Note: George intially replied in a series of comments to my earlier post. Not all of his comments appear to have made it, even though my email alerted me that they were indeed posted. (Prof J, this appears to have happened with one of your comments too -- there might be a bug in this system). In any case, I have pieced together George's reply in a separate post here (hopefully, I haven't missed anything). Enjoy! DA
============================================
David has kindly alerted me to his critique and invited me to reply. So here goes.
A 40-minute public lecture is, first of all, not the best means in which to cover all the issues related to such a sweeping proposition as one holding that we can do better than we have with the fed. In fact my lecture is just the barest-bone summary of a much more complete argument contained in my, Bill Lastrapes, and Larry White's working paper, "Has the Fed Been a Failure?" which is available online through both Cato and SSRN links. I urge David and his readers to have a look at that paper which addresses several of the issues he takes up in his comments here.
With particular respect to those comments, a few points. First, of course the Fed answers to Congress, and has its goals set by that body. But note: my paper isn't a critique of the goals themselves (though there are indeed cogent criticisms to be made of the dual mandate in particular). It merely asks whether the Fed has been successful in achieving these goals. I claim that it hasn't been.
Regarding the Fed's powers, it is a very serious mistake to assume, as David seems to do, that these are properly gauged by noting that it supplies but a small component of the total money stock, most of which consists of various sorts of bank deposits. In fact, by controlling the monetary base (which consists not only of the stock of paper currency, as David indicates, but also of the stock of bank reserves in the form of credits with the various Federal Reserve banks), the Fed operates a lever by which is is capable of regulating the total stock of money and the total flow of credit. Think of a government monopoly of shoes for left feet and consider the degree to which that monopoly would influence the total availability of shoes and you will begin to get the right picture.
Concerning the fact that the Fed adjusts the available stock of base money through open-market operations and discount window (or other kinds of) lending rather than by dropping stuff from helicopters, I'm sure I've never suggested otherwise and that none of my critical observations concerning the Fed's performance hinges on the helicopter-money assumption.
David asks whether the "political reality," consisting of the abuse of the Fed as a tool of inflationary finance and such, could possibly be altered by replacing the Fed with another institutional arrangements. The answer is that is can, if the alternative is a decentralized one in which no very large degree of influence is concentrated in a body over which the executive or Congress exercise considerable influence. Of course, even such an arrangement can be abused, but only through its being altered again. Whether that happens depends to a considerable degree on the state of professional economic opinion. For any economist to apologize for the Fed on the grounds that Congress is bound to saddle us with something at least as bad is for that economist to forget, first, that is is economists' responsibility to plead for better institutions and not to spare politicians the necessity of having to explain why they aren't following the economists advice.
David suggests that I have "truncated" the sample period used in comparing pre-Fed and Fed performance in a manner calculated to make the pre-Fed period look especially good, by leaving out the Civil War and earlier disturbances. But the sample periods I used were chosen not for such a strategic reason but (1) because the comparisons are meant to be between the Fed and the "National Currency" regime that preceded it, which was set up during the Civil War and (2) because consistent statistics for the comparisons I'm concerned with simply don't exit for earlier periods or even, in many cases, for the full National Currency period. Without such statistics comparisons become arbitrary. For the CPI, statistics David cites from before the 1780s are especially doubtful, though no-one denies that prices rose considerably during the revolutionary, 1812, and Civil Wars. That we can have inflation without the Fed is of course not a revelation. Nor does it contradict the claim that the inflation record, and the peacetime inflation record especially, has been worse under the Fed than under previous U.S. monetary regimes.
Concerning Canada's experience during the Great Depression, readers will find a very different take on this in our paper. Briefly, David sees it as proof that bad regulations rather than the Fed were to blame for the banking crisis. We see it as proof that the Fed was a poor solution to the problem of crises, that is, that there was a better, deregulatory solution. These claims aren't exactly inconsistent. But to suggest that Canada's experience should be viewed as undermining the case against the Fed is a stretch.
As for the Fed mimicking what private clearinghouses used to do: Wicker and Timberlake, the foremost authorities on that matter, both think the clearinghouse solution was better. This, too, is treated in the paper.
Once again, I'm grateful to David for inviting me to reply to his criticisms.
Sunday, 5 December 2010
Saturday, 4 December 2010
George Selgin on Replacing the Fed
In reply to one of my recent posts defending the Fed's actions over the course of the recent financial crisis, a reader asked me to consider George Selgin's recent talk, A Century of Failure: Why it's Time to Consider Replacing the Fed. I'm a big fan of Selgin's work and this is definitely a video worth watching. The main purpose of this lecture is to encourage people to be less complacent in their views of the modern day institution of central banking. (A short and useful history of the 19th century debates on central banking can be found in Vera Smith's 1936 thesis: The Rationale of Central Banking.)
I have some sympathy for many of the points made by Selgin in his lecture. But as it's no fun agreeing with people, I want to offer some criticism.
I am trying to imagine myself as a layperson attending this lecture. What impression would I be left with? The main impression would be that the Fed has failed miserably in its "promise" to maintain full employment, maintain price stability, to stabilize the business cycle, and to prevent banking panics. Comparing pre and post Fed data shows this. The Fed is like the Wizard of Oz. It's time to replace the Fed (he does not have time to say with what).
My own view on this, George, is that you are largely barking up the wrong the tree. Let me explain why.
First, people seem to have a view of the Fed as some mysterious organism with great powers and an ability to set its own agenda. It is important to remember that the Fed was created by an act of Congress in 1913. The Fed's powers and agenda are not set by the Fed; they are set by Congress. For example, the Fed's "promise" to help sustain "maximum employment" was not the Fed's idea; it was imposed upon the Fed by the Humphrey-Hawkins Full Employment Act in 1978. Many, if not most, central bankers are horrified by this legislated responsibility; and what is happening right now in the U.S. is a perfect example why.
And what are the Fed's great powers? The main power rests in the Fed's monopoly control over the supply of small denomination paper money (cash) and reserve balances (electronic version of cash). It is important to remember that this is not the only component of the U.S. money supply; most of the U.S. money supply is created by private agencies (largely in the form of electronic demand deposit liabilities that circulate from account to account in the payments system).
