Monthly Archives: August 2013

Peter Orszag, Barack Obama’s former OMB director, argues that structural factors – like labor market mismatch, globalization, and automation – are unlikely to explain much of the recent shift the the Beveridge Curve. That is, we have a historically low hiring rate given the number of job openings and unemployment.

While it would be foolish to discount cyclical dynamics, we ought to pay heed to certain structural inconveniences. Some economists like to classify recessions into letter shapes including: “V” (rapid fall, rapid recovery), “U” (fall, stagnate, recover), “W” (double-dip and recover), “L” (fall and stagnate). Europe, and much of the United States (with apologies to North Dakota) are somewhere in between the latter, crappier, two. Measured by income or unemployment, at least.

But job openings tell a fundamentally different story:


What we see is an (approximately) L-shaped recovery for hires and a very V-shaped recovery for openings. Openings are showing a rapid recovery because they fell twice as hard. (So it’s unfair for Orszag to claim that openings are recovering much faster without noting the respective falls). While this data set does not go far back, we can see this tension of shape only in this recession. Previously, as theory and common sense would expect, both followed a similar path, if to different magnitudes. This time, one might say, there are two different recessions. (And as I tackle in a later post, openings should map very well to aggregate demand as a whole, suggesting a much stronger demand-side recovery than many suggest.)

This suggests the skill mismatch thesis has more support than Orszag believes. He makes an interesting point: the opening-hire ratio is abnormally high even for Retail Trade, which isn’t a particularly skill intensive sector. While that’s a fair characterization, retail is also a remarkably noisy data set:


Now, if we wanted to draw any inference, there clearly is a negative trend since 2011. That’s important because this deterioration doesn’t go as far back as 2008 – or even 2009 – as would be suggested by a cyclical downturn. This is an important distinction from ferment in the labor market as a whole. It’s entirely fair to argue that this inference derives from too-noisy data: but it’s the only inference one can make. We certainly may not conclude that the opening-hire ratio in retail trade speaks against mismatch theories as a whole.

For example, there seems to be no problems for workers in “Food and Accommodative Services” another historically low-skill, low-wage market:


In fact, we should note that not only the magnitude, but also the shape, of hirings and openings are in harmony – in 2001 as well as 2009. This tells us something has changed between then and now in the market as a whole that has not changed in the minimum wage market. A best guess might be skills.

Research and common sense suggests workers at the bottom crust of our labor market are slightly more persistent against globalization and automation than those in the middle. Technology and globalization tend to hollow out jobs open to middle-class, blue-collar builders and factory workers: jobs that made the 20th century American. On the other hand, it’s markedly more difficult to outsource your fry cook to China.

As I’ve noted before, many of the problems caused by sticky wages have likely evaporated. Aggregate demand is well short of where it should be, without front-loaded spending cuts, but it’s becoming harder to attribute as a primary cause. Paul Krugman recently cited evidence that industries that were hit the hardest are recovering the quickest, which is great evidence in favor of the cyclical downturn hypothesis.

However, while it’s certainly clear that there was an incredible aggregate demand shortfall between 2008 and 2012, it’s harder to argue that this deficit continues today. Let me be clear: I think smart stimulus today – the type that boosts supply, demand, and low-income welfare – is a good policy today. However, the fact that many of the less desirable shifts to which Orszag refers begin years after the trough informs me that structural adjustment may be an important component of the recovery.

Some on the right, at this point, throw their hands up and claim “we’ve done what we can”. I’m not so complacent. America lost jobs that aren’t coming back. A recession only made it easier to plow through the industrial hurdles of such a change. This is precisely the time to offer high-quality, technical education through free two-year colleges targeted at our broad middle class. This is precisely the time to roll back payroll taxes completely. This is precisely the time to expand the earned income credit.

There’s one very important argument in Orszag’s column that deserves more attention: internal recruiting. There’s some more evidence that this might be true:


A healthy labor market “churns” a lot: a lot of people get fired, a lot get hired, and still others quit. But we’re not seeing a recovery in fires, hires, and quits. Fewer people are fired if they can be internally rehired to do something more important. There is an important problem with this argument, that is “layoffs and discharges” are down to their trough in a healthy market. Regardless, the problem with internal job markets is that only the employed benefit: and a rise thereof would suggest painful problems for the long-term unemployed. Economists know employers look for many “signals” that provide information about a candidate (in other words, its not the amazing education you get at Harvard that get you hired). One potentially important signal is employment itself. That’s a big problem.

Orszag notes that “over the past three years, the number of job openings has risen almost 50 percent, but actual hiring has gone up by less than 5 percent. Companies are advertising a lot more jobs, in other words, but not filling them.” That’s fair enough, but it’s somewhat tricky to look at the recovery without scrutinizing the downturn. The real problem is the L-shaped hires graph and V-shaped recovery graph. And if we don’t do something about it soon enough, jobs Americans never had will go overseas.

I’ve seen many posts today about our sluggish jobs recovery. Most people are pointing to data that show most of the job creation is in ultra low-wage, crappy sectors like fast food. (Here are James Pethokoukis, Tyler Cowen, and Mark Thoma on the matter.)

I think there’s a silver lining to this. Without considering part time jobs (which are not relevant to this post) there are three types of households: dual income, single income, and no income. The latter two indicate that one or both earners, respectively, cannot hold their job consistently, have high turnover, and are living off insurance.

Dual-income families have higher median incomes not only because there are two earners, but each individual earns more on average. Educated people from healthier backgrounds are more likely to get married – and stay married.

Let’s say I’m a genie. I can create jobs as I want. The process is simple, I specify the income said job will earn, and the market efficiently allocates my magical capital into productive labor. So I can wish for the marginal job to command $100,000, $50,000, or $20,000. Or less. Naturally, within this framework anyone with a genie would just hit some uselessly large number until all of America is rich and prosperous. But let’s stay within a reasonable bound.

Let me pose a question: what creates more marginal welfare: an efficiently allocated job pulling $20,000 or an efficiently allocated job earning $40,000. Most people will be quick to say the second job, of course.

But here’s the thing. Better jobs – like the ones we want to create – are more likely to go to families that already have an earner. That’s because the spouse of someone earning $75,000 a year may be “unemployed” because she (or maybe he) can’t get a great position, but will hold out instead of becoming a fry cook. She’ll take the executive assistant position paying $40,000, though.

As you can see, if your intention is to help America’s poorest – and that is precisely where the marginal dollar generates the most utility – you want to create jobs that are suitable to America’s poorest. Obviously there’s a point at which my tenuous argument breaks down. I would hands down rather disemploy a fry cook over an engineer or scientist (but not doctors – definitely not doctors).

There’s another, subtler point. Two $20,000 jobs are better than one $40,000 job – sure one shows up better on the output/hr productivity statistics: but the other employs two people. Furthermore, you may not believe wage flexibility is good (I don’t), but if you do the best way to achieve said flexibility is not through deflation of existing jobs but creation of crappier ones. That’s basic arithmetic.

This is not just a cyclical story. As many have claimed, automation and globalization will hurt the solid middle before it touches the bottom of the barrel. America is divided as much on income as it is on culture. A solidly middle-class housewife or husband will – to my approximation – rather remain unemployed because she can afford it rather than “stoop” to the jobs that are being created.

We may see more single-earner middle class families with a dual-earning poor who need it. This isn’t consolation for the grim path of our economic future, but it suggests there is reason to be optimistic at this stage in the recovery. These dynamics and frictions cannot be ignored: sometimes a higher paying job is not what the economy needs, hard as it is to believe.

