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Update: Mark Schieritz writes in the comments:

Thanks for reporting on my interview! I believe however you are confusing my role as a journalist conducting an interview with my own view on things. I do believe that the ECB should act more forcefully and I have said that on numerous occasions (e.g. on my blog http://blog.zeit.de/herdentrieb). When interviewing officials however it is my duty to challenge there actions and as I write for a German audience it is my duty to challenge them from a German perspective. Peter Praet has enough rooms to defend himself.

(I think that’s fair. As I told him, I think this only further implicates the European elite by serving a certain “German perspective” that requires such a deep prior that any and all monetary stimulus is always and everywhere evil. And while journalists are responsible for their audience, they are also beholden to the truth: and at least given what I know the perspective peddled in this interview is an unfair representation of reality. To a layman reading the interview, the tone is dominated not necessarily by the clarity of Praet’s thought, but the forceful austerity of Schieritz’ question.

In any case, read this post and substitute “elite” for “Mark”.

That said, since I believe this was originally written in German, I cede some things are lost in translation. But where are the elite “challenging the actions” of Jens Weidmann?)

It’s no secret that the European Union is collapsing under the weight of its own bind. The political situation across the continent looks not unlike what it did before a great war more than fifty years ago and, relatedly, the economy doesn’t look better. John Oliver lambasted the fascist politics that are taking over the union last Sunday. While it may be hard for many Americans, including Oliver, to understand why Europe hates its elite so much, you need look no further than the austerity complex at Die Zie, described on Wikipedia as:

 well-regarded for its journalistic quality. With a circulation of 504,072 for the second half of 2012and an estimated readership of slightly above 2 million, it is the most widely read German weekly newspaper […] The paper is considered to be highbrow. Its political direction is centrist and social-liberal, but has oscillated a number of times between slightly left-leaning and slightly right-leaning.

The most widely read weekly paper, it might be to Germany what Thomas Friedman is to the Beltway elite. Enter our protagonist, Mark Schieritz, in conversation with Peter Praet of the ECB in what may be the most spectacularly absurd interview of the year.

For context, inflation in Germany rolled in this month below its own low expectations at a barely-discernable-from-deflation 0.5% (consensus was 0.7%). Investors around the world are on the edge of their seats for the ECB meeting this Thursday when Draghi is widely-expected to announce Europe’s first round of quantitative easing.

Mark starts the interview curious that the ECB isn’t hiking rates because “business activity is picking up in Europe”. When Praet accurately notes that inflation is well-below target – that, indeed, 0.7 is less than 2 – he wonders whether that is “a little formalistic”. This defines the psychology of establishment economic thought across the pond: not only a requirement that the stipulations of rules-based policy themselves be hawkish, i.e. “close to, but below 2%”, but that even when we are far from meeting that goal, following rules are merely “formalistic”.

In the German mind, the one and only purpose of monetary policy must be further pain and austerity.

When told that persistently below-target inflation would harm the ECB’s credibility, Mark notes that many “experts’ expect inflation to soon again rise of its own accord. This statement is a great window into the minds of the European elite, motivating the idea that inflation is something that exists of its own accord, outside of monetary authority. This is not surprising for a country scarred by years of hyperinflation when, indeed, political and fiscal theories of the price level dominated. In most times, however, inflation is “everywhere and always a monetary phenomenon”. European policymakers for some reason believe supply, not demand, is the problem (how else would inflation come “of its own accord”). Of course, there is debate among sensible people about whether the central bank can do this in a liquidity trap, except journalists at Die Zeit have nowhere near the level of economic sophistication to actually understand that debate.

The story gets worse. When Praet gives Mark the canonical reasons for which low inflation is deadly he concludes that we cannot “allow inflation to be too low for too long”. You would think that even if people had subjective contention on what constitutes “too low” and “too long”, they would agree that given their own reference, inflation should not fall below that threshold.

Not so for Mark who wonders “why would that be dangerous?” In fact, the German elites want inflation to be too low for too long. And, unfortunately, this is probably not a logical paradox. The core elite know that austere policy is terrible for Europe as a whole. Indeed, what ignorant fools like Jens Wiedmann want is inflation that is devastatingly low for Europe and Spain, but just enough to keep the uninformed but vengeful German electorate appeased.

The interview has not climaxed yet. Praet makes a very sensible claim that inflation is an insurance policy and goes on to note that it is necessary to facilitate economic adjustment. Since Mark has not read an economics textbook, he is yet again left wondering why. He disagrees with Praet’s correct answer about external devaluation noting that

Prices and wages in den crisis countries had risen far too rapidly over many years. The low rate of inflation helps companies there to regain competitiveness vis-à-vis rivals in the north. Why do you want to counter that?

