Saturday, October 20, 2012

The State of the World

There is some stuff in this Krugman blog post that is worth discussing. It's hard to get past his usual self-aggrandizement (I am a remarkably prescient forecaster; I am an island of clarity in an ocean of confusion; blah blah blah), but I'll try. We need to be tolerant, even when it's hard.

Here's what Krugman thinks is the key effect of the financial crisis:
Here’s how I interpret what we see in the historical data: financial crises leave an overhang of private-sector problems, principally excessive debt on the part of some subset of economic agents — households, in the case of the United States. Because these agents are either forced or strongly induced to slash spending, the “natural” rate of interest, the interest rate consistent with full employment, falls sharply — and in the case of a severe crisis, falls well below zero.
He's got the sign wrong. Suppose that for various reasons debt constraints bind more severely. That's in Eggertsson-Krugman for example. They just impose debt limits exogenously, but you could do something more sophisticated and tie the debt limits to the value of collateral, or what a would-be borrower stands to lose from default. In any case, what you get is more severe credit frictions, which make safe assets - government debt and safe private liabilities - more valuable. Why? These assets are now more useful at the margin in financial trade and as collateral. The safe market rate of interest is now too low, relative to where it should, or could, be. The "natural rate of interest" has not fallen. For more detail, see this post, point #1.

Krugman thinks economists and policymakers (past and present) are subject to "conceptual confusion." According to him, there are three facets to this:

1. Krugman is worried that people think he is being inconsistent (see my previous post for example). How can the Reinhart-Rogoff regularity (extended recovery after a financial crisis) be a regularity, and also represent an opportunity for Keynesian policy? Here's the heart of Krugman's argument:
...there are simple policy actions that could quickly end this depression now, there were simple policy actions that could have quickly ended depressions past. The problem is that now and then policy makers tend not to take these actions — which is why some of us write books.
A simple and quick solution is at hand. Easy. To buy this argument, you have to think that Krugman is really really smart, and the remainder of the human race is really really stupid. There are plenty of economists - with and without Nobel prizes - who don't think the solutions are easy.

2. Demand/supply and bubbles:
Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much — and we can’t expect those people to return to past spending habits.
What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

But the bubble component of housing prices after, say, 2000, does not appear to have been entirely a good thing, as it was built on false pretenses. Various kinds of deception resulted in housing prices - and prices of mortgage-related assets - that, by anyone's measure, exceeded what was socially optimal. As a result, I think we can make the case that pre-2008 real GDP in the US was higher than it would have been otherwise. Further, the housing-market and mortgage-market boom could have masked underlying changes taking place in US labor markets - for example David Autor's "hollowing out" phenomenon. One could argue that there was a cumulative effect in terms of the labor market adjustments needed, and that these adjustments took place during the recent recession, and are still taking place. See for example this paper by Jaimovich and Siu. That's why all the long-term unemployed. So that's not some confusion. People are talking about alternative ideas that have some legs, and may have quantitative significance. Why dismiss them?

3. Sectoral shifts:
One last point: we still keep hearing the “structural” argument, that we have to expect prolonged high unemployment because it takes time to turn construction workers into manufacturing workers or whatever. One answer is that this portrait of the economy is factually wrong: job losses have not been concentrated in a few sectors or professions, they have been broadly spread across the economy. But there’s also a conceptual answer: if shifting workers across sectors requires mass unemployment, how come the bubble years — when we were moving out of manufacturing into housing — weren’t high-unemployment years? Why does moving into the bubble sectors mean more jobs, but moving out into other sectors mean fewer jobs? I’ve never heard a coherent answer.
Answer: If you're not listening, you can't hear. There is plenty of unusual behavior in the recent labor market data: (i) the jobless recoveries that Krugman highlights here; (ii) the large drop in employment relative to output in the recent recession; (iii) the abnormally large fraction of long-term unemployed. One element of unusual behavior is the failure of residential construction to lead the recovery. David Autor and others (as mentioned above) have highlighted the recent shift out of middle-skill occupations. There is plenty here for any labor economist or macroeconomist to sink their teeth into. How do you tie together the financial crisis, the shifts in employment across sectors, and the changes in the skill mix? It's well-known that sectoral changes have macroeconomic consequences - economists have been discussing this at least since the early 1980s.