Update: I just came across this fantastic post from Nick Rowe explaining why exactly fiat money isn’t a liability to the central bank.

Paul Krugman has a new, mostly-great post on the Pigou Effect. I have one pretty big quibble:

One way to say this — which Waldmann sort of says — is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away. Of course, you can invoke various kinds of imperfection to soften this result, but in that case it depends very much who gets the windfall and who pays the taxes, and we’re basically talking about fiscal rather than monetary policy. And it remains true that monetary expansion carried out through open-market operations does nothing at all.

Now, Krugman has said this before. Brad DeLong called him out on the fact that fortunately we don’t believe in Ricardian equivalence. But let’s say we do. Let’s say we are operating in a world of rational expectations without any ad hoc “imperfections to soften this result”. Krugman claims that a drop is effectively a lump-sum tax cut, and representative agents would save it all in expectation of future financing efforts.

A common refrain across blogosphere holds that Treasuries are effectively high-powered money at the zero lower bound. There is a cosmetic difference – redeemability – that plays in important role within the highly stylized, unrealistic, thought experiments that are representative agent models.

Fiat money is a final transaction. Even when the coupon rate is zero, the principal on the outstanding liability must be “redeemed” by the government. Therefore, outstanding government debt does not constitute net wealth in either the government’s or household’s budget constraint.

I’ve been toying with this distinction in my head for a while now, but Willem Buiter got there almost a decade ago. In this little-cited (according RePEc it has only self-citations, which is odd given the important result) paper, Buiter shows that a helicopter drop does not function as a tax cut. The result derives from the pithy, contradictory, but fair assumption that fiat monies are are an asset to the private holder but not – meaningfully – a liability to the public issuer.

Therefore, an dissonance between the household and government perception of the net present value (NPV) of terminal fiat stock results in discordant budget constraints in the model. In this sense, the issuance of money can increase the household’s budget constraint in a way open-market operations cannot, increasing consumption and transitively aggregate demand.  (For those interested, the math is presented in the previously linked paper as well as, in better font, this lecture). The so-called “real balances effect” is, for lack of a better word, real.

We don’t have to assume any sort of friction or “imperfection” that mars the elegance of the model to achieve this result, but Krugman is right: it very much is about who gets the windfall and who pays the taxes. For every liability there does not exist an asset.

Without resorting entirely to irrational expectations (what some might term, “reality”) there is a further game theoretic equilibrium in which helicopter drops have expansionary effects. Douglas Hofstadter (whose name I can never spell) coined the idea of “super-rationality”. It’s very much an unconventional proposition in the game theoretic world. But it’s very useful. Wikipedia synopsizes it as:

Superrationality is an alternative method of reasoning. First, it is assumed that the answer to a symmetric problem will be the same for all the superrational players. Thus the sameness is taken into accountbefore knowing what the strategy will be. The strategy is found by maximizing the payoff to each player, assuming that they all use the same strategy. Since the superrational player knows that the other superrational player will do the same thing, whatever that might be, there are only two choices for two superrational players. Both will cooperate or both will defect depending on the value of the superrational answer. Thus the two superrational players will both cooperate, since this answer maximizes their payoff. Two superrational players playing this game will each walk away with $100.

Superrationality has been used to explain voting and charitable donations – where rational agents balk that their contribution will not count; but superrational agents look at the whole picture. They endogenize into their utility functions the Kantian Universal Imperative, if you will.

In this case, superrational agents note that the provision of helicopter money will not be expansionary if everyone saves their cheque, and note the Kaldor-Hicks efficient solution would be for everyone to spend the cheque, thereby increasing prices and aggregate demand.

This may be too rich an argument – in a superrational world we would not have the Paradox of Thrift, for example – but is more robust against imperfections. For example, as an approximately superrational agent who understands the approximately superrational nature of my friends, I know that they will probably spend their money (I mean they’ve been wanting that new TV for so long). I know that will create an inflationary pressure, and while I would like to save my money, I know they will decrease its value and I’d rather get there before everyone else.

I see this as a Nash Equilibrium in favor of the money-print financed tax cut.

Paul Krugman, though, is worried that accepting the existence of Pigou’s Effect undermines the cause for a liquidity trap:

What caught me in the Waldmann piece, however, was the brief discussion of the Pigou effect, which supposedly refuted the notion of a liquidity trap. The what effect? Well, Pigou claimed that even if interest rates are up against the zero lower bound, falling prices will be expansionary, because the rising real value of the monetary base will make people wealthier. This is also often taken to mean that expansionary monetary policy also works, because it increases money holdings and thereby increases wealth and hence consumption.

And that’s where I came in (pdf). Looking at Japan in 1998, my gut reaction was similar to those of today’s market monetarists: I was sure that the Bank of Japan could reflate the economy if it were only willing to try. IS-LM said no, but I thought this had to be missing something, basically the Pigou effect: surely if the BoJ just printed enough money, it would burn a hole in peoples’ pockets, and reflation would follow.

What Krugman wants to say, is that the liquidity trap cannot be a rational expectations equilibrium, if monetary policy can reflate the economy at the zero lower bound. In New Keynesian models, if the growth rate of money supply exceeds the nominal rate of interest on base money, a liquidity trap cannot be a rational expectations equilibrium. The natural extension of this argument is that if the central bank commits any policy of expanding the monetary base at the zero lower bound, we cannot experience a liquidity trap (as we undoubtedly are).

It’s crucial to note this argument – while relevant to rational expectations – has nothing to do with Ricardian Equivalence. In short, the government may want to do any number of things with the issuance of fiat currency – like a future contraction – but it is not required under its intertemporal budget constraint to do anything. This is fundamentally different from the issuance of bonds where the government is required to redeem the principal even at a zero coupon rate. Therefore, in the latter scenario, Ricardian Equivalence dictates that deficits are not expansionary.

The argument follows as the NPV of terminal money stock is infinite under this rule, which implies consumption exceeds the physical capacity of everything in this world. Therefore, rational agents would expect that the central bank will commit to a future contraction to keep the money stock finite. They do not know when and to what extent, but by the Laws of Nature and God are bounded from being rational.

In this world of bounded rationality, we must think of agents as Bayesian-rational rather than economic-rational. That means there is a constant process of learning where representative agents revise their beliefs that the central bank will not tighten prematurely. In fact, the existence of a liquidity trap is predicated on the prior distribution of the heterogenous agents along with their confidence that a particular move by the central bank signals future easing or tightening.

Eventually, beliefs concerning the future growth of the monetary base must (by Bayes’ Law) be equilibrated providing enough traction to escape the liquidity trap. But enough uncertainty on part of the market and mismanaged messaging on part of the central bank can sufficiently tenure the liquidity trap.

This is all a rather tortuous thought experiment. Unless one really believes that all Americans will save all of the helicopter drop, this conversation is an artifact. More importantly, a helicopter drop is essentially fiscal policy that doesn’t discredit the Keynesian position against market monetarism to begin with.

Ultimately, there is one thought experiment that trumps. Helicopter a bottomlessly large amount of funding into real projects – infrastructure, education, energy, and manufacturing. Build real things. Either we’re blessed with inflation, curtailing the ability to monetize further expansionary fiscal spending or we’ve found a free and tasty lunch. Because if we can keep printing money, buying real things, without experiencing inflation, we are unstoppable.

Here’s a good liberal’s plan for saving Detroit: Deregulate Drastically. (Sorry, I have a penchant for pointless alliteration). We generally consider expectations in the context of monetary policy; but it has crucial implications for capital inflows as well. Imagine the Federal Government – in concert with Detroit – stipulated the following rule:

Until Detroit’s per capita income reaches 85% of the national level, all local and federal regulations governing labor and capital transactions are suspended.

