Deflation Puzzle

Larry Summers writes an eloquent FT column "A world stumped by stubbornly low inflation"

Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely

And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers. 

Central bankers [at the G20 meeting] communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates.

So why is inflation slowly declining despite our central banks' best efforts? Here is a stab at an answer. I emphasize the central logical points with bullets.

• Interest rates have two effects on inflation: a short-run "liquidity" effect, and a long-run "expected inflation" or "Fisher" effect.  

In normal times, to raise interest rates, the central bank sells bonds, which soaks up money. Less money drives up interest rates as people bid to borrow a smaller supply, and less money also reduces "demand," which reduces inflation.  In the long run, higher inflation and higher interest rates go together, as they did in the 1980s.

However, we are now in a classic "liquidity trap." Interest rates have been zero since 2008. Money and bonds are perfect substitutes. The proof of that is in the pudding: the Fed massively increased excess reserves from less than $50 billion to almost $3,000 billion, and inflation keeps trundling down.

• In a liquidity trap, the liquidity effect is absent. 

The liquidity effect will remain absent as the Fed starts raising interest rates, and would remain absent if the Fed were to cut rates or reduce them below zero as other central banks are doing. You can't have more than perfect liquidity.

The Fed isn't even planning to try. It plans to keep the $3,000 billion of excess reserves outstanding and raise interest rates by raising the interest rate on reserves. There will be no open market operations, no "tightening" associated with this interest rate raise.  But even if it did, we're $2,950 billion of excess reserves away from any liquidity effect, so it wouldn't matter.

• When the liquidity effect is absent, the expected inflation effect is all that remains. Inflation must follow interest rates. 

Central banks thought they were raising inflation by lowering interest rates, following experience from the normal-times liquidity-effect correlation between lower interest rates and higher inflation. But that experience does not apply when its liquidity effect is turned off.

With no liquidity effect, lowering interest rates further below zero can only, slowly, lower inflation further. Central banks desiring inflation may have followed a classic pedal mis-application.

Do I "believe" this story? Belief has no place in science. It is the simplest coherent story that explains the last few years, not needing lots of frictions, irrationalities, and other assumptions. I have some equations to back it up. But we don't "believe" anything at least until it's published and has survived critical examination, replication and dissection. Still, I think it merits consideration.

Shh. I like zero inflation. If central banks have the wrong pedal but are driving the right speed anyway, why wake them up? Even Larry seems to have given up on the Phillips curve:

...suppose that officials were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases.

There is no sign of the dreaded "deflation vortex," any more than there is any sign of dreaded monetary hyperinflation. We're drifting down to the Friedman rule. As Larry emphasizes, don't get excited over forecasts from models that rather spectacularly did not forecast where we are today. 
Central banks' desire for 2% inflation, and the Fed's rather puzzling interpretation of its "price stability" mandate to mean perpetual 2% inflation may also be relics of the bygone liquidity-effect regime. 

Appreciate the first half of the column which turns the signs around. It's a great bit of rhetoric.

I have to register mild disagreement with Larry's "solution" to the supposed "problem," 

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

He doesn't say which monetary policies would work, given they have not done so yet. But these are topics for another day.

(Note: If quote and bullet formatting doesn't show up, come back to the original.)

EERE’s FY2017 Renewable Power Budget Webinar

The Department of Energy (DOE) hosted a Renewable Power Budget Webinar this week hosted by Deputy Assistant Secretary for Renewable Power Doug Hollett. Wind & Water Technologies, Solar Technologies, and Geothermal Technologies are discussed. Please see the Slideshow below.

EERE’s FY2017 Renewable Power Budget Webinar from maryvin

Premium increase insurance

Marginal Revolution and the Wall Street Journal both pass on a great quote from Warren Buffett:

It’s understandable that the sponsor of the proxy proposal believes Berkshire is especially threatened by climate change because we are a huge insurer, covering all sorts of risks. The sponsor may worry that property losses will skyrocket because of weather changes. And such worries might, in fact, be warranted if we wrote ten- or twenty-year policies at fixed prices. But insurance policies are customarily written for one year and repriced annually to reflect changing exposures. Increased possibilities of loss translate promptly into increased premiums. . . .

