Here We Go Again: How Much is Too Much?

This comment is going to leave me subject to a lot of criticism because it (a) defies conventional wisdom, and (b) currently evokes strong feelings in a specific direction. Nonetheless, I am going to proceed anyway. Tyler Cowen writes:

I see two big and very real problems: slow income growth for many income classes and a problem with excessively high returns to finance at the very top.

This isn’t really about Tyler, but rather about the fact that he is among a group of individuals who are so self-assured about this point. Once more I would like to ask, “what are the optimal returns to finance?” The conventional wisdom is that the financial crisis proved that we had invested too heavily in finance, those who worked in finance were overpaid, etc. But how do we know how much is too much? The conventional wisdom seems to suggest that we can define “too much” in the same terms as pornography — we know it when we see it. But this is ludicrous. Even if one is willing to concede that it is somehow obvious that the returns to finance were excessive, it is still necessary to understand at what point these returns exceed optimality. Unfortunately, those who are most self-assured that the returns to finance were too large have offered no criteria for such an assessment. The financial crisis in and of itself is purportedly evidence.

A serious analysis would begin by understanding what is actually being done in finance. A popular view that I hear in the punditry is that we invested too much in finance and not enough into actually making things — whatever that means. As I have talked about before, financial intermediaries do create things. They transform illiquid assets into liquid liabilities. To the extent to which these liabilities are information-insensitive (Gary Gorton’s term), these liabilities can be considered “safe.” Ricardo Caballero has made the case that the world has a shortage of safe assets. If Caballero is correct, then the world of finance could play a significant role it mitigating that shortage and potentially create large welfare gains.

If one wants to talk about the optimal returns to finance, it is first necessary to understand the size and the scope of welfare gains created by financial innovation. Doing so requires an understanding of the purpose and the role of financial intermediaries and an explicit framework for determining optimality. Once that is done perhaps Tyler and the others will be proven correct that we need a smaller financial sector. Perhaps not. Until then, however, let’s have a moratorium on declaring something to be “too much” without having an explicit objective measure as to what is optimal.

Politics

Everything that is wrong with politics can be found here.

TED Talk: Art Rolnick

Art Rolnick on early childhood education.

Bullard’s “Death of a Theory”

St. Louis Fed President James Bullard has released a paper entitled, “Death of a Theory”. Overall, I think that the paper is a useful overview of the issues surrounding the use of monetary and fiscal policy in the context of the New Keynesian model and in recent experience.

The basic argument made by Bullard is as follows:

1. The conventional wisdom prior to the crisis was the fiscal policy was largely ineffective as a stabilization tool and therefore stabilization should be left to monetary policy.

2. The New Keynesian model suggests that monetary policy is ineffective at the zero lower bound.

3. The effectiveness of fiscal policy is dependent on the role of monetary policy. Given the ineffectiveness of monetary policy at the zero lower bound, there is a potential role for fiscal stabilization policy.

4. There are three problems with this viewpoint:

i.) The political process in the United States is ill-equipped to make timely and effective decisions on fiscal policy.

ii.) Monetary policy over the last few years has shown that monetary policy is not ineffective at the zero lower bound.

iii.) “The actual fiscal stabilization policy experiment did not involve funding increased government spending with lump-sum taxes, as contemplated in the theory, but instead involved heavy borrowing on international markets. In models, the borrowing would be interpreted as promised future distortionary taxes, but it is exactly the shifting of distortionary taxes into the future beyond the period of the binding zero lower bound and financial market turbulence that can undo most or all of the benefits that might otherwise come from the fiscal stabilization program.”

Some useful quotes can be found after the jump.

Varieties of Phillips Curves

As one might have guessed from my previous post, I am skeptical of the use of the Phillips curve for generating predictions. One reason that I am skeptical is because I’m not entirely sure about the direction of causality between output and inflation. (The original Phillips curve was concerned with the relationship between unemployment and wage inflation. The present discussion of Phillips curves follows the contemporary literature in referencing the relationship between output and inflation.) Once again, the source of disagreement can be found in the differences between the New Keynesian and Monetarist literature.

