Current Fed Policy Successful At Stabilizing Prices

The FOMC is beginning a two-day meeting, in which market expectations are high that new monetary stimulus will be enacted (though economists and analysts have recently shifted their expectations to September). Apart from those pushing for monetary stimulus as a means of NGDP targeting, a number of others claim the Fed should act because it is failing on both aspects of its dual mandate. Previously I’ve noted the difficulty faced by the Fed in meeting its employment mandate, so for today I want to look at the price stability mandate.

When discussing the price stability mandate, most commenters typically refer to an inflation target of 2% based on the FOMC’s preferred measure of core PCE inflation (See the report for more on previous measures and Bernanke’s argument for using a measure of core inflation). The preferred measure is clearly set forth by the FOMC, but what about the 2% target? Widely regarded as being explicit, actual Fed statements regarding a target suggest otherwise. In 2010, the Federal Reserve Bank of St. Louis published a short essay asking, Is the Fed’s Definition of Price Stability Evolving? The essay points out that:

Relatively few Federal Reserve officials have publicly indicated what level of the inflation rate corresponds to price stability.

Noting a few exceptions, the essay highlights comments by former Fed officials, William Poole and Alan Greenspan, suggesting a target for core inflation closer to 1%. One might dismiss these comments as irrelevant today so instead, consider those made by current Chairman Bernanke (my emphasis):

It is not clear whether Chairman Bernanke, or any other current member of the FOMC, accepts either of these definitions of price stability. However, before he replaced Greenspan in January 2006, then Fed Governor Bernanke publicly stated in 2005 that his “comfort zone” for core PCE inflation was between 1 and 2 percent. More recently, Bernanke stated that the FOMC’s “mandate-consistent inflation rate” is generally judged to be “about 2 percent or a bit below.”

Unless Bernanke has made more recent statements revising this judgment, 2% is clearly not a target but rather the ceiling of his target range. Having clarified the Fed’s own measurement of success, here is graph showing the actual results of core PCE since 2000:

Inflation falls noticeably below Bernanke’s range in late 2009 and then again in late 2010. However, take a close look at the inflation readings during the first half of 2012. Core PCE has averaged 1.9% and held within a range just below 2%. One can argue about the correct measure or target the Fed should use, but by the Fed’s own standard of price stability, current policy is proving very successful. If these conditions persist, those hoping for further monetary easing may be disappointed.

"A World Class Value Manager" Finds Current Investments Limited

The Reformed Broker, Joshua Brown, offers Some Anecdotal Stuff from a World Class Value Manager that strikes a chord with my feelings about current investment opportunities. Here’s a key portion of the post:

I ask them why the almost 20% cash position, is there something they're seeing in the macro data or the headlines that their peers (who are much more heavily long) don't necessarily see?

No, they tell me, they don't play that game in terms of trying to read the macro tea leaves or anticipate the political outcomes in the 17-nation Euro Zone.  Rather, they've got a 20% cash pile because as they've sold things, they've not been able to find replacement candidates worth buying given their bottom-up approach.  It's a combination of stocks not being cheap enough around the world to offer the "margin of safety" they live by and earnings growth being non-existent across much of the global landscape.

One pocket of interesting buys is in European multi-nationals that do most of their business outside Europe.  These stocks are being pressured because of the Euro exchanges they are listed on despite the fact that they don't have the perceived exposure to Euro economies that people assume.

My personal cash position has been well above 20% for some time now since the focus of my portfolio is based on a 3-5 year time horizon. At each dip in the market, I’ve picked up a couple new stocks or added shares to positions, only to sell some of those positions as markets rallied back near current levels that remain uninspiring. Multiple expansion has been a primary driver of this year’s US market rally as corporate profits enter a recession. If this trend continues, as I expect, further multiple expansion seems unlikely and the potential for contraction remains well outside most investors’ radar. 

Regarding the pocket of opportunities in Europe, I have also been watching several large multi-nationals come under intense selling pressure as specific country’s markets get sold. While I don’t expect sentiment to change in the near future, investors will likely be rewarded for their patience. Although the “world class value manager” remains a mystery, based on these anecdotes, I definitely wish I had more access to his investment outlook and fund.  

Bubbling Up...

Each day I scroll through, skim, and read upwards up a few hundred blog posts. Many provide good insights, pose interesting questions or offer notable quotes. Although I wish there was enough time to highlight the best posts each day individually, I don’t believe attempting that feat would be beneficial to myself or readers. Instead, I’m going to try and present a batch of the best links each day with quotes that hopefully spark a desire to click through and read further. Any suggestions of clever titles for these posts would be appreciated. Without further adieu, here are today’s posts that are Bubbling Up...

