It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain.
At one level, it is easy to understand the popularity of the deficient demand hypothesis. First off, it's pretty much the first thing any undergrad learns in the way of macro theory. Second, they tend to learn it as a factual and self-evident explanation of the way the economy actually operates; not as an hypothesis or interpretation of the way an economy may work. Third, it is apparently easy to "see" evidence of deficient demand out there (much in the same way people can "see" the Phillips curve here?). They can "see," for example, that many firms cite a lack of product demand as a reason for holding back on making commitments to future capacity (including the addition of fulltime workers). The flip side of deficient demand is a "savings glut." People claim to see this as well; for example, in the form of low inflation and low Treasury yields.
Well, heck...I can see these things too. But the question, surely, is not what we record in our measurements. The question is how these measurements are to be interpreted. Interpretation (or explanation) necessarily entails a theory. (I define theory as a set of assumptions leading to a set of conclusions through the use of deductive logic.) And it is frequently the case that a given phenomenon has more than one plausible (or no less plausible) interpretation.
Before I go on, I want to make something clear. I do not disapprove of the practice of asking people what motivates their behavior. I would, in fact, like to see more in the way of this type of field work; see here. Having said this, we need to be careful in interpreting any given survey response as supporting one or some other theory. This is especially true in macroeconomics, where general equilibrium (system wide feedback effects) are likely to be important. According to Krugman, this is what makes macroeconomics hard.
And he is right. Unlike partial equilibrium analysis, it is conceptually difficult to identify independent "supply" and "demand" schedules in a dynamic general equilibrium system--everything is interelated, after all. Consider, for example, a shock that contracts the supply of some object (oil, credit, etc.). The ensuing price rise may lead oil-intensive sectors to curtail not only their demand for oil, but also their demand for a variety of complementary intermediate inputs. To the suppliers of these inputs, this will look very much like a "lack of demand" for their products. They are obviously not wrong for saying this. But upon hearing such reports, it would be rather hasty to conclude that these reports necessarily imply that "aggregate demand is too low."
With that out of the way, let me now discuss the deficient demand hypothesis. Some people may have been led to think that I don't believe that there is a demand problem. That's not quite true. It seems clear enough to me that the aggregate demand for investment (broadly defined to include investment in recruiting activities) is depressed. I'm just not very sure of the source of this depression. Understanding what these "fundamentals" are is necessary, I think, if we want to identify an appropriate policy response (more generally, the properties of an optimal policy rule).
Let me try to formalize what I mean here by way of a simple model that is, I think, sufficiently flexible to accommodate a range of views. I describe the model in some detail here (it is an OLG model). The fundamental economic friction is limited commitment, leading to an asset shortage; see here. The asset shortage gives rise to role for government debt (or money). The model highlights a portfolio choice problem: people must decide how to allocate a given amount of savings between two available asset classes, money and capital.
The key parameter in the model is the expected return to capital investment. A shock that depresses this expectation leads wealth-maximizing agents to substitute out of capital and into money. There is a collapse in aggregate investment spending (leading to a decline in future GDP); and there is a corresponding "flight" into government securities (money). For a fixed stock of money, the price-level drops (reflecting the increase in the market value of money); that is, the shock is deflationary. In short, the model generates something that resembles what we experienced in the recent recession.
Now, let's imagine that these expectations remain stubbornly depressed. What are the policy implications? Would it help if I told you that this is a model where increasing government spending (on investment), or lowering the interest rate (on government securities), or increasing the inflation rate, all serve to stimulate real economic activity? (This is, in fact, a property of the model.) It's tempting, isn't it? The economy is depressed and you have the tools to "fix" it. But hold on a minute. Before proceeding with your government stimulus plan, shouldn't you first ask why expectations appear to be so stubbornly depressed?
