1st Day of Micro - Households and Governments are NOT the Same

Classes began this week and for what its worth, I have successfully completed my first week of class as a PhD student in economics. My choice of school, George Mason University, was primarily due to the desire to join the mainline of economics, not the mainstream (see Living Economics: Yesterday, Today, and Tomorrow by Peter J. Boettke for details on the difference).

Although I am excited about the opportunity, one area of economics where I feel my incoming views might contradict those of professors’ is related to modern money regimes. An example of this distinction is the contrasting beliefs that governments with fiat currencies, who sell debt in their own currency, cannot become insolvent versus the seemingly widespread belief that the US government will default if drastic actions to cut deficits/spending are not promptly taken. You can imagine my joy/relief, when during my first microeconomics class, Walter Williams used the following example to demonstrate the fallacy of analogy (approximate quote):

If a household has expenditures greater than their income they’ll go bankrupt, therefore if governments have expenditures greater than their income, the government will go bankrupt. Well, the latter is not necessarily true. Why? Because governments can always pay their debt, can’t they? They’ll just print money.

While I can’t/won’t claim that all GMU econ professors, Austrians, or Libertarians recognize this distinction (I’m not even sure which of the latter two, if either, Williams’ associates with) , I imagine the percentage that do is higher than many critics believe. For my part, I’m excited about the potential for further intersections between my classes and readings on modern money.

(Note: Unfortunately, for those who enjoy this blog, my priorities are shifting to the PhD program for the foreseeable future. I will try to update the blog as much as possible, but in doing so, will probably focus more posts on class readings, topics and discussions. Thank you to all my readers for support and to commenters for helping further my education.)

Federal Reserve Admits Inability to Control Inflationary Expectations

Another solid post by Izabella Kaminska at FT Alphaville on The unintended consequences of QE. This one offers observations from a Federal Reserve Bank of Dallas working paper, by William White, about “Ultra Easy Monetary Policy and the Law of Unintended Consequences“. Here is one section worth highlighting:

A further concern is that the reductions in real rates seen to date, associated with lower nominal borrowing rates and seemingly stable inflationary expectations, might at some point be offset by falling inflationary expectations. In the limit, expectations of deflation could not be ruled out. This in fact was an important part of the debt/ deflation process first described by Irving Fisher in 1936. The conventional counterargument is that such tendencies can be offset by articulation of explicit inflation targets to stabilize inflationary expectations. Even more powerful, a central bank could commit to a price level target, implying that any price declines would have subsequently to be offset by price increases.

However, there are at least two difficulties with such targeting proposals. The first is making the target credible when the monetary authorities’ room for maneuver has already been constrained by the zero lower bound problem (ZLB). The second objection is even more fundamental; namely, the possibility that inflationary expectations are not based primarily on central banker’s statements of good intent. Historical performance concerning inflation, changing perceptions about the central banks capacity and willingness to act, and other considerations could all play a role. The empirical evidence on this issue is not compelling in either direction.

Repeating a key statement there, contrary to the hopes and dreams of market monetarists, the Fed surprisingly admits that:

inflationary expectations are not based primarily on central banker’s statements of good intent.

Moving on, another portion of the paper expresses concern that low rates will hurt margins in various means of financial intermediation. Japan remains a good example in this matter as low interest rates and a flattening curve have drastically reduced net interest margins, almost entirely wiping out profitability among the banks. Separately, we should heed the lesson from Denmark that negative rates (which reduce margins) can pressure banks to compensate by charging higher rates on loans.

All of this gets back to an issue previously discussed by Ryan Avent, Steve Roth and others, which is the asymmetric nature of monetary policy. In short, the Fed’s ability to fight inflation is far greater than its ability to create it.

In conclusion, Kaminska and White are spot on:

Yet herein lies the irony. For, if it’s clear that low-yield policies and QE buy time, and only time, this inevitably puts the onus on governments, not central banks, to steer the economy out of the path of the unintended consequences of monetary policy.

Indeed, as White concludes:

If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.

Monetary policy provides a bridge to an expected future outcome, but cannot ensure the structure (economy) on the other side is built high enough. Governments, through fiscal policy, must provide institutions and incentives to support (or at least not hinder) growth. The US government has performed far better than those in Europe, but has still fallen short. As we approach the end of the monetary bridge, it appears there may be a steep drop ahead.

