evan Soltas has previously shown that RGDP appears to be sticky. He constructed some impulse response functions and found that there is no instantaneous self-correction mechanism. On the nominal side, there is substantial evidence indicating that inflation is sticky. The correlation coefficient for the relationship between the current inflation rate and the inflation rate measured one quarter ago is 0.75. Another way of saying this is that about 50% of the variability in current inflation can be predicted by inflation one quarter ago.

Does NGDP, the sum of inflation and RGDP, suffer from the same stickiness? If it does, this could have serious implications for NGDP level targeting. If it takes a long time for past NGDP surges to slow down, this could affect the speed at which central banks can change expectations of NGDP. central banks may need to take even more drastic action to adjust NGDP at the necessary speed, causing monetary policy to be blunt and not credible.

To answer this, I looked at the NGDP time series from 1947 to today and constructed a multiple regression model to explain the current NGDP continuously compounded annual rate of growth as a function of the NGDP growth rate for the past six quarters. As only the coefficients for the past two quarters were statistically significant at the 95% confidence level, I settled with testing NGDP as an AR(2) model. The results of my regression are listed below:

Call:

lm(formula = n[, 1] ~ n[, 2] + n[, 3])

Residuals:

     Min       1Q   Median       3Q      Max 

-14.5968  -2.1681  -0.1866   2.0848  13.5262 

Coefficients:

                 Estimate  Std. Error t value   Pr(>|t|)    

(Intercept)  2.82257    0.47431   5.951     8.93e-09 ***

n[, 2]         0.43320    0.06257   6.923     3.67e-11 ***

n[, 3]         0.13255    0.06250   2.121     0.0349 *  

---

Signif. codes:  0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1 

Residual standard error: 3.943 on 251 degrees of freedom

Multiple R-squared: 0.2631,     Adjusted R-squared: 0.2572 

F-statistic:  44.8 on 2 and 251 DF,  p-value: < 2.2e-16 

From this, we can say that about 26% of the variability in current NGDP growth is explained by past NGDP growth. To get a better idea of what the relationship looked like, I also plotted the predicted values of NGDP versus the actual values:

While the intercept is not statistically significant different from zero, the slope is 1, with standard error of 0.10, suggesting that the model does do a reasonable job of estimating actual NGDP. So does this data prove NGDP is sticky, making instantaneous NGDP expectation adjustment impossible?

As with most economic questions, the answer is "not necessarily". Perhaps NGDP is sticky because of certain nominal frictions in the economy, such as staggered wage contracts or menu costs. These traits, while they endow nominal shocks with real effects, also mean that nominal levels in the economy have momentum. If wages are suppressed for extended periods of time, the economy would be able to stay at higher levels of aggregate activity for longer. Alternatively, information itself can be sticky. So even if economic agents stand at the ready to change prices and to be flexible, they don't observe economic conditions quickly enough, acting in a way that creates nominal momentum.

A first pass analysis would suggest that these frictions would fundamentally limit the ability of NGDPLT to achieve stability. If elevated current NGDP always predicts elevated future NGDP, then there would be no way for a central bank to credibly commit to quick NGDP corrections.

However, given some recent discussion of Milton Friedman's thermostat, we have to ask if this result is regime dependent. Take inflation for a concrete example. The Federal Reserve has, for most of its recent history, targeted the rate, not the level of inflation. What this means is that if the Fed overshoots one year, there's no expectation for the Fed to compensate with lower than normal inflation for the next year. There's no expectation for monetary policy to correct the elevated inflation, which allows all the frictions mentioned above to keep inflation persistent. But if there's an expectation that the Fed will engage in corrective policy as in level targeting, then inflation may not be as persistent. Higher inflation today would actually predict lower inflation tomorrow as the central bank quickly acts to restore the original price level trend. Applied to NGDP targeting, if people perceived that current NGDP growth was higher, they would have an expectation that future NGDP growth would be slower. They could then act on that expectation and quickly restore trend NGDP. We could also test this hypothesis by testing if inflation or NGDP autocorrelations are higher in rate targeting countries than level targeting countries. However, I do not know of any central banks that have a formal committment to any kind of level targeting, so I'm not sure how robust my results would be.

This discussion of autoregressions and NGDP stickiness is also an instance where the Lucas critique defends the effectiveness of monetary policy. While I can run a multiple regression and find "evidence" that NGDP growth is sticky, because my arguments are not microfounded I have no theoretical reason for why NGDP growth would stay sticky in a level targeting regime. So to fully understand how nominal persistence can affect NGDP targeting, we need a microfounded model that can analyze the intertrelated process of nominal frictions, policy and expectation formation: a hole that market monetarists must be able to fill.