1) Full reserve degenerates to fractional reserve, absent regulations to stop it. by Ralph Musgrave

“Thus when private banks start “lending money into existence” as the saying goes, inflation ensues, but that inflation does not need to be reversed by periodic severe recessions, as occurs under the gold standard.

Moreover, banks and those they lend to are not greatly concerned about the inflation. Reason is that in making a loan, BOTH bank and borrower become creditor AND debtor. I.e the agreement (at least initially) is: 1. The borrower owes the bank £Y till the loan is repaid, and 2, the bank owes the borrower £Y, which obligation the bank undertakes to transfer to anyone that the borrower chooses – using his/her cheque book. Initially, to repeat, both bank and borrower are both debtor and creditor, so neither are bothered by inflation.”

2) Paul de Grauwe: The ECB Can Save the Euro – But It Has To Change Its Business Model

“It is surprising that the ECB attaches so much importance to having sufficient equity.  In fact, this insistence is based on a fundamental misunderstanding of the nature of central banking. The central bank creates its own IOUs. As a result it does not need equity at all to support its activities. Central banks can live without equity because they cannot default.

The only support a central bank needs is the political support of the sovereign that guarantees the legal tender nature of the money issued by the central bank. This political support does not need any equity stake of the sovereign. In fact it is quite ludicrous to believe that governments that can, and sometimes do, default are needed to provide capital to an institution that cannot default. Yet, this is what the ECB seems to have convinced the outside world.“

Woj’s Thoughts: Political support is complicated by the lack of a fiscal and political union. Although the ECB could set rates on sovereign debt, it cannot ensure those rates flow through to private borrowers or that private credit expansion returns. The ECB can buy considerable time, but alone cannot save the Euro.

3) Biggest EPS Miss Since Lehman, And This Time It's Not The Tsunami's Fault

Citi Credit Weekly - “Undoubtedly, part of the reason that Spain and Greece have come back into focus is that the earnings of US companies continue to be so uneven. With more than half of S&P500 companies having reported, we’re only now starting to get the full picture, and viewed from the top down perspective it’s far less pretty than even last week led us to believe. Relative to expectations, top line revenues have been especially weak, with nearly all sectors surprising to the downside, even as EPS and EBITDA have tended to beat.

But even those sorts of statistics tend to hide the true weakness because equity analysts tend to revise expectations down while earnings season is still ongoing, which explains why some 72% of S&P500 companies manage to beat expectations in a weak quarter.”

Woj’s Thoughts: Quarter after quarter, revenues continue to miss expectations across the board while the majority of earnings beat. Are analysts systematically underestimating margins? Are companies buying back more stock to boost earnings? Or, are clever accounting practices becoming increasingly efficient in displaying earnings growth?

4) Conservatives and the State by Francis Fukuyama

“When I was asked by the editors of the Financial Times to contribute to a series on the future of conservatism, I hesitated because it seemed to me that in both the US and Europe what was most needed was not a new form of conservatism but rather a reinvention of the left. For more than a generation we have been under the sway of conservative ideas, against which there has been little serious competition. In the wake of the financial crisis and the rise of massive inequality, there should be an upsurge of left-wing populism, and yet some of the most energized populists both in the US and Europe are on the right. There are many reasons for this, but one of them is surely that publics around the world have very little confidence that the left has any credible solutions to our current problems.

The rise of the French Socialists and Syriza in Greece does not belie this fact; both are throwbacks to an old and exhausted left that will sooner rather than later have to confront the dire fiscal situation of their societies. What we need is a left that can stem the loss of rich-world middle class jobs and incomes through forms of redistribution that do not undermine economic growth or long-term fiscal health.

But if you can’t solve the problem from the left, maybe you can do it from the right. The model for a future American conservatism has been out there for some time: a renewal of the tradition of Alexander Hamilton and Theodore Roosevelt that sees the necessity of a strong if limited state, and that uses state power for the purposes of national revival. The principles it would seek to promote are private property and a competitive market economy; fiscal responsibility; identity and foreign policy based on nation and national interest rather than some global cosmopolitan ideal. But it would see the state as a facilitator rather than an enemy of these objectives.”