Facing Decline, Will Australia Follow the US or Europe?

Is Australia… in the same boat as Europe? That is the question being posed by Izabella Kaminska at FT Alphaville following a report from Variant Perception. A main concern in their eyes is:

The Australian banking system is highly reliant on external funding and will likely become dependent on the RBA for liquidity in the near future. Our view is that the RBA will have to become much more activist in supporting its major banks as the structural slowdown in China and the housing market continues.

We believe the RBA will ultimately be forced to take similar action to developed market central banks either by aggressively cutting interest rates or propping up banks through domestic open market operations akin to the liquidity injections seen by the ECB.

Quantitative easing is also a possibility if the RBA is forced to buy bank debt to try to stave off a financial crisis. Under such a scenario, the AUD would fall considerably.

The crisis-stricken economies along the eurozone periphery share one key characteristic: their external debt is too high and their net international investment position (NIIP) – measuring the difference in stock value between assets held abroad and asset held domestically by foreigners – is deeply negative. Yet, a closer look and you will find Australia and its neighbour New Zealand in the same company, with negative NIIP well above countries such as Turkey and Brazil.

Here’s the chart that emphasizes the NIIP point:

When the RBA is ultimately forced to aggressively cut interest rates and supply liquidity, its struggles in maintaining and promoting growth will rival those of the Fed and ECB. Similar to the US and portions of Europe, a primary driver of previous growth and now deflationary force is excess household debt accompanied by a bursting housing bubble. The RBA’s actions will be necessary to try and forestall a banking crisis but will most likely fail in spurring renewed private credit expansion. If the RBA can prevent a major financial crisis, then the severity of the fall will largely be determined by the government’s budget deficit (and fallout from China). If the government attempts to balance its budget or constrict the deficit, Australia may start to truly resemble Europe.

Previously I posed the question, Australia: Market Monetarist Success or Post-Keynesian Failure? Recent data is starting to push the odds in favor of the latter.

Why Cash "Parked" at the Fed Will Remain There

Following the ECB’s decision in July to stop paying interest-on reserves (IOER), many economic pundits have been and continue to pressure the Fed to pursue a similar action in hopes it will revive bank lending. At that time, I was highly suspicious of these arguments are countered that Making IOER Negative Equates to Raising Taxes And Raises Potential Of New Recession. My reasoning was, in part, based on the view that banks cannot lend out reserves and the total amount of reserves in this system is largely determined by the Fed’s open market operations.

Apparently having heard enough of these arguments, the NY Fed has presented its own reply about Interest on Excess Reserves and Cash “Parked” at the Fed:

In this post, we use the structure of the Fed’s balance sheet to illustrate why lowering the interest rate paid on reserve balances to zero would have no meaningful effect on the quantity of balances that banks hold on deposit at the Fed.

For our discussion, here is the section that really stands out:

The View from the Balance Sheet

It’s important to keep in mind, however, what determines the total quantity of these balances. One way of understanding the issue is by looking at the Fed’s balance sheet, a simple version of which is presented in the table below.

   As the table shows, the balances that banks hold on deposit at the Fed are liabilities of the Federal Reserve System. The other significant liability is currency in the form of Federal Reserve notes. Together, this currency and these deposits make up the monetary base, the most basic measure of the money supply in the economy. The composition of the monetary base between these two elements is determined largely by the amount of currency used by firms and households (both in the United States and abroad) to make transactions and by banks to stock their ATM networks.

   What determines the size of the monetary base? As with any other institution’s balance sheet, the Fed’s dictates that its liabilities (plus capital) equal its assets. The Fed’s assets are predominantly Treasury and mortgage-backed securities, most of which have been acquired as part of the large-scale asset purchase programs. In other words, the size of the monetary base is determined by the amount of assets held by the Fed, which is decided by the Federal Open Market Committee as part of its monetary policy.

   It’s now becoming clear where our story’s going. Because lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed, it must not change the total size of the monetary base either. Moreover, lowering this interest rate to zero (or even slightly below zero) is unlikely to induce banks, firms, or households to start holding large quantities of currency. It follows, therefore, that lowering the interest rate paid on excess reserves will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed.