The New Keynesian Phillips Curve

As discussed previously the New Keynesian Phillips curve is derived based on the assumption that prices are sticky. Specifically, one of two assumptions is made. First, it is assumed that only a subset of firms are capable of adjusting their prices in any given period (literally, assuming the can opener). The second alternative assumption is that it is costly to adjust prices. Based on these types of assumptions, the NK Phillips curve is given by:

where is the rate of inflation, is the discount factor, is the expectations operator, is the output gap, and is a parameter.

The NK Phillips curve essentially implies that inflation is determined by “excess capacity.” When output is below potential, this exerts negative influence on the inflation rate. (This is why you often even commentators on financial news networks say that they don’t anticipate inflation given the excess capacity in the economy.) However, when output is above potential there is upward pressure on inflation. Regardless, the causation in the NK Phillips curve runs from output to inflation.

The Monetarist Phillips Curve

Long before A.W. Phillips plotted his curve, Irving Fisher had discovered the statistical relationship between employment and inflation (International Labour Review, 1926). Fisher identified the statistical relationship and made the following claim regarding causation:

“But as the economic analysis already cited certainly indicates a causal relationship between inflation and employment or deflation and unemployment, it seems reasonable to conclude that what the charts show is largely, if not mostly, a genuine and straightforward causal relationship; that the ups and downs of employment are the effects, in large measure, of the rises and falls of prices, due in turn to the inflation and deflation of money and credit.”

In other words, Fisher saw the direction of causation as going in the opposite direction as New Keynesians; inflation was causing fluctuations in employment.

This Fisherian view of the Phillips curve was embraced by Milton Friedman and fellow Old Monetarists under the accelerationist hypothesis. In Friedman’s 1967 address to the American Economic Association, he details a relationship between the unemployment and inflation with causation running from the latter to the former. Friedman hypothesized that the only way that a central bank would be able to achieve an unemployment target below the “natural rate of unemployment” was through accelerated increases in the rate of inflation. Again, this is in contrast to the NK Phillips curve.

New Monetarists have much the same view as Old Monetarists, however, the conclusions depend on the level of information and monetary policy. For example, suppose that there are two type of individuals, buyers and sellers. Assume that money growth is stochastic. For simplicity assume that money growth is either “high” or “low”. There are two periods of analysis. Increases in the money supply take place in the second period. Now suppose that buyers know in the first period if money growth will be high or low. Sellers do not have this knowledge. In addition, define the value of money as:

where is the rate of money growth and is the value of money. It follows that when money growth is high the value of money is lower than when money growth is low. Thus, since buyers know about the state of money growth prior to the sellers, they will seek to spend more of their money balances when money growth is high than when it is low. Put differently, increases in money growth causes higher rates of inflation and a higher level of production. This is the basic Fisherian view of the Phillips curve.

The central bank could remove the uncertainty surrounding money growth by simply announcing and committing to a money growth target. However, since buyers no longer have the informational advantage, the positive correlation between inflation and output disappears. In fact, the higher rate of money growth implies that the cost associated with holding money rises thereby causing buyers to economize on money balances and reducing consumption. (This is the insight of the Friedman rule and the discussion of the optimal quantity of money.) Thus, when money growth is known with certainty, there is a negative relationship between inflation and output.

So Why Do We Care?

The reason that we care about the varieties of Phillips curves is because they provide vastly different implications. The New Keynesian Phillips curve implies that inflation is, in part, caused by the relationship between output and potential. So long as output is below potential, this exerts negative pressure on inflation.

The Monetarist view is in direct contrast to NK Phillips curve. Rather than output exerting a causal influence on inflation, the causation is reversed. However, even this conclusion has been shown in recent years to be dependent upon the structure of information available to different economic agents about monetary policy. If all agents are perfectly informed as to policy, the relationship between inflation and output is negative.

