New From the Fed: TBG

That is, "Threshold Based Guidance." 

The Federal Open Market Committee's statement today included the following:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Since the federal funds rate hit the zero lower bound - four years ago - other monetary policy tools have taken on a more prominent role.  One of them is the Fed's ability to influence expectations, which it tries to do by making promises about future policy ("forward guidance").  Because long-term interest rates depend on expected future short term rates, convincing people that short-term rates will be low for longer can bring down long-term rates, and thereby reduce the cost of investment and credit purchases.  One of the difficulties that the Fed has to get around, though, is that people believe it places a high priority on keeping inflation low and would tighten policy at any hint of the economy heating up.  As Mark Thoma explains:

The Fed believes that policy will be most effective if it can convince people policy will remain loose even after there are signs of a strong recovery.

However, one of the problems the Fed has had in its communications strategy is convincing people it will carry through with this commitment even if inflation drifts above the 2 percent target. In some sense, the Fed has too much credibility on inflation.

The adoption of numerical thresholds -- in particular an inflation threshold that is a half a percent above target and the commitment to maintain present policy "at least" until the thresholds have been met -- is an attempt to overcome this communication problem though a commitment to a clear, well-defined policy rule.

This month's announcement was a shift from its previous statements, which had provided forward guidance in terms of the timing of expected rate increases - e.g., in October, the FOMC said "exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

Of course, quite a lot can happen between now and mid-2015 and the economy may do considerably better or worse than anticipated. Nobody really believes the Fed would keep the federal funds rate target at zero through mid-2015 if the economy suddenly boomed in 2013 (and, though some seemed to interpret it that way, its wasn't trying to claim that it would).  Alternatively, if things aren't much better in 2015, the fed funds rate could stay at zero considerably longer.

Shifting to thresholds spares the Fed the embarrassment of repeatedly re-adjusting the date in its forward guidance.  Announcing that it will allow forecast inflation to go up to 2.5%, which is 0.5% above the long run goal it formalized in January, seems to be an attempt to convince everyone that the Fed doesn't treat its 2% goal as a "below, but close to" target like the ECB does, and that it is willing to give a little on the "stable prices" side of its "dual mandate" in service of its other objective, "maximum employment."  But it won't let inflation get out of hand (or even close) - its a "dovish" statement only  by the standards of monetary policy discourse long-dominated by inflation "hawks".  Stating the goal in terms of the Fed's forecast of inflation means that it won't feel obliged to tighten in response to a burst of inflation it sees as transitory (e.g., due to an energy price shock).  However, putting it in terms of forecast inflation also makes it a little squishier (which is part of Stephen Williamson's critique).

In his press conference, Ben Bernanke also suggested that the threshold based guidance had an "automatic stabilizer" characteristic (and it appeared he was making this argument off the cuff): in the event of a negative shock to the economy, the threshold would cause markets to lengthen the period of expected zero short-term rates, which would bring long-term rates down.  A positive shock would cause the market to expect the threshold for potentially raising rates to come sooner, which would lead to higher long-term rates.

The other part of the Fed's announcement was that it planned to purchase $45 billion of Treasuries per month, which is intended to continue the expansionary effect of its effort to shift the composition of its balance sheet towards longer maturities ("operation twist").  It will also continue to buy $40 billion of mortgage backed securities per month.  This follows through on its October statement that it would be purchasing assets and expanding its balance sheet with no definite limit or end date until a substantial improvement in the labor market "is achieved in a context of price stability."

Overall, the Fed really seems to be stepping up to the plate and seriously trying to address the crisis of persistent high unemployment as best it knows how.  Bernanke's genuine concern about unemployment was evident in the press conference.

Of course, it remains to be seen how much effect the Fed's policies will really have (the Economist's Greg Ip struck a cautionary note) and fiscal policy appears likely to be either somewhat, or highly, contractionary in the coming year depending on the outcome of the "fiscal cliff" bargaining.

As an academic economist, I was particularly amused by Bernanke's response to a question in the press conference about how the FOMC chose the thresholds.  He said that they were based on staff assessments "under so-called optimal policy, or in the best policy that we can come up with, what would the interest rate path look like and how would it be connected or correlated with changes in unemployment and inflation."  That embodies the tension between academic and policy-making economics.  Bernanke comes from the academic world, where we write and discuss papers about "optimal" policies - usually specified in terms of the utility functions of "agents" in the economy - but he now works in the world of "the best policy that we can come up with".