Network Models Can Restore Emergence in Economics

Currently active on my kindle is Positive Linking: How Networks Can Revolutionise the World
by Paul Ormerod. For a brief background of how I came upon this subject, my most recent interest in economics began a couple years back when I began reading classic works of Hayek and Keynes, among others. Probably surprising to many, I found the work of both these giants in the field to offer timeless insights about the macroeconomy that had seemingly been lost leading up to the financial crisis. More specifically, I was curious about the broader ideas of uncertainty and emergence that each touches on, though in different manners. Allowing my reading selections to follow a random path, I stumbled upon books in theoretical and particle physics discussing those intriguing subjects in the context of chaos theory and network effects. Ormerod’s book, among other things, is trying to encourage mainstream economics to re-incorporate these lost ideals from the past with new lessons from physics and other social sciences.

Aside from Ormerod, there are numerous others simultaneously working to construct new models of the economy that include these areas of research. One of those is Steve Bannister, at Naked Keynesianism, who offers this conclusion to a critique of the Lucas critique:

I propose two things to restore the dominating importance of emergent macro properties on economic behavior. One is a recommitment to econometric modelling. Ever increasing data and increasingly better tools will continually improve modelling and forecasting results.

The other is a methodology that is vastly underused in economics, but widely used in various other sciences: network system analysis based on the mathematical theory of graphs. These methods lets us directly measure and model emergent dynamic behaviors from groups, like the individuals in an economy. No added up methodological individualism required; no agent-based model needed. Observe, model, and predict directly at the macro level.

While I believe empirical models, properly done, are fundamental to understanding and policy, network models provide us with a dynamic theory, emergent macro behaviors, that  support our correct Keynesian beliefs that it is the macro foundations of micro behavior that matter, not the other Lucasian way around.  

The Money Multiplier Fairy Tale

Recently I discussed an ongoing debate between Simon Wren-Lewis and Lars P. Syll about mainstream versus heterodox economics. Well, there is apparently at least one topic upon which both men agree. Syll directs us to a piece from Wren-Lewis titled Kill the Money Multiplier!

I think I know why it is still in the textbooks. It is there because the LM curve is still part of the basic macro model we teach students. We still teach first year students about a world where the monetary authorities fix the money supply. And if we do that, we need a nice little story about how the money supply could be controlled. Now, just as is the case with the money multiplier, good textbooks will also talk about how monetary policy is actually done, discussing Taylor rules and the like. But all my previous arguments apply here as well. Why waste the time of, and almost certainly confuse, first year students this way?

I’ve complained about this before in this blog, and in print. (In both cases I was remiss in not mentioning Brad DeLong’s textbook, which does de-emphasise the LM curve.) The comments I received were interesting. The only real defence of teaching the LM curve was that it told you what would happen if monetary policy acted in a ‘natural’ way due to ‘impersonal forces’, whereas something like the Taylor rule was about monetary policy activism. Well, I count this as an excellent reason not to teach it, because it gives the impression that there exists such a thing as a natural and impersonal monetary policy. Anyone who was around during the monetarist experiments in the early 1980s knows that fixing the money supply is hardly automatic or passive.

I know this is a bit of a hobbyhorse of mine, but I really think this matters a lot. Many students who go on to become economists are put off macroeconomics because it is badly taught. Some who do not go on to become economists end up running their country! So we really should be concerned about what we teach. So please, anyone reading this who still teaches the money multiplier, please think about whether you could spend the time teaching something that is more relevant and useful.

Last month I tried to show that IOR Killed the Money Multiplier and was directed by Ramanan to the following quote from Marc Lavioe:

You seem to imply that the textbook multiplier still applies when reserves earn no interest. I think that this is a misleading statement. It implies that there is a bunch of agents out there,

waiting for banks to provide them with loans, but that there are being credit rationed because banks don’t have access to free reserves. ...Rather what happens when excess reserves are being provided with no remuneration of reserves is that the fed funds rate drops down, as banks with surplus reserves despair to find banks with insufficient reserves, having no alternative but a zero rate. The drop in the fed funds rate may induce banks to lower their lending rates, and hence induce new borrowers to ask for loans or bigger loans, but it really has nothing to do with the standard multiplier story. If there is no change in the lending rate, new creditworthy borrowers just won’t show up. There is never any money multiplier effect.

My first year as an economics PhD student begins in less than one month. Hopefully we skip over the money multiplier, but if not, it’s nice to know I have company in the mainstream and heterodox sects that don’t believe in this fairy tale.  