These views provide non-trivial differences in prescriptions for policy.

Conflicting Views of Inflation

What causes inflation?

One might think that this issue is fairly resolved in modern macroeconomics, but it is not. There are largely two competing visions of inflation circulating, the New Keynesian view and the Monetarist (Old and New) view.

The New Keynesian View

The basic New Keynesian model can be represented by the following three equations:

where y is the output gap, R is the nominal interest rate, is the inflation rate, E is the mathematical expectations operator, , , and are stochastic shocks with mean zero and finite variance, and a, b, , are parameters. The first equation is the dynamic IS equation, the second is the New Keynesian Phillips curve, and the final equation is the Taylor Rule that governs monetary policy.

Within the New Keynesian framework, the central bank is an inflation fighter. What I mean by this is that the central bank adjusts the short term nominal interest rate, R, in response to realized inflation. The higher the value of , the greater the responsiveness of the central bank. Inflation, within this framework, is pinned down by the Taylor principle (). To illustrate this suppose that there is some cost-push shock in the economy ( is positive). The cost-push shock causes an increase in realized inflation. However, if the central bank adheres to the Taylor principle, the central bank will raise the short term interest rate by more than the increase in inflation. With sticky prices, this leads to an increase in the real rate of interest and therefore a reduction in “aggregate demand” and thereby the output gap. The reduction in the output gap reduces inflation (see the New Keynesian Phillips curve).

So what determines inflation in the New Keynesian model? In short, inflation is determined by the central bank target of inflation. Deviations from this target are caused by shocks to supply () and demand (). The demand shock is (given the derivation of the model) a household preference shock (e.g. households wake up one morning and decide that they prefer current to future consumption). The supply shock is a shock to marginal costs, which causes firms to increase their prices. So long as the central bank adheres to the Taylor principle, the inflation rate can be uniquely determined.

A separate, but related question is what causes inflation in the New Keynesian model? Conceivably, it is the shocks to supply and demand. The central bank doesn’t create inflation, it prevents it through the Taylor principle.

The Monetarist View

The New Keynesian View is in stark contrast to the Monetarist View. In the Monetarist View, the central bank is not an inflation fighter, but rather an inflation creator. To understand why, let’s consider this from a New Monetarist perspective.

The New Monetarist framework is interested in examining money, monetary arrangements, intermediation, monetary policy, etc. from a perspective in which (*gasp*) money is actually important. You will note that in the New Keynesian framework above, money was never mentioned. This is because money is inconsequential for analysis within the NK model. The main reason why money is unimportant in NK models, however, is by assumption. Money, if it is introduced, is done through reduced form methods like putting money in the utility function or requiring that individuals must buy goods with money. These reduced form approaches, however, fail to capture the characteristics of money that make it important and therefore it is not surprising that they fail to identify that money isn’t important.

New Monetarist economics, in contrast, concerns itself with environments in which money is essential. It is therefore not surprising that one gets substantially different results. In NM models, the goods price of money is an endogenous determined. Put differently, the value of money is determined within the model rather assumed. If the goods price of money is zero, this means that money has no value and therefore a monetary equilibrium doesn’t exist (money is not simply assumed to be unimportant).

In equilibrium the goods price of money is determined as follows:

where is the goods price of money, is the quantity of real money balances demanded given the quantity of consumption , and is the aggregate supply of money. If we think of the goods price of money as the inverse of the price level, this implies that the price level is determined by the following equilibrium condition:

In other words, the price level is pinned down by the ratio of the money supply and money demand. It is deviations between the money supply and money demand that cause fluctuations in the price level. It follows that the central bank in this type of framework is an inflation creator. Money growth causes inflation.

So why does this distinction matter?

