A Reply to Steve Williamson -- Why Dynamic Stories are Important

Steve Williamson caused a firestorm in the blogosphere over his modeling results that helicopter drops in liquidity traps reduce the inflation rate. While hist first few posts were filled with mathematical equations, he was gracious enough in a recent post to present a story of what's going on in the model (my emphasis is bolded)

Next, conduct a thought experiment. What happens if there is an increase in the aggregate stock of liquid assets, say because the Treasury issues more debt? This will in general reduce liquidity premia on all assets, including money and short term debt. But we're in a liquidity trap, and the rates of return on money and short-term government debt are both minus the rate of inflation. Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.

Translated further, Steve's story is as follows:

1. The central bank prints more money
2. People don't want to hold onto that money
3. To make sure people hold onto that money, the inflation rate must fall (to make holding money more attractive)
4. Hence, printing money lowers the inflation rate.

Any cursory scholar of monetary economics should find that counterintuitive. I would suggest that it's counterintuitive because it's, well, wrong. In particular, the jump from (2) to (3) isn't clear at all. If everybody receives a helicopter drop, and nobody wants to spend it, then how does inflation fall? Or in the words of Paul Krugman: "How does this requirement translate into an incentive for producers of goods and services — remember, we’re talking about stuff going on in the real economy — to raise prices less or cut them?"

On the other hand, a much more realistic view would be a "monetary disequilibrium" or otherwise stated as David Hume's price specie flow mechanism as described by David Hume in his essay "On Money". At the moment that people get more money, the inflation rate is fixed. Hence the rate of return isn't high enough to hold money, and so people spend that money. This causes prices to rise and generates inflation.

Here's the fundamental problem with Steve's model: he acts as if equilibrium conditions are enough to explain causality. Sure, in equilibrium it must be that the inflation rate must equal the liquidity value of holding onto money. But that can happen in two ways. Either the inflation rate could fall (Steve's story), or people could hold less cash lower real cash balances, thereby raising the marginal value of their liquidity holdings. Dynamic stories matter, and if you can't explain how you get to equilibrium, you may end up on the wrong side of truth.

Edit: Adjusted for a few comments from Nick Rowe

Quartz: China can boost consumption by moving children and the elderly into cities

Here is a link to my fourth Quartz article, which was on Chinese urbanization and how it relates to the whole consumption/investment debate. An excerpt:

The first chapter of Chinese urbanization was a story of migrant workers. The next chapter will be about their families.

As China continues to grow, rich, effective urbanization will require more than just providing job opportunities. It will require new policy initiatives to bring more children and elderly from the countryside into the city. By doing so, the Chinese government can begin to address Chinese income inequality, rebalance the economy toward services and consumption, all the while setting the stage for further economic reforms.

According to population data from the Chinese National Bureau of Statistics, over the past 30 years the proportion of Chinese people living in cities has more than doubled from around 20% to over 50%. Most of the migration into the cities has been in the form of migrant laborers leaving the countryside in search of higher wages.

As a result, prime age laborers are overrepresented in the cities while children and the elderly are underrepresented. According to the 2009 population survey, the proportion of people in cities between the ages of 0-19 was about 2 percentage points lower than in the villages. This number was reversed for people between the ages of 20-39. When mothers and fathers move to the cities in search of higher wages, they leave their children behind to be taken care of by grandparents. As such, if urbanization is going to continue, it will need to bring these groups into the fold.

Quartz: Emerging markets need to stop focusing on their exchange rates

Here's a link to my 3rd Quartz article on how much of the emerging market sell-off was about monetary policy failures in the emerging markets themselves. In particular, by trying to maintain exchange rate policies, central banks in these countries overexpose themselves to foreign economic conditions. The highly positive response to the recent delay of taper serves as further evidence that many of these emerging economies need better ways of insulating themselves from foreign monetary shocks. Much of the work, draws on blog posts from Lars Christensen. His examples comparing monetary policy in Australia and South Africa versus policy in Brazil and Indonesia were particularly helpful. A few excerpts:

The sell-off in emerging markets is not an omen of a prolonged economic contraction. Although capital flows were also turbulent after the 2008 financial crisis, growth in emerging markets continued. Nor is this a sign of financial crisis. “One thing most people seem to agree on is that this is not a replay of the late 1990s,” writes Ryan Avent in the Economist. A combination of exchange rate flexibility and low external debt means that emerging markets are unlikely to experience the same level of carnage as was seen in the 1997. Rather, the sell-off is a statement about how monetary policy has been unable to stabilize output in emerging markets and the importance of monetary reform. 

