What is Dead can never Die: American Austerity Edition

Yesterday, Sir Mathew Yglesias proclaimed that "2014 is the year American austerity came to an end"

Which kind of cracked me up. I guess the syllogism is (1) we had austerity, (2) austerity hurts growth, (3) growth picked up in 2014. (4) Therefore Austerity is over.


Here's the data series from 2000 through q3 of 2014 (and it's the same data Matt is using):

From this graph I concluded one of two things must be true depending on one's definition of austerity.

Either austerity means nominal cuts and we never had any of it, or austerity means cuts relative to trend and we are still savagely in its grasp.

Relative to the 2000-2009 decade trend, total government spending is roughly 35% lower in q3 of 2014 than it should be. Hard to say austerity is over by that metric.

When I tweeted this at Sir Mathew, he responded that it "seemed like semantics". One of us, and it could easily be me, does not know what that word means.

Tip-ped over

I know people, I'm the economics professor. I'm supposed to give answers instead of ask questions, but I'm afraid that all I have here is questions. Read on if you dare.

The 10 treasury bond is yielding around 1.7% (none of what follows relies on the exact values of the numbers).

The 10 year TIPS yield is around  -.7%.  So a common calculation of inflation expectations, so called break-even inflation is at 2.4%.

From this information, I arrive at two important (at least to me) questions:

(1) Is this a reasonable measure of inflation expectations and (2) If so, what does it mean about the economy?

I question (1) because of concerns about the lack of liquidity in the TIPS market, the old issues of market segmentation, and just generally because equilibrium conditions in financial markets that aren't enforced by pure arbitrage don't actually seem to hold in the data.

I did a bit of research and found a couple Fed branch bank papers on the topic (see here and here).  Both papers conclude (if I am reading them correctly) that the break-even inflation calculation of inflation expectations probably understates expected inflation!

So that leads to question 2. If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high? 

If inflation expectations at the 10 year window are rising, but returns on 10 year treasuries are simultaneously falling, then the equilibrium real rate of interest on safe assets is getting lower and lower (in our case more and more negative).

Does this mean that 4 years after the crisis, people's willingness to undertake risky investments is actually falling? If so, isn't that a very bad sign for the direction of future economic activity?  The Baa seasoned bond yield is 4.9%. If inflation expectations are 3%, then the real return to capital is 1.9%?

Or does it mean somehow that the supply of safe assets is shrinking faster than the demand for safe assets is falling? Can we just blame Europe?

 

Or are we just making a big mistake in calculating inflation expectations?

 

 

The Devil is in the Details

Monetary economics superstar M. Woodford has made a big splash with his 97 page opus belittling the Fed's QE moves and calling for (more or less) NGDP targeting.

Here's Krugman on the paper.

There are three big problems with Woodford's approach. (1)The macro model he uses to produce his results, (2) his assumption that the Fed can commit to anything not in their period by period best interest, and (3) the way he completely ignores real political constraints faced by the Fed.

Let's talk about each of these.

The Model:

 It is laid out in Eggertsson & Woodford (2003).

First off, here are a few quotes from the paper:

For simplicity we shall assume complete financial markets and no limits on borrowing against future income.

Our model abstracts from endogenous variations in the capital stock, and assumes perfectly flexible wages (or some other mechanism for efficient labor contracting), but assumes monopolistic competition in goods markets, and sticky prices that are adjusted at random intervals in the way assumed by Calvo (1983), so that deflation has real effects. We assume a model in which the representative household seeks to maximize a utility function

Real balances are included in the utility function, following Sidrauski (1967) and Brock (1974, 1975), as a proxy for the services that money balances provide in facilitating transactions. 

 The paper presents no evidence that the model is consistent with the data, no evidence that it is capable of producing the kind of economic situation in which we currently labor, no evidence that it has any kind of forecasting power.

All conclusions about policy drawn by Woodford are contingent on the maintained assumption that the underlying model of the economy is correct. And we know that it decidedly is not!

Can the Fed commit?

I am a broken record on this subject, but in its current configuration, there is no way the Fed can credibly commit to an optimal but time-inconsistent policy.  The forward guidance / NGDP targeting solutions require the public to believe that the Fed will continue to tolerate inflation higher than they would like AFTER THE ECONOMY RECOVERS. Krugman put it best when he said the Fed must credibly commit to behave irresponsibly!  They can't because there is no mechanism that forces them to deliver the policy after the economy actually recovers.