At the risk of oversimplifying, imagine that there are two possible answers to this question. [1] agents are rationally pessimistic; they forecast low returns on their investments because the environment (including the likely evolution of future government policies) dictate such a view. [2] agents are irrationally pessimistic; they forecast low returns on their investments for psychological reasons (e.g., Keynes' animal spirits).
Under interpretation [1], the decline in investment and flight to money is a rational response to an unfortunate event that has altered the economic landscape. One might imagine a rather muted enthusiasm for government stimulus under this interpretation. Under interpretation [2], the depression is caused by a collectively irrational flight to government bonds (Brad DeLong) or money (Nick Rowe); see their debate here. Under this interpretation--which is what I think most people have in mind when they speak of deficient demand--there is a strong case to be made for government intervention. There is obviously room here for reasonable people to disagree.
I want to conclude now with what I think is a shortcoming of the deficient demand hypothesis. It seems to me that the hypothesis leads us to think of a recession the way we might view a deflated balloon. The fundamental structure of the balloon remains intact, even if it is deflated. All that is needed to get back things to normal is a puff of fresh air. And if the private sector seems unwilling or unable to blow, then let the government do it instead. What could be simpler and more obvious?
My own observations over the years have led me to view recessionary events more like Humpty Dumpty after his great fall. Hands up all of you who think that the financial crisis had a severe impact on the economy's "structure." What do I have in mind here? Think about the disruptions that must have occurred in the form of terminated relationships (firm/worker, creditor/debtor, supplier/retailer, etc.). Think about the disruptions created out of a growing realization that resources have been misallocated (i.e., investments that looked good ex ante, now look like a bad idea ex post).
The main point is that a crisis destroys capital, broadly defined to include relationship capital--the glue that keeps the structure of economic relationships intact and productive. Sure, a breach in this structure may lead to deflated expectations and deficient-demand-like phenomena. But do not confuse symptoms with causes. The process of reallocating resources and rebuidling relationships after a traumatic event like the recent financial crisis is likely to take some time. This would be true even if all the king's men knew how to put Humpty Dumpty back together again.
Monday, 13 December 2010
Friday, 10 December 2010
Is the Deficient Demand Hypothesis Consistent with the Facts on Labor Market Turnover?
What's holding back the U.S. labor market? Why does employment growth remain slow? Why does the unemployment rate remain so persistently high? Is a prolonged jobless recovery possible? These questions are naturally at the forefront of current policy debates.
Some economists believe--were trained to believe, I would say--that the lacklustre performance of the labor market is easy to explain: there is a lack of demand. Just ask firms why they're not hiring: a lack of product demand frequently tops the list reasons provided.
I'm not sure that economists can rely on answers like this to identify the type of aggregate shock that is afflicting the economy. Think about the original multisector real business cycle model of Long and Plosser (JPE 1983). A negative productivity shock to one sector in their model economy could lead to a decline in the production and employment in many sectors of the economy. This is because firm level production functions use the intermediate goods of many sectors as inputs into their own production processes. To an individual producer, it would appear as the demand for his product is declining. And he would be correct. This lack of demand, however, bears no relation to the concept of "deficient demand" in the Keynesian sense.
In any case, let us take this deficient demand hypothesis seriously for the moment. Then I want to ask how this hypothesis might be reconciled with the labor market data I present below.
The first diagram plots the average monthly flow of workers between employment and unemployment (all data is from the U.S. Current Population Survey). The red line plots the EU flow (the flow of workers who made a transition from employment to unemployment). Leading up to the recession (shaded area), we see that in a typical quarter, roughly 1,750,000 workers per month exited employment into unemployment.
The blue line plots the UE flow (the flow of workers who made a transition from unemployment to employment). Leading up to the recession, we see that in a typical quarter, roughly 2,000,000 workers per month exited unemployment into employment.