...Since all capital controls eventually leak, emerging markets can commit to stabilizing either the exchange rate or domestic output—not both. Economists Joshua Aizenman, Menzie Chinn, and Hiro Ito (pdf) have shown that this tradeoff is real. In the 1972 to 2006 time period, “Greater monetary independence [was] associated with lower output volatility while greater exchange rate stability [implied] greater output volatility.” 

Between these two options, the answer should be clear. Central banks in emerging markets need to focus on domestic output, and not the exchange rate.

Some Noahpinion Posts: Gold, Macro, and Bubbles

I just wanted to remind my readers that I am spending this fall guest blogging at Noahpinion, and so far I have three posts up. 

First, I have one on the determinants of the value of gold. A key excerpt:

Gold glitters, but from an investment perspective it does little else. It is backed by neither cash flows (like stocks are) nor a value at maturity (like bonds are). It's just a metal that, historically, has always been highly valued: a value that exists beyond its role in jewelry or in industry. 

So what gives? Broadly speaking, when people make a bull case for gold, they tend to talk about two catalysts. First, they argue that because central banks are engaging in expansionary monetary policy, this will lead to massive levels of inflation that will drive gold prices higher. Second, they argue that gold is valuable because it acts like a panic button and serves as insurance against crisis. These in fact, were the primary motivators behind Paulson's famous bet on gold. In this post, I hope to show that the theory underlying (1) is flat out wrong, and that the logic behind (2) does not correspond to the actual challenging facing the world right now.

Second, I had a post on an elementary outline of general equilibrium theory as it applies to macro. I particularly enjoyed writing the post because I had the chance to play around with drawings to illustrate the theory. In the post, I argue:

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

Third, I had a post arguing that there is little evidence for a current bubble in stock prices. I think this was the weakest of the three posts, but I took a look at both forward and backwards PE ratios and concluded that the evidence did not smell of a crisis.

Without a doubt, QE has been an incredible boon for financial markets. Backed by QE3, the SP500 stock index has risen by more than 12% year to date. Yet in spite of this increase in the stock market, overall real economic conditions remain relatively stagnant. Year over year inflation as measured by the core PCE price index ticks in at only 1.2% YoY, and last quarter's real GDP grew by only 1.4% YoY. This disconnect is a bit unsettling, because it suggests that bullishness in the stock market has failed to translate into broader growth. On this basis, some commentators, such as Frances Coppola, have argued that quantitative easing does nothing for the broader economy and worsens economic inequalities. But this concern can be reduced to an even simpler question: Has recent stock market growth just been a bubble?

Not Quite Blogging

This is a good time to announce that I am taking a break from writing economics blog posts on this blog for the Fall Term. Instead, I will be featured on Not Quite Noahpinion! Our team profile can be found here, and I already have a post on gold returns up.

But don't worry, this blog won't completely die out. I will be writing more technical pieces for this blog. In particular, I want to write some tutorials on some R functions, as I have accumulated a good bit of experience with them over the summer and I hope to make the beauty of R more accessible to my fellow college researchers.

I encourage you to follow Noah's blog, and as always, you can stay in touch with me through Twitter (@yichuanw). Tune in for more economics come winter!

Quartz: High-speed rail is at the foundation of China’s growth strategy

This is a link and data supplement to my second (solo) Quartz column, which was about China's high speed rail system. The thrust of the column is that, even though high speed rail is oft maligned as an overinvestment, it actually serves many crucial roles to help China both grow in absolute terms and rebalance towards consumption. I feel like this argument will be a gold mine for China infrastructure bulls like Scott, as by digging through some Chinese news articles I found nuggets like this (my translation)

Wan Xiao [the train station manager] explained, at 10 PM on June 25th, after the railway administration released the news on the website that the line would open on July 1st, that evening around 50,000 people called to ask about the train, and over 14,000 messages were left.