All we can ever hope for from the Fed in its current configuration are time-consistent polices. Woodford's is not.

Here's Krugman again, giving a not technically correct but yet informative explanation of the problem:

What Mike demonstrates is the point that liquidity-trap worriers have been making for a long time – actually, ever since my 1998 piece. Current monetary policy is indeed ineffective in a liquidity trap; but there is still scope for central bank action in the form of credible commitments to keep monetary policy easy in the future, when the economy is no longer at the zero lower bound. The trouble is how to make those credible commitments. 

Actually, it’s a two-stage problem. First you have to convince the central bank itself that it’s a good idea to signal that you won’t return to normal policy (say a standard Taylor rule) as soon as the economy lifts off from the liquidity trap; then you have to convince the private sector that the central bank will not, in fact, just revert to type once the crisis is past.

There's even a third problem. There's no way to convince the private sector that the Fed won't simply revert to type because when the time comes, the Fed will have no incentive not to revert to type!

What about Politics?

Suppose by some amazing coincidence that Woodford's policy conclusions would also follow from the true model of the economy. Suppose also that we can just dismiss all the literature on time inconsistency by commanding the Fed to "just do its job". We still have the problem that the Fed is not independent of politics.

Romney has already said he wouldn't re-appoint Bernanke. There's at least a .4 chance he'll be President. What hope would a Fed have of running a loose policy after the economy recovers in an all Republican government?

The Republicans control the House now. The Republican party seems to be flirting with a return to the Gold Standard! And the Fed is gonna announce, oh, we're gonna keep rates at zero even after the economy recovers?

The Fed has bosses. A sizable fraction of those bosses will never sign off on the kind of polices Woodford advocates. They would be doing so for the wrong reasons, but those ignorant gold-bug bosses would actually be extremely likely to be right.

LeBron speak with forked video on macro

I've never seen anything like this before.  LeBron dishes on different macro-economic theories.

The thing is, the video is itself hyperlinked.  So, you can click WITHIN the video to go to any of the four embedded videos, and then return to the top.

Plus, the explanations are really good.  I just can't get over how much Tyler sounds like John F. Kennedy in inflection and accent, though.

The ZLB is floor not a ceiling

Again and again I see the economy's problem described along these lines:

"At the ZLB (zero lower bound), the real interest rate is too high to get us to the optimum. The nominal interest rate cannot fall any further by definition. So to get to the optimum the expected rate of inflation must rise."

Those are Simon Wren-Lewis' words (they appear in a comment at the link), but Krugman and many others tell roughly the same story.

As always, I have questions.

In the IS/LM framework many (not Wren-Lewis) are using, doesn't this mean that we are getting "growth" by firms investing in projects with a negative NPV now made profitable by an even more negative discount rate?

Second, how is that inflation expectations rise and the nominal interest rate remains unchanged?

From Fisher, we think of the nominal rate as the required real rate of return plus a premium to offset expected inflation. So it's hard for me at least to think about expected inflation doubling (from 1.5 to 3 percent) or tripling (from 1.5 to 4.5 percent) without the nominal rate rising. For that to happen the required real return would have to fall one for one with the rise in expected inflation.

In other words, the ZLB is a floor, but not a ceiling.

Is the upcoming election holding the Fed back?

The US economy is going nowhere fast. Growth is low, unemployment is high and inflation (core and headline) are falling below 2%, re-kindling worries about deflation.

But the Fed is sitting pat. Sure they've done a lot in my view. Dropped rates to zero, promised to keep them there a while, pumped trillions of reserves into the system, ran a couple rounds of quantitative easing and don't forget about "operation twist". Nor do I have much confidence that, at this point in the proceedings, monetary policy is capable of a miracle cure for the economy.

But holy spumoli people, don't they have to do something? Sure they do; they're the Fed, dammit!

Bernanke can't keep saying that the Fed is not out of ammo but never fire the gun. The Wolfersons are KILLING him!

Could it be possible that the Fed does not want to be seen "goosing" the economy in the run-up to the Presidential election?

Might the Fed be guarding its vaunted "independence" by avoiding any actions that could be considered politically motivated?

