the Economy: Home and the World

A constellation of seemingly contradictory events over the past five years – high unemployment, stagnant wages, anecdotal evidence of astounding technological growth, alleged robotization of everything, all ensconced in a grim uncertainty about the future – has brought about something incredible: prominent economists can now reasonably question the value of new technology.

This ranges from Martin Wolf’s generic essay questioning techno-optimists to a star-studded paper arguing that “under the right conditions, more supply produces […] less demand as the smart machines undermine their customer base”. Economists as prominent as Larry Summers and Paul Krugman have voiced their fears about robot-driven unemployment, and a general stagnation in living standards, if we don’t radically reassess our relationship with inequality and capital-driven growth.

I’m not here to necessarily disagree with any of these sentiments as much as explore their implications when taken to a logical conclusion. As a first pass, let’s start with a simple economy, consisting of capital owners and rentiers providing capital, high-skilled technology workers producing innovation, and low-skilled laborers producing commodity goods and services. Your production function in this world would look something like Y = A*F(K, B*G(K_r, L)) where F is of Cobb-Douglas form and G is any more general CES function, K is capital, L is labor, and K_r is innovation.

From one perspective, this is the crux of the problem. Go back to Piketty whose argument can be summarized as “when the capital stock increases by n%, the marginal return on capital decreases by less than n% and therefore K/Y increases”. Summers (in his review of the book) noted that no studies suggested that capital-labor elasticity, net of depreciation, was greater than 1. But once you have the slightly modified production function, what matters is the substitutability between K_r and L which, as I’ve written before, is governed as mu = 1 – 1/sigma where sigma is the classical elasticity of substitution between capital and labor, and mu is the robot-labor substitutability. As mu tends towards 1 (which, with improving technology, is not unreasonable) sigma grows without bound.

So we can stipulate that in the world of our robot overlords it isn’t unreasonable to expect that an unprecedented proportion of national output would accumulate to capital owners. But what does this say about living standards and employment? For one there will be a shift in employment among the unskilled laborers from highly substitutable commodities to services that benefit from human interaction (artisans coffeeshops, massage parlors, art vendors, street artists, and botanical gardeners for example).

And while there will be displacement within the unskilled population, they will – as a whole – very likely be much better than they were before. This statement isn’t the result of a careful empirical study as much as a reflection of certain fundamental, economic gravities. Let’s say robots replace workers in all manufactured goods and consumer durables production. The high standard of living in the United States isn’t derived from that employment itself as much as the collective result of that unemployment – a middle class that has multiple cars, microwaves, abundant food, television sets, carpets, furniture, and other staples of the modern home.

So the stagnationists need to further argue that the purchasing power for these products will somehow evaporate from the laboring masses. This is where it gets much harder. Because if millions of workers who once had the employment (and, therefore, the skills) to build said products and the products themselves clearly – within this population – there exists a supply and demand which, in equilibrium, creates prosperity for the masses.

As the largest consumer base in the world, this market also provides abundant profits (if at low margins) for the capitalists – the old fashioned kind who buy the old-school machines and factories necessary for the production of the goods thereof. So in this hypothetical world it will by definition be economically profitable for a capitalist to finance the sort of old-school capitalism that brought so much wealth to the middle-class. And this is as true globally as it is domestically (Chinese, assembly-line workers are  the victims of the sort of automation we’ve just described).

So here is a challenge for anyone who believes technology will result in both unemployment and a broad-based decline in living standards for the unskilled. Describe the precise mechanism in this world that will prevent the old equilibrium – that is both preferable both for the marginal capitalist and the working class as a whole – from reemerging. Or, if that isn’t your preferred interpretation of the economy, explain why supply or demand have somehow changed among this working class to make the question moot in the first case.

If you want an economic intuition for why this will be highly improbable, notice that this technology effectively means the marginal cost of production will fall to the commodity cost (which, itself when automated will, in the perpetual run, be the cost of recycling that unit of ore, or whatever). You would have to believe wages falling below this level at a mass-scale (something like a physical paralysis overcoming all that exist) for this explanation to remain reasonable.

This isn’t a model, it’s imprecise and unrigorous but is still a better interpretation of the world than some of the more formal models I’ve seen written on the subject. Take the Benzell, Kotlikoff, LaGarda, and Sachs paper which uses an OLG model with low and high tech workers to map certain equilibria in which technology decreases consumer purchasing power. Even if this is the best paper on the subject I’ve seen, the model is baked with not just incorrect assumptions but mechanics that are fundamentally divorced from the way technology operates. For example, mapping “code” as some sort of capital-like stock makes little sense. They stipulate that A_t = d * A_{t-1} z * H_{t-1} where A is the stock of code, d is the depreciation rate of code, z is the productivity of high skilled laborers and H is the quantity of high skilled laborers.

Expect code doesn’t depreciate it the way they model it as. The crux of the problem, they say, is:

Things change over time. As more durable code comes on line, the marginal productivity of code falls, making new code writers increasingly redundant.

Eventually the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code. The remaining high-tech workers find themselves working in the service sector. The upshot is that high-tech workers can end up potentially earning far less than in the initial steady state.

Their view of the world essentially requires one to believe that eventually we will have perfect code – code that never needs to be improved, rewritten, updated, redeployed, or debugged. There is some irony in 4 economists building such dramatic conclusions into their argument, but the problem here isn’t an assumption that code will eventually live on its own, updating itself, improving itself (presumably by using “machine learning”). It’s that what’s lacking from here is any imagination about what a world with perfect code would look like.

You would ave driverless cars moving everyone from point A to point B without a single accident. You might well have a revolutionized biotech industry that can run scalable tests virtually and suggest perfect medicine without any human work whatsoever. You might cure cancer and heart disease. You might identify markers of suicide and track and help those prone years before the fact.

Of course I’m just listing random, utopian ideas. None of these might happen, none of these might even be possible. The fact is we don’t know. If we knew it would already be here. This is why some startups work and others fail. And this is the problem with a lot of what Autor writes as well. To be able to divine the effect of technology on employment and have a say on the living standards thereof you need to make assumptions about what the world many years hence will look like. No one is capable of making these assumptions.

This is why Martin Wolf can write that the Roman can imagine the America of 1840 but neither of the two could imagine the America of 1940. Once you have technological growth, the logical conclusion is unknown. Economic models might have been contrived before, but they at least tried to abstract and understand dynamics that already existed, that we can fundamentally comprehend. You are kidding yourself if you think models that talk about code depreciation in a world where “the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code” are economics or science.

They are speculation at worst and thought-provoking philosophy at best. So file this talk about robot driven stagnation next to Nick Bostrom’s paper that we are all human simulations.

Let me end this with a rejoinder – that the technology-capital driven world will actually be freer, more equal, and more egalitarian than the one we live in today. Code and soft intellectual property in general is so much harder to restrain in the hands of the few than factories, machines and physical land (which, in the capitalist world is defended by the government’s monopoly on violence to anyone who threatens the sanctity of property). If you describe me a world where 3D printers replace workers, and magically one where these workers don’t have any of the fruits from the 3D printers, are you telling me the code that generated the item can really be locked up forever?