So, the Fed has the ability to create (and destroy) cash. But what does it do with the cash it creates? Can it simply inject it into the economy? No, not exactly. The Fed is largely restricted to using its newly printed cash to purchase government bonds. In emergency situations, it is permitted--indeed, it is expected, by the Federal Reserve Act passed by Congress--to make short-term cash loans in exchange for collateral; see my earlier post.
The Fed does not have the power to engage in helicopter drops of money.
Of course, this does not mean that Fed power cannot be abused. If the U.S. Treasury is having a hard time raising money through debt issue, it may pressure the Fed to purchase the debt with new money. Whether this is a good or bad thing obviously depends on the circumstances. But one can obviously see the incentive that politicians might have to use the Fed's monopoly to extract resources via an inflation tax. This is why the Fed tries to defend its "independence" from the Treasury to the best of its ability. At the end of the day, however, we have to recognize that Congress created the Fed -- and Congress can dismantle the Fed. This is the political reality under which the Fed must operate. Is this the Fed's fault?
Would this political reality be altered if the Fed was replaced by an act of Congress with another institution? If so, please explain.
To make the point that the Fed "failed in its promises" to deliver wonderful things, George looks at pre and post Fed economic data. The pre-Fed sample period is roughly 1870-1913. The post-Fed era is 1913-present. This is a rather convenient truncation and division of the data.
1870-1913 was a time of peace and extraordinary prosperity (punctuated by severe recessions). In contrast, the early part of the modern era featured the largest civil war in in the history of mankind (Europe and her current and former colonies). This was followed by the Korean war, the cold war, the Vietnam war, the war on poverty, followed by the lesser wars in Iraq wars and Afghanistan. Wars are periods of extreme fiscal strain; and it is not surprising that the inflation tax is invariably used to help finance a part of wartime expenditure. Would this have been less the case had the Fed not existed? To answer this question, let us go back further into American history, say, to 1861.
I want to label the diagram above "How to Generate Inflation without the Fed." Here is another diagram (source):
Yeah, yeah...I can see what happened in 1933. But what I want you to also look at is the run up in the price level from 1745 - 1820 (it increased almost four-fold). My general point here is that there is more to inflation than simply whether a central bank exists or not. Political factors are the deeper cause; and this is what I mean by barking up the wrong the tree.
What about the failure of the Fed to prevent the wave of bank panics during the Great Depression? George, you know better than me that there were severe regulations restricting banks from diversifying their assets across state lines. Canadian banks suffered from no such restrictions and, indeed, no Canadian bank failed during the Great Depression (though Canada, like many other countries experienced a large contraction in output). This is not to absolve the Fed from any mistakes it may have made, but there is a difference in critiquing a policy and a critiquing an institution.
What of the Fed's conduct over the recent crisis? Well, I've written about this in my earlier post. Many people do not know that the Fed was granted no supervisory role over the majority of the institutions adversely affected in the financial crisis; see my post here: Did the Fed Fail as a Financial Supervisor?
And yet, when the shit hit the fan, the Fed was expected to act immediately (and believe me, Congress was very glad to have this responsibility thrust upon the Fed at the time, and to save their Monday morning quarterbacking duties for, well, Monday morning). The Fed, in fact, essentially replicated the actions of what many of the private clearinghouses did in the past to ameliorate the adverse consequences of a financial panic.
Anyway, here you have my 2 cents worth on the matter.
Having said all this, you may find it surprising to learn that I agree with George: It is time to consider replacing the Fed. But then again, I always think it is time to consider reshaping or replacing the institutions we use to govern ourselves. Let the discussion begin!
I have some sympathy for many of the points made by Selgin in his lecture. But as it's no fun agreeing with people, I want to offer some criticism.
I am trying to imagine myself as a layperson attending this lecture. What impression would I be left with? The main impression would be that the Fed has failed miserably in its "promise" to maintain full employment, maintain price stability, to stabilize the business cycle, and to prevent banking panics. Comparing pre and post Fed data shows this. The Fed is like the Wizard of Oz. It's time to replace the Fed (he does not have time to say with what).
My own view on this, George, is that you are largely barking up the wrong the tree. Let me explain why.
First, people seem to have a view of the Fed as some mysterious organism with great powers and an ability to set its own agenda. It is important to remember that the Fed was created by an act of Congress in 1913. The Fed's powers and agenda are not set by the Fed; they are set by Congress. For example, the Fed's "promise" to help sustain "maximum employment" was not the Fed's idea; it was imposed upon the Fed by the Humphrey-Hawkins Full Employment Act in 1978. Many, if not most, central bankers are horrified by this legislated responsibility; and what is happening right now in the U.S. is a perfect example why.
And what are the Fed's great powers? The main power rests in the Fed's monopoly control over the supply of small denomination paper money (cash) and reserve balances (electronic version of cash). It is important to remember that this is not the only component of the U.S. money supply; most of the U.S. money supply is created by private agencies (largely in the form of electronic demand deposit liabilities that circulate from account to account in the payments system).
So, the Fed has the ability to create (and destroy) cash. But what does it do with the cash it creates? Can it simply inject it into the economy? No, not exactly. The Fed is largely restricted to using its newly printed cash to purchase government bonds. In emergency situations, it is permitted--indeed, it is expected, by the Federal Reserve Act passed by Congress--to make short-term cash loans in exchange for collateral; see my earlier post.
The Fed does not have the power to engage in helicopter drops of money.
Of course, this does not mean that Fed power cannot be abused. If the U.S. Treasury is having a hard time raising money through debt issue, it may pressure the Fed to purchase the debt with new money. Whether this is a good or bad thing obviously depends on the circumstances. But one can obviously see the incentive that politicians might have to use the Fed's monopoly to extract resources via an inflation tax. This is why the Fed tries to defend its "independence" from the Treasury to the best of its ability. At the end of the day, however, we have to recognize that Congress created the Fed -- and Congress can dismantle the Fed. This is the political reality under which the Fed must operate. Is this the Fed's fault?
Would this political reality be altered if the Fed was replaced by an act of Congress with another institution? If so, please explain.
To make the point that the Fed "failed in its promises" to deliver wonderful things, George looks at pre and post Fed economic data. The pre-Fed sample period is roughly 1870-1913. The post-Fed era is 1913-present. This is a rather convenient truncation and division of the data.