Will we see QE3 or a higher inflation target on the first Wednesday in November?

I think this has to be a factor in the Fed's decision about the timing of further action. Things may worsen enough for them to feel they have to act no matter what, but I think they may be trying to muddle through with the status quo until after the election.

Tell me why I'm wrong in the comments.

Another sh*&^y jobs report

Wow. 80,000 net new jobs in June. The last three months (after revisions) now come out to 68,000 - 77,000 - 80,000 and that "trend" is not going to help anyone anytime soon. As Mungo noted, job growth needs to almost triple for unemployment to significantly fall.

People, an infrastructure bank is not going to fix this. QE III is not going to fix this. Retroactive NGDP level targeting is not going to fix this. Tax increases are not going to fix this.

This morning Twitter is again ablaze with calls for the Fed to "finally" act.

Remember this is a Fed that has already kept its policy rate at nearly zero for multiple years and promised to do so until late 2014. A Fed that has vastly expanded its balance sheet pumping trillions of new reserves into the system. A Fed that has already engaged in a couple rounds of quantitative easing.

I believe that at the core of the calls for the Fed to act is a desire for higher inflation. Sure, that's fine with me, lets give it a try. But I don't think running inflation at say 4% is going to be a magic bullet.

Are there still nominal contracts that haven't yet been expired, adjusted or abrogated 4 years into this mess?

Can inflation double and nominal interest rates stick at their current rates? Will the Fisher effect really be neutered?

Even if real rates become a bit negative, will firms really start to make massive investments in projects they would expect to be unprofitable when discounted at zero percent or one percent?

When people call for the Fed to finally act or accuse Bernanke of dereliction of duty ask them this question:  What can the Fed do that will fix this mess, how exactly would the policy action be implemented and by what mechanism would it effect the cure?

And if their answer is that merely adopting a new policy target will cause an expectational change that fixes the mess?

RUN!!!

Angus impossibility theorem

Here it is:

There is no such thing as a purely micro-founded macro model that is actually useful for forecasting.

The original RBC models were, more or less, purely micro-founded models. But, they didn't track anything. They could match some unconditional moments, but couldn't replicate realistic dynamics.

People, we don't even have very good micro foundations for money! We just put it in the utility function or arbitrarily assume a "cash in advance" constraint. That's one reason why the original RBC models didn't even contain money.

Amazingly to me, Central Banks in the Western world have spent a lot of money and economist-hours trying to construct dynamic stochastic general equilibrium (DSGE) models that are actually useful for forecasting.

This effort has largely led to the de facto abandonment of micro-foundations. In the quest to make the models "work" we often either choose whatever micro-foundation that gives the best forecast regardless of micro evidence about whether or not it is accurate, or we just add ad hoc, non-micro-founded "frictions" to create more inertia. Or we just add more and more "shocks" to the model and say things like, "much of the variation in X is caused by shocks to the markup".

So macro has to live in this weird world where, to correctly evaluate policy changes and welfare, we need to use fully micro-founded models that we know do not track reality, and to track reality, we need to come perilously close to giving up on micro-foundations altogether.

No wonder we are so often in a bad mood!

The mysterious recession, take II

Yesterday I claimed that the behavior of the US economy in our current recovery is, contra Matt Ygelesias, "mysterious", in that we have not seen the common "v-shape" or recovery to the original trend.

Ace commenter John Thacker pointed out that Greg Mankiw (and others) have argued that macro aggregates have a unit root and thus reversion to a fixed trend is not to be expected.

I don't want to get into a big discussion about the power of unit root tests here, so let me show a picture (from the blog Calculated Risk) that illustrates what I was trying to say (clic the pic for a more glorious image):

The graph shows job losses in the recessions since WWII. All but the last three could be reasonably described as "sort of V shaped" and except for them, time to recovery seems almost independent of the severity of the recession. Our current situation is notable both for the severity of the job losses and the extreme slowness of the job market to recover.

Most Excellent

What a tremendous premise! Axel Leijonhufvud interviews Friedrich Hayek. The incomprehensible takes on the increasingly obscure. Who wins? Judge for yourself.

Best part was where FAH insisted that Axel call him "Slash." (Okay, that didn't really happen). (But it would have been cool.)