These include, but are not limited to – minimum wages, severance, Fair Labor Standards, and all immigration restrictions. (That is, if an employer located in the City of Detroit can vouch two years of employment for any immigrant, they will not need to operate under all the crazy guest worker provisions).

The only regulation will require Detroit to hire two unemployed residents of the City or long-term unemployed American for each immigrant. This institutes a de facto wage floor against prevailing global wages which is necessary to increase the per capita income of the city. While a long stream of poor labor will always make everyone better off – it will after a point decrease per capita wages of each country even if increasing the  average of both.

However, unlike Adam Ozimek at Modeled Behavior, I don’t think immigration should be the centerpiece of any plan to save Detroit, when there are better regional options at the ready. If firms are given a Federal credit to relocate distally long-term unemployed, Detroit has a large group of people that have atrophied skills, poor social habits (not of their fault), and extremely low marginal value to a scaled firm.  

Now, in general I don’t think regulations are killing the American economy, I support reasonable increases in the minimum wage, and genuinely believe work and child safety laws have made the country a better place. But if Detroit is the only locality to benefit (or suffer) from relaxed regulations, the benefit comes from the difference in cost of production in Detroit vs. elsewhere. This is usually a Prisoner’s Dilemma-esque race to the bottom for the poor (to the extent we’re talking about sensible regulations), but in tight and rare situations provides a deficit-free way of giving Detroit breathing space.

All sorts of firms will want to capitalize this opportunity which will both repopulate Detroit and cap long-term national unemployment. But much of the recovery will take place without the law taking effect. Let’s say we stipulate a mass deregulation that begins in exactly one year. Once we’ve credibly convinced the market towards this commitment, firms will today begin shifting operations significantly increasing employment and wage expectations by the time the law takes effect. The argument against minimum wage goes that it prevents people who want to work for less from doing so, curtailing personal liberty and decreasing employment. Just by virtue of mutating expectations, there’s a case to be made that even if today many are willing to work below minimum wage, after accounting for expectations of future growth aggregate demand will rise sufficiently that by the time deregulation occurs few will want to make use of it.

There are two possibilities: either this works (increases employment and incomes) or it doesn’t. Shocker, I know. Anti-deregulation Pro-regulation liberals should be happy either way. If it doesn’t work we learn that the costs of deregulation are not all that high, and lends further support for a broader program of sensible, national regulations. If it does work, many of Detroit’s poorest are brought out of poverty, repopulation saves pensioners, and employment soars.

In fact, if the Federal Government credibly convinces the market of such a move – and guarantees long-term unemployment credits – there’s a non-negligible chance that by the time of deregulation the “rule” already requires re-regulation. Let’s say I want to produce cheap shoes, and learn about this program. I will begin preparatory operations today increasing both employment and wages.

This is unfair for all the other cities that must abide by Federal law, but that’s the point. We wish to give an “unfair advantage” to the poor. The only other viable option, that does not include a complete shutdown, requires massive Federal stimulus which will hurt the rest of America far more than a distorted regulatory code.

In fact, capitalizing on distortions should become a key lever of interregional stabilization. One great way to save Detroit – and the environment – at the same time would be to institute a rigorous cap-and-trade program, and providing Detroit a disproportionately high number of permits (distributed from the rest of the country). Each of these solve a key efficiency gap that is lost through simple fiscal stimulus which can be ineffective because of bureaucratic concerns.

Furthermore, regulatory policies often effect the young more than the old – minimum wages are a great example. The best way to repopulate a dying city is with fresh, young talent. A mix of deregulation and supply-side stimulus including good public education and retraining programs might once again make Detroit a model city. A model for dying cities across the rich world.

I was thrilled to hear that Raghuram Rajan was tapped as D. Subbarao’s successor at the Reserve Bank of India. Rajan’s firepower is welcome at a time when India’s financial markets are running amok. What should we expect from a Rajan Reserve and – more importantly – what will be at the top of his task list.

A few months ago, I argued that we ought to be cautiously optimistic about India’s economic future. Though I wrote before the rapid depreciation in the Rupee, I maintain my position that India’s economic fundamentals are stable. Unfortunately and unsurprisingly, the Indian news media is missing the forest for the trees in their coverage of the falling Rupee and “soaring” inflation.

Let me be clear: Raghuram Rajan’s chief objective will not and should not be “stabilizing” the Rupee. The amount of Indian debt held in foreign – usually dollar-denominated – currencies is not substantial, and hence the Rupee depreciation poses no immediate pressure since the exchange-rate value of repayment will has not increased too much.

More importantly, all signs suggest India’s recent depreciation isn’t the result of a significant structural shift emanating from a loss of confidence in the Rupee, but the consequence of “taper talk” across the pond. As markets anticipate tighter monetary policy in the future, we would expect a rising dollar.

Unfortunately, a falling Rupee precipitates more expensive energy imports. Since the Government of India spends nearly $10 billion on fuel subsidies – which have incredible political support – weakening terms of trade may induce deeper deficit spending. Rajan’s first step towards a more independent RBI should be to stop providing the government with artificially cheap debt by creating a captive demand for Indian bonds. Rajan has expressed similar sentiments:

[T]he RBI still forces banks to invest 24% of their core deposits in government bonds, far above what is needed to give banks a safety buffer of liquid assets. This creates captive demand for public borrowing (although during an economic soft patch such as today’s, cautious banks may voluntarily hold more than the minimum). The RBI also buys government bonds in the market. It argues this makes markets work smoothly, but most outsiders think the aim is to put a lid on government-bond yields. A spike in yields in November has been followed by a big, $14 billion RBI bond-purchase programme.

Reducing the capital reserve ratio hits two birds with one stone – deepens the expanding private credit market while signaling independence from the central government. Rajan, unlike his predecessors, has an intellectual starpower that suggests he can enact such institutional change. As I’ve noted, the Indian credit market has been very resilient to the financial crisis. While growth halted significantly, gross credit as a percent of GDP continued its steady climb – something that cannot be said for other developing countries.

Rajan’s most important task should be moving the RBI towards a rule-based exchange rate policy. The debate between rules and discretion in the developed world largely concerns some permutation of a Taylor rule stipulating the optimal policy rate given a level of inflation and output gap. India is not ready for this debate – and that’s for the better. A healthy Taylor rule requires an accurate estimate of the output gap which is founded on long-run trend growth. “Trend” growth is a useless concept in countries like India and China, whose growth rates have both a high mean and variance.

Rather, India should adopt a form of rules-based intervention in the foreign exchange (FX) market. Today, the RBI operates on spot and forward interbank FX transactions “depending on monetary conditions” to moderate volatility. The well above-normal correlation between FX interventions and the exchange rate – as opposed to exchange rate movements – suggests the RBI’s modus operandi is very discretionary at the time being. This May, Kaushik Basu (formerly India’s Chief Economic Adviser) and Aristomene Varoudakis released a study suggesting emerging market central bankers would benefit from a rules-based intervention in the interbank market.

The reasons for this are multifold. Quite simply, a credible rule allows a central banker to set expectations to achieve a result without actually doing anything, in this case purchasing reserves. A large-build up of un-steralized foreign reserves tempts a flood of liquidity with unanchored inflationary expectations that countries like India cannot afford. On the other hand, sterilization entails fiscal costs which is the interest rate paid on external liabilities: a study by Gustavo Adler and Camilo Tovar estimated that this costs Latin American emerging economies 0.5% of GDP on average.