Technology monopolies, one might say. But, as I’ve argued before, many technology monopolies are actually contestable markets. Google makes a profit by advertising goods to the consumer, but it’s not clear what the consumer’s costs are. (This is something I would love to see debated and modeled in a more convincing and clarifying manner). If Google decided to charge even $500/yr for its search I would be happy to bet would be irrelevant in under 2 years.

The burden of proof on future technology seems to lie with those who believe growth will be more exclusive, rather than inclusive.

Interfluidity has an excellent post on Greece and I don’t wish to repeat what he’s written much more fluently than I could. But I want to use something he said as a segue into a deeper conversation about how we should think about Greece (and sovereign default in general):

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

There’s no getting around the fact that Greece needs debt relief. The IMF has made this clear in no uncertain terms. If the fundamental purpose of finance is to align asymmetric incentives in an efficient way, creating an environment of trust, and hence lending and development, the Greek dilemma is more than a failure of European integration. It’s a failure of finance itself.

Where Steve Randy Waldman channels his fury at the political failure of European authorities, Michael Pettis has an extraordinarily prescient essay – from February! – begging Europeans to pay attention to financial distress and poorly aligned incentives. You have two ways of doing this. You can either tell Greece that you won’t roll over its debt unless it engages in a series of politically unpalatable policies to secure your principal or you can recognize that success is shared and create a debt structure that reflects this mutual enterprise.

Quite simply, the Greek government should sell optionality on its prosperity. As much as countries are not corporations one of the purposes of Chapter 11 is to ensure that senior creditors do not force an inefficient liquidation on the entire corporate structure. For example, selling assets to meet financing requirements even if the company has a really good ten-year plan. Or, for example, forcing a degree of austerity that would wreck domestic agency to make your initial investments whole.

And whatever you think about fiscal policy, that’s exactly what this is. Whether you like Syriza or not, that is the democratically-elected government of Greece and hence its representative. And, therefore, by proposing a restructuring scheme that forces the other party into capital controls that asphyxiate domestic business you are partaking in precisely the form of liquidation that Chapter 11 seeks to avoid.

At least in the case of a distressed shipping company – or whatever – it’s possible to see why someone would want this. The number of senior creditors are small, the upside is capped, and the benefits to immediate liquidation are obvious. In the case of forcing Greece to make whole its current capital commitments the benefits are distributed across millions of European tax payers, the costs are concentrated among the Greeks, and that’s not even considering the spillovers of financial distress and turmoil generated by the plan.

And don’t kid yourself that the referendum changes things. A “no” vote only exacerbates the above and the “yes” vote seems to be the precise definition of “kicking the can”. As I’ve written before, if you eventually default (and Greece will, in some fashion or form, default) it will always have been better to default one day before after the fact.

Senior creditors are, when they cannot be made whole, given the option to buy equity (at what would be a discounted price relative to normal liquidity conditions). Some will sell these and write-off their losses, furnishing a lucrative industry in special situations investing. Regardless, creditors painfully recognize their losses, and move to align their incentives with the firm, gaining optionality in the process.

One obvious way to do this is to exchange a meaningful portion of the principal for GDP-indexed bonds. These have been discussed in detail elsewhere. It’s not clear that these are a bad idea, but it’s certainly not clear they’re a good idea, either – or the quickest and most obvious way to align European incentives. Argentina sold GDP-warrents in 2002 and investors were recognizing dramatic losses years after the fact (that’s not necessarily an indictment of the idea as much as that they are a straightforward salve). Not to mention Greece actually offered something like a GDP-bond in 2012 without any of the benefits proponents advocated (again, this might be an issue of magnitude but that’s not really the question).

Rather, Greece can sell calls on its export revenue. For one, this isn’t subject to the same measurement complexities that plague GDP (and when we’re talking billions of dollars in coupon payments, this matters). More importantly, exports are a much quicker and sensitive guide to adjustment performance than GDP, which can years to reflect structural improvements. Now the obvious flaw of export calls by themselves is that it’s not clear that the Greece government really cares about higher exports (even if its population does).

Here we can incorporate German sensibilities. Exports that fall below some benchmark on which the option is indexed incur a penalty in proportion to outstanding debt that would come out of a pool of “optional austerity” consisting of pensions, national assets, and defense spending. This would ensure that authorities engage in the sort of reforms – removing red tape, reallocating taxes, subsidizing the right things, and encouraging devaluation over unemployment – in a way that austerity resulting from failure would be predictable.

The final part is important. The IMF wants to give Greece a 20-year grace period before requiring any debt payments. What if we cut that in half, and indexed the coupon payments by an reverse exponential weighted average of net export performance over the next 10 years. This would allow Greece the freedom to implement policy that is responsible but not too responsible.

Maybe austerity is necessary and maybe it’s not. We can recognize the corruption of the Greek government without making a claim on how much austerity it needs. Michael Pettis has the key point:

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.

And we shouldn’t expect Greece be any different. Without growth any Greek repayment schedule is doomed. Economically yes, but politically certainly. By opening a market determined pool of austerity as Greece misses its export (or other benchmark) targets, and offering the upside on any growth above that benchmark over the next 10 years, authorities will be forced to focus on a long-term economic salve. And, in this world, we let Greece grow and pay back what it can first, if that doesn’t work take a cut from its optional austerity pool, and if that doesn’t work let it default once and for all. And that’s basically what Eurocrats should have done decades ago.

Addendum: Tyler Cowen doesn’t agree with the Steve Randy Waldman post on what I think is weak reasoning. Germany is trying to maximize its return as senior creditor. In a Chapter 11 (not that this is the same, but follow the logic), the court’s responsibility is to maximize stakeholder value. To the extent this is more than a plain wealth transfer – that it will further depress demand in a region already rife with unemployment and poverty – further austerity does not meet the criterion. Sure, the German government has a responsibility to its taxpayers, but the per capita cost of a “stakeholder maximizing” agreement, I suspect, is not meaningfully important. (Yes, folks, the ECB’s monetary policy very likely had fiscal risks).

For Germans maybe it’s about setting precedent. For one, it really isn’t clear that Greek is strategically defaulting because it doesn’t feel like it (the austerity it has endured remains testament to its commitment to a European project). As IMF reports I’ve linked to before suggest, in most cases default isn’t costly precisely because markets don’t believe it sets some sort of precedent of irresponsibility.

Regardless, to the extent setting precedent is about the continuity of the European project, one can’t seriously argue that recent brinkmanship (on either side) has served greater service to further unity. Germany should allow this because there seems to be near-unanimous consensus that its preferred policy landscape is not maximizing the value of the European enterprise.

(On the criticism of American economists, he is right. Capital controls are a form of austerity – granted maybe an ideal form of austerity – requiring much short-term pain for potential long-term payoffs. It is easy to sit at Princeton and suggest that this is a good idea, when trade credit dries up and importers cannot purchase energy to turn on the lights it is quite a different matter).

On what might be the eve of capital controls in Greece – bifurcating the unified currency zone – I want to bring some attention to an 2008 IMF paper and literature review of the costs of sovereign default. The most interesting result is… well, I’ll let the authors speak for themselves:

Perhaps the most robust and striking finding is that the effect of defaults is short lived, as we almost never can detect effects beyond one or two years.