When the recession hits, there is a large upward spike in the EU flow, as one would expect (people losing their jobs and becoming unemployed). This part seems consistent with the deficient demand hypothesis. However, look at what happens to the UE flow. While it does not rise as sharply as the EU flow, it rises nevertheless...and continues to remain high even as the EU flow declines. Is this surge in job finding rates*(see update below) among the unemployed consistent with the deficient demand hypothesis?
Note: the y-axis on the graphs below should read "thousands," not "millions." (Thanks to himaginary).
The next diagram plots the transitions between unemployment and nonparticipation (not in the labor force). The blue line denotes the UN flow (the flow of workers from unemployment to nonparticipation) and the red line denotes the NU flow (the flow of workers from nonparticipation to unemployment).
As you can see, these monthly flows are huge. And as one might expect, the UN flow rises dramatically during the recession. These are "discouraged workers;" and the phenomenon seems consistent with the deficient demand hypothesis.
But again, the surge in discouraged workers appears to be more than offset by a surge in "encouraged workers." How is this consistent with the deficient demand hypothesis?
It seems to me that this sort of data appears to be more consistent with an increase in reallocative activities in the labor market, rather than deficient demand. But maybe not. And if not, then I am curious to know what sort of stories people might tell to square their pet hypothesis with the data above.
Addendum: 11 Dec 2010
Nick Rowe asks about the NE and EN flows during this period. Here is the data:
In the following diagram, I plot the transitions into and out of employment. To do this, I define nonemployment = unemployment + nonparticipation.
If anyone would like to see anything else plotted, just let me know.
Update: December 21, 2010
I have to admit to being puzzled by many of the responses I received on this post. And then I came across this comment on my post by Brad DeLong: Department of Huh? I suddenly see what appears to be confusing people; in particular, the claim I make above (starred) about the surge in job finding "rates." This statement definitely belongs in the Department of D'oh!
Let me explain what happened here. When looking at labor market data, I usually deflate all series by some population measure. And so, I construct objects that I call the employment rate, the unemployment rate, the job finding rate, and so on. Perhaps I should call them "ratios" instead of "rates." In any case, for the purpose of this blog post, I chose to post levels. There is clearly a surge in the UE flow. And of course, there is also a surge in the job finding "rate" when one defines this object as UE/P (the conventional definition of this rate is UE/U). Mea culpa for the confusion.
Having said this, my typo in no way detracts from the substantive question I raised: Are these (level) flows consistent with the deficient demand hypothesis?
The data shows a large increase in the EU (job losers) and UN (discouraged worker) flows. It seems easy to understand these flows in the context of a deficient demand story. What I was trying to get people to do, however, was to square this same story with the large increase in the UE (job finders) and NU (encouraged worker) flows. How does depressed demand, leading to reduced job openings, also encourage more workers to look for work? It's an interesting and legitimate question, I think. And the answer is not obvious.
I expressed a view that the phenomena in question might be difficult to square with a deficient demand story and invited readers to share their thoughts on the matter; i.e., perhaps I was missing something. I want to thank everyone who responded thoughtfully to the question I posed.
Some economists believe--were trained to believe, I would say--that the lacklustre performance of the labor market is easy to explain: there is a lack of demand. Just ask firms why they're not hiring: a lack of product demand frequently tops the list reasons provided.
I'm not sure that economists can rely on answers like this to identify the type of aggregate shock that is afflicting the economy. Think about the original multisector real business cycle model of Long and Plosser (JPE 1983). A negative productivity shock to one sector in their model economy could lead to a decline in the production and employment in many sectors of the economy. This is because firm level production functions use the intermediate goods of many sectors as inputs into their own production processes. To an individual producer, it would appear as the demand for his product is declining. And he would be correct. This lack of demand, however, bears no relation to the concept of "deficient demand" in the Keynesian sense.
In any case, let us take this deficient demand hypothesis seriously for the moment. Then I want to ask how this hypothesis might be reconciled with the labor market data I present below.