In spirit of Basu’s best work, How to Move the Exchange Rate If You Must, employs intuitive game theoretic concepts to further his assertion. Basu and Varoudakis note that since FX markets exhibit a dynamic with many, price-taking agents juxtaposed with a few, strategic oligopolists who can affect the exchange rate: tempting Cournot competition.

Basu and Varoudakis show, qualitatively, that under imperfect conditions, large players benefit from committing to a demand curve. But once it announces its intention of achieving this demand curve, actual operations are unnecessary:

Note that once the central bank makes the schedule intervention and moves the demand curve to D1 equilibrium exchange rate will be p1. At that rate the central bank does not buy or sell dollars. In other words, the exchange rate will have been moved with the announcement of the intention to accumulate or drain specific amounts of reserves at various exchange rate levels.

While the economic benefits of achieving exchange rate stability without a buildup of foreign reserves is tremendous, the political benefits are greater still. Rajan, de jure, is beholden to a government founded on shaky parliamentary conditions that will almost certainly be predicated on volatile coalition governments. 

This limits central bank independence regardless, but if the Bank has clearly committed to a rule-based regime, the barrier for political disruption will be greater. By engaging in openly discretionary policy, the Bank today implicitly announces a tryst with the governing coalition as it has no credibility to burn. Furthermore, while no man is above the mess that is an Indian Parliament, the international, intellectual, and disciplinary prestige of Rajan is likely to serve as a force towards more determined reasoning, even in the midst of irrationality.

Ultimately, monetary and fiscal policy are not divorced as in the United States. While Rajan has correctly expressed interest in loosening liquidity requirements that artificially depress yields, he can play a key role in India’s political decisions:

  1. Inflation derives from expectations on the future. With the current deficit and consumer price inflation, it would not be surprising if the market expects significant monetization in the future. India must restrain its future self. The best way to achieve this is to set a minimum target for the percent of all debt sold in inflation-protected contracts. Earlier this summer, India engaged in its first inflation-indexed bond (IIB) auction: for a paltry sum. Rajan should play a key role in amping this up: IIBs will not only offer India cheaper financing by removing the inflation-risk premium, but will convince the market that future inflation will be lower as monetization is not as viable.
  2. Widespread success of such an auction might curtail a rapidly rising demand for gold, which accounts for a whopping chunk of India’s trade deficit.
  3. If Rajan is unwilling to rein in depreciation against the dollar, food and energy prices will continue to rise. As the government is deeply involved in both markets, he will shape debates on India’s future welfare goals.

Ultimately, those approaching the RBI through the lens of a “Taylor rule” or “NGDP target” will be disappointed. Rajan will not be independent of governmental forces and, for the large part, this is okay. There is no currency crisis that’s endemic to Indian monetary mistakes, and even if there were India has less to worry about than most developing nations.

The leading light at the end of Rajan’s tunnel will be deeper liberalization of capital and retail markets. As a democracy, it is subgame imperfect for India to default on its debt, and hence the Rupee has a natural advantage to the Renminbi in international capital markets. China has paced well ahead of India in structural growth, but unique institutional arrangements suggest India can lead the BRICs in monetary policy.

Rajan will never lead an independent reserve, but he can start the transition. And that’s infinitely more important than changing the repo rate by a point or two.

A new paper, from Jonathan Meer and Jeremy West at Texas A&M, suggests that minimum wage does have adverse consequences on the labor market: just not in the way most economists think. Meer and West argue that employment levels are a red herring in estimating consequences of a price floor and hence we should look at net job growth. Indeed they conclude:

Using a long state-year panel on the population of private- sector employers in the United States, we find that the minimum wage reduces net job growth, primarily through its effect on job creation by expanding establishments.

I don’t want to critique this study as much as use it as a window into an equally curious debate: sticky wages and a Keynesian recession. The standard theory holds that downward wage inflexibility results in disemployment as wages are kept artificially high for any number of reasons.

In many ways, the sticky wage thesis posits the same transmission mechanism as the classical view that minimum wage creates unemployment (the policy ramifications are unclear, and I support an increase in the minimum wage, but that’s because I think more unemployment of the right kind is good). Meer and West offer both empirical and theoretical reasons why observing employment growth, and not level, is economically appropriate which implies that employment growth – adjusted for population – is a better indicator of potential gap than unemployment rate.

This is important considering “potential income” is a remarkably abstract concept based on estimates of long-run supply-side factors that cannot be evident contemporaneously. Indeed, if the Keynesian argument is to be accepted in whole, contraction of aggregate supply is one possible reason we are not experiencing outright deflation.

Consider the historical relationship between change in the potential gap and population-adjusted employment growth:


This is a pretty scary graph because it looks like we’ve caught up with our pre-recession rate of employment growth.  Unemployment will continue to fall, but will not accelerate if the wage rate is again appropriate. Historically, at every other such point, the pace of recovery slows down. Because it’s over. This paints a prominently different picture than suggested by unemployment levels:


And, indeed:


(Edit: I want to point out here that this pattern isn’t new, and I’m not the first to point it out. I only find it suddenly relevant in the context of the paper I cited which tells us that if stickiness and minimum wages act similarly, we’re now at the point where the sticky effect is less relevant. This can be a good thing since it implies job growth is faster, but it also means the recovery will not be accelerating. That’s a big “if” but has theoretical appeal in concert with the fact that historically other points at which job creation reaches it’s pre-recession peak represent an adjusted labor market. One way to interpret this is a continuing recovery without the acceleration our output gap might suggest I’ve suggested below a few reasons why this may not be the case).

While the level of unemployed workers remains uncomfortably high, the rate at which that level is falling is back at its pre-recession high – and there is little precedent for it to rise any further.

This does not mean the recession is over, or that aggregate demand is sufficiently high. It does mean that, were we to use the same logic as Meer and West, sticky wages and a dis-equilibrated labor market cannot sufficiently explain our troubles.

This has five possible implications:

  1. The Meer and West employment dynamic cannot be translated to a Keynesian “sticky minimum wage”, if you will. This may well be the case – the empirical foundation of their paper considers the economy at all times. The conclusion we strive to make concerns economies specifically mired in recession, which may be a confounding variable.
  2. Wages are not as sticky as we believed and even the low dose of price level inflation since 2008 has been sufficient to adjust the market.
  3. Aggregate supply has contracted more than we would like to admit.
  4. An amalgam of points (2) and (3) suggest that the potential gap is not as high as estimated by the CBO.
  5. Excess capacity and other Keynesian forces are far stronger than we previously anticipated.

As far as policy is concerned, the result in its crudest suggests we are no longer in a Keynesian short-run, if sticky wages are the only important factor. This means that while inflation will have its traditionally expansionary effect through the money illusion and wealth and “hot potato” effects, it will no longer move the labor market towards equilibrium. In other words, the marginal benefit of a change in the price level is falling towards zero.

The evidence is too clear that further deficit-spending will not spark the bond vigilantes and that debt monetization will not bring rise to runaway inflation; therefore, it is unlikely that the United States should engage in any further austerity by prolonging the sequester and January payroll tax hikes.

However, we should perhaps question the modality of sticky wages vis-a-vis the unemployment rate, and focus on employment growth which suggests a more robust recovery relative to supply. This is not a call for a smaller government. Indeed with interest rates at historical lows, now is as good a time as ever for the government to engage in sound investments like green energy, smart grids, or infrastructure. Now is as good a time as ever to risk monumental tax reform that brings in too little, rather than too much.

Ultimately, the evidence for large output gaps and lacking demand is far greater than the evidence against – and perhaps in the throes of fiscal crisis we should have engaged in more aggressive stimulus. Indeed, just one paper suggesting a relationship elsewhere unfound and theoretically unprecedented should not change our interpretation of the economy too seriously.