1870-1913 was a time of peace and extraordinary prosperity (punctuated by severe recessions). In contrast, the early part of the modern era featured the largest civil war in in the history of mankind (Europe and her current and former colonies). This was followed by the Korean war, the cold war, the Vietnam war, the war on poverty, followed by the lesser wars in Iraq wars and Afghanistan. Wars are periods of extreme fiscal strain; and it is not surprising that the inflation tax is invariably used to help finance a part of wartime expenditure. Would this have been less the case had the Fed not existed? To answer this question, let us go back further into American history, say, to 1861.
I want to label the diagram above "How to Generate Inflation without the Fed." Here is another diagram (source):
Yeah, yeah...I can see what happened in 1933. But what I want you to also look at is the run up in the price level from 1745 - 1820 (it increased almost four-fold). My general point here is that there is more to inflation than simply whether a central bank exists or not. Political factors are the deeper cause; and this is what I mean by barking up the wrong the tree.
What about the failure of the Fed to prevent the wave of bank panics during the Great Depression? George, you know better than me that there were severe regulations restricting banks from diversifying their assets across state lines. Canadian banks suffered from no such restrictions and, indeed, no Canadian bank failed during the Great Depression (though Canada, like many other countries experienced a large contraction in output). This is not to absolve the Fed from any mistakes it may have made, but there is a difference in critiquing a policy and a critiquing an institution.
What of the Fed's conduct over the recent crisis? Well, I've written about this in my earlier post. Many people do not know that the Fed was granted no supervisory role over the majority of the institutions adversely affected in the financial crisis; see my post here: Did the Fed Fail as a Financial Supervisor?
And yet, when the shit hit the fan, the Fed was expected to act immediately (and believe me, Congress was very glad to have this responsibility thrust upon the Fed at the time, and to save their Monday morning quarterbacking duties for, well, Monday morning). The Fed, in fact, essentially replicated the actions of what many of the private clearinghouses did in the past to ameliorate the adverse consequences of a financial panic.
Anyway, here you have my 2 cents worth on the matter.
Having said all this, you may find it surprising to learn that I agree with George: It is time to consider replacing the Fed. But then again, I always think it is time to consider reshaping or replacing the institutions we use to govern ourselves. Let the discussion begin!
Thursday, 2 December 2010
Oh, the Outrage...
The U.S. Congress created the Fed in 1913. One of its duties is to prevent, or at least, to mitigate the adverse consequences of major financial disruptions, like the one that occurred in the Panic of 1907.Financial panics, like the one we recently experienced, are characterized by (among other things) a sudden lack of "liquidity." What does this mean? It means that all sorts of debt instruments are treated like junk, whether they "deserve" to be treated as junk or not. In a panic situation, the baby frequently gets thrown out with the bath water. Good assets (well-collateralized debt instruments) get penalized (severely discounted) along with bad assets.
A part of the Fed's mandate is to serve as lender-of-last-resort. What does this mean? It means that it stands ready to discount what it perceives to be good quality paper at a rate less than the market discounts such paper. This means lending cash at a lower-than-market interest rate on a short-term loan, if the debtor is in a position to put up high-grade collateral. This is what happens at the Fed's discount window. This is what happened with the Fed's other emergency lending facilities. The Fed was doing what Congress (representing the wishes of its citizens) has mandated.
What was the result? All the loans due have been paid back with interest. Yes, that's right. Contrary to the impression one gets from the media, the Fed did not "give" people or firms money. It lent them the money on a short term basis and in exchange for high-grade collateral (even if ascertaining the quality of collateral in emergency conditions can sometimes lead to mistakes).
The Fed has made a healthy profit on these activities. Last year, it remitted an extra $25 billion to the U.S. Treasury (the U.S. taxpayer). What sort of "bailout" makes money for the U.S. taxpayer?
So what is the source of all the outrage directed at the Fed? My own interpretation is that members of Congress like to use the Fed as its whipping boy. The Fed is a central bank and the Fed helped banks. And people hate banks. They hate banks because...well, because they won't lend people money. They also hate banks because they lend people too much money (leading to crisis). Go figure.
Addendum: 03 Dec 10
I said above that the Fed only accepts high-grade collateral when it makes a short-term cash loan. While this describes normal Fed practice, it evidently does not describe all the lending that took place in its emergency facilities during the crisis; see here: Crisis-Hit Banks Flooded Fed with Junk.
What I should have said is that when the Fed makes a short-term cash loan, it does so only when it has a high expectation that it will be paid back. The collateral for the loan is put up to protect the Fed in the event of default. And as the article mentions, when the collateral put up was lower-grade material, the Fed protected itself by applying a large "haircut" (discount) on the collateral. (Presumably, the haircut applied by the Fed was less than the haircut the market was willing to give, but so what--this is the point of being a lender-of-last resort!).
In any case, my basic point stands. The Federal Reserve Act of 1913, an Act of Congress, explicitly allows and expects the Fed to act the way it did during any financial crisis. Section 13(3) of the act reads as follows:
13.3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
So maybe you don't like what the Fed did. That's fair enough. But this is no reason to blame the Fed. If you want something different, you should lobby Congress to change the Federal Reserve Act. Or lobby Congress to abolish the Fed. And then you'll have Congress managing monetary policy (unless you live in the fantasy world of Ron Paul, and actually believe that Congress would shackle itself to a gold standard). At the end of the day, I am sure that American voters will get what they deserve.
Wednesday, 1 December 2010
The Fed's "Bailout" List Disclosed
I know that a number of you suspicious types have been waiting for this moment. I have written about the Fed's disclosure practices in the past; see, for example, here. In a nutshell, I think that disclosure is desirable, though not necessarily in real time (e.g., during a financial crisis). In any case, we have this from the Fed today:
The full press release and a link to financial transaction data is available here. I haven't had time to look through the data, but if you find anything interesting, please let me know! (I notice that information relating to the Fed's discount window operations is not available...not sure why).
The Federal Reserve Board on Wednesday posted detailed information on its public website about more than 21,000 individual credit and other transactions conducted to stabilize markets during the recent financial crisis, restore the flow of credit to American families and businesses, and support economic recovery and job creation in the aftermath of the crisis.