The first diagram plots the average monthly flow of workers between employment and unemployment (all data is from the U.S. Current Population Survey). The red line plots the EU flow (the flow of workers who made a transition from employment to unemployment). Leading up to the recession (shaded area), we see that in a typical quarter, roughly 1,750,000 workers per month exited employment into unemployment.
The blue line plots the UE flow (the flow of workers who made a transition from unemployment to employment). Leading up to the recession, we see that in a typical quarter, roughly 2,000,000 workers per month exited unemployment into employment.
When the recession hits, there is a large upward spike in the EU flow, as one would expect (people losing their jobs and becoming unemployed). This part seems consistent with the deficient demand hypothesis. However, look at what happens to the UE flow. While it does not rise as sharply as the EU flow, it rises nevertheless...and continues to remain high even as the EU flow declines. Is this surge in job finding rates*(see update below) among the unemployed consistent with the deficient demand hypothesis?
Note: the y-axis on the graphs below should read "thousands," not "millions." (Thanks to himaginary).
The next diagram plots the transitions between unemployment and nonparticipation (not in the labor force). The blue line denotes the UN flow (the flow of workers from unemployment to nonparticipation) and the red line denotes the NU flow (the flow of workers from nonparticipation to unemployment).
As you can see, these monthly flows are huge. And as one might expect, the UN flow rises dramatically during the recession. These are "discouraged workers;" and the phenomenon seems consistent with the deficient demand hypothesis.
But again, the surge in discouraged workers appears to be more than offset by a surge in "encouraged workers." How is this consistent with the deficient demand hypothesis?
It seems to me that this sort of data appears to be more consistent with an increase in reallocative activities in the labor market, rather than deficient demand. But maybe not. And if not, then I am curious to know what sort of stories people might tell to square their pet hypothesis with the data above.
Addendum: 11 Dec 2010
Nick Rowe asks about the NE and EN flows during this period. Here is the data:
In the following diagram, I plot the transitions into and out of employment. To do this, I define nonemployment = unemployment + nonparticipation.
Update: December 21, 2010
I have to admit to being puzzled by many of the responses I received on this post. And then I came across this comment on my post by Brad DeLong: Department of Huh? I suddenly see what appears to be confusing people; in particular, the claim I make above (starred) about the surge in job finding "rates." This statement definitely belongs in the Department of D'oh!
Let me explain what happened here. When looking at labor market data, I usually deflate all series by some population measure. And so, I construct objects that I call the employment rate, the unemployment rate, the job finding rate, and so on. Perhaps I should call them "ratios" instead of "rates." In any case, for the purpose of this blog post, I chose to post levels. There is clearly a surge in the UE flow. And of course, there is also a surge in the job finding "rate" when one defines this object as UE/P (the conventional definition of this rate is UE/U). Mea culpa for the confusion.
Having said this, my typo in no way detracts from the substantive question I raised: Are these (level) flows consistent with the deficient demand hypothesis?
The data shows a large increase in the EU (job losers) and UN (discouraged worker) flows. It seems easy to understand these flows in the context of a deficient demand story. What I was trying to get people to do, however, was to square this same story with the large increase in the UE (job finders) and NU (encouraged worker) flows. How does depressed demand, leading to reduced job openings, also encourage more workers to look for work? It's an interesting and legitimate question, I think. And the answer is not obvious.
I expressed a view that the phenomena in question might be difficult to square with a deficient demand story and invited readers to share their thoughts on the matter; i.e., perhaps I was missing something. I want to thank everyone who responded thoughtfully to the question I posed.
Wednesday, 8 December 2010
Nominal Interest Rates and Inflation Expectations in the U.S.
The following two charts of courtesy of my St. Louis Fed colleague, Kevin Kliesen.
The first chart plots nominal yields on U.S. Treasuries since September 1 to the present. Seems like there has been a significant increase in nominal yields since QE2 was announced at the November 2-3 FOMC meeting. 5-year notes are up 63bp and 30-year notes are up 30bp.
