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Getting Nominal Income Targeting Wrong

October 18, 2013
the Economy: Home and the World
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Just a short note this time. (Also see Scott Sumner on this.)

Excerpted from a recent St. Louis Fed Note:

Getting policymakers to agree on a specific rule of this form would seem relatively easy because GDP is well defined; there would be no debate about the variables as there would be with the Taylor rule. Moreover, the range of disagreement aboutgdpT also seems relatively small. The FOMC has already agreed on a 2 percent inflation objective, and there appears to be a consensus that potential output growth is probably in the range of 2.5 to 3.5 percent. The disagreement about nominal GDP target would be relatively narrow, in a range from about 4.5 percent to 5.5 percent.

So what prevents the Fed and other central banks from adopting nominal GDP targeting? Again, there are a number of reasons, but an important and sufficient reason is that nominal GDP targeting requires policymakers to be indifferent about the composition of nominal GDP growth between inflation and the growth of real output, and, in general, they are not. For example, let’s assume the target is 5 percent and nominal GDP is growing at 6 percent. Would policymakers react the same if the composition was 1 percent inflation and 5 percent real growth, or 5 percent inflation and 1 percent real growth? It seems unlikely. In addition, nominal GDP targeting suffers from the other considerations that prevent policymakers from adopting policy rules. For example, policymakers’ response to the alternative situations would depend on current labor and financial market conditions and activity; the composition of GDP, especially between consumption and investment; global economic conditions; and so on. In short, adopting a nominal GDP target is unlikely for many of the same reasons policymakers are unlikely to adopt a traditional Taylor rule—or indeed, any specific policy rule. The economy is too complex to be summarized by a single rule. Economies are constantly changing in ways difficult to explain after the fact and nearly impossible to predict. Consequently, policymakers seem destined to rely on discretion rather than rules.

 

Most of the piece is a good discussion of “rules vs. discretion” in monetary policy. That’s something I’m not going to get into right now. I was, however, a little surprised to see economists at the Fed mistake nominal income targeting for an indifference between inflation and growth of real output.

This is rather absurd claim because the (well argued, if disagreeable) thesis of the article is that changing dynamics of the economy undermines the efficacy of rules relative to discretion. But for policymakers to be indifferent between inflation and real output under a nominal income target, the economy must be perfectly static. An economist is indifferent between the two if and only if he believes that the rate of inflation will be constant, and the rate of real growth will be constant. In effect, he must ignore completely the possibility of severe demand shocks. But the possibility of severe demand shocks was the whole point said policymakers opted for discretion over rules. Being indifferent between inflation and output at a given point in time is completely different from being indifferent between inflation and output.

In reality, inflation changes relative to real growth all the time. The whole idea behind a nominal income target is its flexibility to these changing conditions allowing policymakers the ability to have different preferences for inflation and output given different economic dynamics. More importantly, individuals are – at some point – always indifferent between two quantities, given a certain level of each.

Ultimately, nominal GDP targeting is prone to structural changes. Lucky for the Fed, it’s their job to deal with aggregate demand.

No End to the Nation-State, Thanks.

October 13, 2013
the Economy: Home and the World
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I came across a Parag Khanna editorial in the New York Times that starts of documenting the CIA’s “Alternative Worlds” scenario – one of which is a so-called “non-state world” – and culminates in some kind of weird romance about the Silk Road days of yore when prosperous traders were the lifeblood of the Arabian Peninsula.

I need to make two quick points, one positive and the other normative. Khanna’s principal charge is that this “non-state world” is already here. The emergence of special economic zones, Dubai, and Hong Kong as centers of international commerce somehow hark the end of the international system as we know it:

A quick scan across the world reveals that where growth and innovation have been most successful, a hybrid public-private, domestic-foreign nexus lies beneath the miracle. These aren’t states; they’re “para-states” — or, in one common parlance, “special economic zones.”