And here, for the first time, I think Praet gets it wrong. (You can see the whole interview below). Since European trade is such an important part of peripheral growth – indeed Germany maintained a surplus only by exporting its savings to weaker countries – what matters isn’t the absolute rate of inflation of Europe as a whole so much as the relative rate of inflation between the periphery and the core. While higher inflation in general would help reduce the real burden of debt, what we need is higher inflation in the core to make peripheral labor more competitive. It makes one whole hell of a lot more sense for Germany to tolerate slightly above-trend inflation for a few years instead of forcing Greek to deflate.

Then there’s some nonsense about low rates hurting savers which is a dumb, but forgivable, mistake before we get to the most remarkable statement in economic journalism:

If the banks have to pay penalty interest [negative rates], you may well be making loans dearer. What happens then?

In the eyes of the European elite, the cost of borrowing increases when interest rates decrease! There is a perverse world in which this makes emotional, though not logical sense, and that is from the perspective of a saver for whom making a loan is more expensive at a lower rate. Of course, that is not what the English means, nor is it economically valuable information even were it to be so, but it gives us a gory insight into how European policymakers think.

Then there’s some huffing and puffing about low interest rates causing a “property price bubble in Germany” – when, no less, I wouldn’t trust Mark to monitor soap bubbles, let alone one of the world’s largest economies. It’s interesting to note that he is both worried about “dearer loans” and bubbles, which are almost mutually exclusive.

The sad part is how Praet ends the interview, discussing more accommodative policy:

That possibility, too, was discussed. But I believe that such purchases would only be made if business activity and inflation develop along lines that are significantly worse than expected.

Even if you don’t believe QE works, and there may be good reasons to hold this belief, it is scary that officials don’t think they need it. Apparently “business activity and inflation” – nonexistent as they are – have not yet reached levels “significantly worse than expected”.

Paul Krugman is right – the Germans are masters that want the beatings to continue until morale improves. I’m not fan of fascism or nutty right-wing racism, but lets hope these asshats get thrown out of office and soon.

Addendum: In the sleepy haze that I wrote this post, I forgot to mention an important point. Among smart commentators in the US, the ECB is viewed largely as an archaically-tight institution, governed by bad economics and a misunderstanding of monetary policy. That isn’t true, the ECB is damned by a cultural and emotional – not economic – unwillingness to follow the right policy. The German elite couldn’t give a shit about the logical validity of their argument, indeed Schiertz hates inflation not for any monetary reason, but as a presupposition to his worldview.

Read the whole interview:

Mr Praet, business activity is picking up in Europe. Hasn’t it become time to prepare increases in interest rates – rather than to ease monetary policy further, as the European Central Bank (ECB) indicated rather clearly last week?

That would not be in line with our mandate. The ECB is required to keep the value of money stable. We understand this to mean an inflation rate of close to, but below, 2% over the medium term. Incidentally, this definition dates back to Otmar Issing …

… formerly chief economist of the Bundesbank and your predecessor in office …

… The rate of inflation in the euro area currently stands at 0.7%. Such a small increase in prices cannot be regarded as satisfactory over the medium term if we want to attain what we have announced.

That is formalistic.

Why formalistic? What is at stake is credibility, an issue of great importance for a central bank. People must be able to rely on our keeping the annual rate of inflation at close to, but below, 2%.That is important for them to take business decisions. That is why we cannot allow inflation to deviate lastingly from our designated target figure, irrespective of whether to the upside or the downside.

Many experts, however, expect inflation to soon again rise of its own accord.

We are assuming that prices will increase only gradually. According to our current projections – new ones will be presented in June – it is only at the end of 2016 that inflation will approach the mark of 2%. And what we have observed recently are rather surprises to the downside, which means that inflation has tended to be slightly lower than expected over the past few months. The longer this increase in inflation is delayed, the greater is the risk of a change in inflation expectations. This would cause firms and households to take very low inflation rates for granted, and to behave accordingly. That is why we cannot allow inflation to remain too low for too long.

Why would that be dangerous?

There is no central bank that would aim for an inflation rate of zero over the medium term – not even the Bundesbank has done so in the past. Normally, the goal of monetary policy is to have a moderate rate of inflation. This could be regarded as a margin of safety to avoid the risk of deflation, which would have grave repercussions for growth and employment. In a monetary union, moderate inflation would also facilitate necessary economic adjustment.