But Meer and West have given us a unique prism to consider not just minimum wages, but maximum employment.

(That last sentence had more cadence than content: the point is not maximum unemployment, as much as a maximum rate of recovery – to many that is disheartening).

The non-accelerating inflation rate of unemployment – or NAIRU – is the level of employment above which we risk dislodged inflationary expectations tempting a positive wage-price feedback loop. Almost everything in macroeconomics comes back to NAIRU which is broadly determined by “supply-side” factors like technology, institutions, etcetera.

NAIRU, a practical tool, is closely associated with two more abstract concepts of general equilibrium: the natural rate of unemployment, and full employment. NAIRU is becoming an increasingly irrelevant concept. I think the “natural labor employment demand” has fallen, but this is not really the same thing. This is closely linked with a case for higher minimum wage, as I’ll explain below.


Consider a world where all consumer goods are automatically produced. Everyone, aside from a small cohort of designers and technocrats is unemployed, and receive goods and services through basic income. NAIRU makes no sense for the labor force as a whole. The rental rate on a robot is only the cost of replacing depreciated capital, without permanently strong patents, labor substitution will increase prices which will tempt further increases in the wage rate (or taxes on technocrats to finance a higher basic income). Hence NAIRU for workers is 100%.

On the other hand, since technocrats aren’t substitutable the opportunity cost is only the wage rate determined by an imperfect market – which naturally includes rents since the barriers to technical skill are non-zero. By definition, NAIRU for technocrats is non-zero since the supply-side of the economy is entirely determined by supply of technocrats. Since markets are imperfect, and rents are high, any increase in wages will come from taxes on capital returns rather than price inflation.

This is an extreme case, but the United States is moving towards an increasingly capital dominated economy. NAIRU was a useful concept when the labor-share of income was 70%, but as it falls to and below 40% – as I imagine it will within two decades – the unemployment of labor becomes a useless concept.


The rate of unemployment – perhaps the most ubiquitous economic statistic – is useless in periods of high inequality. When unemployment rate is high, economists today like to claim that GDP is “below potential”. The “output gap” is measured – sensibly – in dollar terms. Unemployment rate, instead, is measured in unit terms.

The output gap includes auto-workers made redundant, as well as factories shut down, and fields unplowed (that of labor, capital, and land respectively). In the previous section I noted the diminishing relevance of NAIRU considering the rising preponderance of capital; but even within labor markets it is a crude measure at best.

Let’s say in an economy, I had a factory rented at $5 billion, an airplane rented at $5 million, and a screwdriver rented at $5. In a recession, suppose I couldn’t afford to lease the screwdriver. What is unemployment? I’d say it’s epsilon, but someone sufficiently crazy can say it is 33% – since one-third of capital units are disemployed.

But let’s say in an economy I have 2 engineers, 8 scientists, and 90 fry cooks. If 20 fry cooks were disemployed by recession, we’d freak out about 20% unemployment, and yet if both engineers were disemployed we’d be content at 2% unemployment. The unit rate of unemployment purports that we are all equal and that, believe it or not, isn’t the case.

An increase of technology allowing for the replacement of precisely one doctor is more disinflationary than that allowing for the replacement of precisely one fry cook. This distinction is not relevant when we are talking about socioeconomics – where unit rate dominates – or when inequality is irrelevant. Neither, when we speak of shifts in NAIRU in 2013, is the case.


We can be disemployed in many forms. A single-mother wishing to work two shifts to save for her son’s college may be given only one. An auto-worker may be laid off. A physician’s assistant may be asked to work only part-time. Not all of these, in practice, are actually measured but each represents an equally valid claim to unemployment as stipulated by economists.

The way many economists talk, NAIRU moves in tension with aggregate supply. That is, when David Brooks suggests NAIRU has increased, he’s saying the output gap isn’t as big as we think it is, and hence fiscal or monetary stimulus cannot be beneficial any longer (never mind the fact the low inflation today suggests he’s wrong anyway). 

That means an increase in NAIRU – as such – isn’t a good thing. But Americans, especially poor Americans, are among the most overworked people in the world. Technology-biased capital change can, on the one hand, increase the unit rate of unemployment. It can also redistribute hours – something I’ve suggested before – which  can have powerful social benefits.

The scenario I set up in the linked post purports a world with large technological automation augmented with a basic income and high quality social programs. In this case, there would not necessarily be an increase in “hour unemployment” as the quantity of labor supplied in hours falls – resulting in a lower equilibrium.

The point here is twofold:

  1. NAIRU can become relevant if measured in hours,
  2. Under proper and justifiably stipulated economic institutions such an unemployment will be illusory, under standard reasoning.

The Case for a Minimum Wage

A common refrain on the economic right suggests that any significant increase in the minimum wage increases NAIRU. Take this from Peter Tulip, a staff economist at the Federal Reserve, asking whether “Minimum Wages Raise the NAIRU”:

Probably yes.

A high minimum wage (relative to average wages) raises nominal wage growth and hence inflation. This effect can be offset by extra unemployment; so the minimum wage increases the Non-Accelerating Inflation Rate of Unemployment or NAIRU.

This effect is clearly discernible and robust to variations in model specification and sample period. It is consistent with international comparisons and the behavior of prices.

I estimate that the reduction in the relative level of the minimum wage over the last two decades accounts for a reduction in the NAIRU of about 11⁄2 percentage points. It can also account for the substantial reduction in the NAIRU in the USA relative to continental Europe. 

My approach to NAIRU – predicated on high inequality and forceful capital-biased tailwinds – renders this type of analysis wanting, for a couple reasons:

  • A higher NAIRU can be “felt” through shorter shifts and fewer months worked – neither of which are socially debilitating. Furthermore, because the fewer hours are worked at a higher wage rate, it is not clear that living standards will fall too steeply. 
  • Minimum wages subsidize labor-substituting innovation. The opportunity cost of replacing one fry cook with automated robots falls as the minimum wage rises – this suggests an expansion of aggregate supply.

None of this is necessarily a good thing and is premised on the assumption that the government will work with employers in crafting policy that supports hour reduction and wage sharing policies. This is how U3 in Germany miraculously fell over the last decade. As the wage share of income falls, it will be incumbent on any government to impose more progressive taxes and perhaps even a basic income: but this isn’t necessary for my theory – except in the extreme.

If you share my conviction that a large part of the American population either works too much, or would like to, leaving little time for family, then a minimum wage sends the market that signal, without causing the unemployed any strife. 

The NAIRU is an idea whose time has gone.

Paul Krugman recently explained the contradiction of a statement like:

I don’t believe in sticky prices, or at least not except for very brief periods, and therefore I believe that the economy is almost always close to full employment.

It is important to note that the observational error of not believing in sticky prices – and evolution, too? – is orders of magnitude worse than the analytical flaws that follow. Krugman’s IS-LM framework suggests that because falling prices can’t reduce interest rates at the zero lower bound, there’s no reason to believe aggregate demand is higher at a lower price level, marginalizing the case for wage flexibility. 

The case against flexibility, though, can be extended into normal times. The argument comes from three papers by the DeLong-Summers duo – the first empirically founding theoretical results in the second, and the third as basis for my own somewhat unorthodox interpretation. All together, there’s good reason to believe the sterile, representative agent models from DeLong and Summers will make Krugman to “eat [his] microfoundations”.