Reviewing the Fed’s balance sheet clearly illustrates that open market operations and large-scale asset purchases (QE) are no more than an asset swap with private banks in which the amount of reserves in the system expands. Banks cannot lend these reserves to the public and can only dispose of them through changes to the Fed’s balance sheet. Therefore, any hope that lowering or ending IOER will stimulate private credit creation can only come from a change in demand based on lower interest rates or revised expectations about future rates and asset prices.

Needless to say, I agree with the Fed that altering policy in this manner will have a negligible effect in spurring demand for loans. On the cost side, this policy presents uncertainty for the continued functioning of money market funds and reduces bank capital. Further, when the Fed eventually wishes to raise rates, IOER permits altering the Fed Funds rate without targeting the amount of reserves in the system. This NY Fed post appears to send a clear message that an "Interest-On-Reserves Regime" Will Rule Monetary Policy For The Foreseeable Future.

The US Dollar Currency Hegemony Will Persist

In the The Real Reason the US Dollar Can’t Lose, Michael Sankowski (Monetary Realism) comments:

One of the big scares out there is there will be a shift away from the U.S. dollar into the Chinese Yuan, and this shift will drive U.S. interest rates dramatically higher. Here’s the Economist throwing in a rather silly statement:

“The good news for the dollar is that the Chinese yuan is not yet widely accepted and suffers from higher inflation, reducing its usefulness. But a shift in the world’s reserve currency could be swifter than many assume.”

This is simply silly. A multi-trillion real value shift can’t happen quickly. The United States still has a huge proportion of valuable real assets. Foreigners want access to those [assets], and that involves getting U.S. dollars at some point. The value of the dollar is tied to the getting access to U.S. markets.

(Note: changed access to assets for clarity)

There is some good discussion in the comments, but I want to highlight a wonderful paper on this subject by David Fields and Matias Vernengo titled Hegemonic Currencies during the Crisis: The Dollar versus the Euro in a Cartalist Perspective (http://www.levyinstitute.org/publications/?docid=1374). The authors initially offer an introduction to money, comparing the Metallist versus Cartalist approach. Although debate about the historical creation of money continues, currently:

Money derives its properties from the state’s guarantee, and the monetary authority ensures the creditworthiness of the state by keeping its fiscal solvency.6 In its own domestic currency the national state is essentially always creditworthy, and default is impossible, since the central bank can always buy government bonds and monetize the debt. (p. 6)

With concerns of solvency removed from the equation, the authors move on to the fear of unsustainable trade deficits:

There is no balance of payments constraint for the hegemonic country and the principles of functional finance apply on a global basis. (p. 6)

Having alleviated these fears about the fall of the dollar, Fields and Vernengo conclude

It is the power to coerce other countries that is central for monetary hegemony. (p. 7)

While China’s remarkable growth has no doubt increased its ability to coerce other countries, it remains nowhere close to matching the US. Current economic struggles in both China and Europe further reduces the likelihood that any nation (or union) will challenge the US global position in the near future. The US dollar looks set to remain the monetary hegemony for the foreseeable future.

Markets Determine Interest Rates...Until The Fed Says Otherwise

About a month ago JW Mason of The Slack Wire asked, Does the Fed Control Interest Rates? This was in response to some back-and-forth regarding the effectiveness of monetary policy. Previously on this blog, I’ve outlined my view that interest rates are determined by expectations about the future path of monetary policy (see here, here and here). In this sense, the Fed does, to varying degrees, control interest rates across the curve. Mason attempts to dispel that view, in part, with the following chart showing the rate structure against moves in the Fed Funds rate:
His conclusion is:

Wouldn't it be simpler to allow that maybe long rates are not, after all, set as "the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia," but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That's what Keynes thought.

So apparently the Fed doesn’t control interest rates. Well, hold on a moment. Not long after Mason’s post, The New Arthurian Economics responded with But why, JW? Why "The past 25 years"?? As you’ll note, the above chart only considers rates back to 1987. Using some clever data mining and chart altering, Art comes up with the following historical look at the Fed Funds rate versus an average of other market interest rates:
Once again, it appears that rates are not following the Fed as closely as one might expect.

