# Monthly Archives: April 2014

## On Pegging the Interest Rate

Back in 2010, Narayana Kocherlakota was subjected to a great deal of criticism about his comment that the FOMCs decision to peg the interest rate at zero for an extended period of time would ultimately lead to deflation. Economists, especially those in the blogosphere, became near apoplectic that Kocherlakota, a distinguished scholar and voting member of the FOMC, would say something so seemingly egregious. Criticism largely came from two camps. The first camp, mostly filled with New Keynesians, argued that this was wrong because what mattered was the market interest rate relative to the natural rate. The second camp, mostly those whose views are consistent with Monetarism, suggested that this was preposterous because Friedman’s 1968 speech to the American Economic Association taught us that attempts to peg the interest rate would lead to inflation, not deflation.

Steve Williamson has taken a lot of flak from fellow economics bloggers because he has relentlessly defended this statement over the years. So last week I did a radical thing, I talked to Steve about this very controversy. In doing so, Steve confirmed what I believed to be his view all along and one that I think is correct: Kocherlakota was correct in his statement AND so was Milton Friedman. To understand why, we need to think about the Fisher equation and the behavior of monetary aggregates.

The entire debate centers around the Fisher equation:

$i_t = r_t + E_t \pi_{t+1}$

where $i$ is the nominal interest rate, $r$ is the real interest rate, and $E_t \pi_{t+1}$ is expected inflation. In the long run, we tend to think of the real interest rate as being determined by real factors, like productivity and preferences. The reason that the Fisher equation is important is because to understand Friedman’s point, we need to understand the effects of monetary policy in the short run and the long run. Thus, we need to understand both the liquidity effect of monetary policy and the Fisher effect.

Suppose, for example, that the central bank increased the rate of money growth. The liquidity effect implies that the short term interest rate would initially decline. However, over time, the Fisher effect implies that expectations of future inflation would increase and push the nominal interest rate higher. Thus, Friedman’s point was as follows. Suppose the current nominal interest rate was 3% and the central bank wanted to peg the nominal interest rate at 2%, in the short run they could achieve this by increasing money growth (i.e. through the liquidity effect). However, the Fisher effect would ultimately push the nominal interest rate higher. Thus, the only way that the central bank could achieve this interest rate peg would be through continuously increasing the rate of money growth to produce lower rates through the liquidity effect. The result of this sort of policy would then be one of ever-increasing rates of money growth and inflation. This result was largely viewed as unsustainable and therefore central banks could not peg the interest rate in this manner.

Kocherlakota’s point was that pegging the nominal interest rate would ultimately lead to deflation. This sounds contradictory to Friedman because he arrives at the opposite conclusion. However, the two points are actually two sides of the same coin. What Kocherlakota is effectively (or perhaps not so effectively, given the outcry) saying is that if the central bank wanted to peg the interest rate at a particular level, then this would require that the central bank start reducing money growth. In fact, for the case in which the central bank kept the nominal interest rate pegged at zero, a positive real interest rate would imply that the central bank would have to pursue a negative rate of money growth to maintain the target.

Thus, Kocherlakota is taking the objective of holding the interest rate constant as given and asking how it is that the central bank can maintain this policy. Friedman, on the other hand, is thinking about how the central bank is likely to try to pursue this policy.

What both Kocherlakota’s argument and Friedman’s argument have in common are what is important. The common element of the argument is that if the Federal Reserve adopts an interest rate peg over a long period of time, the ability to maintain that peg is dependent on the rate of money growth. The central bank can either adopt the rate of money growth consistent with the interest rate peg or they cannot maintain the interest rate peg.

What seemed to confuse people about this entire issue is that their understanding of Federal Reserve policy clearly contradicted any prediction of deflation. Nonetheless, this is the wrong way to interpret Kocherlakota’s argument. The argument he was making was essentially that if the Federal Reserve chose to leave the interest rate at zero for an extended period of time, this would imply that eventually they would have to pursue a policy that was deflationary. If they didn’t pursue that type of policy, they couldn’t maintain their peg of the nominal interest rate. In addition, since we don’t expect the Federal Reserve to pursue a policy consistent with negative rates of money growth, the statement should be seen as a criticism of the Federal Reserve’s original attempt at forward guidance which suggested that the FOMC would keep the interest rate at zero for an extended period of time.