We academics will be debating how sub-optimal the Fed's policy is for years, but at least they're trying to come up with the best policies they can.

See also: Binyamin Applebaum's NYT story, Neil Irwin, Michael Woodford and David Beckworth.

A Review of Roger Farmer's Books

My review of Roger E.A. Farmer's Expectations, Employment and Prices and How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies has finally appeared in the Eastern Economic Journal.

Farmer's ideas are spiritually Keynesian, but he accepts the belief which developed out of the work of Friedman, Lucas and others, that macroeconomic theory should be consistent with microeconomic optimization.  His point of departure from standard DSGE models (both of the Real Business Cycle and New Keynesian varieties) is that he allows for the lack of a unique equilibrium in the labor market.  This opens up a key role for asset values and confidence in determining output, with the policy implication that monetary policy should be directed at stabilizing asset prices.

Expectations is addressed to a professional audience economics book, while How the Economy Works second is written for a general audience.  How the Economy Works also provides a nice overview of how macroeconomics has evolved which would be a good background for laypersons and students about some of the debates within the field.

A subscription is necessary to read the review, which concludes:

The financial crisis and recession have led to considerable hand-wringing and soul-searching by macroeconomists. Caballero [2010, p. 85] argues that “macroeconomic research has been in ‘fine-tuning’ mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in ‘broad-exploration’ mode.” Farmer's work answers that call nicely. It is a synthesis in the best sense of the word, blending Keynesian insight with key subsequent developments such as rational expectations, the permanent income hypothesis and the search model of the labor market. It deserves the attention of macroeconomists, who will find it a healthy challenge to their thinking.

Dark Matter: A Quick Revisit

Back in the days before the 2007-8 financial crisis, one of the big sources of anxiety among (some of us) macroeconomists was the US current account deficit, a measure of how much the US was borrowing from the rest of the world each year.

After running deficits for most of the 1980s, an export boom helped bring the current account back into a small surplus in 1991 (aided, that year, by the financial assistance the US received from other countries to pay for the Gulf War).  The deficit began to grow again in 1992, and in the mid-2000's seemed to be on an ever-increasing path.

US Current Account (% of GDP), 1980-2006

The flow of borrowing naturally generated an increasing net stock of debt - the United States' foreign liabilities exceeded its assets in 1986, and the net international investment position (assets minus liabilities) became increasingly negative during the 2000's.

Note that the change in the net international investment position doesn't exactly track the current account deficit because of changes in the values of assets.

And yet, while this data seemed to indicate that the US was on an unsustainable borrowing path - and perhaps facing the risk that the willingness of the rest of the world to lend to it could quickly evaporate in a "sudden stop" crisis, like a number of emerging market countries had experienced - the US continued to receive more in income from its foreign assets than it made in payments to foreign holders of US assets.  That is, the income balance part of the current account remained positive.

US Net Income from Abroad, 1980-2006

How could the US consistently generate positive net income from its assets even as it became an increasingly large net debtor?  Ricardo Hausmann and Federico Sturzenegger turned this question on its head - they argued that if the US was earning net income, it should not be considered a net debtor.  In their account US foreign assets were under-estimated, with the official numbers leaving out what they dubbed "dark matter".  In a December, 2005 op-ed, they explained:

We propose a different way of describing the facts. We measure the assets according to how much they earn and the current account by how much these assets change over time. This is just like valuing a company by calculating its earnings and multiplying by a price-earnings ratio. Of course this opens up methodological questions, but the discrepancies with official numbers are so big that the details do not matter. To keep things simple in what follows we just take an arbitrary 5 per cent rate of return, which implies a price-earnings ratio of 20.

Let's get to work. We know that the US net income on its financial portfolio is $30bn. This is a 5 per cent return on an asset of $600bn. So the US is a $600bn net creditor, not a $4,100bn net debtor. Since the assets have remained stable then on average the US has not had a current account deficit at all over the past 25 years. That is why it is still a net creditor.

We call the $4,700bn difference between our measure of US net assets and the standard numbers "dark matter", because it corresponds to assets that generate revenue but cannot be seen. 