Many of the transactions, conducted through a variety of broad-based lending facilities, provided liquidity to financial institutions and markets through fully secured, mostly short-term loans. Purchases of agency mortgage-backed securities (MBS) supported mortgage and housing markets, lowered longer-term interest rates, and fostered economic growth. Dollar liquidity swap lines with foreign central banks helped stabilize dollar funding markets abroad, thus contributing to the restoration of stability in U.S. markets. Other transactions provided liquidity to particular institutions whose disorderly failure could have severely stressed an already fragile financial system.
As financial conditions have improved, the need for the broad-based facilities has dissipated, and most were closed earlier this year. The Federal Reserve followed sound risk-management practices in administering all of these programs, incurred no credit losses on programs that have been wound down, and expects to incur no credit losses on the few remaining programs. These facilities were open to participants that met clearly outlined eligibility criteria; participation in them reflected the severe market disruptions during the financial crisis and generally did not reflect participants' financial weakness.
The full press release and a link to financial transaction data is available here. I haven't had time to look through the data, but if you find anything interesting, please let me know! (I notice that information relating to the Fed's discount window operations is not available...not sure why).
Tuesday, 23 November 2010
The 2005 Real Wage Shock
In the course of preparing for my discussion of Rob Shimer's paper (see my post here), I had my RA (the tireless Constanza Liborio) dig up some aggregate wage data for the U.S. economy. Let me preface the discussion that follows by saying that I am wary of putting too much stock in aggregate wage data (the composition bias, in particular, is potentially a big problem; see here). O.K., with this caveat in mind, let's take a look at some data.
As a measure of real wages, I use the BLS Employment Cost Index. Evidently, this measure is preferred by the likes of Bob Hall and others because it includes non-wage benefits. In what follows, I examine quarterly data for the sample period 1990:1 - 2010:3. The following chart plots the (annualized) rate of growth in nominal wages. The red line is a five-quarter rolling window I use to smooth out the series. The shaded areas represent NBER recession dates.
Prior to the most recent recession, nominal wages grew on average by about 3.5% per annum. The data shows a significant deceleration in nominal wage growth during the last recession. The composition bias suggests that actual wage growth displayed even greater "flexibility," as unemployment is typically concentrated among lower wage workers.
As I want to construct a measure of real wages, I need some measure of inflation. To this end, I use the GDP deflator, which is plotted in the next diagram.
Prior to the most recent recession, this measure of inflation averaged just above 2% per annum (the Fed's implicit inflation target). There was, however, a notable run up in the early 2000s, with (trend) inflation peaking at just over 3% in 2005 and early 2006. It is interesting to note that the rise in inflation over this period occurred while nominal wage growth decelerated. The next diagram plots the growth rate in real wages.
Now, the focus of Shimer's paper was apparent "ridigity" in real wage growth during the recent recession; a development that he interpreted as explaining the recent anemic behavior in employer recruiting intensity. As for myself, I was rather struck by the rapid deceleration in real wage growth in 2004, leading to falling real wages in 2005.
I want to take this data at face value for the moment and speculate a bit on what role these wage developments may have had in bursting of the U.S. home price "bubble" in 2006.
The story I have in my head revolves around an idea I first saw exposited by Joseph Zeira in his fine (and much under appreciated) paper: Informational overshooting, booms, and crashes.
The basic idea in Zeira's paper is as follows. Imagine an asset whose dividend grows a H% per year. Everyone knows that this growth will one day come to an end. When this date arrives, the dividend grows at L% per year forever (a simplifying assumption), where L < H. The only uncertainty in this thought experiment pertains to the date of the "regime change."
Zeira demonstrates that the equilibrium (rational expectations) asset price rises over time, and continues to rise as long as dividend (read: real wage) growth expectations continue to be met. Then comes the shock. I am tempted to call this a Wile E. Coyote moment, but of course, everyone in this model--unlike that hapless desert dog--knows that there is a date of reckoning. They just don't know beforehand when it will happen. So what happens?
Naturally, the asset price plummets like stone cast from heaven, before settling down along its new "fundamental" value (reflecting a new era of diminished expectations...gosh, I'm sounding a lot like PK these days). It appears as if asset prices "overshoot" their long-run fundamental value, before crashing.
To an outside observer, the asset price dynamics just described may be interpreted as a typical "irrational" boom and bust cycle (perhaps justifying some form of financial market regulation). In the context of the model world just described, this interpretation is completely wrong. This type of boom bust dynamic is, in fact, the natural consequence of how information is priced in an efficient asset market.
The picture I have in my head then is the following. Real wage growth appears relatively robust over the late 1990s and early 2000s. The return to labor, perhaps more than any other variable, measures the capacity for the average household to service debt. In the first half of the 2000s, creditors are looking at a recent history of relatively robust real wage growth, justifying credit expansion (even into subprime). By 2005, however, evidence of flagging fundamentals (anemic real wage growth) led to a (rational) revision downward in the real wage growth regime. Credit supply and real estate prices soon began to reflect this change in economic fundamentals.
Anyway, that's my crazy idea for the day. Feel free to share your thoughts...
As a measure of real wages, I use the BLS Employment Cost Index. Evidently, this measure is preferred by the likes of Bob Hall and others because it includes non-wage benefits. In what follows, I examine quarterly data for the sample period 1990:1 - 2010:3. The following chart plots the (annualized) rate of growth in nominal wages. The red line is a five-quarter rolling window I use to smooth out the series. The shaded areas represent NBER recession dates.
As I want to construct a measure of real wages, I need some measure of inflation. To this end, I use the GDP deflator, which is plotted in the next diagram.
I want to take this data at face value for the moment and speculate a bit on what role these wage developments may have had in bursting of the U.S. home price "bubble" in 2006.
The story I have in my head revolves around an idea I first saw exposited by Joseph Zeira in his fine (and much under appreciated) paper: Informational overshooting, booms, and crashes.
The basic idea in Zeira's paper is as follows. Imagine an asset whose dividend grows a H% per year. Everyone knows that this growth will one day come to an end. When this date arrives, the dividend grows at L% per year forever (a simplifying assumption), where L < H. The only uncertainty in this thought experiment pertains to the date of the "regime change."