Reducing the Debt-per-Dollar Ratio: A Long Road Ahead

Last week, in response to a post by Scott Sumner, I argued that Debt Surges Don't Cause Recessions...Excessive Aggregate Amounts Do. A recent post from Pragmatic Capitalism, Failing to Connect the Boom to the Bust, offers the following chart to support the importance of credit expansions in understanding business cycles:

Commenting on the post from Pragmatic Capitalism, The Arthurian comes to a similar conclusion:

During the boom you get lots of credit expansion, so total debt goes up a lot. During the bust you get little credit expansion, and total debt goes up only a little. But total debt goes up, either way. (Until the crisis, of course. And that's why there eventually is a crisis.)

There ya go: When credit expansion declines, you have recession. When total debt declines, you have depression. There's a definition for you.

Don't worry, it's not set in stone. It's not fate. It's just stupidity. We *insist* on using credit for growth. We *insist* on using credit for everything. We *insist* on using bank-issued “inside money” as our primary form of money. Change that, and we change the world forever.

Always keep in mind the ratio between inside money and outside money.

Some people want to go back to gold. Some people want 100% reserve. I just want to reduce the debt-per-dollar ratio to a workable level, and keep it there. The same system we knew and loved for 60 years, only not so extreme.

Clearly in agreement with the conclusion, I decided to explore the italicized statement above. Earlier in the post, The Arthurian said:

you can get a feel for the ratio between inside money and outside money, by looking at a picture of debt per dollar of circulating money. Or at debt per dollar of base money.

Since the graphs at those links were a bit out of date, here are the updated versions:

Debt-per-Dollar of Circulating Money

Debt-per-Dollar of Base Money

Both charts depict the persistent rise in debt-per-dollar from the 1950’s until the late 2000’s. Although the decline is pronounced in the past few years using either metric, the degree to which the ratio has retraced its 60 year rise is markedly different. Choosing the appropriate measure is therefore necessary if we are going to implement The Arthurian’s plan “to reduce the debt-per-dollar ratio to a workable level.”

Since both graphs use the same measure of total debt, the stark difference in rate of decline is clearly due to changes in circulating money (M1) versus base money (MB), shown in the following chart:
Digging a bit deeper, the sharp rise in base money over the past few years is largely attributable to an increase in excess reserves:This chart, which is incredibly important for our discussion, suggests that the rise in excess reserves is the primary driver between the diverging rates of decline in the two measures of debt-per-dollar. Why is this important? The increase in excess reserves, engineered by the Federal Reserve, is primarily just an asset swap with private financial institutions. Since the Federal Reserve is purchasing US Treasuries and agency-MBS (liabilities of the US government), the economic sector which is really witnessing a decline in its debt-per-dollar is the US government.

Deconstructing the argument one more time, this graph again shows total credit market debt owed, now also separated out by the federal government and the private sector (blue line):
For nearly 60 years, private debt growth (credit expansion) continued unabated both in nominal terms and relative to federal debt. Although this provided a tailwind for economic growth, the legacy of accumulated debt is burdensome interest costs. While spending by the federal government is unconstrained by income, due to monetary sovereignty, the private sector is not so fortunate. When accrued interest costs (debt) become large enough, an economic shock (either exogenous or endogenous) may cause the private sector to increase savings and/or debt repayment and thereby decrease consumption and investment. If these actions are pursued in the aggregate, a “paradox of thrift” debt-deflation can take hold. In the US, this has been partially offset by the rapid rise in federal debt, but not fully given the exorbitant relative size of private sector debt.
Since private sector debt expansion and contraction has been a primary driver of the economy for at least 60 years, the debt-per-dollar ratio that best depicts the private sector should be the desired metric for policy reduction and stabilization. As shown above, the decline in debt-per-dollar of base money largely reflects an increase in excess reserves that does little to reduce the private sector debt burden. This last chart, however, displays private sector debt-per-dollar of circulating money:
Having decreased sharply since the onset of the Great Recession, this ratio remains at heightened levels only last witnessed at the beginning of the new millennium. We may still have a long way to go but reducing this debt-per-dollar ratio to a reasonable level will be worth it.

ECB's Means (Lost Decade With High Unemployment) To An End (Structural Reform)

Early in the week, global stock markets were falling fast as Spanish yields surged higher across the curve. Fearing that markets would quickly spiral out of hand, Jon Hilsenrath (WSJ) stemmed the tide by signaling forthcoming action from the Federal Reserve next week. Not to be outdone by his US counterpart, the ECB’s Mario Draghi provided a bazooka of open mouth operations by stating:

"The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough"

As Bruce Krasting points out, this is not the first time an EU politician has proclaimed an end to the crisis. While details of Draghi’s plan remain largely unknown (and undecided?), even his best efforts will do little to spur economic growth. Spain is suffering from excessive private debt, a bursting housing bubble and as Krasting notes:

its competitiveness. The domestic economy will never recover without a currency devaluation (and debt restructuring). If Mario has his way, Spain will suffer from a decade of recessions with unemployment over 20%.  How could he possibly call that outcome a success?