This hypothesis generated a considerable amount of discussion, nicely summarized in this Economist article from January 2006.  Many economists were skeptical of such a blithe interpretation of the situation.  One of the people quoted by the Economist was William Cline:

Mr Cline agrees with the dark materialists when they say there is “something misleading about calling a country that makes money on its financial position the world's largest debtor”. But sadly he does not think Americans can stop worrying. After making $36.2 billion in 2004, America made just $4 billion on its net foreign assets in the first three quarters of 2005. If it continues on its present trajectory, it will shell out about $190 billion in 2010, Mr Cline calculates. Using Messrs Hausmann and Sturzenegger's methodology, America's net foreign assets would then amount to minus $3.8 trillion. A dark matter indeed.

Seven years later, the US current account remains in deficit, though much less so:

US Current Account (% of GDP), 2001-2011 

That is, the US is still borrowing from the rest of the world, but at a reduced pace.  The value of the US' net foreign assets has been volatile as markets and currencies have gyrated over the past several years, but the official data says the US is even more in debt to the rest of the world now:

 And yet, the balance of income on foreign assets is more in favor of the US now than ever before:

US Net Income from Abroad, 2001-2011

Repeating Hausmann and Sturzenegger's calculation today says that (as of the end of 2011) the US was a net creditor by $4540 billion.  Relative to the official net international investment position of $4030 billion, that implies a stock of "dark matter" of $8570 billion!

Although the main source of "Dark Matter" in Hausmann and Sturzzenegger's original reckoning was the "know how" that helped US firms earn higher returns on Foreign Direct Investment (i.e., this was the main missing export), the most relevant for understanding what's happened since is probably the idea that the US exports "liquidity" and "insurance" services by selling assets that are considered safe and liquid by the rest of the world (e.g. US Treasury and "agency" - Fannie Mae and Freddie Mac bonds), while buying riskier assets.

The worry, circa 2005, was that buyers of US debt would run for the exit, leading to a spike in US interest rates and a collapse in the dollar.  The crisis we actually got had the opposite effect, as everyone rushed into US debt, which has helped drive yields down.  The US' net income is boosted by the fact that its paying very low returns on all those Treasuries being held abroad these days.  In Hausmann and Sturzenegger's framework, the financial crisis has been a huge boon to US exports of (unmeasured) liquidity and insurance services.

Macro Update

The BLS released a moderately good jobs report this morning: payrolls rose by 171,000 in October.  The unemployment rate ticked up by 0.1 to 7.9%, but this was due to a large increase in the labor force. In the household survey (separate from the survey of firms where the headline jobs number comes from), the labor force grew by 578,000.  The number of people employed rose by 410,000, while the number unemployed rose by 170,000, hence the increase in the unemployment rate.  The increase in labor force participation may be a sign that some previously "discouraged" workers may now feel like it is at least worth looking for work (to be counted as "unemployed" one must be looking for work).

The payroll figures for the past two months were also revised upward, by 50,000 for August and 34,000 for September.  While this represents a pick up in the pace of job growth, unemployment remains very high - and some have been out of work for a long time - and the recovery is excruciatingly slow.  As Catherine Rampell notes:

Getting the economy to 5 percent unemployment within two years — a return to the rate that prevailed when the recession began — would require job growth of closer to 280,000 per month.

Calculated Risk provides a useful graph of the employment-population ratio for persons aged 25-54 (as a way of taking out the effect of demographic changes), which illustrates how far the labor market has to go:

Last week's GDP release was also consistent with the picture of a slightly improving but still way-too-slowly growing economy.  The BEA's advance estimate put third-quarter real GDP growth at a 2% annual rate, which is mediocre, but better than the 1.3% in the second quarter.

That is, the economy is growing, and so is employment, but still not fast enough to make up lost ground in the 2008-09 recession.  James Hamilton commented on the report at Econbrowser.

However, historically speaking, downturns caused by financial crises are larger and more persistent than typical recessions.  Moritz Schularick and Alan Taylor and Carmen Reinhardt and Kenneth Rogoff both argue that the US is actually doing a little better than might be expected based on evidence from the aftermaths of past financial crises. That is a useful perspective, particularly for evaluating economic policy (as one might right before an election..).  Arguably, US economic policy has been moderately successful if you grade on a curve compare to an appropriate counterfactual.  However, that is little comfort to the over 12 million who remain unemployed.