Up to now, climate change has not produced more frequent nor more costly hurricanes nor other weather-related events covered by insurance. As a consequence, U.S. super-cat rates have fallen steadily in recent years, which is why we have backed away from that business. If super-cats become costlier and more frequent, the likely—though far from certain—effect on Berkshire’s insurance business would be to make it larger and more profitable.

As a citizen, you may understandably find climate change keeping you up nights. As a homeowner in a low-lying area, you may wish to consider moving. But when you are thinking only as a shareholder of a major insurer, climate change should not be on your list of worries.

The puzzle to me is, why doesn't Berkshire Hathaway write ten- or twenty-year policies at fixed prices? Or, better, why does it not offer a second contract, that ensures you against the event that your regular insurance will be repriced every six months? If people are worried about it, and nobody else is doing it, it would seem they could charge a huge premium.

You may say BH doesn't want the risk, but in a previous letter Buffett explained that BH was selling 99 year put options. And being hugely diversified is precisely what allows a company like this to take some risk.

If it doesn't want to hold the risk it could sell it. Surely there are lots of investors who are  skeptics of climate change -- not warming, but the claim that warming will give rise to more extreme weather and higher insurance payouts; people who cheered at that quote in the WSG -- and would be happy to put their money where their mouths are in the reinsurance market.  

(These thoughts are obviously related to health insurance,  premium increase insurance and long-term guaranteed renewable contracts that solve the preexisting conditions problem.)

Sanders multiplier magic

The critiques of Gerald Friedman's analysis of the Sanders economic plan  continue. The latest and most detailed and careful so far is by David and Christina Romer.

Bottom line:

1. The central idea in Friedman's analysis is that taking $1 from Peter to give to Paul raises overall income by 55 cents.  From this, you get multipliers from raising taxes and spending, from higher minimum wages, more unions, and so forth. 
2. I chuckle a little bit that so many economists who previously liked multipliers now don't like their logical conclusions. 
3. The Romers charge a serious, elementary arithmetic mistake in treating levels vs. growth rates. If they're right Friedman's whole analysis is just wrong on arithmetic.

The analysis

One might have expected that a sympathetic analysis of the Sanders plan would say, look, this is going to cost us a bit of growth, but the fairness and (claimed) better treatment of disadvantaged people are worth it.

Friedman's having none of that. In his analysis, the Sanders plan will also unleash a burst of growth, claims for which would make a fervent supply-sider like Art Laffer blush.

"The Sanders program... will raise the gross domestic product by 37% and per capita income by 33% in 2026; the growth rate of per capita GDP will increase from 1.7% a year to 4.5% a year." And, apparently, raise the growth rate permanently.

More stunning still are Friedman's claims about employment, shown at left here

and here.

Multipliers

So, where does this spurt of growth come from? The answer is the magic of multipliers.

But it's not just run of the mill fiscal stimulus multipliers.  After all, Friedman also says that the Sanders program would reduce the deficit, and by 2025 turn the Federal Budget to surplus!

How are multipliers so strong?

There seem to be two basic answers. First, Sanders assumes that there is a large multiplier from income transfers.

If the government takes $1 from rich Peter, and gives that $1 to poor Paul, overall income rises 55 cents! The one quote that makes this clearest is

The stimulus from regulator[y] changes is in Table 9. In general, the assumption is that wages have a multiplier of 0.9 compared with a multiplier of 0.35 for profits accruing to high-income persons. A wage increase coming out of profits, therefore, has a multiplier of 0.55.