The answer to that question is actually quite simple and was given by JW Mason in a post titled Pain Is the Agenda: The Method in the ECB's Madness:

Here's an editorial in the FT on the occasion of last summer's ECB intervention to support the market for Italy's public debt:

Structural reform is the quid pro quo for the European Central Bank’s purchases last week of Italian government bonds, an action that bought Italy breathing space by driving down yields. ... As the government belatedly recognises, boosting Italy’s growth prospects requires a liberalisation of rigid labour markets and a bracing dose of competition in the economy’s sheltered service sectors. This is where the unions and professional bodies must play their part. Susanna Camusso, leader of the CGIL, Italy’s biggest trade union, is threatening to call a general strike to block the proposed labour law reforms. She would be better advised to co-operate with the government and employers... The government’s austerity measures are sure to curtail economic growth in the short run. Only if long overdue structural reforms take root will the pain be worthwhile.

A couple of things worth noting here. First the explicit language of the quid pro quo -- the ECB was not just doing what was needed to stabilize the Italian bond market, but offering stabilization as a bargaining chip in order to achieve its other goals. If ECB was selling expansionary policy last year, why be surprised they're not giving it away for free today? Note also the suggestion that a sacrifice of short-term output is potentially worthwhile -- this isn't some flimflam about expansionary austerity, but an acknowledgement that expansion is being give up to achieve some other goal. And third, that other goal: Everything mentioned is labor market reform, it's all about concessions by labor (including professionals). No mention of more efficient public services, better regulation of the financial system, or anything like that.

The FT editorialist is accurately presenting the ECB's view. My old teacher Jerry Epstein has a good summary at TripleCrisis of the conditions for intervention; among other things, the ECB demanded "full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; "reform [of] the collective wage bargaining system ... to tailor wages and working conditions to firms’ specific needs...”;  "thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, "making more stringent the eligibility criteria for seniority pensions" and raising the retirement age of women in the private sector. Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This is well beyond what we normally think of as the remit of a central bank.

So what Krugman presents as a vague, speculative story about the ECB's motives -- that they want to hold politicians' feet to the fire -- is, on the contrary, exactly what they say they are doing.

It's true that the conditions imposed by the ECB on Italy and Greece were in the context of programs relating specifically to those countries' public debt, while here we are talking about a rate cut. But there's no fundamental difference -- cutting rates and buying bonds are two ways of describing the same basic policy. If there's conditions for one, we should expect conditions for the other, and in fact we find the same "quid pro quo" language is being used now as then.

Here's a banker in the FT:

The future of Europe will therefore be determined by the interests of the ECB. Self-preservation suggests that it will prevent complete collapse. If necessary, it will overrule Germany to do this, as the longer-term refinancing operations and government bond purchase programme suggest. But self-preservation and preventing collapse do not amount to genuine cyclical relief and policy stimulus. Indeed, the ECB appears to believe that in addition to price stability it has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.

Again, there's nothing irrational about this. If you really believe that structural reform is vital, and that democratic governments won't carry it out except under the pressure of a crisis, then what would be irrational would be to relieve the crisis before the reforms are carried out. In this context, an "irrational" moralism can be an advantage. While one can take a hard line in negotiations and still be ready to blink if the costs of non-agreement get too high, it's best if the other side believes that you'll blow it all up if you don't get what you want.  Fiat justitia et pereat mundus, says Martin Wolf, is a dangerous motto. Yes; but it's a strong negotiating position.  

The whole post is well-worth reading, but these comments say it all. By working to prevent an all out collapse of the EMU, Draghi is merely taking the necessary actions to maintain his position. If Spain or other European countries must “suffer from a decade of recessions with unemployment over 20%” in order to implement the desired structural reforms than so be it. Whether or not that outcome is politically feasible remains an open question, but I have my doubts. Draghi was not the first to claim “it will be enough" and won’t be the last to make that claim either.

The Fed Controls Long-Term Interest Rates

Casey Mulligan recently offended a significant portion of the economics blogosphere by stating that:

New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy. Politicians, and a few economists, have been imploring the Federal Reserve to help the economy grow before November. But the effects of monetary policy on the wider economy are small.