Skidelsky: Keynes, Hobson, Marx

Keynes biographer Robert Skidelsky:

President Lyndon Johnson asked John Kenneth Galbraith to write him a speech on economic policy. After glancing at it LBJ said 'You know Ken, the trouble with economics is it's like peeing in your pants. It feels hot to you, but leaves everyone else cold'.

He follows that nugget with a nice essay about Keynes, J.A. Hobson and Karl Marx in light of recent economic history.  This discussion of how Keynes linked his theory of fluctuations in The General Theory to his essay on economic growth, Economic Possibilities for Our Grandchildren, was particularly interesting:

However, by 1943, he had sorted out his thoughts on the matter. He now envisaged three phases after the war. In Phase I, which he thought might last 5 years, investment demand would exceed full employment saving, leading to inflation in the absence of rationing and other controls. In this phase consumption should be restricted in order to reconstruct the war damaged industries.

 

In phase 2, which he thought might last between 5 and 10 years, he foresaw a rough equilibrium between full employment saving and private plus public investment, with the state pursuing an active investment policy.

 

In Phase 3, i.e. by about 1960, he thought that investment demand would be so saturated that it would not be able to match full employment saving without the state having to embark on wasteful and unnecessary programmes. In this phase, the aim of policy should be to encourage consumption and absorb some of the unwanted surplus of saving by increasing leisure and more frequent holidays. This would mark the entrance to the 'golden age' of capital abundance. Eventually Keynes thought that 'depreciation funds would be almost sufficient to provide all the gross investment that is required'.

On a related note, John Quiggin recently had an interesting essay on Keynes' prediction in Economic Possibilities, of much greater leisure time (Matthew Yglesias suggests it is coming true, a little bit).

Actual Politician for State-Contingent Fiscal Policy!

Matthew Yglesias points to Maine Senate candidate Angus King's views on the expiration of the Bush tax cuts:

I was in favor of ending the Bush-era tax cuts immediately, but after continued poor employment numbers, we need a more nuanced approach. We should consider pegging the sunset of these tax cuts to something non-arbitrary, like a certain amount of GDP growth, or a lower level of unemployment. This would avoid the unproductive brinkmanship that Congress engages in over this issue – and could prevent our fragile recovery from being further slowed down.

This is essentially what I suggested in June (HC op-ed, blog post).  Nice to see someone who might actually be in a position to do something having similar thoughts.

The Fiscal Trigger Finger That Did Not Itch

In April, 2011, I suggested that the biggest flaw in the 2009 fiscal stimulus effort was that it wasn't "state-contingent" - i.e., that it should have been designed to automatically adjust with circumstances (which turned out to be much worse than expected when the administration first proposed the recovery act).  

That was an idea that came to my mind with the benefit of hindsight, but now Matthew Yglesias informs us that the idea of putting "triggers" in the stimulus was considered at the time.  I'd really like to know why they didn't include them - I think the US economy would be in much better shape if they had.

They - or the incoming Romney administration - may want to consider state contingent fiscal policy again when they deal with the "fiscal cliff" at the end of the year.

Richard on Gold

The inclusion of a plank supporting a commission to study a return to the gold standard in the Republican platform has prompted a number of economists to explain (again) why it is a bad idea.

In an LA Times op-ed, my Wesleyan colleague Richard Grossman writes:

History provides ample evidence that the gold standard is a bad idea. After World War I, the major industrialized nations established the gold standard, which is widely seen as having contributed to the spread and intensification of the Great Depression. The gold standard tied the hands of monetary policymakers, forcing them to maintain high interest rates in order to maintain the price of gold, thereby making a bad economic situation even worse.

See also Paul Krugman.  My version of the case against gold is in this earlier post.

Dirty Mario?

From a story by the Times' Landon Thomas about ECB President Mario Draghi:

“You do not go back to the lira or the drachma or whatever,” Mr. Draghi declared at that same early-August news conference. By alluding to the former currency of his home country, Italy, and seeming to place it in the same category of woebegone Greece, Mr. Draghi — who played a crucial policy role in the euro’s creation — signaled that he was taking the bears’ skepticism personally. 