Zeira demonstrates that the equilibrium (rational expectations) asset price rises over time, and continues to rise as long as dividend (read: real wage) growth expectations continue to be met. Then comes the shock. I am tempted to call this a Wile E. Coyote moment, but of course, everyone in this model--unlike that hapless desert dog--knows that there is a date of reckoning. They just don't know beforehand when it will happen. So what happens?
Naturally, the asset price plummets like stone cast from heaven, before settling down along its new "fundamental" value (reflecting a new era of diminished expectations...gosh, I'm sounding a lot like PK these days). It appears as if asset prices "overshoot" their long-run fundamental value, before crashing.
To an outside observer, the asset price dynamics just described may be interpreted as a typical "irrational" boom and bust cycle (perhaps justifying some form of financial market regulation). In the context of the model world just described, this interpretation is completely wrong. This type of boom bust dynamic is, in fact, the natural consequence of how information is priced in an efficient asset market.
The picture I have in my head then is the following. Real wage growth appears relatively robust over the late 1990s and early 2000s. The return to labor, perhaps more than any other variable, measures the capacity for the average household to service debt. In the first half of the 2000s, creditors are looking at a recent history of relatively robust real wage growth, justifying credit expansion (even into subprime). By 2005, however, evidence of flagging fundamentals (anemic real wage growth) led to a (rational) revision downward in the real wage growth regime. Credit supply and real estate prices soon began to reflect this change in economic fundamentals.
Anyway, that's my crazy idea for the day. Feel free to share your thoughts...
Sunday, 21 November 2010
A Wile E. Coyote Moment
Paul Krugman has teamed up with NY Fed economist Gauti Eggertsson to produce a new working paper: Debt, Deleveraging, and the Liquidity Trap. Krugman provides a bit of background about this project on his blog. I see that at least a couple of people have already commented on paper; e.g., Nick Rowe and Steve Williamson. I thought that I'd join in on the fun.
And fun it is. Eggertsson and Krugman (henceforth, EK) certainly have a way with words. The imagery is splendid; my favorite, of course, being the Wile E. Coyote moment (or the Minsky moment) as reflecting the shock that unexpectedly slips the rug out from underneath the financial system.
O.K., so it's fun. But is it progress? I think it is. In particular, it's encouraging to see that the authors (Krugman, in particular, I suppose) are starting to take seriously the notion that agent heterogeneity and financial market frictions may be important elements to include in a theory of the business cycle. It should go without saying these latter two properties are the sine quibus non of modern macroeconomic modeling methodology. As EK say in their abstract: "Making some agents debt-constrained is a surprisingly powerful assumption...". Yep, it's a real eye-opener alright. (For a few other surprises relating to the power of this assumption, see my entry here).
And fun it is. Eggertsson and Krugman (henceforth, EK) certainly have a way with words. The imagery is splendid; my favorite, of course, being the Wile E. Coyote moment (or the Minsky moment) as reflecting the shock that unexpectedly slips the rug out from underneath the financial system.
O.K., so it's fun. But is it progress? I think it is. In particular, it's encouraging to see that the authors (Krugman, in particular, I suppose) are starting to take seriously the notion that agent heterogeneity and financial market frictions may be important elements to include in a theory of the business cycle. It should go without saying these latter two properties are the sine quibus non of modern macroeconomic modeling methodology. As EK say in their abstract: "Making some agents debt-constrained is a surprisingly powerful assumption...". Yep, it's a real eye-opener alright. (For a few other surprises relating to the power of this assumption, see my entry here).
I want to keep this post reasonably short, so I limit myself to one (albeit important) aspect of the EK paper: the financial market friction, in the form of a debt constraint. Let me explain take a moment to explain the gist of it (for those who may be unfamiliar).
The key friction giving rise to this constraint is limited commitment (or limited enforcement). In lay terms, think about this as the unwillingness to make good on one's promises. Taking out a loan would be no problem at all -- if debtors could be relied upon to honor their debt, in particular, by servicing it and paying it off out of their future earnings. But if debt default is a relatively low-cost proposition, then debtors may be tempted to exercise the option. To the extent that creditors anticipate these future default incentives, they are likely to restrict credit supply. The result is that people may not be able to get credit even if they are, in principle, able to pay it off.
As an aside, most people probably think of debt constraints as the consequence of "market failure" leading to an inefficiency. But as I explain here (A theory of inalienable property rights), legally imposed debt constraints might be the solution to a social problem when financial markets work too well. I mention this here because the social problem I highlight stems from heterogeneous time-discount factors, which is also a property of the EK model. In the absence of a debt-constraint, the impatient mortgage their future and embark on consumption trajectory that takes them to hell. Unfortunately for the rest of us, it is a hell that they share with the rest of society (a negative externality, in my model); so we prevent them from doing this.
Alright, back to the main story. So they have two types of agents in their model: patient and impatient. In an unfettered financial market, the latter are eventually enslaved to the former. But an exogenously imposed debt constraint prevents this extreme case from happening. Instead, the impatient hit their debt ceiling and then roll their debt over forever, paying interest to the creditors (the patient). If we call the patient agents "China" and the impatient agents "USA," we might start talking about "global imbalances." But let's not go there (though, if you're interested, you might want to go here).
And now for the Minsky moment: an unanticipated drop in the exogenous debt limit. The shock appears to be modeled as permanent. Imagine that a debtor is servicing a constant stock of $100 of debt (he'd like to borrow more, but creditors cannot secure themselves beyond $100). Following the Minsky moment, his debt limit is dropped to $75 (forever). Creditors are now worried that they cannot secure themselves beyond $75. So how does our debtor respond?
It seems to me that he will respond by defaulting on that portion of the debt he is able to; i.e., $25. I mean, why wouldn't he? It is not like he is committed to paying back debt; after all, the debt limit is rationalized in the first place by the limited commitment/enforcement friction.
And so, following a Minsky moment, we would expect a significant redistribution in wealth away from creditors toward debtors. Now that debtors have a lower cost of debt service, we can expect their consumption to increase (they are still debt-constrained, after all).