Responding to both Mason and Art, in the comments, I offered my own answer to the question. In short (you can read the full comments if you choose), market expectations of future Fed action are sticky. During the post-war period until about 1980, inflation was consistently rising despite mainstream economic views that suggested those conditions would not persist. Following a lengthy inter-war period of near rock-bottom interest rates, market participants were slow to adjust expectations to the actual height of interest rates that would occur before sustained disinflation began. Once disinflation began in the early 1980’s, market expectations were equally slow in recognizing how long disinflation could persist and therefore how low the Fed would ultimately take rates (and hold at zero).

Contrary to this expectations based view, Jazzbumpa, of Angry Bear, countered with a link to his previous post on Who Determines Short Term Interest Rates? His conclusion, supported by various graphs:

The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.

This leads to two important questions on the subject:

1) Does the Fed have any real power to influence interest rates?2) What would happen if they attempted to move counter to the market?

These questions have plagued me for the past few weeks, but I think I’ve found the answer.

As I pointed out in one my comments:

The Fed acts in certain intervals and operates under a corridor system. In this manner, the Fed sets the target rate but permits fluctuations within a band between the discount rate and IOR rate.

Now let’s imagine that during an interval between FOMC meetings, private credit expansion is causing banks to demand more reserves. Absent open market operations that increase the supply of reserves, the Fed Funds rate will move higher towards the upper bound of the targeted range. Witnessing this change, the Fed can choose to respond by either expanding the supply of reserves to maintain its current policy rate or by raising the rate to match the “market-determined” interest rate. The same principle would apply in reverse to a decline in demand for reserves. In this manner, the Fed FOLLOWS the market in supplying reserves and setting the Fed Funds rate.

Not surprisingly, the story above complements the paper by Scott Fullwiler “Interest Rates and Fiscal Sustainability”, which notes:

“More recently, Fullwiler (2003) and Lavoie (2005) have demonstrated that the central bank’s obligation to promote the smooth operation of the payments system means that the provision of reserve balances are necessarily non-discretionary. (p.12)”

After much thought, I’m willing to concede that the Fed primarily acts (or has acted) passively in setting short-term rates. This view, however, does not entirely undermine the expectations theory for long-term interest rates or the Fed’s ability to control interest rates. If market participants are aware that the Fed reacts to market moves, then future expectations regarding a “market-determined” interest rate provides a reasonable proxy for the Fed Funds rate. Separately, the Fed could announce a ceiling on long-term Treasury rates and dare the market to test its resolve. Therefore, I accept that in practice the market determines interest rates, but retain the view that operationally the Fed could control interest rates.

A real test of the Fed’s power to manipulate interest rates would require the Fed to either act counter to the market or cap specific rates along the curve. Although the latter seems more likely than the former, I don't expect either action to occur anytime in the near future. Considering central banks outside of the Fed, the ECB may soon provide a real-world experiment by setting a ceiling on rates. Though the EMU holds stark differences with the US monetary system, it will be enlightening to witness a central bank truly take on the markets. This debate is far from over...   

Macroeconomics Could Benefit From Complexity

In chaos versus complexity, Greg Fisher states (my emphasis):

Dynamic networks – or complex systems – are very different to the systems studied in Chaos Theory.  They contain a number of constituent parts (“agents”) that interact with and adapt to each other over time.  Perhaps the most important feature of complex systems, which is a key differentiator from chaotic systems, is the concept of emergence.  Emergence “breaks” the idea of determinism because it means the outcome of some interaction can be inherently unpredictable.  In large systems, macro features often emerge that cannot be traced back to any particular event or agent.

To understand the concept of emergence further, we can look at water.  We know the qualities of oxygen atoms and we know the qualities of hydrogen atoms, so presumably we can determine the qualities of H20, water?  Actually we cannot.  Really, however freakishly this might sound, we cannot.  It turns out that we are familiar with the qualities of water only because we have observed them empirically.  The properties of water are emergent.  If any reader wished to delve further in to this, I would recommend Stuart Kauffman’s book Re-Inventing the Sacred.  In this book, Kauffman wrote that

“it is something of a quiet scandal that physicists have largely given up trying to reason ‘upward’ from the ultimate physical laws to larger-scale events in the universe”

The reason for the inability to reason ‘upwards’ from hydrogen and oxygen to water is because the properties of water are emergent and therefore indeterminable from the properties of the constituent atoms.