“It’s like Dirty Harry saying, ‘Make my day,”’ said Stephen Jen, a former economist at the International Monetary Fund who now manages a hedge fund based in London. “You can’t imagine Greenspan or Bernanke saying something like this,” he said, referring to the previous and current U.S. central bank chairmen, Alan Greenspan and Ben S. Bernanke. “It was very Italian and very powerful.” 

Mr. Draghi’s weapon of choice, of course, is more subtle than the Smith & Wesson .44 Magnum favored by Clint Eastwood in the “Dirty Harry” movies. But from a financial markets perspective, there is no less firepower in his suggestion that the E.C.B. might buy the bonds of countries like Spain and Italy if they commit to tough measures to reduce deficits and restructure their economies. 

Of course, what made Eastwood's Inspector Callaghan "Dirty" was his willingness to break the rules.  If he really means to save the Euro,  Mario Draghi may need to show a similar disregard for legal niceties.  I'm not an expert on the ins and outs of the Maastricht treaty, so I won't take a position on whether large-scale purchases of the bonds of distressed governments by the ECB exceeds its authority (or on the related question of whether the "European Stability Mechanism" is constitutional), but some - particularly in Germany - have been making that case (see, e.g., here and here).

Some of the relevant language from the Maastricht treaty:

Article 104 1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments...

Article 104b 1. The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

If Draghi is serious about doing whatever it takes to save the Euro, he won't let that slow him down.

Critics of intervention can make appeals - perhaps with some validity - to the "rule of law," but this is a case where following the letter of the law (at least if its interpreted strictly) would lead to a real human disaster if the Euro cracked up in a crisis.

Some people found Dirty Harry's rule-breaking objectionable (Pauline Kael called it "fascist medievalism"). But John Wayne's perspective - in the context of explaining why he turned down the role - might be instructive for Draghi:

I thought Harry was a rogue cop. Put that down to narrow-mindedness because when I saw the picture I realized that Harry was the kind of part I'd played often enough: a guy who lives within the law but breaks the rules when he really has to in order to save others.

A little rule breaking is part of the tradition of central banking - as Brad DeLong explained, modern central banking came into being when the Bank of England acted outside its legal authority by assuming the role of "lender of last resort" during the panic of 1825.

Unlike Dirty Harry, whose magnum had six bullets, there will be no question of whether or not Dirty Mario has run out of firepower.  The question that remains is the extent of his willingness to use it, even if it means risking having to turn in his badge later.

Draghi probably wouldn't like the analogy, but I'd imagine its preferable to being called "Super Mario" all the time.

Rich and Paul

From Ryan Lizza's New Yorker profile of Paul Ryan:

In 1988, Ryan went to Miami University, in Ohio, where he got to know an economics professor named William R. Hart, a fierce and outspoken libertarian in a faculty dominated by liberals. The two quickly discovered their shared fascination with Rand and Hayek. Ryan got his first introduction to movement conservatism when Hart handed him an issue of National Review. “Take this magazine—I think you’ll like it,” he said.

Rich Hart (nobody calls him "William" or "Bill") was a colleague of mine for several years when I worked at Miami.  He certainly was "outspoken" - I figured that much out on my visit to Oxford as a job candidate, when I quickly realized politics probably wasn't the safest subject. After one of his colleagues - Rich wasn't the only conservative there - described Hillary Clinton as a "communist" I changed the topic.  After getting know Rich a little better, I'm sure he wouldn't have held the fact that our political views were very different against me.  Indeed, he was always quite kind in his dealings with me and supportive of the junior faculty.

I never had a precise sense of what Rich taught in his macroeconomics class, but, while he may have reinforced the political inclinations Paul Ryan brought with him to Miami, I highly doubt he could be held responsible for Ryan's absurdly ignorant take on monetary policy:

Perhaps Ryan’s most unconventional opinion on monetary policy came in the summer of 2010, when he told Ezra Klein that the Federal Reserve should actually raise interest rates even as the U.S. economy was still struggling: “[T]here’s a lot of capital parked out there, and we need to coax it out into the markets,” he said. “I think literally that if we raised the federal funds rate by a point, it would help push money into the economy, as right now, the safest play is to stay with the federal money and federal paper.”