Of course, the paper is richly caveated and many of the regressions performed include Latin American countries which occupy a different role in world trade and the international financial system than Greece, not the least the dual dynamics of default and Grexit that complicate any simple analysis, especially given the beyond monetary interest implicit creditors (i.e. the ECB) have in maintaining the Euro.

The authors, Borensztein and Panizza, identify four primary casualties of default: reputation, freedom to trade, the domestic banking system, and the incumbent government. These can be measured by credit rating or spread, trade balance, currency dynamics, and political upheaval respectively. Their conclusion points to an important pattern in historical defaults (including voluntary restructuring) – they were necessary and, more importantly, markets agreed.

Necessary in contrast to strategic – whereby the government elects to shortchange its financial creditors instead of its political creditors on the expectation that the former will be more forgiving than the latter (such as pensioners who vote). Part of the question might be what qualifies as strategic, and we’ll get to that. For now, the question of Greek default can be captured as:

The “default point” for a sovereign should be the point at which the cost of servicing debt in its full contractual terms is higher than the costs incurred from seeking a restructuring of those terms, when these costs are comprehensively measured.

Here is where the Syriza negotiating position becomes tenuous. If we define strategic default as any default that could be avoided by another negotiating party that could realistically realize general support from the electorate, it’s not clear the Varoufakis argument that Greece has made 75% of the compromise and creditors ought to yield on the rest is correct. With over two-thirds of the population favoring a deal over “rift with Europe”, and approval ratings falling by some 35 percentage points since April – Syriza seems to be overplaying its hand with respect to how much more Greek’s are willing to give up.

This conversation should be divorced from your moral calculus of Greek’s obligation – whether that be from the Left that Greek’s have realized more peacetime austerity, unemployment, and pain than any other nation and cannot reasonably give up more or whether it be from the Right that it’s incredulous Greece can pay out pensioners and maintain living standards well above some implicit creditors like Latvia where living standards are lower. The only thing that matters is the divergence between what the government will give up and what the people are willing to give up – and the people seem to be saying “make that deal now”.

Syriza is, of course, well aware of this and hence delaying default to the latest extent possible (in hope of extracting a deal without further concessions). As the IMF paper suggests, this is generally not a good thing:

High political costs have two important implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to “gambles for redemption” and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs. Delaying default might be costly for at least three reasons: (i) Non-credible restrictive fiscal policies are ineffective in avoiding default and lead to output contractions; (ii) Delayed defaults may prolong the climate of uncertainty and high interest rates and thus have a negative effect on investment and banks’ balance sheets; (iii) Delayed default may have direct harmful effects on the financial sector.

Many of the costs outline here seem to identify precisely the problem Greece is facing today – in extending its negotiation (gamble?) rather than defaulting. I’m an outsider. Maybe Varoufakis really thinks he can get his creditors to eat the rest of burden but it’s important to note here that this would still be default – at this point it really is only a question of partial versus complete default.

Europe really would want to accept this deal – partial capital loss would be much preferable to whatever restructuring Syriza would exact in the absence of a deal – but there is the natural concern of other peripheral countries asking for a similar deal. While I am more optimistic on Greece than some – like Larry Summers – I don’t fully share the confidence that most of the credibility problems would be gone in 2 years.

For one, let’s consider the third cost of default: freedom to trade. They divide this into two categories: (1) the emergence of retaliatory embargoes against defaulters and (2) the evaporation of trade credit necessary for importers to function. (1) is basically a theoretical concern at this point – something international macro papers use in their models but not a real or credible threat, especially with an EU country. (2), the authors find, doesn’t have a genuine long-run impact on existence of trade creditors.

I’d push back against this for Greece, and we don’t need to look further than 2012 to see why. In the first Euro crisis, trade credit insurers uniformly reduced their coverage of Greek debt on the risk that importers would still be obligated to repay their credit in Euros even when Greece gets on the drachma – and no one wants to be exposed to risk of external debt default. This is bad. Headlines such as “Greece Struggles To Keep The Lights On As Trade Credit Crunch Bites” weren’t figurative – energy exporters were no longer comfortable with Greek importers with the absence of trade credit insurance.

Therefore, unlike other countries which would default on their own currencies, Greece faces the legitimate struggle of feeding itself with baklava and olive oil – further escalating the political incentive to delay default.

You might reply that default need not imply Grexit and you might well be right, but that’s not the point. Default will with certainty bring about harsh capital controls on real and financial assets. A Euro in Greece will no longer be a real Euro and, unless importers have huge foreign balances with which to collateralize their purchases, the depreciation of the Greek Euro versus the Euro Euro will unleash similar dynamics on trade credit insurers as in 2011.

Unless, of course, investors have a credible schedule of when capital controls would be relaxed but if the government was in any position to give markets that relief it’s highly unlikely they would need capital controls in the first place.

But I’m less pessimistic than someone like Summers because my key reading of the IMF paper is that reputational costs remain small in the medium-term. If Greece defaults there’s no reason – after extensive depreciation of the drachma – why Greece couldn’t credibly commit to increasing revenues given the rapid external devaluation of its labor and obtain financing to scale those revenues and invest in, well, whatever.

I’m not as sanguine as Krugman, with his exception that he cannot think of “any examples that fit this story”. The trade credit disaster in 2011 is enough to provide one of an example of what might happen in a drachma world. And here economic recovery stands in one-to-one contrast with financial stability, i.e. to what extent can Greece dramatically undervalue the drachma.

If Greece defaults this will be the important dynamic it needs to figure out. One good bet might be to determine a drachma level that is sufficiently weak – but strong enough to finance highly price-inelastic imports such as energy inputs without entering into another fiscal death-spiral – and use its Eurosystem collateral (which would be expropriated in the event of default) to guarantee that level. By definition, there has to be an optimal level, and if Greece comes close enough to this, markets should have faith that it will defend against further devaluation. This would be a critical first step in reentering international debt markets.

There would be little margin of error here, as it works in the same sense that a one-time wealth tax “works” (as they are, in principle, the same thing). Further devaluation, or inflation that puts pressure on Greece’s FX reserves, could result in a currency crisis that is much harder to solve the second time around.

I’m not nearly an expert on the subject, but I imagine if the right thing happens, it will happen in the next 2 days. If and when Greece defaults and imposes capital controls it will always have been better, after the fact, for it to have happened before it actually did. Barclays noted that capital controls could provoke a political crisis bringing a moderate, Eurocrat party into power – “default without EA exit”, it wrote.

This might be necessary, if not sufficient, given the bargaining platform of Syriza – which seems to be leverage Europe’s commitment to the Euro and preference of partial over complete default to minimize its concessions – over a maximal commitment not to default. Krugman likes to denounce VSPs, but if default happens (as the IMF paper confirms) it is better it be supervised by a internationally credible party that would default only in the worst of circumstances.

Regardless who is in power, it will be prudent for the Greek government, if forced into default (i.e. involuntary restructuring), to offer a restructuring no worse than that to which it has already committed in negotiations – this may at least temper future market turmoil.