(You can check my translation of "万晓介绍，6月25日晚上10点，当铁路局通过官方网站发布汉宜铁路7月1日开通的消息后，当晚的访问量就达到了其上限人数5万人次，留言达到1.4万多条。")

I had a lot of fun reading these Chinese news articles, and I'm sure my parents got a kick out of seeing me finally reading Chinese of my own accord.

There were three points from the column that I wanted to elaborate on.

First, instead of focusing on some kind of Rail/GDP number, I decided to focus instead on Rail Turnover/Length of Rail. I felt that this statistic was more descriptive because it captured the idea of rail intensity, or how much each stretch of rail was being used. In many of these overinvestment narratives, you hear about how there are all these train stations that aren't being used and how it's all just overbuilt. But when you look at the sheer amount of people and cargo that are being moved on the rails, it makes you question whether the problem is excess capacity or actually excess demand.

Second, while I partially addressed ridership concerns in the article, I wanted to go further into the effect of high speed rail on the composition of transportation infrastructure in China. Obviously, if China builds more rail, airlines become less competitive. I see this as an advantage because it allows China's infrastructure to grow in a more environmentally friendly manner. Additionally, better rail infrastructure takes the burden off of highways by moving more passengers onto the faster moving trains. Therefore, by emphasizing the trains, China can take the burden off of the "planes and automobiles" part of its transport strategy.

While this may seem self evident now, there were actually concerns high speed rail would actually worsen the highway situation. In an editorial criticizing Chinese rail, China expert Patrick Chovanec outlined a bear scenario in which the introduction of high speed rail crowds out slow speed passenger rail (which it has). The migrant workers, who then cannot afford to pay for these high speed rail tickets, then opt for bus travel, further crowding the highways.

But given the ridership statistics I pointed out in my article, that just doesn't seem to be the case. Moreover, recent evidence suggests that rail has had the benefit of crowding out auto travel. One example I found was from the Qiangjiang news, which reported that after the opening of the Wuhan-Yichang rail line, demand for bus service from Qianjiang -- a city alongside the high speed rail tracks – to Wuhan fell by nearly 60 to 70%. The Yichang transport station this year also saw its ground transport volume unchanged from one year ago at 45,000 passengers. Given the massive growth in rail, this suggests that the bear case outlined by Mr. Chovanec hasn't come to pass.

Third, while my article focused on the passenger side of rail development, freight rail has also become more intense. In particular, freight intensity in many inland provinces, such as Guangxi, Hunan, and Qinghai has been growing at a steady pace. This bodes well for the development of inland infrastructure, as it means more freight needs to be moved, and high speed rail will help open up the capacity for that to happen.

As always, a link to the data is on the data page. Please reach out if you have any questions.

A Primer On General Equilibrium, or Why Money Matters

This post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to balance their cash and apple balances. Apples are transacted, bellies are filled, and life is good.

But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.

But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras' law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples because not everybody spends all their wealth on apples. Instead, some people may put their wealth in money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to monetary economics:

If there is an excess supply of goods, it must be the result of excess demand for money.

The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "deep magic" of macro.

While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the unique representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.



The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So in this version of the model, the reason apples aren't eaten today is because people want to wait and eat apples tomorrow. So we get a corollary to the above conclusion:

If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.

Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.

So if recessions are caused by an excess demand for goods tomorrow, how does policy fix a recession? Here, our microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.

If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, just tries to change the relative price of consumption today and tomorrow to resolve the general glut. But just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of the more general political difficulty of the price system. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.

Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.

So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).

Now we get to the fun part -- applying this framework to some of the policy debates of the day.

Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.

Interestingly enough, quantitative easing is not in this picture. However, that's a long conversation that will receive its own post in the future.

We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more money today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.

The Ricardian critique of fiscal policy also pops out of this framework. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.

In this context, the Federal Lines of Credit proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.

I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal production. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.

Pictures were drawn in Paper 53.