First of all, I’ve read Kauffman’s book and would personally recommend it to anyone interested in physics, complexity and/or emergence. Second, the difference between chaos and complexity, although it may appear subtle, highlights a critical concern for the study and modeling of complex systems. The macro economy is one of these complex systems in which “the outcome of some interaction can be inherently unpredictable.”
Peter Lewin moves this discussion into the realm of economic modeling with his (Complex?) Thoughts on Heterogeneity and Complexity; Quality and Quantity (my emphasis):

Returning to the theme of the relationship between quantity and quality, quantitative modeling works when both the independent and dependent variables are meaningful, identifiable quantifiable categories that can be causally related. The model ‘works’ then in the sense of providing quantitative predictions. The inputs and outputs can be described in quantitative terms. But, when the outcome of the process described by the model is a new (novel) category of things, no such quantitative prediction is possible. Ambiguity in the type and number of categories in any system destroys the ability to meaningfully describe that system exclusively in terms of quantities. We have a sense then of the effects of heterogeneity. Variation applies to quantitative range. Heterogeneity (variety) applies to qualitative (categorical) range. Diversity incorporates both, but they are significantly different. Heterogeneity may not be necessary for complexity, but heterogeneity does militate in its favor. For example, compound interaction between quantitative variables (categories) can be an important characteristic of complex systems, but complex systems are likely to result from substantial heterogeneity, especially where heterogeneity is open-ended, in the sense that the set of all possible categories of things is unknown and unknowable.  

Heterogeneity rules out aggregation, which, in turn, rules out quantitative prediction and control, but certainly does not rule out the type of ‘pattern prediction’ of which Hayek spoke. In fact, erroneously treating heterogeneous capital as though it were a quantifiable magnitude has led to misunderstandings and policy-errors, such as the those associated with the connection between investment and interest rates - errors that could have been avoided with a better understanding of capital heterogeneity and its effects. The capital-structure is complex, but it is intelligible. We can understand and describe in qualitative (abstract) terms how it works and render judgment on economic policies that affect it. And, as a result of Hayek’s insights into complex phenomena, we have an enhanced appreciation of what is involved.

Economics is slowly moving in the direction of recognizing that heterogeneity not only exists in the real world, but is critical to understanding how the system works. Unfortunately, we are not yet at the point where most economists accept the inherent inability to quantitatively forecast macroeconomic outcomes and render accurate policy proposals from those conclusions. Many physicists now accept the consequences of and are incorporating complexity into models of various systems. Economics and economic policy would benefit greatly from moving in the same direction.  

Weak Euro Favors European Core Over Periphery

Sober Look asks the question, Who really benefits from the weak euro? Combining data from a couple of charts reveals the percentage of a country's GDP from exports to outside the Eurozone:
Based on this data, it becomes less of a surprise that Ireland’s economy has turned around the most of the bailed out countries.

What’s striking is that after Ireland and Belgium, the next four countries that benefit from a weak-Euro policy represent the core. Considering the periphery’s relatively small percentage of GDP from extra-Eurozone exports (with Spain not even making the list), further weakening of the Euro can not be expected to return those countries to economic growth or a sustainable fiscal position. With governments still being pressured to contract deficits, the only remaining growth engine is a generally indebted private sector.

The ECB may finally recognize the necessary steps to prevent a collapse of the EMU, but future growth remains elusive.  

Low Interest Rates and the Financial Crisis

Arjun Jayadev recently presented the following chart showing the effective interest rate for households and private non-financial corporations:
Jayadev was trying to dispel the notion that

the key cause of the financial turmoil in the U.S over the last two decades was the excessively low interest rates.

Attempting to reconcile this new data with my own views on recent economic history, I came to the conclusion that low incomes were a more likely cause of the financial troubles.

After providing my own analysis, a couple questions remain:

1) The data was calculated using interest payments from the household sector. Yet some interest payments are tax deductible, notably mortgage interest payments. Changes in tax policy that increase deductions or credits related to interest payments, thereby reducing the effective interest rate, may therefore not show up in this data. Is there a way to account for tax policy changes in regard to effective interest rates? How would this alter the above chart?

2) The effective interest rate as shown above does not appear to account for changes in credit quality. Given comparatively weak income growth and high debt-to-income ratios, I would argue that general credit quality was deteriorating over the past two decades. If that’s true, why weren’t effective interest rates higher in the past 20 years than during the 1950-1970 period?