This is not, however, what happens in the EK model. Why not? Well, because following the Minsky moment, they impose the following behavioral assumption on debtors: "Suppose furthermore that the debtor must move quickly to bring debt within the new, lower, limit, and must therefore deleverage to the new borrowing constraint." [pg. 7]. Of course, this is what I assumed too. The difference is that EK assume that the deleveraging process does not entail default. Somehow, despite an implicit limited commitment friction, debtors are committed to deleveraging by paying down their debt. And, of course, paying down their debt means reducing consumption.
Is it not interesting how one is able to derive such polar opposite predictions from two plausible views of how debt is discharged following an unexpected financial market shock? Naturally, I am biased toward my view--not necessarily because it is descriptively more accurate (though we obviously do see defaults in the data) -- but because it appears logically more consistent with the frictions underlying the debt constraint in the model. If a prescribed behavior is inconsistent with the model environment, then (in my view) even more than the usual amount of caution is warranted in weighing the model's predictions and interpretation of events. (This is not to say that internal consistency is the only desired criterion of a model, of course.)
It would be interesting to explore the robustness of the EK results in the context of a model that takes the source of the debt limit (and its propensity to change) more seriously. (Not that the other shortcuts they take deserve any less attention.) All in all, I like the paper because it at least makes at some attempt to formalize a popular interpretation of recent economic events. It's a small step forward and should, I think, spur a lively debate and future refinements...which is what our science is all about.
The key friction giving rise to this constraint is limited commitment (or limited enforcement). In lay terms, think about this as the unwillingness to make good on one's promises. Taking out a loan would be no problem at all -- if debtors could be relied upon to honor their debt, in particular, by servicing it and paying it off out of their future earnings. But if debt default is a relatively low-cost proposition, then debtors may be tempted to exercise the option. To the extent that creditors anticipate these future default incentives, they are likely to restrict credit supply. The result is that people may not be able to get credit even if they are, in principle, able to pay it off.
As an aside, most people probably think of debt constraints as the consequence of "market failure" leading to an inefficiency. But as I explain here (A theory of inalienable property rights), legally imposed debt constraints might be the solution to a social problem when financial markets work too well. I mention this here because the social problem I highlight stems from heterogeneous time-discount factors, which is also a property of the EK model. In the absence of a debt-constraint, the impatient mortgage their future and embark on consumption trajectory that takes them to hell. Unfortunately for the rest of us, it is a hell that they share with the rest of society (a negative externality, in my model); so we prevent them from doing this.
Alright, back to the main story. So they have two types of agents in their model: patient and impatient. In an unfettered financial market, the latter are eventually enslaved to the former. But an exogenously imposed debt constraint prevents this extreme case from happening. Instead, the impatient hit their debt ceiling and then roll their debt over forever, paying interest to the creditors (the patient). If we call the patient agents "China" and the impatient agents "USA," we might start talking about "global imbalances." But let's not go there (though, if you're interested, you might want to go here).
And now for the Minsky moment: an unanticipated drop in the exogenous debt limit. The shock appears to be modeled as permanent. Imagine that a debtor is servicing a constant stock of $100 of debt (he'd like to borrow more, but creditors cannot secure themselves beyond $100). Following the Minsky moment, his debt limit is dropped to $75 (forever). Creditors are now worried that they cannot secure themselves beyond $75. So how does our debtor respond?
It seems to me that he will respond by defaulting on that portion of the debt he is able to; i.e., $25. I mean, why wouldn't he? It is not like he is committed to paying back debt; after all, the debt limit is rationalized in the first place by the limited commitment/enforcement friction.
And so, following a Minsky moment, we would expect a significant redistribution in wealth away from creditors toward debtors. Now that debtors have a lower cost of debt service, we can expect their consumption to increase (they are still debt-constrained, after all).
This is not, however, what happens in the EK model. Why not? Well, because following the Minsky moment, they impose the following behavioral assumption on debtors: "Suppose furthermore that the debtor must move quickly to bring debt within the new, lower, limit, and must therefore deleverage to the new borrowing constraint." [pg. 7]. Of course, this is what I assumed too. The difference is that EK assume that the deleveraging process does not entail default. Somehow, despite an implicit limited commitment friction, debtors are committed to deleveraging by paying down their debt. And, of course, paying down their debt means reducing consumption.
Is it not interesting how one is able to derive such polar opposite predictions from two plausible views of how debt is discharged following an unexpected financial market shock? Naturally, I am biased toward my view--not necessarily because it is descriptively more accurate (though we obviously do see defaults in the data) -- but because it appears logically more consistent with the frictions underlying the debt constraint in the model. If a prescribed behavior is inconsistent with the model environment, then (in my view) even more than the usual amount of caution is warranted in weighing the model's predictions and interpretation of events. (This is not to say that internal consistency is the only desired criterion of a model, of course.)
It would be interesting to explore the robustness of the EK results in the context of a model that takes the source of the debt limit (and its propensity to change) more seriously. (Not that the other shortcuts they take deserve any less attention.) All in all, I like the paper because it at least makes at some attempt to formalize a popular interpretation of recent economic events. It's a small step forward and should, I think, spur a lively debate and future refinements...which is what our science is all about.
Thursday, 18 November 2010
Wage Rigidities and Jobless Recoveries
I recently attended an interesting conference hosted by the Atlanta Fed on Employment and the Business Cycle, where I had the pleasure of discussing this paper by Rob Shimer: Wage Rigidities and Jobless Recoveries. This was a fun paper to read, and I learned something new and interesting.
The backdrop for the paper is, of course, the recent financial crisis and associated recession. The level of GDP has essentially recovered its pre-recession level, while employment appears not to have recovered at all--these joint dynamics are referred to as a "jobless recovery."
The hypothesis Shimer puts forth is this: [1] there was a shock (or shocks) that led to an evaporation in the value of the economy's capital stock; and [2] real wage growth is "sticky" in the sense that it appears insensitive to macro shocks.
The type of evidence that lends some support for this latter hypothesis is displayed in the following diagram (also used by Bob Hall in his talk).
As an aside, I personally do not find such evidence wholly compelling. First, I think that composition bias is a big problem in the aggregate data; i.e., the first people to be let go in a recession are the least productive. Second, I have personal experience in the construction sector that leads me to believe that actual wage flexibility is much greater than what is recorded in official statistics. But in any case, I'm not here to argue about the evidence; let me take it as a fact that real wage growth is "sticky" in the sense described above. (Note: the basic story goes through as long as the real wage is not perfectly flexible).