So, there is a lot going on. If we want to think of our current predicament as an aggregate demand management problem, we're missing all or most of what is important. It's certainly not simple, but it's a lot more interesting than an IS-LM model.

45 comments:

  1. "The safe market rate of interest is now too low, relative to where it should, or could, be."

    I dread the fact that I'm going to inevitably have to spend who knows how many hours deciphering some paper(s) explaining the "interest rates are really too low" argument, but I'll try just asking:

    Is the problem that other assets are just too unsafe, or considered too unsafe, and that's why their interest rates are not low – so if you just raise the rates on the government assets that are considered safe that will do nothing to address the lack of perceived safety of the other assets, and just push the rates of those other assets even higher, making it even more expensive and prohibitive for companies to start new projects.

    Raising government interest rates is going to do nothing to make other assets safer for investors. It's going to do nothing to create more safe assets.

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    1. "Raising government interest rates is going to do nothing to make other assets safer for investors. It's going to do nothing to create more safe assets."

      I think you can understand this part. If you create more safe assets (that's supply, right?) the price goes down, and the interest rate goes up.

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    2. Ok, the government can create lots more safe assets by selling government bonds. This will give investors all the safe assets they want, and the price of safe assets will go down, and their interest rate will go up.

      But, this won't do anything to make the non-government assets safer. This won't do anything to make the bonds of a private company worth more, to make their interest rates less, so more projects will clear the hurdle rate, so more projects will get funded, so more people will get hired to work on new projects.

      If anything it will do the opposite, by diverting a lot of money out of the economy, and driving up the hurdle rates for private business projects, so less are launched.

      So, how exactly is this supposed to help the economy – as opposed to hurt it?

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    3. Interesting point!

      I believe the intuition here is to change the behavior of people who'd rather *hold cash* than invest in corporate bonds. The basic idea is the offer them something as safe as cash (government debt) and then funnel the money they spend to buy these bonds into government spending. You are certainly correct that this also gives the folks who *wanted to buy corporate debt* a better alternative than cash! I guess the thinking there is that all spending (private or public) is equal, so diverting this money will do no damage.

      I believe the overall recovery that Krugman and company are hoping for involves getting this government spending into the hands of currently no/low income workers and giving them a way to pay down their debt. The hope is that once their debt levels get low enough, they will start spending on consumption. This will get more businesses interested in investment. And the government slowly backs off from it's deficit. The government has sorta spun a new spending whirlwind into place.

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    4. Stephen, isn't this just upside down semantics, similar to Scott Sumner's "loose" and "tight" monetary policy?

      You're saying the government should issue more debt until the interest rate rises? Doesn't the interest rate rise in response to inflation?

      How is this different than regular old Keynesian and monetary policy other than you being agnostic on government spending vs. tax cuts and skeptical that a "natural" rate can be quantified?

      Krugman's saying we should increase the deficit now by issuing more debt and the market's telling us this by buying our debt at negative real rates. And that this combined with monetary policy will push the inflation rate higher, which in turn will push up interest rates.

      How is what you're saying different?

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  2. Stephen,

    The safe market rate of interest is now too low, relative to where it should, or could, be. The "natural rate of interest" has not fallen.

    Note that this implies that there is gap between the two interest rate values that needs to be closed. That sounds very similar to closing the output gap view. You and Krugman may be closer than you realize.

    Also, I think a better way of framing this is that the short-run natural rate of interest is below the long-run natural interest rate. The long-term natural interest rate is based on expected trend productivity growth, time preference, and labor growth as found in a standard growth model. The short-run natural rate reflects temporary deviations from the trend values due to certain shocks and is equivalent to your safe asset interest rate. The spate of bad economic shocks (financial crisis, budget ceiling crisis, Eurozone crisis, etc.) over the past four years has pushed the short-run natural interest rate below its long-run value.

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  3. "Also, I think a better way of framing this is that the short-run natural rate of interest is below the long-run natural interest rate."

    No, you haven't understood. That's wrong.