A few weeks ago I wrote about the unusually strong US net international position. I missed Brad Delong’s rejoinder:

Where Ashok Rao shies at the jump here is in failing to specify where he thinks the market failure is, and how to correct it. Is the demand by foreigners for safe dollar-denominated assets an improper one? And why today is it only the U.S. government–rather than, say, Apple or Wal-Mart–that can tap this funding source? Or is there a deeper problem in that Apple and Wal-Mart could tap this funding source but really do not want to–that they already have all the capital and funding that they think they can use? These are the questions that people are worrying…

I’m going to shoot at the hip here because the honest answer is that I’m really not sure.

To define the terms, I’m not really sure “market failure” is the right concept to think about here. We are talking about certain events led by single actors with a lot of agency and market power (foreign central banks, state owned exporters, finance ministry policy directives, among others). But we can begin to answer the question: are Treasuries unfairly valued given a concerted foreign interest in maintaining high dollar reserves.

There are multiple equilibria here, and that’s exactly what China doesn’t like. On the one hand, China (and its less reserve-oriented neighbors) would like to be free of the “dollar trap” – and yet any move that would motivate such a shift would open domestic central banks to incredible balance sheet risk. So the current equilibrium is maintained by foreign taxpayers who are unwilling to eat the fiscalized risk of prevailing monetary policies.

The next question becomes why aren’t other liquidity providers offering competition to the US Treasury (which, per my argument, would be “undersupplied” in some sense). The simple answer is US corporations with the credibility to offer safe, liquid debt are already sitting on piles of cash without any meaningful investment opportunities – they themselves are funders, and do not need any funding source. Moreover, for risk and liquidity reasons these bonds are undesirable from a central bank perspective. US Treasuries are traded 8-10 times as frequently as all AAA corporate debt, on a volume basis. The liquidity and risk is reflected in a historically high AAA10Y spread:

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The spread spiked in the late-1990s for the reasons previously outlined – Asian markets suddenly rocked by the instability of large external debts and low dollar reserves instituting policies to maintain defensive central bank positions. The mid-2000s decline is a little puzzling – as Asian countries continued to pour into Agencies and Treasuries – “reach for yield” hypotheses and a declining trade position might serve to explain the decline in spread – though this is still an open question.

The important point is that we’ve returned, and never really recovered from, the 1990s environment of relatively high spreads.

So the first question is whether this spread by itself is a “market” failure. From a Chinese perspective, I can’t answer the question – though I imagine the freedom to trade huge quantities without rattling the markets is part of the problem, especially since all AAA credit isn’t really securitized into a hyper-safe and hyper-liquid AAA tranche.

The simpler answer seems to be that people want the US government to be a bank. This is a role it fulfilled with glee in the mid-2000s – not just through its fiscal deficit, but the flurry of agency-backed mortgage origination which, in a foreign investors eye, was a guaranteed dollar deposit (the high liquidity basically means it was always callable). This is a role it didn’t play before 2002 and is one it hasn’t played since 2007. In a sense spreads are returning to the old normal in which the US government is refusing to be a bank. (Note this would also be politically hard to maintain without the guise of Agencies as it effectively requires the issuance of debt without any corresponding increase in spending or decreases in taxes).

In that case, there’s nothing fundamentally improper about the situation today – the big change isn’t an attitude from Asian central banks as much as the withdrawal of US liquidity provision thereof.

This doesn’t answer the question of whether Asian policy is correct, but it does make the question sort of irrelevant – foreign demand (i.e. the alleged global saving glut) isn’t what seems to matter here as much as the decrease in government-guaranteed securities. (Or, more accurately, in their expected stock some n years from now).

Here’s a tangential puzzle. Equity prices are relatively high (implying, given a constant risk preference, an increase in expected earnings growth rate) and yields are relatively low (implying, given a constant capital share of output, a decrease in expected earnings growth rate). So one of the “givens” must be incorrect. Yet if risk premium really fell meaningfully a number of previously unprofitable investments should be in the black, on the margin, encouraging further spending and borrowing by the Apples and Walmarts of the world. That’s not what happened. Maybe, as Tyler Cowen has prompted (if not advocated) to me, it was a fall in labor’s share – but that’s a decades-long process and probably can’t explain short-run dynamics.

More on this soon.

Steve Schwarzman has an op-ed more or less arguing that capital requirements magnify procyclical financial dynamics forcing banks to stop lending when the economy needs it the most. A lot of his points don’t seem wholly unreasonable – if a little unlikely, though we’re obviously talking about tail risk situations – though I find it implausible that this isn’t better than what we had before.

Regardless I want to offer a simpler framework to debate the topic. In short, we need market regulation of risk. This isn’t to say we need an unfettered free market as much as a market informed and credible policy towards regulation. In theory one could potentially achieve this by truly committing against any bailout. Actually achieving such a commitment seems impossible (short of a Rand Paul White House, Elizabeth Warren Senate, and Allen West House). Nothing I’m about to say is especially new, I’m sure it’s been written by a number of commentators before – but it is worth rehashing what a market-determined regulatory system would look like.

A pure market pricing of risk is hard, especially when noting that bank events don’t follow a normal distribution. (One could otherwise imagine banks facing a penalty if their CDS spread breaches a pre-set value). To keep it simple lets restrict acceptable capital to paid-in equity. The core of a market mechanism for regulation must somehow make it easy for a bank to issue equity in a liquidity crisis without paying a steep discount.

Of course there’s nothing free in this world and this discount must be financed by some haircut on the value of its debt as an insurance premium. Further, this discounting mechanism ought to kick in only in a “crisis” situation. One simple solution would require a bank to buy very far out of the money barrier puts on its shares struck at a reasonable measure of its value proportional to its risk-weighted debt.

“Reasonable measure” can be defined in any number of ways and doesn’t really change the theme of the framework. It could be a moving average of closing prices over the past two years. It could be some credible and formulaic measure of the capital it needs to finance its current liabilities. It could be some function of its price-to-book value. The measure doesn’t matter so long as it is well-correlated with general financial health, as the market will price and adjust for any relative discrepancies.

If the puts kick in at some predetermined, low fraction of the bank’s “reasonable value” it can sell its shares for a large premium to current prices – transferring wealth from insurers to shareholders in an elastic and predetermined manner. Because the number of puts it holds is proportional to its relevant, current liabilities, it can in principle finance itself through any liquidity shortages without systematic distortions.

Further, the maturity of the puts it sells should match one-to-one with the debt it issues (and hence, obviously, doesn’t work for deposits) – forcing the bank to constantly be cognizant that it finance its current liabilities without any problems.

These puts can even be traded between banks to stabilize and spread risk in an even and efficient manner. Since the writer of the put obligation owns the right to buy bank shares this – in a fundamental sense – represents high-quality equity (as they will be called upon only in the times when equity matters). So if the barrier kicks in at 50% of current value, and the bank’s “reasonable value” is its current value, the put represents (at worst) one share of the bank to its writer. (Since the bank would obviously sell it at a premium – though I still haven’t fully teased through this, it might be easier to consider as a convertibility clause though I’ll leave that for another post – in theory it really shouldn’t be very different. I can’t find it now but I think someone at either PIIE or AEI has written about this: links would be appreciated).