My instinct is that accounting for tax policy changes and credit quality differences in the above chart would reflect comparatively lower effective interest rates during the last two decades. Contrary to Jayadev and Josh Mason’s work, this outcome would support the view that low interest rates were a cause of the financial turmoil. However, this result would not place the blame primarily on the Federal Reserve but rather on a confluence of actions from the government and non-government sectors. 

What are readers’ thoughts on these questions and/or my initial conclusion?

Fiscal Cliff Takes Center Stage With Recession Looming

Courtesy of Pragmatic Capitalism:

Some of the highlights of the CBO report are below:

What Policy Changes Are Scheduled to Take Effect in January 2013?

Among the policy changes that are due to occur in January under current law, the following will have the largest impact on the budget and the economy:

• A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. (Provisions designed to limit the reach of the alternative minimum tax, or AMT, expired on December 31, 2011.)

• Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.

• Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.

• Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire.

What is the Budget and Economic Outlook for 2013?

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:

• The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.

• Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.

• Because of the large amount of unused resources in the economy and other factors, the rate of inflation (as measured by the personal consumption expenditures, or PCE, price index) will remain low in 2013. In addition, interest rates on Treasury securities are expected to be very low next year.

While I have previously called for a US profit recession, currently taking place, I’ve remained in the camp (with PragCap) that held current budget deficits are large enough to stave off a recession. Next year, however, is a whole different ball game. The CBO’s baseline comes surprisingly close to matching my own expectations for 2013. There will be some form of compromise in Congress (there always is), but I simply don’t believe the political will or desire exists to prevent a substantial shrinking of the deficit.

If the CBO baseline is reasonably accurate (or understates the intended reduction), I fully agree that the US will enter recession in 2013 (or late 2012 depending on Congressional actions). Oddly enough, I also think this outcome will lead to a larger deficit than expected as counter-cyclical policies take hold. The US recession will probably be shallow in that case, absent a major shock from Europe or China, where risks remains high. Markets and politicians have largely ignored this issue to date, but soon enough it will take center stage.

FOMC Projections Provide No Hint Of Further Action

Dave Altig, executive vice president and research director at the Atlanta Fed, has this to say about monetary policy (my emphasis):

I'm not really aware of any models matched to real-world data that suggest monetary policy actions can (at acceptable cost) quickly and completely overcome all of the shocks and headwinds that may present themselves.

You may believe otherwise—that is, you may believe that, for current circumstances, monetary policy is a panacea. Or, less dramatically, you may believe that more monetary stimulus would surely yield something better than what was implied in the June SEP. Fair enough. But you should not believe that lackluster numbers in the SEP tell you anything about individual FOMC participant's views on the efficacy, desirability, or likelihood of further monetary actions, one way or the other.

You may want to reread that last sentence, which got my attention. A significant amount of time and effort is currently being spent trying to understand why FOMC participants are not pursuing greater action in light of forecasts that don’t quickly meet the Fed’s mandated goals. If Altig is correct, which I believe he is, than much of this effort is wasted. In my opinion, the FOMC’s mandate is to maximize employment and maintain stable prices over the medium-to-long run, not at every moment.

Proponents of further monetary stimulus, who will be disheartened by Altig’s message, are also usually reluctant to acknowledge the Fed’s success in stabilizing prices. There are certainly reasons one might prioritize the employment mandate, but that is also the far more difficult mandate for the Fed to achieve. Given the Fed’s determination to sustain its credibility and independence, it should come as no surprise that the more easily achievable target is seemingly favored.

So when the next Summary of Economic Projections (SEP) is released, don’t be surprised if a less than ideal short-run forecast is combined with a lack of action.

(Based on Altig’s statement I can only assume that he reads or accepts little from market monetarists, who frequently claim that NGDP targeting offers a practical panacea for monetary policy.)

(h/t Mark Thoma)

Dutch Housing Bubble Bursts. Who's Next?