There is an important lesson to be learned from this controversy and debate. The lesson is that even though policy is conducted with the federal funds rate as an intermediate target or with interest on reserves as an instrument, it is still necessary to know the underlying path of the money supply associated with this interest rate policy.

## Review of Piketty’s Capital in the 21st Century

My review of Piketty’s Capital in the 21st Century will run in the May 5 issue of National Review. In the meantime, here is a link to a longer version of the review.

## What is Fair?

I recently read Thomas Piketty’s Capital in the 21st Century (my review of which will soon be published by National Review, for those interested). In reading the book, an implicit theme is that of fairness. Throughout the text, Piketty argues that his evidence on inequality suggests that there is a growing importance of inheritance in the determination of income and that this trend is likely to continue. It seems that Piketty sees this as problematic because it undermines meritocracy and even democracy. Nonetheless, when we start talking about there being too much inequality or too great of an importance of inheritance, this necessarily begs the question: How much is too much?

Economists have common ways of dealing with that question. There are vast literatures on optimal policies of all different types. The literature on optimal policy has a very consistent theme. First, the economist writes down a set of assumptions. Second, the economist solves for the efficient allocation given those assumptions. Third, the economist considers whether a decentralized system can produce the efficient allocation. If the decentralized allocation is inefficient, then there is a role for policy. The optimal policy is the one that produces the efficient allocation.

When Piketty and others talk about inequality and policy, however, they aren’t really talking about efficiency. Meritocracy-type arguments are about fairness. Economists, however, often shy away from discussing fairness. The reason is often simple. Who defines what is fair? Let’s consider an example. Suppose there are two workers, Adam and Steve, who are identical in every possible way and to this point have had the exact same economic outcomes. In addition, assume that we only observe what happens to these individuals at annual frequencies. Now suppose that this year, Adam receives an entirely random increase in pay, where random simply refers to something that was completely unanticipated by everyone. However, this year Steve loses his job for an entirely random reason (e.g. a clerical error removed Steve from the payroll and it cannot be fixed until next year). After this year, Adam and Steve go back to being identical (the clerical error is fixed!) and continue to experience the same outcomes the rest of their lives.

This is clearly a ridiculously stylized example. However, we can use this example to illustrate the difference between how economists evaluate policies. For someone concerned with a meritocratic view of fairness, the ideal policy in the ridiculous example above is quite clear. Adam, through no actions of his own, has received a windfall in income. Steve, through no fault of his own, has lost his income for an entire year. Someone only concerned with meritocracy would argue that the ideal policy is therefore to tax the extra income of Adam and give it to Steve.

Most economists, armed with the same example would not necessarily agree that the meritocratic policy is ideal. The most frequently used method of welfare analysis is the idea of Pareto optimality. According to Pareto optimality, a welfare improvement occurs when at least one person can be made better off without making another person worse off. In our example above, Pareto optimality implies that the optimal policy is to do nothing because taxing Adam and giving the money to Steve makes Adam worse off.

Advocates of meritocracy, however, are unlikely to be convinced by such an argument. And there is reason to believe that they shouldn’t be convinced. For example, if Adam and Steve both knew that there was some random probability of unemployment ex ante, they might have chosen to behave differently. For example, suppose that Adam and Steve each knew in advance that there was some probability that one of them would lose their job. They might have each purchased insurance against this risk. If we assume the third party insurer can costly issue insurance and earns zero economic profit, then when Steve became unemployed, he would receive his premium back plus what is effectively a transfer from Adam.

Of course, in this example, there still isn’t any role for policy. Private insurance, rather than policy, can solve the problem. Nonetheless, as I detail below, this does give us a potentially better starting place for discussing fairness, efficiency, and inequality.

Suppose that inequality is entirely driven by random idiosyncratic shocks to individuals and that these events are uninsurable (e.g. one cannot insure themselves against being born to poor parents, for example). There is a potential role for policy here that is both fair and efficient. In particular, the policy would correspond to what economists traditionally think of as ex ante efficiency. In other words, a fair policy would be the policy that individuals would choose before they knew the realization of these random shocks.