The government a requirement like the one outlined above would achieve three things:

  • Dampen (maybe even counter) procyclicality.  Banks are able to issue shares at a premium in bad times compared to a steep discount they would face today. It becomes easier to raise capital in a crisis relative to balance sheet than any other time. The worse the crash the bigger the premium.
  • Incentivize better risk allocation. Because banks are forced to buy puts that effectively gauge the probability the bank and financial system will fail to the extent that its share price falls below the barrier, they will actively mitigate risk in a manner convincing to markets (not just regulators) and hence be rewarded for prudence and punished for recklessness. Because of this, we wouldn’t need crazy Basal rules to judge “risk-weighted debt” and have meaningless Tiers of capital, as the market will discount each to the extent necessary. (And, so, limiting the actual procedure to equity capital doesn’t render the other stuff meaningless but channels their value through a simpler avenue).
  • Actively reduce the need for outside (government) assistance during a crisis.

This doesn’t mean relegating any genuine regulatory decisions to the market, but rather only helps government policymakers to focus on the questions that matter: not how various assets should be discounted by risk, but what role is the government willing to take in financial stability and when will it act. In this sense, we can sort of explicate the too-big-too-fail subsidy. Therefore government can make important decisions such as what “reasonable value” means, and the extent to which a bank needs to be able to finance itself in any situation (that is the high level situation we are trying to answer now, anyway, but this leaves the hard work up to the competence of the market).

The government can even play simpler but more powerful role – require banks to hold capital in whatever manner such that the option-implied probability of crisis (as defined over the barrier range) is below some, small n percent. Indeed, perhaps this should be the inspiration for such regulation: banks issue disaster puts on its stock and by government diktat must keep the price of these low enough to keep the probability of said disaster below a socially acceptable level (which could be determined by correlation of failure – that, again, is for another post).

Received wisdom among India watchers holds that gold imports are a threat to Indian economic development, the rupee, the current account, and everything else we hold economically dear. This fear manifested itself in an outright (if ineffective) ban for the better part of the country’s history post-Independence, and has more recently involved all sorts of quirky taxes and duties to prevent the import of gold.

A few things are clear. Indians are crazy about gold. Last year India overtook China as the world’s largest consumer, which was particularly detrimental to the official balance of payments, where gold was 3% of the country’s 4.7% trade deficit. This frenzy reached a point where, this April, an executive director of the RBI proposed a loony scheme of a government gold monetization plan arguing that the government wouldn’t invest the capital in other schemes as it would open itself to delta risk unless it is perfectly hedged (as, astonishingly, financial transactions tend to work…)

The Indian financial commentary hive mind would be better off understanding the systematic reason for gold imports (and fixing that) rather than obsessing over imports using terms that make little sense in this context, such as current account deficit. Even the Economist seems to completely miss the context of such “imports”:

Some argue that India’s gold imports should be reclassified as a capital flow, which would make the current-account deficit look less scary. But the official fear of gold is rational. Whatever the accounting treatment, money flowing out of India to buy bullion strains its balance of payments. And wealth stored in ingots or jewellery rather than bank deposits or shares is unavailable for investment. India’s household savings rate is high, but as much as half is now squirrelled away in physical form.

Pune’s wide boys aside, the traditional gold consumers are southern peasants buying jewellery. They have no access to formal finance; gold requires no paperwork, incurs no tax and is liquid. But over the past decade the mania has spread. By weight consumption has doubled, for several reasons: a surge in money earned on the black market; investors chasing the gold price; and the dismal returns savers get from deposit accounts. Real interest rates are low, reflecting high inflation and a repressed financial system that is geared to helping the state finance itself.

Unfortunately that’s just now how savings works (indeed, by identity, savings are investment – not necessarily business investment, but investment nonetheless and the heart of this debate is whether gold purchases imply deferred consumption and hence greater inventory accumulation, accounted for as investment in national income accounts). In fact, just reading the emphasized, there should be no fear of gold: since deposits seem to be highly oversubscribed and therefore a poor investment, gold seems like a fair alternative for store of value.

But let’s dispel fears of “money flowing out of India” first. Let’s say an Indian exporter sells canonical widgets to an American producer, receiving dollars in return. That is a current account inflow. It can do a few things with this income. Let’s explore three common alternatives:

  1. Reinvestment in US Treasuries,
  2. Purchase of gold, then repatriated to India (though physical location really doesn’t matter),
  3. Investment in India (let’s say a national infrastructure bond).

Surely the accounting effect of the first two options is the same. In the former case India is exporting capital directly to the US government and in the latter case it is exporting capital to the American bank from which it purchased its gold which is then recycling that capital back into the American economy. These are indisputable accounting relations that hold in every transaction.

Now the Economist wants to blindly compare (1) and (2) with (3) without detailing a third transaction in the process. Say the firm wants to “invest in India” and purchase government-issued bonds to build a high-speed rail service between Bangalore and Bombay. That would be rather noble of them, indeed. Unfortunately, having exported to a US firm, the firm has no INR with which to participate in this auction. Therefore, it first needs to identify a US exporter that sold goods to India and received INR in return. Even after it does this, and trades its USD for INR at USDINR, it’s not like investment in India suddenly improves – indeed the original INR was already invested in India in the first place. (Of course, this doesn’t mean both investments are equal and one might perform much better than the other. If this is your anti-gold argument I suggest you open a hedge fund shorting gold rather than writing for the Economic Times).

A household buying gold really is no different. It either has to buy it in rupees or dollars, but ultimately someone ends up with the rupee which is in some form invested in India. A current account surplus is a capital account deficit – that’s how these things work.

The question we’re implicitly answering is whether gold constitutes deferred consumption (investment) or not. To the extent there is a strong consumption aspect to gold (and there might well be) the fear is self-contradictory as it reflects nothing about inability to invest the savings as the Economist reports: indeed in this case these purchases wouldn’t be savings at all.

But the more likely situation is that gold does, in many ways, confer deferred savings and many other attributes of wealth including:

  1. A store of value,
  2. A source of liquidity – as gold-collateralized loans are an effective means by which an otherwise underbanked population can access financing,
  3. A source of wealth effect consumption increases.

Indeed the official fear about gold treats it as if it is a poor investment, which ipso facto means it shouldn’t be included in the current account. Even then, for many poorer Indians gold offers access to a banking system that otherwise requires 10th grade board exam results to borrow money at reasonable rates. Gold is an investment in an alternative source of financing to loan sharks that charge annualized rates north of 60% on a good day. Gold also doesn’t depreciate or perish. It might loose value but that is completely a capital loss.

This is a mistake that anyone who doesn’t understand why S = I might be prone to make. Business investment, i.e. a firm investing in machinery or platform development, isn’t the only form of investment. If I earn $1000 and place it under a mattress that is an interest-free investment in the form of deferred consumption (indeed if I burn it, it will be an investment to that amount rolled over in perpetuity, with an ultimate value of (1/discount rate)*1000).

This isn’t intuitive to most people. It’s very, very common to hear that gold is an unproductive investment or that “Americans are saving too much and not investing enough”. In fact, what they really mean to say is that interest rates as they stand are creating an investment situation in which an inefficient amount of funds are invested in very low return areas (such as inventory) and are not optimally productive.

In India this means opening up sources of safe, high quality investment allowing just the sort of liquidity transformation that finances the “development” everyone wants. In fact, if anything, gold import bans and taxes worsen the current amount by the premium one has to pay for smuggled gold, which in some part accrues to foreign smugglers and miners who have some claim on the delta between black market and open market gold. That is a pure current account loss and one which Indian policymakers need to address by removing import controls completely.