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    1. You argue real returns are "too low" due to demand from agents that intermediate safe assets. Can you explain what you mean by that? It implies agents facing paltry real returns are reluctant to finance real economic activity. They are being effectively "crowded out" by preferred habitat (safe asset) investors.

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    2. Stephen, I do understand what you are saying but see you making a distinction without a difference. Your story is that the financial crisis has destroyed many safe assets and thus increased the price and lowered the yield on the remaining safe assets to an inordinately low level.

      The very reason, however, that formerly safe assets were destroyed in the first place is because of massive shift in investors preferences toward safe assets. It was this shift that disrupted financial intermediation and destroyed formerly safe assets. And that shift is effectively the same thing as increased in desired saving and/or a decrease in desired investment. So again, a difference without a distinction.

      The bigger point, however, that I would like to hear your response on is the implication of your view that the safe asset interest rate is below where it should be. That sounds like you are saying there is some kind of some kind of gap to close. In the past you have talked about the government issuing more safe assets as a solution. Is this the point here? If so, then does this not imply there the economy is operating below its capacity?

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    3. This is an interesting debate. I want to see some blog posts about this! What does the "natural rate of interest" really mean, and what are the constraints on its behavior?

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    4. Noah,

      Here is a good intro article into the natural interest rate. What I call the long-run natural interest rate the authors call the "long-run real equilibrium rate", and what I call the short-run natural interest rate they call the "neutral real interest rate".

      http://www.norges-bank.no/upload/62923/ec_bull2_07_neutral_real_interest_rate.pdf

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    5. David,

      "The very reason, however, that formerly safe assets were destroyed in the first place is because of massive shift in investors preferences toward safe assets."

      No. You have the causation going the wrong way.

      Noah,

      "What does the "natural rate of interest" really mean?"

      Woodford likes this notion, but I'm not sure it's useful, just as the "natural" rate of unemployment is not so helpful. People seem to want some summary statistic that will tell them if an inefficiency exists. Good luck. The funny thing is, you can find plenty of people who will quote you a number for the natural rate of unemployment (Kocheralakota says it's 5.5%). The natural rate of interest seems important to some people, but I've never seen an estimate.

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  4. "You argue real returns are "too low" due to demand from agents that intermediate safe assets."

    No, safe assets are scarce. That's supply.

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    1. "The safe market rate of interest is now too low, relative to where it should, or could, be."

      I don't understand.. If there is a shortage/excess demand for safe assets, that would imply their PRICE is too low which would imply their real rate of return is too high no?

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    2. No. If there is shortage, the PRICE is too HIGH.

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  5. This is just wrong. Draw an s&d diagram with a price ceiling. A shortage is an excess demand - people want to buy more than there is that exists. Which means the price is too low.

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  6. If a shortage implies the price is too high.. how would lowering the price induce suppliers to produce/supply more and get rid of the shortage?

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  7. "Draw an s&d diagram..." Then shift the supply curve left.

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  8. A shortage is an excess demand by definition. what you describe is an equilibrium with a smaller supply not a shortage. In which case the rate of return you are describing is the market clearing rate and so is not "too" anything, high or low. If there is a "shortage" because rates don't equal their market clearing levels then it must necessarily be a price that is too low/a rate that is too high.

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    1. I'm not suggesting that financial markets don't clear.

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    2. Then that's fine. You agree there is no shortage. Everyone who wants to hold safe assets at the market clearing interest rate does hold safe assets. So the safe market rate of interest is not "too low". It is infact at it's "natural level" which has declined. Now if for some reason, say a ZLB, the nominal market price is prevented from adjusting upwards then the expected rate of deflation exceeds the real rate of interest and there will be an excess demand for safe assets. The argument Krugman etc. make is that in this case the expected price level is the adjustment variable that equilibrates.. making the natural rate you describe and the market rate equal. But what you are describing is how the natural rate changes.. It is not an explanation of any "shortage"

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  9. If you manage to refute FF, instead of just repeatedly saying he/she's wrong, I'll be impressed. A shortage of safe assets is equivalent to a glut of funds chasing safe investments. If there is a glut of funds, lowering the cost of funds clears the market. Period. What else could you have in mind?