It matters because it is an often overlooked aspect of inflation targeting. When forecasts are being conducted on inflation, care needs to be taken as to how inflation should be forecast. The NK approach would have inflation forecasts based on the NK Phillips curve. The NM approach would have inflation forecasts based on money growth.

Unfortunately, simply taking these models to the data doesn’t resolve this issue. For example, NK advocates would argue that money growth doesn’t do a good job predicting inflation and therefore the NK approach is better. However, the empirical evidence upon which these claims are made rely on simple sum measures of the money supply, which are severely flawed (more on this later). In addition, from the NM side, one could easily point to the failure of the NK Phillips curve in fitting the data. While New Keynesians like to point out that the fit improves by incorporating lagged terms of inflation, it also undercuts the notion of microfounded macroeconomic models and suggests a circularity between fitted the data to the model and the model to the data.

In short, the differences between the New Keynesian view on inflation and Monetarist view on inflation are stark. In the NK view, the central bank acts as an inflation fighter using the nominal interest rate to mitigate and control inflationary pressures. In the NM view, the central bank is an inflation creator. The price level is determined by the relationship between the money supply and money demand. This distinction is not minor.

(Note: The inflation fighter vs. inflation creator terminology comes from the work of Robert Hetzel.)

Nobel Prize Lectures (Sargent and Sims)

On Money and Banking, Part 1

There has been a great deal of discussion about the gold standard and related issues of fractional reserve banking, money creation, and inflation in recent years. In order to have a useful conversation and debate, however, we must begin with a serious discussion of money and intermediation. What follows is a broad discussion of money. The reason is both to organize my thoughts and to define and contrast public and private money as well as what is meant by backed versus fiat money. Subsequently, the discussion turns to the interaction between money as a store of value and medium of exchange. Finally, I discuss private note issuance on the part of banks and the “backing” of such notes.

Money: Public and Private

Our current monetary system consists of both public and private money. By public money, I am referring to what is typically called base money (although it might even be more accurate to refer to the physical currency in circulation). Private money is that which is created by banks. This naturally raises questions as to whether there is something that distinguishes each from one another. In order to understand this, we need to think about what banks are and what banks do.

Banks are financial intermediaries. They issue liabilities in order and invest the proceeds in assets. In this sense, they are no different than an insurance company or a pension fund. Where they differ is in the types of liabilities that they issue. An insurance company issues state-contingent liabilities (i.e. if there is an auto accident, the insurance company pays out to the policyholder). A pension fund pays out state-contingent liabilities. Bank liabilities, however, most often offer immediate redemption in base money. There is nothing, however, that states that banks need to offer this type of liability. It is entirely possible that banks could offer time-contingent liabilities just like a pension fund. For example, a bank could issue a deposit liability and promise redemption a date in the future. The bank could then serve as intermediary between borrowers and lenders.

The primary difference between banks and the other financial intermediaries is the type of liability that they issue and its characteristics. Insurance and pension liabilities do not routinely circulate as medium of exchange. What makes bank liabilities special is that they do circulate as medium of exchange. When one uses a check at the store, it is like saying, “I don’t have any physical currency on me, but if you contact these people, they will give it to you.” Why do bank liabilities have this quality? Conceivably, it is because the liabilities promise immediate redemption. I can take the check to the bank and cash it whereas I would have to wait until the purchaser reached retirement age to redeem a liability tied to the pension fund.

Thus, banks are not only financial intermediaries, but money creators. A natural question is then where does the money come from? Do banks simply create money out of thin air?

Money: Backed and Fiat

Under a gold standard, money is redeemable in gold. In other words all money (both publicly and privately issued) is redeemable in gold. Assuming that there is a central bank, it is possible that I could show up at a bank and redeem my deposit for currency issued by the central bank or in gold (or a gold certificate). Even if I redeem the deposit for currency, I could always go back to the bank and redeem the currency for gold. (If there is no central bank, there is no public money, but we will leave this until later.)