It's also visible here explaining how a balanced budget still has a multiplier

the average value of the (governent spending) multiplier from 2017-26 is 0.89, falling from 1.25 to 0.87 as the output gap closes 

Other taxes are assumed to reduce effective demand with a multiplier of 0.35

[The] balance of revenue and spending programs will increase employment and economic growth because the spending program has a larger fiscal multiplier than do progressive tax increases. 

So tax $1 and spend $1 raises GDP by 54 cents.

He cites many standard sources for multipliers. He does not give a theory.  The standard story is that poor Paul consumes a lot more of his income, while rich Peter was investing it all in venture capital startups.  Consumption is good, savings is bad, so GDP rises.

From this central assumption, the rest of the magic follows.  Friedman creatively goes far beyond conventional deficit multipliers, to conjure multipliers out of tax increases, raises in the minimum wage, greater unionization, increased social program spending, and so forth. For example

 I assume that the Paycheck Fairness Act will raise women’s wages by 1% relative to men’s, and there will be an increase of 0.2% a year for the next decade.  I assume that 50% of the increased cost goes to higher prices and 50% comes from profits, and these are assumed to lower spending by higher income people with a multiplier of 0.35.

This, I think, is the central case. Admire it for its courage, and creative use of Keynesian arguments. These are the kind of interventions that most economists admit reduce growth, but some argue for on other grounds. But in Keynesian economics, taking money from low marginal propensity to consume people, and giving it to high marginal propensity to consume people raises GDP.

Snark

At this point, I stop in a bit of amusement at all the criticism. After all, these are just standard Keynesian arguments. The individual multipliers in Friedman's analysis are all conservative, and cite standard middle-of-the-road sources. The economists now so critical of this analysis, including the Romers, former democratic administration CEA chairs who wrote the open letter from past CEA chairs, and Paul Krugman, have been making big multiplier arguments for years to argue for more spending.  The "new Keynesian" academic literature includes multipliers far above two, so one can point to "science" if you wish. (Gauti Eggertsson, Christiano, Eichenbaum and Rebelo ; a simple example with multipliers as large as you want.)

The Romers are right to emphasize that multipliers only operate where "demand" is slack, and monetary policy doesn't steal the show. But the asterisks about fixed interest rates and output below "capacity" have been overlooked by the mainstream many times before. It's a rare Keynesian economist who ever thinks the economy is operating at full capacity. And Friedman has the former monetary asterisk, and he addresses the latter by claiming a large return to the labor force and increased productivity.

Even that view is not so out of the mainstream. For example,  Brad DeLong and Larry Summers wrote an influential Brookings paper arguing for very large fiscal multipliers, with some of the same flavor. There is hysterisis; a multiplier will bring people back to the labor market (as Friedman claims), those people will regain skills, productivity will increase; higher investment will give us better capital and also increase productivity. Demand creates its own supply.

Friedman is apparently just taking the consumption-first, poor-people-spend-more-than-rich-people, undergraduate ISLM analysis, with a bit of Delong-Summers hysterisis, to its logical conclusion. I agree in a way: take those ideas to their logical conclusion and you get silly propositions (old essay on that). Robbing Peter to pay Paul raises income; wasted government spending is good; theft improves the economy, transfers even from thrifty poor to spendthrift rich improve the economy, hurricanes are good for us, social programs, unions, minimum wages raise GDP, and so forth. Well, if the logical conclusions are patently silly, maybe one shouldn't have been making small versions of those arguments all along. Economic Homeopathy is not wisdom. 

Arithmetic 

But the Romers uncover a deeper puzzle. Even with these assumptions -- government spending multipliers around 0.8, and a transfer multiplier of around 0.55 -- you still don't get the wild increase in growth that Friedman claims. So how does he do it? Their answer: 

We have a conjecture about how Friedman may have incorrectly found such large effects. Suppose one is considering a permanent increase in government spending of 1% of GDP, and suppose one assumes that government spending raises output one-for-one. Then one might be tempted to think that the program would raise output growth each year by a percentage point, and so raise the level of output after a decade by about 10%. In fact, however, in this scenario there is no additional stimulus after the first year. As a result, each year the spending would raise the level of output by 1% relative to what it would have been otherwise, and so the impact on the level of output after a decade would be only 1%.