As it turns out there is a sizable literature in economics that examines these very issues and derives optimal policy. The conclusions of this literature are important because (1) they take the meritocratic view seriously, and (2) they arrive at policy conclusions that are often at odds with those proposed by advocates of meritocracy.

It is easy to make an argument for meritocracy. If people make deliberate decisions that improve their well-being, then it is easy to make the case that they are “deserving” of the spoils. However, if people’s well-being is entirely determined by sheer luck, then those who are worse off than others are simply worse off due to bad luck and a case can be made that this is unfair. Unfortunately, for advocates of meritocracy, all we observe in reality are equilibrium outcomes. In addition, individual success is often determined by both deliberate decision-making and luck. (No amount of anecdotes about Paris Hilton can prove otherwise.) I say this is unfortunate for advocates of meritocracy because it makes it difficult to determine what amount of success is due to luck and what is due to deliberate actions. (Of course, this is further muddled by the fact that when I say luck, I am referring to entirely random events, not the definition of the person who once told me that “luck is when preparation meets opportunity.”)

Nevertheless, our economic definition of fairness allows us to discuss issues of inequality and policy without having to disentangle the complex empirical relationships between luck, deliberate action, and success. Chris Phelan, for example, has made a number of contributions to this literature. One of his papers examines the equality of opportunity and the equality of outcome using a definition of fairness consistent with that described above. Rather than examining policy, he examines the equality of opportunity and outcome within contracting framework. What he shows is that inequality of both opportunity and outcome are both consistent with this notion of fairness in a dynamic context. In addition, even extreme inequality of result is consistent with this definition of fairness (such extreme inequality of opportunity, however, are not supported so long as people care about future generations).

Now, of course, this argument is not in any way the definitive word on the subject. However, the main point is that a high degree of inequality is not prima facie evidence of unfairness. In other words, it is not only difficult to disentangle the effects of luck and deliberate action in determining an individuals income and/or wealth, it is actually quite difficult to figure out whether a particular society is fair simply by looking at aggregate statistics on inequality.

This point is especially important when one thinks about what types of policies should be pursued. Advocates of a meritocracy, for example, often promote punitive policies — especially policies pertaining to wealth and inheritance. Piketty, for example, advocates a global, progressive tax on wealth. The idea behind the tax is to forestall the importance of inheritance in the determination of income and wealth. While this policy might be logically consistent with that aim, but it completely ignores the types of things that we care about when thinking about optimal policy.

For example, consider the Mirrlees approach to optimal taxation. The basic starting point in this type of analysis is to assume that skills are stochastic and the government levies taxes on income. The government therefore faces a trade-off. They could tax income highly and redistribute that income to those with lower skill realizations. This represents a type of insurance against having low skills. On the other hand, high taxes on income would discourage high skill workers from producing. The optimal policy is one that best balances this trade-off. As I note in my review of Piketty in National Review, this literature also considers optimal taxation with regards to inheritance. The trade-off here is that high taxes on inheritance discourage wealth accumulation, but provide insurance to those who are born to poor parents. The optimal policy is the one that best balances these incentives. As Farhi and Werning point out in their work on inheritance, it turns out that the optimal tax system for inheritance is a progressive system. However, the tax rates in the progressive system are negative (i.e. we subsidize inheritance with the subsidization getting smaller as the size of the inheritance gets larger). The intuition behind this is simple. This system provides insurance without reducing incentives regarding wealth accumulation.

Economists are often criticized as being unconcerned with fairness. This is at least partially untrue. Economists are typically accustomed to thinking about optimality in the context of Pareto efficiency. As a result, economists looking at two different outcomes will be hesitant to suggest that a particular policy might be better than another if neither represents a Pareto improvement. Nonetheless, this doesn’t mean that economists are unconcerned with the issue of fairness nor does it suggest that economists are incapable of thinking about fairness. In fact, economists are capable of producing a definition of fairness and the policy implications thereof. The problem for those most concerned with fairness is the economic outcomes and policy conclusions consistent with this definition might not reinforce their ideological priors.