Across Africa, the Middle East and Asia, hundreds of such zones have sprung up in recent decades. In 1980, Shenzhen became China’s first; now they blanket China, which has become the world’s second largest economy.

The Arab world has more than 300 of them, though more than half are concentrated in one city: Dubai. Beginning with Jebel Ali Free Zone, which is today one of the world’s largest and most efficient ports, and now encompasses finance, media, education, health care and logistics, Dubai is as much a dense set of internationally regulated commercial hubs as it is the most populous emirate of a sovereign Arab federation.

This complex layering of territorial, legal and commercial authority goes hand in hand with the second great political trend of the age: devolution.

In the face of rapid urbanization, every city, state or province wants to call its own shots. And they can, as nations depend on their largest cities more than the reverse.

Mayor Michael R. Bloomberg of New York City is fond of saying, “I don’t listen to Washington much.” But it’s clear that Washington listens to him. The same is true for mayors elsewhere in the world, which is why at least eight former mayors are now heads of state.

Scotland and Wales in Britain, the Basque Country and Catalonia in Spain, British Columbia in Canada, Western Australia and just about every Indian state — all are places seeking maximum fiscal and policy autonomy from their national capitals.

There’s a good argument that as urbanization proceeds and technology improves, cities ought to have more autonomy in local decisions. But that’s hardly true right now. Mayor Bloomberg can say whatever the hell he wants but, as it happens, he has to listen to Washington. It is the American people from the Dakotas and Carolinas that signed into law Dodd-Frank, which will regulate New York City’s largest and most important export. It was a Federal Judge that ruled against stop-and-frisk, and Bloomberg wasn’t even able to strongarm the state judiciary when it came to his ban on Sugary drinks.

If there’s one city-within-a-nation that has the political and economic clout, it’s New York City. If there’s one man to exploit that, it’s Bloomberg. And it’s not really worked out all too much in his favor. Indeed, since the death of Benjamin Strong, economic power has shifted from New York City to Washington, where the most important financial and economic decisions are made. And as shitty as the government in DC may be, they represent the people of the United States, not New York.

Let’s take the more surprising example of India, which as far cry from “autonomous cities”. Take a look at this McKinsey report (which, as far as they go, is pretty good) on India’s Urban Awaking. One of the clearest detriments to progress in urban India is the abject disempowerment of the urban voter. Few Indian cities – aside from New Delhi, which is its own state – have a more-than-ceremonial mayor. City politics are dominated by the Chief Minister of encompassing state. That means local action in Chennai is dominated by the mess-of-a-women that is Jayalalitha. And it’s no better in the more “advanced” cities of Bombay or Bangalore. Local politics is slave to rural concerns.

The money is in the cities, but the votes are in the country. National pro-urban policies are in complete disrepair, while India’s urban taxpayers fund the world’s largest welfare program for the villagers. It’s a good program as far as redistribution goes, but horrible in its effect on the productivity and progress – modern commerce – about which Khanna speaks. Not only does it come with the inefficiencies of taxes in general, but it engenders a culture of demechanization as the Indian government wants to guarantee maximum employment in the shittiest jobs as far as they are in the country.

A city-state? I think not.

And sure, there will always be a Dubai, Singapore, or Hong Kong. But as far as commerce go, the whole of the United States doesn’t do too badly. We’re the most economically free country, save two Asian city-states with a population less than New York City, and that counts for something. Power is also concentrated at the national level. As far as international politics go, who even cares what the Sheiks in Dubai want? It’s all about Obama, Putin, Assad, and Jinping. These are people who derive their powers from a national electorate.

But there’s a deeper, more normative problem, with Khanna’s assessment:

The Arab world will not be resurrected to its old glory until its map is redrawn to resemble a collection of autonomous national oases linked by Silk Roads of commerce. Ethnic, linguistic and sectarian communities may continue to press for independence, and no doubt the Palestinians and Kurds deserve it.

And yet more fragmentation and division, even new sovereign states, are a crucial step in a longer process toward building transnational stability among neighbors.