To begin, consider a standard neoclassical growth model and let us consider a point on along the balanced growth path, where output and wages are growing, and employment (per capita) remains fixed over time.
Now, imagine that we shock the economy by evaporating some fraction of its capital stock. The subsequent transition dynamics are familiar to macroeconomic theorists and there is no need to describe them in detail here. The important thing is that real wages initially fall (since labor productivity falls and wages are flexible) and that the economy eventually returns to its balanced growth path.
Next, let us repeat the experiment, but assuming instead that real wages continue to grow along their balanced growth path (that is, the real wage does not respond to the shock). What do the subsequent transition dynamics look like? My own expectation was that the economy would once again return to its balanced growth path, but that the period of transition would be extended owing to the assumed rigidity in the real wage. Everyone I quizzed about this had the same expectation.
Surprisingly, to me at least, this intuition turns out to be completely wrong! Output and employment drops on impact, but then output stays along its new balanced growth path, with employment remaining below full employment forever; see the following diagram.
Now, I have to admit that my first thought at reading this result was that it must surely be wrong. But, of course (this is Shimer after all), it turns out to be correct. You can verify this for yourself by reading the paper. But as this will probably take more effort than you're willing to expend, let me give you a much simpler example that conveys the basic intuition.
An OLG Model
People live for 2 periods and they value consumption only in the last period of life; write the utility function of a person born at date t as Ut = ct+1. This simplifying assumption implies that the young save all their income.
The young are each endowed with one unit of time, which they supply inelastically to the labor market. Let N denote the population of young workers; and assume that N remains constant over time. Let wt denote the real wage at date t.
The old are in possession of the economy's capital stock Kt. The old hire young labor at the prevailing wage, produce output, and then consume the profit (the return on capital). Capital depreciates fully after it is used in production.
There is a standard neoclassical production technology Y = F(K,N) satisfying Y = f(k)N, where k = K/N is the capital labor ratio. Let F be Cobb-Douglas and let 0 < α < 1 denote capital's share of output. Then we have f '(k)k = αf(k).
Now, the demand for labor satisfies: wt = FN(Kt,Ntd) and the supply of labor satisfies Nts = N. In a competitive equilibrium, the real wage must satisfy:
[1] wt = FN(Kt,N) = (1 - α)f(kt); where kt = Kt/N.
In what follows, I set the exogenous growth rate to zero, since doing so is not important for explaining the main result. Now, as the young save all their earnings, it follows that the next period capital stock (per young person) is given by:
[2] kt+1 = (1 - α)f(kt)
In other words, the dynamics are equivalent to the standard Solow model we teach to undergrads. The nondegenerate steady state capital-labor ratio is characterized by:
[3] k* = (1-α)f(k*) [Note that k* = w* ]
Alright then. Begin at a point on the balanced growth path (here, a steady state with zero growth) and evaporate some capital, so that K0 < K*. This is a crude way to model the impact effect of a financial crisis. The transition dynamics should be familiar to any student of the Solow model; in particular, see [2]. In a decentralized version of this model, employment remains fixed at N, but the real wage (and the real wage bill) initially declines, before transitioning back to their original steady state values.
O.K., now let's repeat this experiment, but this time under the assumption that the real wage remains fixed at its initial steady-state value, wt = w* for all t. In this case, the level of employment N0 < N is determined the demand for labor; i.e.,
[4] w* = FN(K0,N0) = (1 - α)f(k*) = k*
Condition [4] implies that the capital-labor ratio remains unchanged; i.e., K0/N0 = k*. That is, the demand for labor declines in proportion to the decline in the value of capital. Since the real wage is fixed, this also implies that the aggregate wage bill declines in the same proportion. And since the wage bill here constitutes the saving that finances new capital, we have:
[5] K1 = w*N0 = K0 [since N0 = K0/k* and k* = w* ]
In other words, the capital stock remains forever fixed at K0 < K* and the level of employment remains forever fixed at N0 < N.
This is a permanent depression! If we extend the model to allow for exogenous growth, the level of employment remains depressed, but the level of output grows and eventually recovers its original level (this is the jobless recovery phase). However, the level of output remains forever below its "potential." Interesting.
Labor Market Search
One of the drawbacks of the model above is that both firms and workers stand to gain by negotiating the real wage downward following the shock. There is nothing in this model that prevents agents from exploiting these gains from trade, so ruling it out exogenously seems wrong (even if it is deemed realistic).
To address this shortcoming, Shimer extends the neoclassical model with the competitive labor market replaced by a search market, with bilateral meetings and negotiations. One of the nice things about the search specification is that the real wage may remain fixed in an equilibrium (if the shock is not too large). In other words, there need not be any inefficiency associated with a fixed wage at the individual level (though, it may induce an inefficiency at the aggregate level).
Shimer shows that the search model with rigid real wages generates dynamics that closely resemble those generated by a standard neoclassical model with rigid real wages. There appears to be an added force at work in the search model though. In particular, the combination of the negative shock and fixed real wage (along its balanced growth path) serves, in a way, to redistribute bargaining power from firms to workers. This is bad news for job creation, because the returns to investing in recruiting activities is now diminished, leading to a prolonged decline in employment. Sounds familiar.
In my view, this is an argument that deserves to be taken seriously. How seriously depends on how seriously one takes the "rigid real wage" hypothesis. Christopher Pissarides has criticized the assumption on the grounds that, in reality, real wages for new hires (or job changers) appear to be quite flexible relative to workers who remain employed. And, as Pissarides points out, the wages of incumbent workers do not factor into hiring decisions in a search model (assuming that the firm is not credit constrained). The key price as far as recruiting is concerned is the expected wage demands of future employees; and these appear to be relatively flexible.
This is all very interesting stuff. Almost makes me want to work in the area again!
P.S. The policy implications also turn out to be very interesting. Despite the "Keynesian" sticky wage property of these models, fiscal stimulus in the form of an increase in government purchases has the effect of crowding out capital investment, with no effect on employment. On the other hand, fiscal policies that subsidize business sector hiring (like a cut in the payroll tax) appear to be effective.
The backdrop for the paper is, of course, the recent financial crisis and associated recession. The level of GDP has essentially recovered its pre-recession level, while employment appears not to have recovered at all--these joint dynamics are referred to as a "jobless recovery."