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    1. 1. The market clears.
      2. Shift the supply curve, not the demand curve.

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  10. Stephen,

    If the supply of safe assets shifts to the left, then shouldn't the price adjust to clear the market? What's keeping the market from getting to equilibrium, and is maintaining the excess demand? Are you saying there is a government price control or price stickiness?

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    1. My guess here is that the demand for safe government bonds immediately moves gov bond prices to a higher equilibrium and their interest rates to a lower equilibrium ,as you and Ram and FF say.

      But the return the government can earn on safe projects is unchanged (or hasn't fallen that much).

      So why isn't the government issuing more debt in order to start on these projects, thus arbitraging away the difference between cost of funding and return on capital? Why hasn't it issued as much debt as it could have?

      The core problem is that there are profitable opportunities not being exploited. There is some sort of "gap". Perhaps the government's monopoly on various sectors is to blame as it prevents others from taking the bull by the horns.

      I think Steve has talked about some of these things in the past, but I may be putting words in his mouth.

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    2. The market clears. Shift the supply curve to the left. What happens?

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  11. "The "natural rate of interest" has not fallen. For more detail, see this post, point #1."

    Why do you put the term natural rate of interest in scare tags? You did the same with the phrase Wicksellian rate in point #1 of the post you link to.

    Do you have a better word? Or do you have problems with the underlying concept that the phrase "natural rate of interest" is supposed to represent?

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    1. I'm not particularly fond of the concept.

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    2. 1. There is no single summary measure of inefficiency.
      2. How do you measure it?

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  12. Doc at the Radar StationOctober 21, 2012 at 8:19 PM

    This makes sense to me. The government (i.e.) needs to increase the supply of safe assets by issuing more debt and doing something productive with the proceeds (bridges to somewhere). When the interest rate on safe assets, for example 10-year treasuries, rises above 4%, then issue less debt. Have I got it right?

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    1. "...doing something productive with the proceeds"

      Whether the government should be spending more, and if so, on what, are other issues. You can increase the quantity of government debt by reducing taxes. The difficulty is that the problem is temporary, and you want a temporary increase in government debt. This requires more dexterity than the fiscal authority in the U.S. is capable of.

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    2. Doc at the Radar StationOctober 22, 2012 at 5:09 AM

      The government could send out "stimulus checks" every quarter until the 10-yr US treasury hits 4% (or some other number). Then it would be: 1) Temporary and 2) Spending discretion would be with individual citizens.

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  13. Gov’t bonds are safe assets, but mean more wasted gov’t investment in boondoggles like Solyndra.
    What is the ROI of gov’t investment? (What is the difference between gov’t spending and investment?)

    Company “safe assets”, or AAA rated paper (=financial products), mean more company investment, and more production in the economy. What is the ROI of company investment?

    The problem, which is not simple to solve no matter what bozo Krugman says (nor is it solved by Sumner’s NGDP target), is that entrepreneurs are not finding US investment opportunities that they are willing to risk their time & assets investing in — because they don’t see high ROIs.

    Also, there has been a huge reduction in Net Worth — a key, mostly non-modeled part of “money”. Important for buying decisions.
    People who make $100,000/yr, with a $800,000 house and equity of $400,000 will, for example, go pay for a haircut every 3 weeks or so. In the pre-2006 house price bubble times.
    After a 25% house price drop, they make $102,000 (2% raise in 2 years!), but with only $200,000 in equity in the same house which is only worth $600,000.
    Now they pay for a haircut every 5 or 6 weeks.
    And they reduce their optional spending in other small ways, too — only 2 weeks of summer vacation instead of 3, keep the car a year longer, fewer new clothes.

    The “only” way back to the (unsustainable) 1995-2006 trend is to both increase Net Worth (back to 2006 level) AND increase the expected Net Worth trend (cannot now happen).
    So, no way back to that trend.

    The 1995-2000 dot.com bubble & pop was hiding and partially substituting for housing bubble. After that dot.com pop, there was an investment move to more “real” assets, like real estate and MBS & CDS & CDO based on MBS.

    A “bubble” is a trend that is unsustainable, yet decisions about the future are being made as if the trend will continue.