The classical world is gone. And thank god for it. It’s not like being born anywhere in Arabia is great today, but it is infinitely better than it was when Islamic culture ruled the world. It’s too easy to think about the “more cultured” days of our classical past.

At a more analytical level, nation states are key to economic mobility and prosperity. Think about what Dubai, Singapore, and Hong Kong represent – other than a gleaming success story of Khanna’s brave new world. They represent inequality and exclusivity. They represent don’t represent talent as much as wasted talent. Indeed, each of them almost solely represents all that was wrong with the world in 2008. Finance is key to a modern economy, and no one is going to deny it. But it would be a brutal joke to say that the kind of nonsense exported from these “modern city-states” is anything like what America (and, ugh, Britain) once did. It’s a joke to assume the real innovation comes from real estate in Dubai instead of modern ways to improve livelihoods in the heart of India and Africa (not the urban fringes thereof).

Within a nation state, because of fiscal union, someone can dream of settling in the country, but also making it to Manhattan. What kind of dream does Dubai represent in the world – other than young American grads that want a consulting gig for two years so they can party a little harder.

The Three Contradictions of Niall Ferguson

October 6, 2013
the Economy: Home and the World
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Brad Delong tries to detangle Niall Ferguson’s most recent blatherings. I’m in sleepy Rochester, Minnesota (under less than desirable circumstances, but celebratory nonetheless) and, like always, Ferguson gives me the chance to write something fun. On the bright side, Ferguson’s article is a rare example of pundits updating their priors. Only, in this case, it’s within the same piece of writing.

To understand the contradictions within this article, one must first understand Ferguson’s pathological relationship with free markets, his intellectual heroes, and aggregate demand. We begin:

What’s so seductive about the efficient markets hypothesis is that it applies nine years out of ten. A lot of the time it works. But when it stops working, you blow up. Much of the time it looks like you’re in the Bell Curve, and then something happens that your model tells you will happen only once in a million years, but which history tells you happens about once every 50 years.

Key to Ferguson’s intellectual framework are mathematically efficient markets, or at least the program prescribed thereof. His hagiographic pieces on Reagan, Thatcher and supply-side reform in general derive from work by the likes of Robert Barro in the context of Ricardian Equivalence or crowding out. Niall Ferguson is a free marketer, but also a Jeffersonian in the image of producerist currents. That is, the bankers, lawyers, and special interests within the government manipulate power against the common man.

But the ultimate implication of efficient markets is embodied in its eponymous hypothesis: the price is always right. Ferguson can live with this “nine times out of ten”. More accurately, this hypothesis (arguably) vindicates Ferguson’s world view nine times out of ten.

But today, the markets are not telling us the United States of America will default on its debt. Not now, nor ever in the future. Today the markets are not telling us that Washington “is playing Russian Roulette with our creditworthiness”. And suddenly, markets are wrong. Suddenly, Sir Niall Ferguson the first is better than the market at evaluating its own signals. This flies in the face of his own ideology.

Capitalizing on his Jeffersonian credo, he tries to blame the Fed on manipulating the market:

So long as the Federal Reserve continues with the policies of near-zero interest rates and quantitative easing, the gun will likely continue to fire blanks. After all, Fed purchases of Treasurys, if continued at their current level until the end of the year, will account for three quarters of new government borrowing.

But in the world of efficient markets – the world in which Ricardian Equivalence, crowding out, and real business cycles too reside – the Federal Reserve cannot trick investors. Indeed, if the market believed we were spending recklessly – sustained only by a massive balance sheet expansion on part of the central bank – eventually inflationary expectations would become unanchored precipitating a rapid rise – not fall – in Treasury yields.

Here emerges the next in Niall Ferguson’s theory. On the one hand, he heaps praise on Milton Friedman and his “skepticism towards government and faith in individual rationality”. And yet, he disregards a key implication of this theory:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

But this would fly in the face of Ferguson’s position on monetary policy.