If this is right, it's absolutely damning. This is a question of arithmetic, not economics. (And I would have to swallow some of my above snark!) 

A clearer (maybe) example: The government spends an extra $1 for one year.  With a 1.0 multiplier GDP goes up $1 that year, period. If the government stops spending next year, GDP goes back to where it was. That's the conventional definition of multiplier, and the one that all Fridman's cited sources have in mind. Per Romers, Friedman misread that calculation and assumed the first $1 of spending raises GDP by $1 forever. In 10 years, you have a multiplier of 10! 

The Romers are cautious, and don't directly make this charge. It's not my job to get into the Hilary vs. Bernie whose-numbers-add-up fight. (At least someone here actually seems to care about numbers and economic plans!) But whether the spreadsheets make this arithmetic mistake or not is an answerable question. I hope to inspire someone with a spreadsheet and a nose for such things to check. This is a great time for a replication exercise! 

(Note: This post has pictures and quotes, which don't translate well when the post is picked up elswhere. If you're not seeing them, come back to the original.)

Update: Joakim Book tries to reproduce the numbers and comes up way short.

Update 2: Justin Wolfers at the New York Times did some old-fashioned journalism: He called up Friedman for a reaction.  The article is great, and clear. Yes, Friedman did the calculation as the Romers allege: An extra dollar of government spending today raises GDP permanently; an extra dollar of permanent government spending raises GDP growth permanently. That is at least not what the cited sources have in mind.

Negative rates and FTPL

I've devoted most of my monetary economics research agenda to the Fiscal Theory of the Price Level in the last two decades (collection here). This theory says, fundamentally, that money has value because the government accepts it for taxes, and inflation is fundamentally a fiscal phenomenon over which central banks' conventional tools -- open market operations trading money for government bonds -- have limited power.

Since I grew up in the 1970s, I figured the FTPL would have its day when inflation unexpectedly broke out, again, and central banks were powerless to stop it. I figured that the spread of interest-paying electronic money would so clearly undermine the foundations of MV=PY that its pleasant stories would be quickly abandoned as no longer relevant.

I may have been  exactly wrong on both points: It seems that uncontrolled disinflation or deflation will be the spark for adoption of FTPL ideas; that the equivalence of money and bonds at zero interest rates,  and central banks powerless to create inflation will be the trigger.

These thoughts are prodded by two pieces in the Economist, "Out of Ammo:" and "Unfamiliar Ways Forward" (HT and interesting discussion by Miles Kimball)

If you want inflation (a big if -- I don't, but let's go with the if) how do you get it? Ultra-low rates, huge bond purchases, and lots of talk (forward guidance, higher inflation targets) seem to have no effect. What can governments actually do?


"Out of ammo" explains

... At least some of them [politicians] have failed to grasp the need to have fiscal and monetary policy operating in concert....

... One such option is to finance public spending (or tax cuts) directly by printing money—known as a “helicopter drop”. Unlike QE, a helicopter drop bypasses banks and financial markets, and puts freshly printed cash straight into people’s pockets. The sheer recklessness of this would, in theory, encourage people to spend the windfall, not save it. 

The "recklessness" part is crucial. "Unfamiliar ways" has a more intricate scheme to communicate that recklessness

..a central bank and its finance ministry ... collude in printing money to pay for public spending (or tax cuts). ...the government announces a tax rebate and issues bonds to finance it, but instead of selling them to private investors swaps them for a deposit with the central bank. The central bank proceeds to cancel the bonds, and the government withdraws the money it has on deposit and gives it to citizens. “Helicopter money” of this sort—named in honour of a parable told by Milton Friedman, a famous economist—is as close as you can get to raining cash from a clear blue sky like manna from heaven, untouched by banks and financial markets.