    How sustainable is the Greek gov’t spending, gov’t borrowing trend? What is the “long term natural rate” of interest? Economists should be talking about the sustainable rate of gov’t spending, and the market interest rate at that gov’t spending level. Talking about gov’t influenced interest rates separately from gov’t spending/taxing rates is much easier, but too simplistic.

    The Greek gov’t is not on a sustainable trend.
    The US gov’t might not be, either.

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    1. "Company “safe assets”, or AAA rated paper (=financial products), mean more company investment, and more production in the economy."

      Yeah, mortgage-backed securities were also AAA rated once, and we see how well that worked out. This is not to say that I approve of the government playing the role of venture capitalist (Solyndra), but not every government investment is unproductive, and not every private investment is. The problem with Greece is not (only) that it borrowed too much, but rather that it borrowed for the wrong reasons and gave away its ability to print money without first addressing its debt problem.

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  14. Steve
    A few comments and questions:

    (1) Please provide me with a model that (with the parameters and assumptions) that gives me the "fundamental" value of : (a) a 500 sq ft. apartment on the Upper West side of Manhattan, built this year. (b) the price of 10-year American style put option on (lets keep this interesting) on AAPL, struck at-the-money spot. Same requirements (parameters, assumptions etc) apply.

    (2) "Fundamental Value" means different things and values to different people. Price deviations from these theoretical values occur all the time (which gives rise to trading) and are not necessary to imply a bubble.

    (3) Maybe you are surrounded by too many right-side-heavy many bubble heads.

    (4) Lastly (not that any defense is needed) Krugman has actually been extremely accurate in his characterisation of the economy, inflation and rates in the last 4-5 years. You have not. So until you do, bow down low from your waist and s-t-fup about Krugman.

    (5) any number of people can solve pde's etc etc.(yes even I can ! :-) ) but only a precious few have true insights like Krugman. Your point of departure is the same hackneyed right-wing supply side canard that can never stand up to even a mild scrutiny.

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  15. It seems to me that the market for financial assets only clears because the central bank makes a promise to produce an artificial scarcity of base money in the future, once the "asset shortage" has passed. Absent such a promise (and absent nominal rigidities), there is no reason that the market-clearing real interest rate couldn't fall far below negative 2% when safe assets are hard to get. (For example, if we had a commodity currency and prices/wages were flexible, the real value of money in terms of current goods could rise far above its expected future value, allowing financial assets to offer arbitrarily low real yields.) But the Fed has a 2% target inflation rate, which is essentially a promise to constrict the supply of base money in the future, leading a lot of agents who would otherwise want to hold scarce financial assets to forego them in favor of base money. By targeting the inflation rate, the Fed is essentially saying, "Stop trying to buy bonds. Instead, hold this base money we produce. We promise we'll buy it back from you in the future (if nobody else does) at a price that gives you an effective yield of negative 2%." And this way people do stop trying to buy bonds, and the market for bonds clears at a price that is artificially depressed by the Fed's promised intervention. Doesn't this promise distort markets?

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    1. It does distort markets. But when we're already in a second-best environment due to lack of commitment (which is why we don't have enough safe assets) then distorting markets is not necessarily bad.

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    2. Andy,

      I can't get past your first sentence. Do you think that financial markets don't "clear" unless the central bank makes particular promises?

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    3. Normally, when there is a binding price constraint, it causes a market not to clear. In this case, as it happens, the central bank's promise both imposes the constraint and changes the demand curve in such a way as to allow the market to clear in spite of it. There are conceivably other ways to impose the constraint (e.g. the government could refuse to enforce bond contracts with a real yield less than -2%) that would not affect the demand curve and therefore would cause the market not to clear. However, given that the constraint is imposed, the central bank's promise is necessary to clear to the market.

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    4. "...when there is a binding price constraint"

      What is the binding price constraint in this case?

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    5. Consider a 1-year zero coupon bond worth 100, in real terms, at maturity. A 2% inflation policy imposes a constraint of P <= 102 in real terms.

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  16. I am a bit surprised that the European crisis has stayed out of the discussion of why the recovery has been so slow.

    I am also surprised with the cult-like behavior of Som Dasgupta and other Krugman followers. Pathetic!

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