The Dutch are currently paying the price for poor housing policy. As outlined by the Unconventional Economist:

the Netherlands housing system all but guarantees unaffordable housing and a susceptibility to housing bubbles, via:

1. ridiculously easy credit, with a third of mortgages guaranteed by the government;
2. mortgage interest tax relief and generous subsidies offered to home buyers;
3. a dysfunctional rental market that encourages households to strive for owner-occupation; and
4. severely restricted housing supply, which ensures that changes in demand flow predominantly into homes prices rather than new construction.

Now it appears the chickens are coming home to roost, with Dutch house price falls accelerating. According to the National Statistics Agency, Dutch house prices fell -8% in the year to July to be down -15% since prices peaked in 2008.

These policies should sound familiar to most Americans. Even though prices in the US have already fallen by well over 15% since the peak and caused lasting damage to the broader economy, a couple of these policies remain firmly in place. The mortgage interest deduction remains a hallmark among tax expenditures, favored by a large majority of Americans despite the benefits primarily accruing to the upper class. Easy credit practices that were formerly maintained by the private sector, with encouragement through Fannie and Freddie, are being continued with government guarantees. According to Dr. Housing Bubble:

In 2005 and 2006 FHA loans were only 5 percent of the entire pool.  Today, they make up roughly 1 out of 4 originations and reached a high of 30 percent in 2009.

Many of these loans are still being provided with a ridiculously low minimum down payment of only 3.5%. Not surprisingly:

eight of the largest US banks now have $79.4 billion in delinquent FHA insured loans.  Of this, 83 percent represent government-guaranteed mortgages.

Trying to prop up the housing market through increasing private debt may work for some years, but it has proven time and time again to be unsustainable.

Which brings me back to the Dutch story and the following chart:

Out of the top nine countries, with respect to debt-to-GDP, several have already experienced a dramatic fall in house prices. The remaining countries have only experienced mild declines from their peaks so far (Here is an interactive graph on house prices from The Economist). My hunch is that households will not be able to sustain such high debt ratios for much longer. As house prices begin to fall more rapidly, households will be forced to deleverage and the decline in demand will ripple throughout each economy. We have seen this movie play out in the US, Japan, Spain and now the Netherlands. Only time will tell if other countries near the top of this list will fall prey to a similar fate.     

Global Inflation Shows No Decoupling

Ed Yardeni offers the following chart on global inflation:
While the two lines begin to converge around the turn of the millennium, the most striking aspect is the correlation since the global crisis began in 2007. Although emerging economies are experiencing consistently higher inflation than advanced economies, the size of that difference has remained fairly constant despite dramatic moves in both directions. What does this imply for global trade and decoupling?

Are the major economies within each group becoming increasingly reliant on each other to support demand?
Are fiscal and monetary policies that alter inflation rates being transferred globally rather than contained? If so, what does that imply about the need for global coordination?
What is the likelihood of growth significantly decoupling when inflation is this tightly correlated?

Hayekian Limits of Knowledge in a Post-Keynesian World

Steve Horwitz explains how The work of Friedrich Hayek shows why EU governments cannot spend their way out of the Eurozone crisis:

Politicians and bureaucrats lack the knowledge to know which pieces fit with which pieces as they cannot know the nature of the idled resources and what consumers want. They are unable to know what is needed to create a sustainable recovery. One of the most fundamental insights of Hayek and the Austrians was that prices, profits, and losses serve as knowledge surrogates to coordinate the decentralised decisions of producers and consumers, themselves often based on knowledge that they could not communicate any other way.

Politicians who are structurally unable to know how best to allocate stimulus resources will inevitably distribute them to those persons and groups who will give them the most electoral support. The Austrian caution about the limits of politicians’ knowledge suggests that no matter what is drawn up on the blackboard, the politicisation of stimulus spending is not an accident and cannot be avoided. Stimulus spending that goes to groups that will provide the most votes will ensure that the right combinations of capital and labour will not be formed.

On this blog I often outline my views of the macro-economy based on the Post-Keynesian tradition (including MMT, MR, circuitists, horizontalists, etc) because I believe they offer the most accurate version of monetary operations and a stock-flow consistent approach. Where I generally depart from these economic sects relates to their specific policy prescriptions. On these matters, I more frequently side with Austrians for the reasons highlighted by Horwitz above.