Before I continue, let’s explain why understanding the effect of price flexibility is key not just to formal discourse, but policy action. Indeed there’s no reason to believe the government has any fundamental authority upon inherent rigidities in the labor market – aside from long run, secular adjustments such as systematic deunionization. Rather, this conversation is directed at the numerous, conservative critics who question Keynesians for citing sticky wages as cause for recession on the one hand, and supporting minimum wage on the other. More generally, questioning flexible wages outside of the zero lower bound, is in important counterpoint to said structural reforms such as right to work, abolishment of minimum wage, or reluctance to provide unemployment insurance.

The first relevant paper from Brad DeLong and Larry Summers considers “The Changing Cyclical Variability of Economic Activity in the United States” concluding that:

the two principal factors promoting economic stability [are Keynesian auto-stabilizers] and the increasing rigidity of prices. We attribute the latter development to the increasing institutionalization of the economy.

They also suggest a rather stylized (and ultimately unconvincing) model in which wages are set in negotiations where workers are backword-looking. Still, the Keynesian framework here brings important question to the assumption that flexibility is everywhere and always stabilizing. Another very important empirical conclusion here, which will become relevant soon, is noting that the autocorrelation in quarterly output growth rose from 0.4 before WWI to 0.8 in 1985.

This finding allowed DeLong and Summers to drop the assumption of serially uncorrelated changes in output stipulated in John Taylor’s staggered contract model. In their 1985 paper (written in profoundly unreadable font) they develop a key insight showing destabilizing effects of increased wage flexibility among perfectly rational agents. To reach this conclusion, the staggered contract model is amended in two important ways:

  1. As mentioned, serially uncorrelated output growth is a senseless assumption that ought to be dropped – allowing for a persistent nominal income shock.
  2. Elaborating the treatment of output to include real interest rates by relaxing the assumption that money demand is interest inelastic.

We can extend the latter point to note that if the real interest rate determines aggregate demand and the nominal interest rate clears the money market inflation creates a wedge between the two altering output by shifting the solution of the IS-LM system. We can qualitatively state the instability of flexibility as:

While a lower price level is expansionary, the expectation of falling prices is contractionary.

And while their model “resisted” analytical solution, the numerical results confirmed that hypothesis. They determined this by measuring the variance of the steady-state output to random demand shocks modeled by unit variant white noise. They find that price flexibility – modeled by g which measures the responsiveness of prices to changes in demand – “is destabilizing at the margin in almost all cases”. Indeed, the result is so striking that only as demand shocks approximate random noise is an increase in flexibility at the margin stabilizing, and even then only when prices are near perfectly rigid to begin with. That both conditions hold is unlikely.

To demonstrate the robustness of their result, DeLong and Summers show that it holds even if extended to Taylor’s more complete 1980 model which includes a more generalized contract length. We learn that even if price flexibility is increased by decreasing the relative length of contracts, or number of overlapping commitments, steady state variance increases. The importance of this result is hard to overstate as it suggests that even with optimizing agents, long contract lengths do not explain variability in the business cycle.

Penultimately, we are shown that this result holds absolutely except “very near” the Walrasian limit (these are mind-games as we are obviously not). They do this by altering the “time” taken in each time step t. Without explaining the math:

Keeping the parameter g [flexibility] the same in the transformed and they transformed model implies that the transformation to a period that covers half as much time involves doubling of the responsiveness of the price level to output deviations.

They suggest this is a preferable method of studying increased flexibility because of the vast inherent difference between one, two, and many period contracts arising from the naturally discrete nature. While varying g is possible, it results in meaninglessly sensitive variations at the upper bound. Therefore, by altering the “time length” of each period allows a continuous movement towards Walrasian conditions.

Quantitatively, they find that given an initial parameter set, only by altering said setup such that the periods are more than 87.5% shorter can any meaningful increases in stability from flexibility be noticed. They explain this effect qualitatively as:

The effect of a shortened period in causing more rapid price changes – and thus more of an incentive to postpone or accelerate spending by one period – approximately balances the stabilizing effects of more rapid price flexibility.

And finally, the most interesting part of the paper vindicates the claim that flexibility is destabilizing against critics who noted that with durable capital that is costly to adjust, since price flexibility leads to less erratic long run interest rates, output follows suit. They go on to show that even if since is determined by long run investment which are itself determined by Tobin’s Q, under an empirically-founded estimate of equity-risk premium with capital depreciation at 0.20, flexibility is destabilizing

They show all this within the highly stylized world of perfect rationality and atomistic agents. In reality, it is likely that flexibility is even more destabilizing considering the psychological trauma of significant deflation and cyclical adjustment. While there is a lot of leeway within representative agent setups to model – if you will – bullshit, that this exercise is developed in the context of strong empirical foundations suggesting a fall in serially correlated output and increases in rigidity moving with increases in stability and prosperity increases my confidence in its validity. Correlation is not a good reason to believe in causation. Theory founded on rigorous mathematics is not a good reason to believe in causation. But correlation with theory is a strong force.

The third paper from the duo, “Fiscal Policy in a Depressed Economy”, doesn’t mention price flexibility at all, and I’m not sure either DeLong or Summers would endorse my interpretation. That said, at the heart of their paper is the belief is the importance of hysteresis effects from fiscal consolidation, where resulting demand shortfall can create long-run unemployment decreasing future tax revenues and increase the deficit.

I suggest that hysteresis as defined in this paper will be more dangerous with greater flexibility. Let’s say all workers suddenly disemployed because of recession are to make a choice – every day – whether to remain in the labor market or not. Let’s say both wages and prices are flexible, with the latter falling more. Because workers suffer from a money illusion during short-run adjustment, they will not notice that (even with automatic stabilizers) real wages have not fallen as much. Therefore, the opportunity cost of exiting the labor market falls, and many more will fall into long-run unemployment traps.

Conversely, because of money illusion and normal irrationalities, fewer people will be tempted to reenter the labor market than if prices had remained at artificially high levels. 

Altogether, this is unorthodox because while most (not, unfortunately, all) economists agree that real wage decreases via inflation is preferable to deflation few question the idea that flexibility is bad even outside of a liquidity trap. Many accept that wage decreases via inflation are good, but note that deflation (flexibility) is preferable to nothing.

However, a more creative (and granted more liable to misinterpretation) read of DeLong and Summers (2012) suggests that wage flexibility may have perverse consequences on labor market churn, which is key to economic health. 

So ultimately I have stronger convictions than Krugman,

Even in a liquidity trap, deflation could be expansionary if it is perceived as temporary, so that deflation now gives rise to expectations of future inflation.

that wage flexibility isn’t all that important. First it’s important to note a difference between DeLong/Summers who argue about the variance of steady-state output which isn’t necessarily related to contractionary or expansionary effects per se. (Though in almost any sense, stability dampens the business cycle which is good). But if you accept my final point that deflation has adverse effects on labor market entry, it’s possible to imagine a situation wherein expectedly temporary deflation is contractionary.

Also note that I really have a tough time constructing a world where deflation is perceived as temporary, in any meaningful sense. In the long-run, very few people outside of Japan believe their central bank will tolerate deflation. So it’s basically a non-statement. In the short run, recessionary-deflationary expectations are self-confirming which makes it difficult for future expectations to clash with present expectations. 

For example, if I expect an increase in prices in some future time period, I won’t decrease production now. But if I don’t decrease production now, aggregate demand doesn’t fall and the demand-side foundations for deflation erode.

Anyway, it’s hard to believe I wrote this long piece in response to people who “don’t believe in sticky prices”. None the less, repeat after me: sticky is stable.

It is difficult to begin a post about Larry Summers – and his suitability for Chairman of the Federal Reserve – due to the sheer volume of current commentary. I’ve refrained from writing too much about Summers because I don’t know much more than the average pundit and therefore cannot add much.