In modern economies, there is no gold standard. If you show up at the bank to redeem a deposit, you will be handed physical currency. If you try to redeem that currency, say a $20 bill, you will receive a $10 bill and two $5 bills or some such combination.

Under a gold standard, money creation is directly tied to the stock of monetary gold (this is true even under a fractional gold standard). An over-issuance of money results in a wave of redemptions (either by individuals or foreign central banks) thereby providing a natural mechanism for controlling the money supply. Under a fiat currency, this mechanism does not exist. However, it doesn’t mean that no mechanism exists.

Critics of fiat money often assert that there is a direct correspondence between money creation and fractional reserve banking. As a result, a common neo-Austrian argument is that fractional reserve banking combined with fiat money will lead to excessive money creation. An extreme Austrian argument is therefore to require banks to hold 100% reserves that are backed by gold.

Defenders of fractional reserve banking often point out that the fractional reserve system is one that naturally arises as a result of profit-seeking. For example, a bank that accepts deposits will, over time, realize that only a fraction of the deposits are actually redeemed on any given day or in any given week and that other deposits are issued during this time. If deposits and withdraws are random, there might be a net inflow or a net outflow to the bank on any given day. By the Law of Large Numbers, the bank would not need hold reserves equal to the amount of deposits over this period, but rather only an amount of reserves that are a fraction of the amount of deposits (enough to cover net outflows of reserves caused by excessive redemptions).

I believe that this defense of fractional reserve banking is correct, but it goes above and beyond the critique leveled by neo-Austrians. What 100% reservists are arguing is that fractional reserve banking leads to money creation. However, as noted above, this is not the source of money creation. For example, insurance companies and pension funds are both financial intermediaries and hold an amount of cash that is a fraction of the liabilities that they issue. However, nobody accuses these intermediaries of money creation. Why? The reason is because their liabilities do not circulate as medium of exchange. Bank liabilities do. But why do bank liabilities circulate? Conceivably it is because they offer immediate redemption. It is not because of fractional reserve banking.

Indeed it is entirely possible that a bank with 100% reserves could create money. Banks could issue deposit liabilities with the promise of redemption at some date in the future and then invest the proceeds in assets in the intermediate term. Barring legal restrictions, it is entirely plausible that deposit holders could write a check for less than or equal to an amount of their deposit and this claim to the deposit could circulate as a medium of exchange just as a standard checking deposit. The reason that this does not seem probable (but is completely plausible) is because of the characteristic of the liability. The deposit issued by the 100% reserve bank is less liquid than a deposit that is instantly redeemable. This counterfactual would again seem to lend credence to the view that it is not fractional reserves that create money creation, but rather the unique characteristics of the deposit liability.

This similarly leads into another issue regarding banks and fractional reserves. A related argument to the link between fractional reserve banking and money creation is that money is being created out of thin air. Since there does not exist any sort of physical commodity for which money can be redeemed, there is a view that money is simply created out of thin air. But is money being created out of thin air? Let’s consider an insurance company. The insurance company issues a state-contingent liability and uses the proceeds to purchase assets. Among the assets is a cash reserve that is a fraction of the liabilities issued. Has money been created out of thin air? No, money hasn’t even been created. So long as the value of the assets are greater than or equal to the liabilities issued, the liabilities are completely “backed” by those assets. The same is true of a deposit issued by a bank. The bank issues deposits and uses the proceeds to purchase assets. So long as the assets on the bank’s balance sheet are greater than or equal to the deposits, the liabilities are completely “backed” by those assets. Thus, deposits are no more created out of thin air than are insurance of pension fund liabilities. What is different is that bank liabilities circulate whereas the others do not.