To explain my position in a bit more detail, I agree that government deficits can help sustain growth and employment while the private sector attempts to increase its savings. This view, however, does not imply that government spending should increase or that it will be productive. Aside from the difficulty of knowing what to produce, government spending and deficits are often prone to corporate favoritism that serves to enlarge the income inequality gap. From my perspective, these concerns too often go unaddressed in proposals for larger deficits and increased public spending. The Post-Keynesians may hold the upper hand regarding causal relationships among macroeconomic factors but they could learn a thing or two about the limits of knowledge.   

NYT Room for Debate - Should the Fed Risk Inflation to Spur Growth?

At the NYT Room for Debate, Mark Thoma, John Cochrane and Edward Harrison address the question, Should the Fed Risk Inflation to Spur Growth?

• Put Inflation Fears Aside - Mark Thoma
• Inflation Should Be Feared - John Cochrane
• There's Little the Fed Can Do - Edward Harrison

Personally I side with Edward Harrison's view that the Fed is ill-equipped to substantially reduce the unemployment rate. There currently appears little reason to fear inflation and Cochrane appears off-base with comparisons between the US and Greece. As for Thoma's policy suggestion, further attempts to stimulate consumption and investment through rising asset prices risks creating new asset bubbles and preventing the household deleveraging necessary for more sustainable growth. Our current troubles primarily stem from fiscal policy decisions and therefore it is the responsibility of Congress, not the Fed, to correct these issues.

(h/t Economist's View)

Low Incomes, Not Low Interest Rates, Were Behind The Crisis

Arjun Jayadev notes that:

A common story holds that the key cause of the financial turmoil in the U.S over the last two decades was the excessively low interest rates. This perspective lays the blame for the financial crisis at the feet of discretionary Federal Reserve policy, and is typically made based on the fact that short term rates such as the federal funds rate or Treasury bill rates had been lower between 2001 and 2011 than in any previous decade. In short, this view claims that rates were “too low for too long.”

Trying to verify this story:

In ongoing work, Josh Mason and I look at actual interest payments to calculate the effective inflation adjusted interest rate on debt for households and for non-financial corporations. We find that the inflation-adjusted effective interest rates for households and non-financial corporations are nowhere near their historic lows during the early 2000s. While the rates are lower than anytime since the 1980s, interest rates were as low during the long period from 1950 to 1970 and certainly in the high inflation period of the 1970s.

Which is accompanied by the following graph:

These findings are actually reflected in data on the real changes in household debt per year:From this graph we see that household debt grew at the fastest pace in the early 1950’s, when effective interest rates were lowest, then slowed through the 1970’s reaching a local low in the early 1980’s, when effective rates were highest. As rates steadily declined from there, debt growth remained positive until the start of the crisis in 2009.

While these findings appear to invalidate the “common story” told above, it leaves questions regarding my own story of the Great Recession. In my story, households (and the private sector generally) accumulated increasing levels of debt compared to income. Interest costs on this debt transferred purchasing power away from the productive sectors (household and private non-financial) to the non-productive sector (financial), which ultimately resulted in a decline of aggregate demand. The above charts show previous periods of comparable increasing debt, so why was this time different?

Since debt was apparently not growing at excessive rates, let’s consider the other half of the equation...income:
Although it’s a bit tough to discern from the above chart, average real disposable personal income has been declining every decade since the series began in 1960. (The 1960’s saw average growth of 4.5%, while the 2000’s witnessed only 2.4% growth). The consistent decline in earnings growth provides a good explanation of why, despite similar rates of debt expansion, household debt-to-GDP looks like this:
The first substantial rise (~1950-1965) in this ratio appears to have been driven by increased borrowing due to low effective interest rates, while the second massive upswing (~1983-2009) was seemingly driven by decreasing effective interest rates combined with weak income growth.

The above chart also helps explain why this time was different with regards to interest costs. Jayadev and Mason’s findings above only highlights the effective interest rate on each dollar of household debt. To understand the true burden of interest costs at the onset of the crisis, we must consider the total interest cost on accumulated debt. Since total household debt is still a much greater percentage of income, and effective interest rates are not significantly lower, the real burden of that debt is much higher.  

Based on this data, it seems reasonable to conclude that low interest rates were not the primary culprit in the financial crisis. A more important area of research may be understanding why debt growth was not slowed by the decline in incomes. This preliminary review suggests that low incomes, not low interest rates, played a greater role in the crisis.