Niall Ferguson could rightly – or at least arguably – take the position that government spending is less efficient than the private sector and hence we should avoid expectations of a future increase in tax rates. Niall Ferguson could express disdain at the ideology of a large government, quite independent from its economic effect, in libertarian spirit. But instead he insists that fiscal crisis is nigh. But this contradicts Ferguson’s every belief in the efficient market.

Niall Ferguson’s two contradictions fold into an ultimate third: a contradiction between aggregate demand and aggregate supply. On the one hand, Ferguson is a fervent supply-sider with a saintly view of the Thatcher and Reagan reforms. On the other, he believes supply matters not at all:

Only a fantasist can seriously believe “this is not a crisis.” […] Net interest payments on the federal debt are around 8% of revenues. But under the CBO’s extended baseline scenario, that share could rise to 20% by 2026, 30% by 2049, and 40% by 2072. By 2088, the last date for which the CBO now offers projections, interest payments would—absent any changes in current policy—absorb just under half of all tax revenues. That is another way of saying that policy is unsustainable.

Someone who believes in the importance of aggregate supply cannot reasonably speak of predictions into the  year two thousand and eighty eight ( = 2088). Someone who believes in the importance of aggregate supply (or, indeed, the efficient market hypothesis) cannot possibly imagine the growth of gross domestic product can be predicted in any sensible fashion by the Congressional Budget Office.

But perhaps Ferguson’s 2010 column – “Today’s Keynesians Have Learned Nothing” – explains everything:

When Franklin Roosevelt became president in 1933, the deficit was already running at 4.7 per cent of GDP. It rose to a peak of 5.6 per cent in 1934. The federal debt burden rose only slightly – from 40 to 45 per cent of GDP – prior to the outbreak of the second world war. It was the war that saw the US (and all the other combatants) embark on fiscal expansions of the sort we have seen since 2007. So what we are witnessing today has less to do with the 1930s than with the 1940s: it is world war finance without the war.

You see, high deficits are okay in times of war, but not of peace. Markets are efficient nine times out of ten, but not when millions are out job in which case bond yields are too low, because… well… because. Aggregate supply is important when it’s used to justify tax cuts and low public spending, but not when we can predict the infinite future like certain Scottish Sages.

As I have documented in detail before, Niall Ferguson’s grand theory is devoted to a time of big government, but of a different kind. He yearns for the day when big governments taxed the poor to finance colonial adventures and fought with each other for glory and nothing else. Indeed, as he’s written before, he yearns for the day when “Britannia bestrode the globe”.

We today owe our intellectual and humanitarian heritage to Franklin Roosevelt. Not because he vindicated principles of easy money or public finance. Not because he vindicated principles of modern liberalism. But – for the first time in the history of our nation and all nations – he demonstrated that government can exist for the great benefit of the many at the minor cost of the few. For almost a century both political parties have lived by this end, if disagreeing on the means.

There is an ideology that accommodates the worst of efficient markets, supply side economics, and neoliberal economists like Milton Friedman. It is called right wing hackery, with Niall Ferguson as its high priest.

“A Perversity Only the British Could Have Devised”

October 2, 2013
the Economy: Home and the World
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Such is Shashi Tharoor’s painfully accurate term for the Westminster System of democracy. As Matt Yglesias pays tribute to the late Juan Linz – who provided some of the best scholarly foundations for Parliament over President – it’s hard not to remember the failures of Indian politics in assessing the weakness of a parliamentary system.

Two caveats: this debate has been subjected to substantial academic research, theoretical and otherwise. My knowledge of modern political science is very limited and so it’s very unlikely I’m adding anything new. Still, very few popular publications even consider this topic, so I’m glad Yglesias brought it up. Another, more important if obvious, point is that institution trumps implementation. That is, a better system can perhaps grease the wheels of effective governance, but can never replace a more deeply seeded reverence to democratic institutions like accountability and citizenship.