The hypothesis Shimer puts forth is this: [1] there was a shock (or shocks) that led to an evaporation in the value of the economy's capital stock; and [2] real wage growth is "sticky" in the sense that it appears insensitive to macro shocks.
The type of evidence that lends some support for this latter hypothesis is displayed in the following diagram (also used by Bob Hall in his talk).
To begin, consider a standard neoclassical growth model and let us consider a point on along the balanced growth path, where output and wages are growing, and employment (per capita) remains fixed over time.
Now, imagine that we shock the economy by evaporating some fraction of its capital stock. The subsequent transition dynamics are familiar to macroeconomic theorists and there is no need to describe them in detail here. The important thing is that real wages initially fall (since labor productivity falls and wages are flexible) and that the economy eventually returns to its balanced growth path.
Next, let us repeat the experiment, but assuming instead that real wages continue to grow along their balanced growth path (that is, the real wage does not respond to the shock). What do the subsequent transition dynamics look like? My own expectation was that the economy would once again return to its balanced growth path, but that the period of transition would be extended owing to the assumed rigidity in the real wage. Everyone I quizzed about this had the same expectation.
Surprisingly, to me at least, this intuition turns out to be completely wrong! Output and employment drops on impact, but then output stays along its new balanced growth path, with employment remaining below full employment forever; see the following diagram.
An OLG Model
People live for 2 periods and they value consumption only in the last period of life; write the utility function of a person born at date t as Ut = ct+1. This simplifying assumption implies that the young save all their income.
The young are each endowed with one unit of time, which they supply inelastically to the labor market. Let N denote the population of young workers; and assume that N remains constant over time. Let wt denote the real wage at date t.
The old are in possession of the economy's capital stock Kt. The old hire young labor at the prevailing wage, produce output, and then consume the profit (the return on capital). Capital depreciates fully after it is used in production.
There is a standard neoclassical production technology Y = F(K,N) satisfying Y = f(k)N, where k = K/N is the capital labor ratio. Let F be Cobb-Douglas and let 0 < α < 1 denote capital's share of output. Then we have f '(k)k = αf(k).
Now, the demand for labor satisfies: wt = FN(Kt,Ntd) and the supply of labor satisfies Nts = N. In a competitive equilibrium, the real wage must satisfy:
[1] wt = FN(Kt,N) = (1 - α)f(kt); where kt = Kt/N.
In what follows, I set the exogenous growth rate to zero, since doing so is not important for explaining the main result. Now, as the young save all their earnings, it follows that the next period capital stock (per young person) is given by:
[2] kt+1 = (1 - α)f(kt)
In other words, the dynamics are equivalent to the standard Solow model we teach to undergrads. The nondegenerate steady state capital-labor ratio is characterized by:
[3] k* = (1-α)f(k*) [Note that k* = w* ]
Alright then. Begin at a point on the balanced growth path (here, a steady state with zero growth) and evaporate some capital, so that K0 < K*. This is a crude way to model the impact effect of a financial crisis. The transition dynamics should be familiar to any student of the Solow model; in particular, see [2]. In a decentralized version of this model, employment remains fixed at N, but the real wage (and the real wage bill) initially declines, before transitioning back to their original steady state values.
O.K., now let's repeat this experiment, but this time under the assumption that the real wage remains fixed at its initial steady-state value, wt = w* for all t. In this case, the level of employment N0 < N is determined the demand for labor; i.e.,
[4] w* = FN(K0,N0) = (1 - α)f(k*) = k*
Condition [4] implies that the capital-labor ratio remains unchanged; i.e., K0/N0 = k*. That is, the demand for labor declines in proportion to the decline in the value of capital. Since the real wage is fixed, this also implies that the aggregate wage bill declines in the same proportion. And since the wage bill here constitutes the saving that finances new capital, we have:
[5] K1 = w*N0 = K0 [since N0 = K0/k* and k* = w* ]
In other words, the capital stock remains forever fixed at K0 < K* and the level of employment remains forever fixed at N0 < N.
This is a permanent depression! If we extend the model to allow for exogenous growth, the level of employment remains depressed, but the level of output grows and eventually recovers its original level (this is the jobless recovery phase). However, the level of output remains forever below its "potential." Interesting.
Labor Market Search
One of the drawbacks of the model above is that both firms and workers stand to gain by negotiating the real wage downward following the shock. There is nothing in this model that prevents agents from exploiting these gains from trade, so ruling it out exogenously seems wrong (even if it is deemed realistic).
To address this shortcoming, Shimer extends the neoclassical model with the competitive labor market replaced by a search market, with bilateral meetings and negotiations. One of the nice things about the search specification is that the real wage may remain fixed in an equilibrium (if the shock is not too large). In other words, there need not be any inefficiency associated with a fixed wage at the individual level (though, it may induce an inefficiency at the aggregate level).
Shimer shows that the search model with rigid real wages generates dynamics that closely resemble those generated by a standard neoclassical model with rigid real wages. There appears to be an added force at work in the search model though. In particular, the combination of the negative shock and fixed real wage (along its balanced growth path) serves, in a way, to redistribute bargaining power from firms to workers. This is bad news for job creation, because the returns to investing in recruiting activities is now diminished, leading to a prolonged decline in employment. Sounds familiar.
In my view, this is an argument that deserves to be taken seriously. How seriously depends on how seriously one takes the "rigid real wage" hypothesis. Christopher Pissarides has criticized the assumption on the grounds that, in reality, real wages for new hires (or job changers) appear to be quite flexible relative to workers who remain employed. And, as Pissarides points out, the wages of incumbent workers do not factor into hiring decisions in a search model (assuming that the firm is not credit constrained). The key price as far as recruiting is concerned is the expected wage demands of future employees; and these appear to be relatively flexible.
This is all very interesting stuff. Almost makes me want to work in the area again!
P.S. The policy implications also turn out to be very interesting. Despite the "Keynesian" sticky wage property of these models, fiscal stimulus in the form of an increase in government purchases has the effect of crowding out capital investment, with no effect on employment. On the other hand, fiscal policies that subsidize business sector hiring (like a cut in the payroll tax) appear to be effective.
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