Larry King, guest blogger

"Here's my problem with nominal GDP targeting; 5% inflation with 0% growth and 1% inflation with 4% growth are not evaluated any differently."

"Now that a judge has ruled against Obamacare, what will happen to the quantitative easing?"

"The Ben Benank should either shave or resign."

Heads I win, tails you lose

I am a little bit confused about Fed policy evaluation 101. I seem to be flunking that course.

Quantitative Easing II was supposed to lower long term interest rates. That was the stated goal of the policy.

Long term interest rates have been steadily rising (even before the latest borrowing binge announcement).

Yet many people say that the fact that rates are rising MEANS QE II is WORKING!

(here is one example)

As my good friend Doug Nelson likes to say, "you have to be a very highly trained economist to come to that conclusion".

Now maybe the Fed is playing the long con and deliberately misinformed the public about the true purpose of their policy. Could you see the Ben Bernank announcing "We want to raise inflation expectations and long term interest rates"?

I think that they actually expected to lower long rates and the episode should be viewed as an example of the idea that the further out in the term structure the Fed aims, the less control they actually have over rates.

I guess there are two kinds of people in this world; those who think the Fed is always wrong and those who think the Fed is always right.

Why didn't I think of that?

In today's NY Times, Christy Romer solves our economic problems:

"The Federal Reserve, Congress and the president need to reaffirm that they will do whatever it takes to restore the economy to full health... They should follow up with powerful fiscal and monetary actions to create jobs — coupled with a concrete plan for tackling our long-run budget problems."

Look, I know the Times only pays $1,000 per column, but this has got to be a joke, right?

What exactly are these mysterious "powerful" policy actions and why didn't the government try them when Dr. Romer was head of the CEA?

Good grief!

life in an alternative universe

Brad Delong says this:

Thus, I would confidently lecture only three short years ago that the days when governments could stand back and let the business cycle wreak havoc were over in the rich world. No such government today, I said, could or would tolerate any prolonged period in which the unemployment rate was kissing 10% and inflation was quiescent without doing something major about it.

I was wrong. That is precisely what is happening.

People, what has the government done?

Let's see, there's the TARP, the Stimulus bill, the GM bailout, the Fed buying mortgage backed securities, cash for clunkers, the Fed pushing short rates to effectively zero, the credit for homebuyers, the extension and re-extension of unemployment benefits, a big deficit financed increase in discretionary spending (aka last year's budget), and now the Fed has commenced QEII.

Nothing "major"? Really?

It's kind of an interesting syllogism at work here. (1) The government can always control the state of the economy, (2) the economy is still bad, therefore (3) the government has not actually attempted to control the state of the economy.

If only there was a term for this kind of thinking!

"Has the Ben Bernank ever run in an election?"

No but he has a nice beard!

People the first three minutes of this video are pure gold:

My old Macro professor goes off on QE backlash

An altogether excellent (and self-admitted) rant by Larry Meyer.

Here's my favorite bit:

What about the Asian economies, including China, which complain that the Fed is contributing to asset bubbles around the world?

The real question we have to ask is why FOMC policy is affecting asset prices abroad: The answer is that the Asian economies competitively intervene in their exchange markets to manipulate the value of their currencies! As a result, they cannot have independent central banks. They are, therefore, importing U.S. monetary policy. Is that policy right for them? Hell no!

How should the FOMC respond to these countries? The Committee should say: You have no one to blame but yourselves. Hasn’t the U.S. government already advised you to float your currencies and not intervene? With respect to China, by the way, wouldn’t an appreciation of the renminbi be just what the doctor ordered? Isn’t just what’s needed to restrain inflation and aggregate demand?

What should Asia be saying to the Fed? Thank you! Please keep the U.S. economy out of a recession that could greatly threaten the global recovery.

So much win! Oh and by the way Asia, you're welcome!

Outsourcing

I feel weird when I link to blogs far more popular than KPC. Most of our readers probably already follow Tyler and Interfluidity. But they both have excellent posts up about our current economic situation and the policy options we face. You people should read these posts so I am linking to them here.

Here's Tyler's post and a teaser:

Still, QEII may do some good. Money matters, even if we don't always understand how or why, and excessively tight money has never done market-oriented economics any favors. Think of QEII as a make-up for some earlier monetary policy mistakes. Some of the relevant alternatives include a trade war with China or direct government employment of the unemployed and with what endgame? QEII is not some terrifying burst of potential hyperinflation.