Paul Krugman has a post discussing America’s net international investment position. Basically, the outputs of domestic production (i.e. GDP) aren’t owned entirely by Americans and an increasing share of assets are owned by foreigners. The central reason for this imbalance is persistent current account deficits – when Chinese exporters recycle their dollar earnings back into the US, they earn an increasing claim to our production.

So the typical reason why a country’s net investment position would deteriorate is a declining current account balance but, as Krugman points out, the US has basically cut its current account deficit in half since its peak in 2006. Therefore he suggests the superior performance of American assets might be the culprit. As far as an explanation for our net investment position is concerned, I think he’s right. But I don’t think that’s the right metric to look at.

We know, since 1999 or so, foreigners have been tripping over themselves to hold Treasury and agency-backed debt. Part of the plan never to have an Asian crisis again was to hoard safe dollar-denominated debt and run a current account surplus. In general, I don’t think equities are the item to look at (and I think Krugman’s percent-of-GDP portrayal of this fact might exaggerate their importance):

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I’ll get back to the corporate bond market later but it’s obvious all the action since 1999 or so has been in the Treasury and agency market. And note these are “percent of total market” figures – America’s bond market is just under twice as large as its equity market. So when you think about the fact that foreigners have been crowding into assets that pay basically nothing nominally and less than nothing really, you have to wonder what we’re getting in return. That’s not an easy question and probably deserves a post of its own, but here’s a good first approximation:

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So GNP = GDP + US returns on foreign assets – foreign returns on US assets. A few things to note:

  1. GNP has always been larger than GDP, at least in US recorded history.
  2. After a nadir in 1999 or so, this ratio has gone up (probably hand-in-hand with global saving glut-ish reasons).
  3. It’s been coming down a bit since 2012, but remains well above average.

And I’ll completely admit this is a crude, but quick, way of getting to the point that the return on capital for American investors is just much, much higher than it is for foreign investors. This, by itself, doesn’t mean much. Presumably our earnings are much riskier and are hence discounted in valuation and maybe we should be worried about the net investment position after all.

But here’s an interesting thought experiment. What if China committed to a new policy of recycling its trade surplus into American gold, which has no nominal return whatsoever. What if, with the financing provided by selling that gold, Americans invested in riskier international companies and corporate paper. Then, in a world where emerging markets perform much worse than the US – in fact, in a world where emerging markets consistently produce negative returns on capital – our investments are rotten. But in pretty much every conceivable world – i.e. a world where technology diffuses from rich countries to poor countries – the US investment will have a better holding-period return. And, nowadays, Treasuries are kind of like gold.

In fact, that’s why growth theorists might be a little puzzled by this turn of events. Capital is supposed to flow from rich countries to poor countries to finance development abroad, just like water should roll down a hill. Clearly that doesn’t square with the incredible amounts of cheap cash flowing into America, and the safe-asset squeeze (whether something that’s an actual market reality, or something that is an artifact of mercantilist/crisis-weary state policy) has a lot to do with it.

This still doesn’t explain valuations, however, unless we adjust for the fact that US and foreign investors have very different risk profiles. Foreign investors (see the first chart) are largely official, and have a single-minded interest in preventing the 1999 sort of debacle where a shortage of dollars resulted in currency havoc and financial crisis. American investors are almost exclusively private corporations that don’t have a shortage of dollar-assets, that almost never borrow in a foreign currency, and live in a world of really, really cheap basis trades.

So private, social, and market valuations diverge.

In some cases, that doesn’t matter. If foreigners suddenly called all their assets and stopped rolling over our debt, it would be a disaster (and we certainly couldn’t fund our liabilities with our foreign assets alone). But that doesn’t matter – the whole premise of the safe asset squeeze is this scenario is highly improbable (otherwise valuations would not have – could not have – been what they are). The more simple description of the entire argument is that US treasuries provide a liquidity service to foreign governments and there is an inefficient shortage thereof. Or, even simpler, the US is a classical bank earning a profit on the spread between its borrowing and lending rates.

Sometimes returns paint a more useful picture than valuations.

Cliff Asness provides a qualified defense of a 2010 letter to Ben Bernanke he endorsed, warning that further QE would “risk currency debasement and inflation”. The piece boils down to the clash between priors that have not come to pass and observed reality. In theory, this is a fair defense: elevated risk of hyperinflation, if accompanied with a similar increase in risk of forever deflation wouldn’t alter the long-term expectation. Paul Krugman responds that Asness fundamentally misunderstood monetary theory – that when short-maturity debt substitutes perfectly for cash, an increase in money cannot increase prices.

That’s not necessarily sufficient. Expected inflation of 2% can be sustained if the entire market believes that inflation will, indeed, be between 1.5% and 2.5%. It would also be sustained if half the market thought inflation would average -2% and the other half thought it would hit 6% – except the Fed’s expected loss function is higher in any scenario of the latter world.

So the question we need to ask is whether the market price of inflation risk beyond some threshold increased because of quantitative easing. And because of the exciting market of inflation floors and caps, we can actually answer that question. Before we answer this question, it’s worth qualifying the value of this analysis, and explaining the nature of the market.

An inflation cap is effectively an out of the money call option struck at some inflation rate for some maturity. Normalizing the payoff at $1 per point, the we can denote this as C(10%, 5) = max{n – 10, 0} where n is the average inflation over 5 years. Then, at every moment in time, we can not just identify the expectation of inflation over a time period, but the probability density function thereof.

Various options pricing frameworks can be used to determine the implied PDF, though I think the partial derivative method using a forward measure is the most common. (This just means future cash flows are discounted by the yield curve of a well-traded bond, instead of a risk-free rate that you don’t know in advance).

Unfortunately, comparing the market for inflation caps with the TIPS (a standard estimate of inflation expectations) is tricky, since it’s far less liquid, and incredible new (introduced, conveniently, around 2008). Therefore, we need some sort of sanity check that the values generated from this data make sense without making huge adjustments for liquidity and risk premia. Looking for an answer, I came across a paper by Yuriy Kitsul and Jonathan Wright at the Fed that exploits a quirk in the TIPS payoff mechanism to see how well it matches the options data.

While you normally think that it’s only possible to infer an expectation from the TIPS breakeven, under reasonable assumptions, it’s actually possible to figure out the market’s expectation that there will be deflation (a cap of 0%) over some time period. The asymmetry that TIPS must payoff its entire nominal face value, even if there is substantial deflation, means that TIPS is actually a compound security: long pure TIPS and long a 0% inflation cap.

Therefore, we can compare the explicit inflation caps implied probability of deflation with the TIPS implied probability of deflation. And what researchers find is even if they don’t match perfectly, they are almost perfectly correlated suggesting that even if the level of the inflation caps market is distorted by liquidity concerns, the dynamics thereof are legitimate.