Although I have repeatedly attempted to show that, under current conditions, monetary policy would be largely ineffective at stimulating the broader economy, this should not be taken as a dismissal of the general potential for monetary policy. Cullen Roche chimes in on the subject with a conclusion that sums up my views:

monetary policy has been very weak in the current environment for several reasons.  The primary reason is due to a lack of demand for debt.  Consumers are saddled with excessive debt so demand for “inside money” has been abnormally weak in recent years.  This is perfectly normal following a credit driven bubble.  And since monetary policy primarily works through altering the cost of “inside money” it’s not surprising that the actions of the Fed have appeared rather ineffective in recent years.  But this unusual environment should not be taken to mean that the Fed has zero options or that monetary policy is never effective.    To do so would be a vast misunderstanding of the basics of banking and the way our monetary system works.  Monetary policy might be a blunt instrument at times, but let’s not make extreme comments that sound ideological or take the uniqueness of today’s environment to make sweeping generalizations.

Beyond this main issue concerning the effectiveness of monetary policy, Mulligan’s post raised the question of whether the Federal Reserve controls long-term interest rates. Since the Federal Reserve could purchase all outstanding Treasuries at a given price/yield, I think it’s fair to say the potential power for strict control exists. A more basic question, however, is whether past and current policy displays control over long-term Treasury rates. I’ve argued affirmatively, drawing on comments from Edward Harrison, Gary Becker and others, that long-term Treasury rates are primarily a function of expected short-term rates over a given period. JW Mason, whose work I highly regard, disputes this claim:

it's not at all obvious that long rates follow expected short rates either. Here's another figure. This one shows the spreads between the 10-Year Treasury and the Baa corporate bond rates, respectively, and the (geometric) average Fed Funds rate over the following 10 years.

If DeLong were right that "the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia" then the blue bars should be roughly constant at zero, or slightly above it. [2] Not what we see at all. It certainly looks as though the markets have been systematically overestimating the future level of the Federal Funds rate for decades now. But hey, who are you going to believe, the efficient markets theory or your lying eyes?

From my perspective, this preliminary conclusion from Mason confuses expected average rates with actual outcomes. Although I can’t speak for DeLong (or others), the notion that markets might/have systematically overestimated and underestimated future Fed Funds rates does not undermine the theory. As the following chart shows, inflation and 10-year Treasury rates were primarily rising from the early 1960’s until the early 1980’s. Based on economic theory at the time (e.g. Phillips curve), it was not unreasonable to expect that inflation would subside with increasing unemployment and the Federal Reserve would lower rates in response. The unexpected persistence of inflation likely caused many investors to consistently underestimate future Fed Funds rates during this period.

By the time Paul Volcker took over as Chairman of the Federal Reserve, many (most) investors had probably come to expect persistent inflation. When inflation crashed in the early 1980’s, it would have been equally reasonable to expect a return to high inflation and Fed Funds rates. The actual outcome has been largely subdued inflation, now going on 30 years. To understand how unexpected this outcome was, one only has to consider that returns on long-term Treasuries has exceeded returns on stocks during this 30-year period (a previously unthinkable feat missed by nearly all investors).

Mason continues his post with the counter claim that:

What profit-maximizing bond traders do, is set long rates equal to the expected future value of long rates.

I went through this in that other post, but let's do it again. Take a long bond -- we'll call it a perpetuity to keep the math simple, but the basic argument applies to any reasonably long bond. Say it has a coupon (annual payment) of $40 per year. If that bond is currently trading at $1000, that implies an interest rate of 4 percent. Meanwhile, suppose the current short rate is 2 percent, and you expect that short rate to be maintained indefinitely. Then the long bond is a good deal -- you'll want to buy it. And as you and people like you buy long bonds, their price will rise. It will keep rising until it reaches $2000, at which point the long interest rate is 2 percent, meaning that the expected return on holding the long bond and rolling over short bonds is identical, so there's no incentive to trade one for the other. This is the arbitrage that is supposed to keep long rates equal to the expected future value of short rates. If bond traders don't behave this way, they are missing out on profitable trades, right?