Such largesse is, in effect, fiscal policy financed by money instead of bonds... But the unaccustomed drama—indeed, the apparent recklessness—of helicopter money could increase the expected inflation rate, encouraging taxpayers to spend rather than save.

Simpler, in my mind, the Treasury borrows and sends checks to voters. The Fed buys the bonds and then cancels them.

In addition to rather convoluted scheme, the pieces are not quite clear why the fiscal counterpart is necessary -- or why money has to be involved with fiscal policy.  That was not a central part of Friedman's helicopters. Miles is clearer about this:

the government give[s] away so much money that people would be convinced there was no way the government could ever sell enough bonds to soak that money up. 

This is clear and good FTPL thinking. The value of money is set by how much there is vs how much people expect the government to soak up via taxes -- or bond sales, backed by credible promises of future taxes.

If the government drops $100 in every voter's pocket but simultaneously announces "austerity" that taxes are going up $100 tomorrow, even helicopter drops would have no effect.

Helicopter drops are a clever fiscal signaling device. Canceling the bonds in the Economists plan is the crucial signaling device. They say "we are really going to be reckless."  When governments sell a lot of bonds, people think  the government is sooner or later going to soak up these bonds with taxes, and do not spend. That's the whole point -- bond sales are set up to raise revenue, not to create inflation.  The whole canceling the bonds thing in the Economists's plan, or the helicopter drama in Friedman's, is a clever psychological device, to convince people that no, the government is not going to raise taxes to soak money or underlying bonds up, so you'd better spend it now before it loses value.

Well if (if) our central banks want inflation, why not get out the helicopters?

Such shenanigans are not possible in the euro zone, where the ECB is forbidden by treaty from buying government bonds directly. Elsewhere they might work as follows: 

monetary financing is prohibited by the treaties underpinning the euro, for example

The US Federal reserve is similarly constrained to always buy something in return for creating money -- it can't send checks to voters.

Why?  The people who set up our monetary systems understood all this very well. Their memories were full of disastrous inflations, and they understood that printing money without clear promises that taxes would eventually soak up that money would lead quickly to inflation. So, yes, central banks are prohibited from doing the one thing that would most quickly produce inflation! For about the same reason that wise parents don't keep the car keys in the liquor cabinet.  (There are also all sorts of good political economy reasons that an independent central bank should not lend to specific businesses or send checks to voters.)

The Economist articles are also quite good at the evidence that current monetary policy is essentially powerless.

If policymakers appear defenceless in the face of a fresh threat to the world economy, it is in part because they have so little to show for their past efforts. The balance-sheets of the rich world’s main central banks have been pumped up to between 20% and 25% of GDP by the successive bouts of QE with which they have injected money into their economies (see chart 1). The Bank of Japan’s assets are a whopping 77% of GDP. Yet inflation has been persistently below the 2% goal that central banks aim for.

The power of open market operations -- buying bonds in return for money - is just dramatically refuted, at least at zero interest rates, by recent experience.

One way to get them back up might be to set a higher inflation target. But when inflation sits so persistently below today’s targets, persuading people that higher targets would produce higher rates will require action, not just words.

Or as I call it, the speak loudly because you have no stick policy. If central banks announce a 5% inflation target, and inflation goes down anyway, now what? Announce a 10% target?

Miles goes on about the power of negative interest rates to stoke inflation, which will be a topic for another day. If negative 2% real rates (2% inflation, 0% interest) didn't stoke "demand" and revive the extinct Phillips curve,  I don't see how negative 3% (2% inflation  -1% interest rate) or negative 5% will finally do the trick. In the standard models I've been playing with,  raising nominal interest rates, and committing to keep them there, is the way for central banks to raise expected inflation. That action would, however, also cool the economy, producing stagflation, and thus be particularly pointless.

I also fully admit that I'm cherry-picking the things I like from the Economist article, and ignoring all sorts of things that seem pretty silly to me. The point: I'm glad to see fiscal-theory thinking making its way out of academic debate into real-world commentary, if only in the "radical ideas" section.  Now, on to the "conventional wisdom" section!