Parliaments’ first weakness is an unnecessary complexity. Outside of French style unions between President and Prime Minister, the parliamentary system has the useless baggage of a President. This isn’t crucial to the system in any way, but already sets the tone for wasteful governance and can be devastatingly abused as evidenced by Indira Gandhi (who Jackie Kennedy rightly called “a bitch”) and her domination of Fakhruddin Ali Ahmed.

Ironically, over the “Third Wave of Democracy”, some liberal scholars eagerly urged African countries on the cusp of democracy to favor a parliamentary system as they believed presidential authority lent itself to dictatorship. Of course, if the world’s largest democracy is any proof, parliamentary systems are – if anything – more prone to authoritarian impulse. President Obama can shutdown the government, but he may not call a State of Emergency authorizing rule by decree. But I’m not asking New Zealand or Austria to abdicate the Westminster System in favor of our (clearly superior) program. Small, central republics can easily achieve governance and efficiency within the confines of a parliamentary system.

I have four general criticisms of parliamentary systems and one specific to America. In general:

  • Students of American history are very familiar with the importance of a separate and independent Legislature, Executive, and Judiciary. A parliamentary system does not wholly murder the division between Executive and Legislature, but – as Shashi Tharoor says – it is a perversity to vote for a legislature not to legislate but in order to form the executive. When only two branches own government, it’s harder for an independent judiciary to execute its task: at least without firm constitutional provisions.
  • Secretaries are talented, ministers are not. Under most forms of parliament, the executive branch is staffed with politicians. The United Kingdom gets a third rate fool in the form of George Osborne for Finance Minister. While I’m not arguing Tim Geithner is a gift from god, we sure as hell wouldn’t have someone who graduated “Modern History”* with a shitty 2:1 as our fiscal captain. But people like Geithner, Paulson, and Lew would never win an election. So where parliaments should have bureaucrats they have politicians. Though the Upper House is in principle designed to avoid this pitfall, public choice concerns generally own.
  • Uncertainty abounds. Parliamentary rule is all or nothing. If the leading party has a majority, there is no room for dissent and the Prime Minister can act (almost) by fiat. If the leading party has a plurality, it is forever in mercy of small, unreliable coalition partners who are bestowed with an outsized voice relative to their national popularity. Small countries like the United Kingdom and much else of Europe are the exception.
  • Parliament cannot have a (real) bicameral legislature. Many populist American Revolutionaries wanted a unicameral legislature. That would have been a disaster. In most times – indeed, even today – the deliberative body that is the Senate is a force for good in political life. While parliaments are granted nominal bicameral bodies (Rajya Sabha, House of Lords, etc.) they are more or less ceremonial, like the head of state. This deprived us of an important component of modern governance.

(*I’m not saying history majors can’t make great economists. Paul Krugman and even Dani Rodrik are good examples of people with somewhat non-traditional undergraduate experiences that become brilliant economists. However, if your undergrad degree in Modern History – with crappy grades – is just part of the Oxford political machine and you spent your days trashing parties with the Bullingdon Club, there’s a good chance you have the brains and wit of a blue blooded politician, not a thinker).

Yglesias notes that a benefit of Parliament is its ability to quickly call an election where needed. American politics are too big and important for this. In Australia campaigning starts just over months shy of the election. In America, the electoral cycle is effectively never ending. You could, of course, argue that I am citing cause when in fact our long elections are the effect of presidential systems. However, looking at elections in presidencies across the world, America still remains the outlier.

Fact of the matter is when you are choosing the Leader of the Free World – by and far the world’s most consequential person – elections become a big deal. There is no way our system can handle the political heat of a parliamentary demand on election.

In fact, parliamentary structure would exacerbate what I think damns American politics: the two-term presidency. I’ve argued before that we should learn from our Confederate history that one, six-year term would be politically superior allowing the president to govern without worries of reelection.

Ultimately, Yglesias may be right that for fledging countries across the world it may be better to copy the Canadians. But as far as our politics go, parliament would only make things worse.