And now we can answer the question at hand: did the risk of high inflation increase after the Fed engaged in QE2? (Note this establishes a correlation, not causation). Per Kitsul and Wright:

Deflation Inflation

And you see two very interesting trends: the probability of high inflation (that above 6%, which is the largest traded strike) sharply increased over the latter half of 2010 and early 2011, the time period over which the effects of QE2 were priced in. This is a general trend across all maturities. While the 3, 5, and 10 year option follow a similar path afterwards, the 1-year cap is much more volatile (largely because immediate sentiments are more acute). Still, you see the probability of high inflation pic up through 2012, as QE3 is expanded.

The takeaway message from this is hard to parse. This market doesn’t exist in the United States before 2008, and isn’t liquid till a bit after that, so it’s tough to compare this with normal times. While the sharp increase in the probability of high inflation would seem to corroborate the Hoover Institution letter, that wouldn’t mean much if it simply implied a return to normalcy. That’s just a question we’ll have to leave for a later day.

What about the probability of deflation? We’ll the interesting point is that for the three higher maturity options, the probability for high inflation and probability of deflation were increasing at the same time. This was a time of relatively anchored 5 year implied inflation, but the underlying dynamics were much more explosive, as can be seen in the above charts.

The punctuated volatility of immediate, deflationary threat is interesting. Moving away from changes for a second, the risk of deflation was consistently higher than that of inflation (though we shouldn’t take this too seriously given liquidity issues) – but only over the span of one year. Over ten years, the likelihood of high inflation was much higher than that of deflation.

What we can learn from the deflation PDFs is that long-term deflation was never a concern in the US (it would be interesting to conduct a similar analysis on the UK and EU, something I’d be happy to do if anyone knows where this option pricing data is – help!) The immediate dynamics are a whole different game. QE2 seems to drastically reduce the chance of deflation, to basically nil, but this isn’t persistent and there’s a lot of volatility. Though it does look as if QE3 was responsible for the death blow, with the likelihood around 10% by the time purchases peaked at $85 billion.

So where does this bring us on Krugman v. Asness?

An important argument the money manager made in his essay is that this question may be decisively settled for the short-run, but we still haven’t successfully exited from this period of weird, unconventional policy regime: the risk of inflation still exists seems to be the message. Markets agree with this: with the 10-year inflation cap probability of high inflation nearing its peak. That said, there’s a good chance, that 2008-2010 represented the trough of high inflation probability – the increases afterwards seem to be a return to normal more than anything else. A 20% chance of inflation above 6% isn’t too bad – and it’s important to keep in mind that the levels of this market are probably biased by selection, risk, and liquidity.

More importantly, the probability of deflation, and variability thereof, moderated. But here’s the end result:


The probability that we’re going to have 2% inflation over the long-run decreased from around 70% in 2010 to 40% in 2012. There’s been a marked increase in the standard deviation of the PDF, which is cause for concern.

Again, I don’t want to put too much stock in these numbers – until we have reads from more normal times (again, anyone, data? I would love to replicate this for 2014 USA, or Europe).

These numbers neither provide a roaring endorsement for QE nor one for some crazy increase in the risk of inflation. While you can defend your use of the word “risk” against failed expectations – there’s a distribution, after all – it’s hard to protest when the increase in risk itself, as priced by the market, has been so modest.

That said, the QE can’t increase inflation in a liquidity trap argument is also unconvincing. There’s little theoretical reason to believe that once the growth rate picks up and overnight bonds are once-again priced at a discount, the exit from unprecedented stimulus wouldn’t cause inflation to increase as the monetary transmission mechanism kicks in, and the money multiplier roars back to life. There is good reason to think that this isn’t going to cause any hyperinflation (not the least that the Fed wouldn’t let it), and “debasement” was certainly too alarming a description.

This letter suffers more from some of its signatories, like Niall Ferguson, who go on to defend its claims with dubious nonsense from Shadowstats than pure content it self. It was wrong, but derivatives markets suggest that inflation risk has increased.

The big departure I’d take is in arguing this increase wasn’t enough to flush out the debt overhang. Though, one ought to ask, whether a better way to get there was moving the distribution to the right, or increase its standard deviation.

Tyler Cowen links to Scott Sumner’s skeptical notes on secular stagnation. As frequent readers know, I’ve been very skeptical in the past myself, but I think the argument has a lot more merit than Sumner gives credit for – i.e. that this is an open question that economists can more decisively accept or reject in ten years.


It seems to me that the Krugman/Summers view has three big problems:

1. The standard textbook model says demand shocks have cyclical effects, and that after wages and prices adjust the economy self-corrects back to the natural rate after a few years. Even if it takes 10 years, it would not explain the longer-term stagnation that they believe is occurring.

2. Krugman might respond to the first point by saying we should dump the new Keynesian model and go back to the old Keynesian unemployment equilibrium model. But even that won’t work, as the old Keynesian model used unemployment as the mechanism for the transmission of demand shocks to low output. If you showed Keynes the US unemployment data since 2009, with the unemployment rate dropping from 10% to 6.1%, he would have assumed that we had had fast growth. If you then told him RGDP growth had averaged just over 2%, he would have had no explanation. That’s a supply-side problem. And it’s even worse in Britain, where job growth has been stronger than in the US, and RGDP growth has been weaker. The eurozone also suffers from this problem.

The truth is that we have three problems:

1. A demand-side (unemployment) problem that was severe in 2009, and (in the US) has been gradually improving since.

2. Slow growth in the working-age population.

3. Supply-side problems ranging from increasing worker disability to slower productivity growth

Only the last two can explain the slowing long run trend rate of RGDP growth, as well as the low real interest rates on 30 year T-bonds.

Both (1) and (2) don’t get to the heart of what Krugman/Summers believe and are implicitly embedded with false assumptions. The “standard textbook model” is a nebulous concept. Even within many of the workhorse, New Keynesian, models the economy will not return to full employment without some external push if the natural rate to which it must correct is below 0%. This is very different from the old Keynesian permanent slump, which suggested that if wages are flexible, downward adjustment would further increase the real interest rate and tempt a vicious, deflationary cycle.

Krugman has definitely agreed before that to the extent that falling prices are expected to be temporary, they can also be expansionary.

More importantly, disregarding the fact that a fall in unemployment to 6.1% doesn’t adequately capture the whole labor market, if you showed Keynes a chart of US unemployment since 2007, he wouldn’t have expected rapid growth if you also told him inflation has consistently been well-below its long-term average every year thereof. Sumner’s suggestion that productivity growth is to blame (while perhaps true) does nothing to change the fact that, if anything, declining supply-side fundamentals should have increased the price level.

In fact, that’s specifically the conundrum that secular stagnation attempts to address. It’s not a comment on the financial crisis and recession as much as a meditation on the decade that preceded it. How could a rapid increase in wealth, credit creation, construction, government spending, and accommodative monetary policy not result in above-average inflation?

John Taylor loves pointing out that the housing bubble was caused by discretionary policy that deviated from his eponymous rule. Not only does that ignore the fact that the target FFR pretty much followed the implied Taylor Rule if one looked at the Fed’s inflation forecast instead of current inflation (which is both noisy and laggy), but also assumes that the equilibrium rate of interest was constant over this period. That deviation from Taylor’s version of the Taylor Rule begat a housing bubble , and not any inflationary pressures suggests this is false.

So if you told Keynes that the unemployment rate had been cut in half without any associated increase in inflation, he’d probably ask you to look at a different metric.