However, I recently read Larry Summers’ decades-old, prescient analysis of the emergent possibility of a financial crisis in the modern monetary system, and the role of central bankers therein. It would not be an overstatement to claim that every ounce of thought and analysis in this paper flies in the face of Summers’ contemporary detractors vis-a-vis his position on both financial deregulation and monetary imperatives. Larry Summers likes regulation mutatis mutandis – he supports it at the core with necessary alterations on the side.

Before I continue, I anticipate a common response from detractors will suggest Summers’ revealed preference for deregulation contradict views expressed in 1991 and must clearly have evolved since. Two points:

  • It is well within the realm of reason that Summers’ views towards regulation did evolve due to the illusory stability of American finance between 1995 and 2006. However, as a rational Bayesian agent, we can be certain that he has the intellectual and analytical foundation to revise his priors as a result of the 2007 crash, whose course he presciently anticipated in 1991. His support of Obama’s regulatory regimen in recent years lends support to this argument.
  • Summers’ aversion to the harsh – even crude – style of derivatives regulation proposed by Brooksley Born does not confirm the argument that Larry Summers opposes any and all financial regulation. It confirms the argument that Larry Summers opposes Brooksley Born. But that’s just not as sexy.

Larry Summers’ unfortunate response to Raghuram Rajan’s warning – in which regulators are accused of Ludditery – are at the heart of a liberal backlash against Summers. Also unfortunately, this does not capture his opinion on regulation. From “Planning for the Next Financial Crisis” (1991, linked above), Summers argues:

Kindleberger’s preconditions for crisis are as likely to be satisfied today as they ever have been in the past. It is probably now easier to lever assets than ever before and the combination of reduced transactions costs and new markets in derivative securities make it easier than it has been in the past for the illusion of universal liquidity to take hold. Asset price bubbles are now as likely as they have ever been. Bubbles eventually burst. The increased speed with which information diffuses and the increased use of quantitative-rule- based trading strategies make it likely that they will burst more quickly today than they have in the past.

The thrust of Summers’ discourse is that the risk of financial crisis had not decreased over the decades leading into the 1990s and may well have increased. While he accepted the contemporary establishment opinion that the risk of panic to the real economy had subsided, he rejects the notion that this emerges from any fundamental efficiency of markets, rather the emergence of Keynesian-style economic stabilizers:

If financial crisis is less likely now than it used to be, the reason is the firewalls now in place that insulate the real economy from the effects of financial disruptions. Most important in this regard is the federal government’s acceptance of the responsibility for stabilizing the economy. Automatic stabilizers that are now in place cushion the response of the economy to changes in demand conditions.

Indeed, Summers goes further to suggest that the risk of financial panic per se has increased with the dominance of the new, derivative-driven financial system:

I conclude that technological and financial innovation have probably operated to make speculative bubbles which ultimately burst more likely today than has been the case historically.

Therefore, critics like Dean Baker – and, yes, Paul Krugman – should be cautious when accusing Summers of not foreseeing the housing bubble and crash in the 2000s. As Krugman himself has argued, we must judge the analytical value of a position not by specific predictions or bets – on which count Larry Summers summarily fails – but by the analytical model behind a prediction. I am now more confident that Summers, like Krugman and others on the left, had the foresight and firepower to incorporate the events of 2007 into their intellectual framework. (I’m personally more impressed by someone using an analytical model to suggest that something big is possible than someone saying something will happen for donkey’s years only to be proved right by the Law of Large Numbers).

Before I go on, let me provide the context in which Summers’ paper was written. The early ’90s were in many ways a time of free banking revival on the right and monetarist conceptions of business cycle moderation in the mainstream. It was not vogue to militate the idea of an activist central bank whose role extends beyond blanket provision of liquidity and ensuring a steady growth in monetary base.

In 1991, conceiving a 2007-esque crisis would have been unimaginable. Yet Summers carefully builds a fictional scenario of financial panic – from its animal spirit antecedent to its dystopian consequent – militating the following:

The result was the worst recession since the Depression. Unemployment rose to 11 percent and real GNP declined by 7 percent. For the first time since the war, there was a decline from year to year in the consumption of nondurable goods.

I don’t cite this paragraph to describe something so mundane as a recession, but the infinitesimally-close resemblance it holds to our own reality. Again, Summers never predicted that this crisis will occur, but notes that within his intellectual framework it could occur. Something, again, that sets him apart from his contemporaries in the early noughties, let alone nineties.

Summers discusses four possible paradigms in which we may respond to a financial crisis that so dearly affected the real economy:

  • Free banking.
  • Monetarist lender-of-last-resort.
  • Classical (Bagehot, 1873) lender-of-last-resort.
  • Modern Pragmatic View.

It’s a detailed discussion, and I want to keep my remarks concise. (Needless to say, Summers politely declines the train-wreck of an idea that is free banking.) Ultimately, he supports what he coins a “modern pragmatic view” which includes broadly:

  • Keynesian stabilizers.
  • Targeted (TBTF) bailouts in the case of financial crisis.
  • Regulation. (Read this one again, if you must).
  • Absolute provision of liquidity.

While a lot of this is mainstream stuff that shouldn’t surprise anyone, I want to highlight a few nuggets that are certainly relevant today:

A minimalist view of the function of the central bank would hold that, in the face of a major disturbance, it should use open market operations to make sure that the money stock, somehow de- fined, is not allowed to decline precipitously; a more activist view would seek to insure that it rises rapidly enough to offset any decline in velocity associated with financial panic. On this monetarist view, there is no need for the Fed to make use of the discount window or moral suasion in the face of crisis. It suffices to make enough liquidity available.

In the emphasized, Larry Summers effectively endorses the benefits of nominal income targeting – were we to stipulate that he is an “activist”. (His recent columns, editorials, and speeches on the importance of employment, and danger of hysteresis convinces me that he is). At the time, a standard monetarist argument held that targeting money supply growth would sufficiently stabilize the business cycle and insulate the real economy from financial panic. The equation of exchange states that:

mv = pq

where m is the money supply, v is the velocity of money, p is the price level and q is the real output. This simplifies to:

y_nominal = mv

Monetarists therefore argue that the central bank should target m. However, Larry Summers correctly argues that during financial panic there is a shortage of safe assets and hence money demand increases, diminishing the velocity v. Hence, to maintain output while accounting for velocity is now simply called targeting nominal income.

I have many times said I don’t know what Summers’ views on monetary policy are. While this doesn’t increase my confidence too much, I’ll note it is incumbent to accept Summers has considered, acknowledged, and supported the benefits of a nominal income target.

We also know little about Summers’ current attitude toward the central bank asset purchases known as quantitative easing (QE). Japan first engaged in this “exotic” policy in the early 2000s having hit the zero lower bound. Most economists would not support this policy, and certainly did not one decade ago. Here is Summers two decades ago:

Yet another [possible treatment to financial panic] is direct intervention to prop up asset prices. If this is possible, it will serve to increase confidence in the financial system and reduce the need for reductions in interest rates that would otherwise lead to a currency collapse. Journalistic accounts such as Stewart and Hertzberg ( 1987) suggest that manipulation of a minor but crucial futures market played an important role in preventing a further meltdown on Tuesday, 20 October 1987. They also assign a prominent role to orchestrated equity repurchases by major companies. Hale (1988) argues that the primary thrust of Japanese securities regulation in general, and especially in the aftermath of the crash, is raising the value of stocks rather than maintaining a “fair” marketplace.