Here's Interfluidity's and a teaser:

But the thing is, human affairs are a morality play, and economics, if it is to be useful at all, must be an account of human affairs. I have my share of disagreements with both Krugman and DeLong, but on balance I view them as smart, well-meaning people who would do more good than harm if they had greater influence over policy. But they won’t, and they can’t, and they shouldn’t, if they exempt themselves from the moral fray. One of the stereotyped insults economists throw at one another is that a piece of analysis is “partial equilibrium”. The phrase is shorthand for coming to a conclusion based on assumptions that could not survive the circumstances under which the conclusion would obtain. I don’t want to single out Krugman and DeLong, but technocratic economists in general engage in partial equilibrium social science when they ignore moral concerns and the constraints “legitimacy” places on feasible policy.

I would add to the last sentence above that it's also problematic to ignore political constraints as well.

The Krugman gambit

Paul seems to only have one card these days, but he does play it very, very well.

It's the "nothing is ever enough card" and he got it out again in Sunday's NY Times.

The way it works is this:

(A) Lobby for any and all expansionary policies.

(B) Then, when an expansionary policy get proposed or enacted, pitch a fit and say that it's way too small and will never work.

(C) When said policy doesn't work (which of course could well be because the policy is bogus) scream "I told you so" over and over at the top of your lungs.

Was the "problem" with the stimulus bill simply that it was too small as Paul claims? Or was it that a temporary burst of government spending no matter how large is not going to come close to curing an economy that is suffering from a severe real shock/wealth loss?

One thing that's for sure as a matter of simple logic is that the fact that Paul said "it's too small", doesn't prove at all that's why if failed. Yet people (and Paul) often act as if it does.

Now he's pulled the same gambit with QE II, a policy that's unlikely to "work" no matter what size is chosen.

Well played, sir. Kudos!

Macro and the non-economist

After playing tennis with a non-economist friend yesterday, he asked me how can macro have two completely different schools of thought which seem to differ even on the basics. I told him that, at the op-ed level, macro had a lot of ideology and politics in it and there were more than two schools of thought!

He then asked how it could be the case that when people look at the same data, they don't arrive at the anything near the same conclusion. He said that it was irritating and frustrating to see constant disagreement by economists over macro issues

I told him two things.

First, there isn't really that much data! Since world war two we are working on what, our 10th business cycle?

Second, macro is largely a non-experimental science thus causation was a b*&#ch to figure out and counterfactuals were in short supply.

I also told him that op-ed level macro wasn't generally serious academic macro (though some of it is).

And he asked me what serious academic macro had done vis a vis predicting the meltdown.

I told him, "very little".

I then told him macro forecasters are like weatherpeople, the worse we do and the worse things get, the more they are in demand. I don't think he was too impressed.

I don't fault modern macro for not predicting the financial meltdown; to me thats a borderline silly complaint.

I do think though that op-ed level macro is often not doing the profession any favors in its quest to be viewed as a science.

My old Macro professor goes Medieval on Modern Macro

Larry Meyer:

"There’s also another tradition that began to build up in the late seventies to early eighties—the real business cycle or neoclassical models. It’s what’s taught in graduate schools. It’s the only kind of paper that can be published in journals. It is called “modern macroeconomics.”The question is, what’s it good for? Well, it’s good for getting articles published in journals. It’s a good way to apply very sophisticated computational skills. But the question is, do those models have anything to do with reality? Models are always a caricature—but is this a caricature that’s so silly that you wouldn’t want to get close to it if you were a policymaker?

My views would be considered outrageous in the academic community, but I feel very strongly about them. Those models are a diversion. They haven’t been helpful at all at understanding anything that would be relevant to a monetary policymaker or fiscal policymaker. So we’d better come back to, and begin with as our base, these classic macro-econometric models. We don’t need a revolution. We know the basic stories of optimizing behavior and consumers and businesses that are embedded in these models. We need to go back to the founding fathers, appreciate how smart they were, and build on that."

Full interview is here.

Obviously many Central Bankers disagree with Larry as the Fed and the ECB and the Central Bank of Canada are heavily invested in DSGE modeling.