This represents a very broad overview of money and intermediation. An obvious question, however, is why we care about these properties and what the implications are. As alluded to in the introduction above, in part 2 I will discuss the role of money both as a medium of exchange and as a store of value and why the interaction between these two characteristics might matter. In addition, if we are to take such interactions seriously, what are the possible implications for monetary institutions? In particular, I will consider the implications of private note issuance on the part of banks and whether it matters if these notes are “backed” by some type of commodity. Finally, part 2 will conclude with a summary of the implications for the gold standard and other monetary arrangements.

How Much Debt is Too Much Debt?

David Beckworth and Ramesh Ponnuru recently penned a piece for The New Republic on nominal income targeting. In response to this Joe Weisenthal and Nicole Gelinas have posted the following graph:

Each of the authors posted the graph and said (essentially), “see we have too much debt” and subsequently suggested that the monetary policy advocated by Beckworth and Ponnuru would make things worse. David and Ramesh have responded to this criticism by defending nominal income targeting. However, I would like to put monetary policy aside for a moment and talk about data and how we should use data.

The graph illustrated above shows the path of household debt as a percentage of income. Joe and Nicole each say that there is too much debt. Okay, but how much is too much? In other words, even if I were to agree with Joe and Nicole as to idea that there is too much household debt at present, how would I know when it had sufficiently fallen to an acceptable level? Saying there is too much debt presumes that there is an optimal amount of debt and that current levels exceed that optimal amount. In order to assess whether or not there is too much debt, it is therefore necessary to have some type of framework for assessing debt levels. Such a framework would presumably require a sufficient understanding of banking, intermediation, liquidity, household preferences, etc.

When reading this, I couldn’t help but to think of this quote from Milton Friedman:

I don’t believe that statistics, as somebody has said, statistics do not speak for themselves. Alfred Marshall once said, “There is no person, no theorist so reckless as he who says that the facts speak for themselves.” The facts never speak for themselves. They have to be interpreted in terms of some understanding of where they come from and what the relation between them is.

Obama Derangement Syndrome

During the last administration Charles Krauthammer identified “Bush derangement syndrome”, which he defined as, “the acute onset of paranoia in otherwise normal people in reaction to the policies, the presidency — nay — the very existence of George W. Bush.” Apparently, it’s contagious because I am noticing more and more people on the right who seem to have been inflicted, albeit with a different strain. Case in point: George Melloan’s op-ed on the Wall Street Journal this morning.

In the op-ed, Melloan laments Obama’s rhetoric and rising food prices:

Barack Obama spends much of his time these days running for re-election, campaigning as a populist, bashing millionaires and extolling the Occupy Wall Street movement. Although “populist” means different things to different people, the Oxford American dictionary says it describes a politician who seeks to represent the interests of ordinary people. So how does the president measure up as a true populist? Not well.

Food prices are an important component of the living expenses of ordinary people, especially the elderly or families struggling to make ends meet. Last week the U.S. Department of Agriculture forecast that food prices will rise by 3.5%-4.5% this year, the sharpest year-to-year increase since 1978. (That year, by the way, was prelude to 1979-80 double-digit inflation, when prices at one point in 1980 were soaring at nearly 15% annually.)

Subsequently, one waits for Melloan to tie those two points together, but to no avail. The remainder of the piece is about how the Fed is monetizing the debt and how inflation hurts the poor. Then we get the conclusion:

As Mr. Obama flies from speech to speech at taxpayer expense in his fuel-guzzling Boeing 747, he may well have little understanding of how much his campaign rhetoric rings false in light of the economic realities he as president had an important role in creating. He probably thinks it’s still 2008 and he is still campaigning on a platform of “hope and change.”

But it’s 2011 and the president’s economic policies have been a disaster. The auguries for the future are not looking good. He is unlikely to change policies; it would be very difficult to do so with the federal fisc in such a mess. So his chosen solution is populist rhetoric. As the old saying goes, that won’t put food on the table.

I read the article twice and I’m still confused. So here are my questions to Melloan:

1. What can Obama do about rising food prices?

2. Is populist rhetoric causing rising food prices?