Now, I know what some of you might be thinking. First, you might be thinking how it is possible that these yields are rising when QE2 was expressly designed to bring these rates down. Well, as Minneapolis Fed president Narayana Kocherlakota explains here, the idea was to lower the long-run real interest rate; i.e., the nominal interest rate net of expected inflation. For this to be true, the nominal rate increases above should be consistent with declines in the real interest rate; and to ascertain this, we need a measure of inflation expectations.
The following chart plots a market-based measure of inflation expectations (the so-called, TIPS spreads--cheesy tutorial available here).
What we see in the chart above is that since QE2 was announced, inflation expectations have moved up by less than the rise in nominal interest rates. What this means is that long-term real interest rates appear to have increased since QE2 was announced in early November. Interestingly, many of my banker friends tell me that this is good news (too much rum in the eggnog, no doubt).
How does one make sense out of all this? Well, here is one story. Evidently (so I am told), the desired impact of QE2 may have manifested itself largely in the period leading up to its official announcement. It is true that the market was widely expecting some sort of quantitative easing. And nominal rates did largely decline, or remain roughly stable, in between FOMC meetings. At the same time, inflation expectations started to rise significantly, having the desired effect of lowering long-term real interest rates. Fed types like to think that this action has stimulated the U.S. economy (certainly, the stock market does not appear to be complaining).
Since early November, nominal rates are climbing higher...with inflation expectations remaining more or less stable (well...some measures do appear to be creeping up). So long term real interest rates appear to be rising. And this, evidently, is a bullish signal, since long-run real rates largely reflect expectations of real growth in the future. Of course, whether the Fed's QE2 policies actually had anything to do with these higher future real rates is debatable. But in any case, it's something to mull over. Pass that eggnog!
The first chart plots nominal yields on U.S. Treasuries since September 1 to the present. Seems like there has been a significant increase in nominal yields since QE2 was announced at the November 2-3 FOMC meeting. 5-year notes are up 63bp and 30-year notes are up 30bp.
Now, I know what some of you might be thinking. First, you might be thinking how it is possible that these yields are rising when QE2 was expressly designed to bring these rates down. Well, as Minneapolis Fed president Narayana Kocherlakota explains here, the idea was to lower the long-run real interest rate; i.e., the nominal interest rate net of expected inflation. For this to be true, the nominal rate increases above should be consistent with declines in the real interest rate; and to ascertain this, we need a measure of inflation expectations.
The following chart plots a market-based measure of inflation expectations (the so-called, TIPS spreads--cheesy tutorial available here).
What we see in the chart above is that since QE2 was announced, inflation expectations have moved up by less than the rise in nominal interest rates. What this means is that long-term real interest rates appear to have increased since QE2 was announced in early November. Interestingly, many of my banker friends tell me that this is good news (too much rum in the eggnog, no doubt).
How does one make sense out of all this? Well, here is one story. Evidently (so I am told), the desired impact of QE2 may have manifested itself largely in the period leading up to its official announcement. It is true that the market was widely expecting some sort of quantitative easing. And nominal rates did largely decline, or remain roughly stable, in between FOMC meetings. At the same time, inflation expectations started to rise significantly, having the desired effect of lowering long-term real interest rates. Fed types like to think that this action has stimulated the U.S. economy (certainly, the stock market does not appear to be complaining).
Since early November, nominal rates are climbing higher...with inflation expectations remaining more or less stable (well...some measures do appear to be creeping up). So long term real interest rates appear to be rising. And this, evidently, is a bullish signal, since long-run real rates largely reflect expectations of real growth in the future. Of course, whether the Fed's QE2 policies actually had anything to do with these higher future real rates is debatable. But in any case, it's something to mull over. Pass that eggnog!
Sunday, 5 December 2010
A Reply by George Selgin
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.
============================================
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.
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).
Subscribe to:
Posts (Atom)