Not necessarily. Suppose the situation is as described above -- 4 percent long rate, 2 percent short rate which you expect to continue indefinitely. So buying a long bond is a no-brainer, right? But suppose you also believe that the normal or usual long rate is 5 percent, and that it is likely to return to that level soon. Maybe you think other market participants have different expectations of short rates, maybe you think other market participants are irrational, maybe you think... something else, which we'll come back to in a second. For whatever reason, you think that short rates will be 2 percent forever, but that long rates, currently 4 percent, might well rise back to 5 percent. If that happens, the long bond currently trading for $1000 will fall in price to $800. (Remember, the coupon is fixed at $40, and 5% = 40/800.) You definitely don't want to be holding a long bond when that happens. That would be a capital loss of 20 percent. Of course every year that you hold short bonds rather than buying the long bond at its current price of $1000, you're missing out on $20 of interest; but if you think there's even a moderate chance of the long bond falling in value by $200, giving up $20 of interest to avoid that risk might not look like a bad deal.

Once again, I think this example confuses some aspects of bond trading. While Mason considers a bond in perpetuity, let’s instead consider a 10-year Treasury with a 4% yield and 2% Fed Funds rate expected to continue indefinitely. Now assume that this expectation for the Fed Funds rate holds true. Entering year ten, if prices don’t adjust, investors will have the option of purchasing notes with equal maturities (the 10-year Treasury only has a year remaining before maturity) that offer either a 2% or 4% yield. Given the option, investors will purchase the 4% note, pushing the price up and yield down until it reaches approximately 2%. Even if 10-year Treasury rates are still 4% at that time, the previously held bond no longer has a long-term maturity and becomes the equivalent of a short-term note/bill. This is why the expected short term rates, and not long-term rates, matter for controlling long-term Treasury rates.     

Despite our differences in opinion over influencing long-term Treasury rates, Mason and I agree that:

for policy to affect long rates, it must include (or be believed to include) a substantial permanent component, so stabilizing the economy this way will involve a secular drift in interest rates -- upward in an economy facing inflation, downward in one facing unemployment. (As Steve Randy Waldman recently noted, Michal Kalecki pointed this out long ago.)

Currently, unemployment and disinflation are persisting far longer than most economists, politicians and investors expected. These outcomes have led the Federal Reserve to maintain a zero percent Federal Funds rate for three years and predict continuation of that policy for at least a couple more. As investors become increasingly convinced that short-term rates will remain at or near zero indefinitely, long-term Treasury rates have continued the secular drift lower that began in the early 1980’s.

So yes, the Federal Reserve can control long-term Treasury rates and has been doing so by adjusting market perceptions of future Fed Funds rates. Unfortunately, as Mason says:

adjusting expectations in this way is too slow to be practical for countercyclical policy.

Monetary policy, in a future crisis, will once again have its time to shine. For now, fiscal policy must take center stage to reduce household debt burdens and counteract previous measures aimed at inducing a credit bubble.  

Representative Agents and Credit-Constrained Households

An interesting debate has broken out recently in the econ blogosphere between mainstream (e.g. Simon Wren-Lewis) and heterodox (e.g Lars P Syll) macroeconomists. Earlier today, Chris Dillow jumped into the conversation with the following:

Simon Wren-Lewis asks heterodox economists a question: how do you answer the question "what do consumers do if they are told that taxes are rising temporarily?" without some appeal to representative agents?

My answer is: I would start from a representative agent model (which predicts consumption smoothing) but I wouldn't stop there. On this issue, as on most other macro ones, I'd ask two further questions.

One is: do we have any reason to suspect that the representative agent perspective might be wrong? For example, some households might not have savings to run down in response to a tax rise, and might be unable to borrow; this is true for a minority (pdf).These people might be forced to cut spending.In this sense, heterogeneity matters, because models in which everyone is credit-constrained or nobody is are both wrong.

As an aspiring heterodox economist, I don’t deny that thinking in terms of representative agents can be useful. My opposition to mainstream macroeconomics, similar to Dillow’s, is that much analysis stops at that perspective. To understand macroeconomics, one has to consider that representative agent models may be wrong and in that case, find other models that better represent reality.

Dillow’s first question (read the full post for the second) addresses an issue that I’ve previously discussed as allowing heterodox economists to correctly predict the financial crisis and ensuing stagnation. Households burdened with excessive debt can become unable or unwilling to borrow regardless of low interest rates and bank liquidity. Monetary stimulus, which targets credit expansion through bank liquidity and lowering interest rates, has therefore been largely unsuccessful since liquidity was restored in the heart of the crisis. The lack of new loans and household (or private sector) deleveraging creates a deflationary drag on economic growth.