More peculiarly, Sumner seems to be missing the Krugman/Summers point entirely by prescribing policies that they would both advocate:

I mentioned that there was a third problem with the Krugman/Summers view. They favor big government Keynesian demand-side remedies for what they see as a sort of permanent liquidity trap. This fits with the newly fashionable anti-neoliberal views on the left. Thomas Piketty’s new book made the wildly implausible claim that neoliberal reforms had not helped countries like Britain. However the countries least likely to be mentioned in discussion of “The Great Stagnation” are precisely those countries that have pretty good supply-side fundamentals, and/or relatively small government. Here’s the Heritage Foundation’s list of the top 10 countries for Economic Freedom […]

Now I don’t want to oversell this list. Many of the top 6 countries have fast population growth. It’s hard for any country to completely overcome the slowdown in the rate of global productivity growth. But I think any fair observer would note that (with the exception of Ireland) the “usual suspects” in the stagnation discussion (Japan, the US, Britain, the 18 eurozone members, etc) are conspicuously missing from that list. And while Ireland undoubtedly was hammered by a big demand shock, their RGDP rose 7.7% over the past 12 months, a rate the US could only dream about. So while the top ten countries are not perfect (Denmark’s performance has been mediocre) they’ve clearly done better than most developed countries. That doesn’t provide much support for the progressives’ claim that the eurozone is doing really poorly because while they have the biggest governments on Earth, their governments need to be even bigger to overcome the Great Stagnation.

There’s pretty much nothing exclusive in those two paragraphs with what Summers and Krugman believe, except perhaps for any credibility assigned to the Heritage Foundation. If you read Summers’ introduction to the definitive ebook on the subject, he notes the following as some of the most promising avenues out of secular stagnation:

  • “Removing barriers for labor mobility between firms by trimming down employment protection legislation.”
  • “Increasing incentives for low-skilled workers to participate on the labor market.”
  • “Simplifying procedures for starting up businesses.”
  • “Applying anti-monopoly policies to reduce the profit margins in new IT industries”.

In fact, the central thrust of the secular stagnation argument is that falling productivity growth, a chief determinant of the prevailing natural interest rate, has fallen to a point where there is a vicious cycle between lower potential growth and lower actual growth.

The comments on the Eurozone are also tough to confirm. While Germany was definitely the success story of the decade, it worked largely because the rest of the world was able and willing to absorb its excess savings, thereby masking instability in the periphery. Instead, the real question is why did the periphery grow so slowly, despite a rapid inflow of capital from Germany and subsequent fall in borrowing rates.

The German model, by the unfortunate but inevitable requirement that international assets and international liabilities must sum to zero, could not have been applied everywhere to similar effect.

This post mischaracterizes what progressives actually believe. The conversation on secular stagnation most certainly does not, at least by itself, advocate “anti-neoliberal” viewpoints. If anything, this is a much stronger case for supply-side reforms than the Reaganites were ever able to produce in the 80s.

Pranjul Bhandari and Jeffrey Frankel argue that the case for nominal income targeting over inflation targeting is stronger in developing countries than their advanced counterparts. The crux of this argument relies on the increased frequency of supply-side shocks in poorer countries, which require perverse policy under an inflation targeting regime.

I’m ambivalent about both the relevance and efficacy of this proposal. It’s a debate we desperately need to have, but it’s not like two of the most important emerging markets (India and China) follow any target to begin with. However, I think nominal income targeting has a few critical benefits the authors (at least in the VoxEu summary) do not cite.

Inflation is hard to define, let alone measure, in rich countries. And a lot harder in poor ones. A common measure of inflation in the United States, the Consumer Price Index, considers the price level a representative agent faces. In places like the US and Europe, it’s pretty easy to outline the parameters that define a representative agent, and the basket of goods he consumes. With a bit of econometric handiwork, the Bureau of Labor Statistics (BLS) has developed sophisticated tools to update the CPI to keep it relevant with a modern consumer. 

Inequality in America may be high, but the overwhelming number of citizens care about the same things: price at the pump, the cost of bread, and so forth. A broad consumption-driven middle-class buys the same stuff. In India, as in many other developing countries, the urban middle-class lives a world apart from its poorer, rural cousin. This has an important macro dimension. The cost of tradables (and hence the exchange rate) matters a lot more for an IT worker in riding a scooter to work than a casual laborer in the heartland of Haryana. 

There is also a lot of uncertainty around the portion of rural transactions that are even monetary in nature, with informal markets and even non-money exchange an important part of life. 

So in the United States, when inflation unexpectedly jumps, it’s a little hard to say who the winners and losers are. In India, to the large extent perishables drive prices, jumps in inflation largely reflect higher wages in rural districts reflected as higher prices in urban fringes. 

There is no representative basket.

Measurement in India is also confounded by tricky conflicts of interest. The bureaucrats that estimate inflation have wages expressly indexed to the CPI-IW. This probably is an order of magnitude or two less important than the more philosophical problems with inflation, but given its slight upward bias over the past decade not something to ignore altogether either. 

Unlike inflation, price level, and real GDP, nominal GDP is something we can estimate pretty well and, more importantly, have an extremely clear definition to work with. This is an enormous advantage in favor of a NGDP based anchor. 

But currently, India doesn’t target anything, and there’s probably good reason for that. Monetary operations in developing countries are in many ways more complex, if less consequential, than those in advanced markets. For example, the Indian economy is far more sensitive to the exchange rate than most rich countries (especially the United States) are. Sensitive both because of institutional arrangements (such as fuel subsidies) whereby the terms of trade are important and because of volatility in capital flows, particularly short-term debt. 

Specifically because India imports certain dollar-priced goods (oil, but other minerals too) the exchange rate affects not only demand, as in most countries, but also supply. A depreciation can lead to unsustainable deficits and infectious inflation much quicker than in advanced countries. 

Fiscal dominance, or at least political interference, is a much larger concern. As Raghuram Rajan noted not long before he was tapped as the RBI chief, by imposing high liquidity requirements on banks – held through Indian government debt – the RBI was effectively financing artificially-cheap borrowing by the Centre. 

So one may ask – a nominal income target, but in what? Nominal rupees or nominal dollars? Or nominal trade-weighted units? It’s a bit like whack-a-mole. A nominal income target in a foreign currency, while something I definitely need to think more about, comes dangerously close to certain worries of competitive devaluation. However, it does at least intuitively deal with most of the problems of just an inflation target, or just a nominal income target.

A final problem with rules-based, as opposed to ad hoc, monetary policy is low labor mobility and dearth of a strong fiscal transfer system. If America is booming, but Alabama is sagging, a deep social safety net via food stamps, unemployment insurance, and social security ensures that an inflation-targeting Fed doesn’t harm Alabama too much with monetary tightening. And wages will move towards equality as Alabamans move out, reducing local supply. But that’s not the case in India, suggesting monetary moves have far more political implications, the rural-urban divide key among these.

I find any sort of long-run target that doesn’t consider exchange rates to be worrisome in the world of free and fickle capital. I’ll be writing more about a dollar-denominated nominal income target for emerging markets in the days to come, but am curious to see what people think about this. However, given the problems with measuring inflation I think we can be sure that were India to choose between the two, it should chart its own course instead of copying the Reserve Bank of New Zealand.