In this capacity, it’s not too hard to believe that Larry Summers anticipated something proximal to the new “market monetarist” position. Indeed:

Quite apart from whatever it does or does not do to back up financial institutions that get in trouble, the Federal Reserve has the ability to alter the money stock through open market operations. In the face of a defla- tionary crisis like the one described above, it is hard to see why it would not be appropriate to pursue an expansionary monetary policy that would prevent the expectation of deflation from pushing real interest rates way up. The use of such a policy would at least limit the spillover consequences of financial institution failures. Whether it would be enough to fully contain the damage is the issue of whether a lender of last resort is necessary, the subject of the next section.

In fact, the “market monetarist” movement has two wings. Those occupying the sturdy, monetarist-activist position like Scott Sumner who argue that fiscal policy is entirely irrelevant and those like Paul Krugman and Brad DeLong who occupy a nexus of Keynesian-Monetarist beliefs militating for both monetary and fiscal easing along with regulation.

It is very clear that at least in the above paper, Larry Summers falls solidly with Krugman and DeLong noting the dangers of budget balancing during a financial crisis:

[Emerging stability] is largely the result of the expansion of government’s role in the economy. When the economy slumps, government tax collections decline and government transfer pay- ments increase, both of which cushion the decline in disposable income. The mirror image of stability in disposable income is instability in the government deficit. Hence, automatic stabilizers cannot work if the government seeks to maintain a constant budget deficit in the face of changing economic conditions.

Perhaps the most vicious criticism of Larry Summers comes from an ultra-Left wing of commenters and economists that allege a conspiratorial tie between Summers and Wall Street embodied by his support for big bailouts (which I do not support) and supposed deregulation. In fact, this is just not the case:

Lender-of-last-resort policy is probably an area where James Tobin’s in- sight that “it take a heap of Harberger triangles to fill an Okun gap” is relevant. It may well be that the moral hazard associated with lender-of-last-resort in- surance is better controlled by prudential regulation than by scaling the insur- ance back. This at least is the modern pragmatic view that has worked so far.

The reference to Harberger triangles and Okun gap is an old quip in favor of Keynesian stimulus: suggesting the gains from employment (a closing Okun gap) are orders of magnitude more important than deadweight losses emergent from taxation (Harberger triangles).

Summers only suggests that during a crisis it is dangerous to let big banks fail and it is better to take a vaccination than unscientifically reject a cure for fear of its side effects. While this position certainly creates a moral hazard and excessive risk taking among big banks, Summers is clear this is handled better with regulation (!!!) than failure, phrasing the argument in terms many on the mainstream left must accept:

 It is difficult to gauge the price of this success. Almost certainly, the subsidy provided by the presence of a lender of last resort has led to some wasteful investments and to excessive risk taking. I am not aware of serious estimates of the magnitude of these costs. Estimates of the cost of bailouts, which represent transfers, surely greatly overestimate the ex ante costs of inappropriate investments. If the presence of an active lender of last resort has avoided even one percentage point in unemployment sustained for one year, it has raised U.S. income by more than $100 billion. It would be surprising if any resulting misallocation of investment were to prove nearly this large.

I fall to the left of many fellow mainstream critics of Summers and hence for many other reasons reject the purported pro-bailout stance. Regardless, with the sort of sane regulatory policies that Summers above clearly supports, I would be more at rest.

Summers carefully notes why the former three policy paradigms (free banking, classical,  and monetarist) fail. In this, he anticipates many of the too-optimistic arguments made by those like Scott Sumner or David Beckworth in favor of a rules-only nominal income target. Indeed, in another paper, he questions the value of a rules-based policy entirely:

[I]nstitutions do the work of rules, and monetary rules should be avoided…Unless it can be demonstrated that the political institutional route to low inflation — to commitment that preserves the discretion to deal with unexpected contingencies and multiple equilibria — is undesirable or cannot work, I don’t see any case at all for monetary rules.

But in this paper itself, he notes that the biggest reason for contemporary economic stability comes not from more efficient markets, monetary rules, or even activist lenders-of-last-resort but deep, automatic stabilizers. He notes:

A major difference between the pre-and post- World War I1 economies is the presence of automatic stabilizers in the postwar economy. Before World War 11, a $1-drop in GNP translated into a $.95 de- cline in disposable income. Since the war, less each $1 change in GNP has translated into a drop of only $.39 in GNP. This change is largely the result of the expansion of government’s role in the economy.

He furthers a powerful case against crude monetarism by noting many reputational externalities from bank failures:

 But the analysis of the potential difficulties with a free banking system suggests that support of specific institutions, rather than just the money stock, may be desirable. De- clines in the money stock are just one of the potential adverse impacts of bank failures. Bank failures, or the failure of financial institutions more generally imposes external costs on firms with whom they do business and through the damage they do to the reputations of other banks. Private lenders have no incentive to take account of these external benefits, and so there is a presump- tion that they will lend too little.

The point here may be put in a different way. Because of the relationship- specific capital each has accumulated, reserves at one bank are an imperfect substitute for reserves at another. Maintaining a given aggregate level of lend- ing is not sufficient to avoid the losses associated with a financial disturbance. 

I thought that last point was especially powerful.

I would sum Larry Summers’ opinion on relevant regulatory institutions as the victory of regulation and moral hazard in a tension between the goal of discouraging risky behavior and resolving the crisis. I would sum Larry Summers’ opinion on monetary policy as erring on the side of expansion and liquidity in a tension between the goal of discouraging inflation while promoting employment.

Miles Kimball argues that any potential candidate to head the Fed must note their position on the following three items:

  • Eliminating the “Zero Lower Bound” on Interest Rates.
  • Nominal GDP Targeting.
  • High Equity Requirements for Banks and Other Financial Firms.

I cannot know Summers’ position on the first – though I will note the e-money argument is still very heterodox, and hence I find it impossible that Janet Yellen will support it and only highly improbable that Larry Summers will.

I noted earlier that Summers accepts any activist monetary policy must increase money supply adjusting for a fall in velocity, which is an effective nominal GDP target. It is for the reader to interpret his position on activist monetary policy as an item, and the extent to which he has revised his views today.

Finally, we can read Kimball’s last item specifically as support for higher equity requirements but more broadly as a belief that regulation is important. While equity requirements are distinct from capital requirements, they share some similarity and Summers wrote here “Raising bank capital requirements would seem to be an obvious approach”, signaling support. Raising equity requirements (that is, forcing banks to finance themselves with stock instead of debt) are in every which way better and hence should receive even more support.

On the topic of regulation – the irony that Larry Summers is the bête noire of the Left vis-a-vis regulation is becoming very clear. If anything, Larry Summers supported a form of deregulation in the ’90s but had the correct intellectual framework and has hence updated his priors correctly since 2007. There is no evidence that Graham-Leach-Bliley (the repeal of Glass-Steagall) was the cause of the recent crisis, and even less evidence that Summers critique of Brooksley Born’s harsh opposition towards derivatives trading can be translated into his opposition of smart derivatives regulation overall.

This paper convinces me that Larry Summers was well-ahead of the curve in a way more respectable than just guessing a random crisis (like Steve Keen – in retrospect, as John Aziz points out, this was a poorly chosen jab. Keen, like Summers, had a model. Others did not.). Rather, he teases out the very specific method in which such a panic might occur and analytically understands exactly what we would need to insulate the real economy and employment.

In 1991, few others could have so presciently described the reasons why the economy is more stable today, how the financial system is becoming riskier, and what role the central bank can or should play to fix that.

What more do you want from your Chairman of the Federal Reserve.

(Oh by the way,  for the record and for the little my two cents are worth, I’m officially noting Larry Summers as my top choice for the job).