Greece and Taxes

An interview for the Greek Reporter, in English, perhaps cheering the like-minded and sure to infuriate some conventional wisdom.

I agree with the "anti-austerians" on one point: Raising taxes was a bad idea. In my emphasis what counts are marginal tax rates on growth-producing activities, rather than Keynesian pump-priming, however, which is an important distinction.

The article says "A recently released study by the Economics Department at the National Kapodistrian University of Athens revealed that Greece has the third highest taxation rate among 21 European countries." If anyone has a link, especially if it's in English, send it in the comments.

Right Wing NPR

I was listening to NPR this morning over coffee, and nearly spilled it. Host Steve Inskeep was interviewing Mark Surman, Mozilla founder, on the topic of Apple refusing to hand over the keys to the Iphone to the Federal Government (and anyone who might be able to hack the Federal Government. Oh, right, that's never happened!)

INSKEEP: One last thing, coming back to this San Bernardino case, we don't know what's in that iPhone. We don't even know if it's important. But let's spin out the worst case scenario as a prosecutor might. Suppose your side wins, that phone is never opened, and as a result, the government misses a chance to find some other suspect and disrupt some attack. The attack goes forward, and people are killed. Will that have been worth it in order to protect encryption?

Surman, probably flabbergasted that anyone should ask such a question, changed the subject

SURMAN: We need to find ways to really be able to seek communications before they're sent or after they're sent and actually work with law enforcement on doing this well. There are alternative ways to get information, getting access to it before or after it's encrypted. What we want to avoid is creating a precedent where encryption can be broken by an arbitrary third party.

But Inskeep kept at it

INSKEEP: So you're saying, in essence, it may well be harder to catch terrorists, but you can still work at it, and the extra difficulty is worth it.

Remember, this is cloyingly liberal NPR, not some foaming at the mouth right wing program!

Like Surman, I often am too polite to give the right answer to such shocking questions in real time. But with the benefit of hindsight, here's a better answer

COCHRANE: Well, come to think of it, you're right there Steve. And while you're at it, let's keep going. These pesky first and fourth amendments sure get in the way of law enforcement, don't they? I mean all this business about going out and getting warrants, and waiting for a judge is so time consuming. If a terrorist gets away while you're busy getting a warrant, and people are killed, will that really have been worth it to protect some sort of centuries old procedures? If someone stirs up trouble on a Jihadi website, why do we have to allow that? And this annoying business about grand juries, and presenting evidence, and discovery, and Miranda warnings, it's so burdensome. What if some terrorist gets away and kills someone?  The police surely should be allowed to just throw anyone suspicious in jail, to make sure they don't do anything bad. Heck, while you're at it, what's with these prohibitions against torture? Bring back the rack, or start chopping people's fingers off until they talk. If you hold back, and some terrorist kills someone, was your little sense of ethics really worth it?  

There is a reason we have all these protections. There is a reason we need to defend them even in times of turmoil.

Perhaps a President Hillary Clinton will bring a sympathetic ear to the right to digital privacy. She undoubtedly wishes her email had been bullet-proof encrypted, not just from the FBI and NSA, but from the Chinese and Russian hackers likely reading every line.

Update: I realize from some of the comments that the point may not have been clear. This isn't about the Apple decision. It's moot, really, anyway, as even Apple can't open the new Iphones. And one can make cost/benefit arguments either way. My point was about the argument: We will hear quite often in coming years and decades, the argument that even one terrorist caught is worth sacrificing privacy and civil liberty. Be prepared to answer, to point out there are costs as well as benefits, and to list what they are. And, finally, I sound more critical of Inskeep than I should. In fairness, he does not offer an opinion. He asks a question, one commonly asked, and may well have been floating a t-ball in the hope Surman would smash it out of the park as I attempted to do.  Many people will ask that question. It's worth asking, over and over, and rehearsing the answer.