A recent quote from a July 2012 Euro Area Bank Survey highlights this issue:

Turning to loan demand developments, euro area banks continued to report, on balance, a significant fall in the demand for loans to enterprises in the second quarter of 2012, although the balance was somewhat less negative than in the first quarter of 2012 (-25%, compared with -30% in the first quarter). As in the first quarter, according to reporting banks, the fall in the second quarter was mainly driven by a substantial negative impact from fixed investment on the financing needs of firms. The ongoing decline in net demand for loans to households for house purchase abated in the second quarter compared with the first quarter (-21%, from -43% in the first quarter), whereas net demand for consumer credit remained broadly unchanged (-27%, compared with -26% in the first quarter). Looking ahead to the third quarter, banks expect a continued decline in the net demand for loans, both for enterprises and households, even if less negative than in the second quarter.

Despite the ECB’s efforts, loan demand continues to fall throughout Europe. Delusional Economics (which provided the above link/quote) sums it up best:

So, once again, this looks far more like a demand side issue than as supply side one. In fact these poor results appear to have even surprised the banks who were expecting far less of a deterioration. But are these results really surprising? Not to me. With private sectors in many economies under financial strain from deteriorating economic conditions and , in many a cases, rising tax burdens this is completely expected behaviour in my opinion. Households under stress don’t have the capacity to take on new credit, no matter what the rates and business therefore have little reason to invest.

Importantly, what this data suggests is that this problem isn’t really something that monetary policy, no matter how unconventional, is going to solve. This looks very much like a job for fiscal because until private sector balance sheets are repaired monetary policy is a lame duck. Obviously the fiscal compact is not going to provide this fiscal relief.

Steve Keen's Proposal for "Sub-Euros" and "an SDR of Europe"

Markets around the globe rallied following Mario Draghi’s statement that he would “do ‘whatever it takes’ to protect the euro zone from collapse.” Unfortunately, for market/Europe optimists, this statement was not accompanied by any specific forthcoming policy action or timeline for action. While open-mouth operations continue to scare the shorts and offer a short-term boost, the spike in optimism will once again be short-lived as growth concerns soon return to the fore.

Over the past couple years, I’ve remained pessimistic about the potential for a United States of Europe. Instead, I continue to believe that the EMU will eventually break-up but remain hopeful that free trade and labor mobility will persist. During this time, I’ve tried to highlight various proposals for solutions to the crisis that appeared both reasonable and feasible. Drawing from the work of Keynes, Friedman and Godley, Steve Keen offers a new proposal that re-institutes national currencies while maintaining the Euro as an SDR of Europe:

Some see the way out of today’s catastrophe as creating what does not exist—the United States of Europe. But if that were ever a possibility, it is far less one after the damage done by Maastricht, and the Franco-German insistence on austerity for the periphery in this crisis. However what is a possibility—and which has echoes in some of the contributions here (such as “Nau” proposal from Gerald Holtham)—is to move the Euro closer to a continental version of Special Drawing Rights.

The Euro could be the currency of inter-European and international trade, while “sub-Euros” created by each of the nations of Europe could be used for domestic trade and, importantly, domestic financial arrangements. The disciplinary aspects of Maastricht—which are currently inappropriately directed at government deficits and are amplifying the downturn—would then be redirected at trade deficits within Europe instead (and matched by pressures to minimize intra-European trade surpluses as well).

The Euro-Drachma, Euro-Peso and Euro-Mark could be introduced at one-to-one parity with the Euro, and all financial assets and liabilities would be denominated in these national currencies rather than the Euro. These national currencies would then float freely for a period (say one year), after which they would be fixed in proportion to the Euro.

The obvious devaluation that would occur for the Euro-Drachma and Euro-Peseta would reduce their foreign debts—and force the nations whose banks over-lent to them to deal with the consequences. It would also end the currency flight that is currently occurring: a Euro-drachma would still be a Euro-Drachma, whether it resided in a Greek or German bank account.

The introduction of such a system could provide a rapid resolution to the current crisis. It could not be pain free, but it would be difficult to imagine that it would impose more pain than is currently being felt by Greece and Spain, or is about to be felt by other countries once the contagion passes on to them.

This system would also introduce what is otherwise impossible in the Euro: exchange-rate flexibility. Economists as widely apart ideologically as Wynne Godley and Milton Friedman observed long before the Euro began that it would fail (a) because it imagined that a market economy would reach a harmonious equilibrium on its own without government intervention—which Godley correctly characterized as a deluded neoclassical fantasy; and (b) because it pushed together widely disparate nations which Friedman noted were utterly unsuited to a currency union.

A step backwards by Europe from dystopian fantastical object of a single currency, to a mini-version of what Bretton Woods should have been, could thus be a workable way out of this crisis and towards the political dream of a non-fractious Europe.