Why?

If there is a need to adjust wage and salary levels, it is an accepted fact that wage cuts are difficult to push through, while wage moderation could well be achieved. Expressed in a simplified manner, moderate inflation thus ensures that wages and salaries fall in real terms even when they remain nominally unchanged.

Prices and wages in den crisis countries had risen far too rapidly over many years. The low rate of inflation helps companies there to regain competitiveness vis-à-vis rivals in the north. Why do you want to counter that?

It is true that there were adverse developments of this kind. In the meantime, however, most of the countries concerned have made significant progress in adjusting prices, and the adjustment process will continue. What we want to prevent, however, is that this turns into a lasting change in inflation expectations for the euro area.

The President of the ECB has indicated that the Governing Council might take action at its next meeting in June. What precisely could you do?

We are preparing a number of measures. We might again lend banks money over an extended period of time, possibly subject to certain conditions. We could also lower interest rates still further. Even the combined use of several monetary policy instruments is conceivable.

As things stand today, when banks deposit surplus funds at the central bank, they receive no interest. The ECB would thus have to impose penalties in future.

Negative interest rates on deposits are a possible part of a package of measures.

That was attempted in Denmark, with a rather mixed outcome, so that the central bank there put an end to the experiment.

The situation is not comparable. The negative interest rates helped mitigate the appreciation of the Danish kroner. In the prevailing environment of low euro area inflation, any appreciation of the currency there is problematic for the whole area because a strong euro would make imports cheaper and push inflation down even further.

Paris will be glad to hear that. France has long urged the ECB to take action against the appreciation of the euro.

Various governments are calling for a number of different measures. We as the central bank are independent and will not be influenced by such demands. Moreover, our focus is not on weakening the euro in order to help exporters in Europe. We are interested, first and foremost, in the impact of the exchange rate on inflation.

You are nevertheless entering uncharted territory.

Doing nothing would also pose risks. We are currently observing that demand for loans is gradually picking up again. For the recovery in economic activity, it is extremely important that the banks actually satisfy that demand.

The ECB’s low interest rates are already proving to be detrimental for all savers. Interest rate cuts would exacerbate the problem.

I have a great deal of understanding for the concerns of savers – my money, too, lies in the bank. We must, however, resolve the crisis now. That will also be to the benefit of savers because interest rates would then rise again in future. It may well seem paradoxical, but a further easing of monetary policy in the prevailing environment could help in this respect.

If the banks have to pay penalty interest, you may well be making loans dearer. What happens then?

Given the orders of magnitude we have been discussing, I do not expect that to occur.

That said, experts are warning that the low interest rates could give rise to a property price bubble in Germany.

Low interest rates are an incentive to seek alternatives to classic savings books or time deposits at banks. However, that may certainly not lead to speculative excesses.

You intend to reduce interest rates nonetheless!

In the case of Germany, there is no justification to speak of a general property price bubble, even though prices have risen rather sharply in individual market segments, such as those for popular locations in a number of major cities. In the event of problems in a specific country, it would be the responsibility of the competent national authorities – in Germany, the Bundesbank and the Federal Financial Supervisory Authority – to take appropriate countermeasures and, for instance, to compel banks to be more cautious in extending credit. That having been said, we must see the euro area as a whole – and property prices are continuing to fall in a many of the countries there.

In the event of your indeed cutting interest rates in June, will there be a broad majority in favour thereof in the ECB’s management?

We had a very good discussion at our meeting last week, both with respect to the assessment of the current situation and with regard to the conclusions to be drawn.

Controversial, by contrast, are bond purchases of the kind undertaken by the US Federal Reserve.

That possibility, too, was discussed. But I believe that such purchases would only be made if business activity and inflation develop along lines that are significantly worse than expected.

 

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A lot of people seem pretty sure that student loans are behind a slow economy. Elizabeth Warren got there first. Then Vox posted a few charts confirming that, yes, those with student debt are less likely to own homes. Today I read that Larry Summers and Joe Stiglitz endorse this idea. Rick Rieder from BlackRock agrees. 

Let me play devil’s advocate.

The facts are clear – home ownership among those with student loan debt is decreasing much quicker than for those without.

Image

It is difficult to reach the conclusion, at least from this chart alone, that student loan debt decreases home ownership. For one, both lines are following the same trend over the same period of time, only one has a steeper slope since the financial crisis. Except this isn’t surprising, student debt is correlated with debt which is poison over a period of deflation (or lower than expected inflation). It is not unique to students.

But more importantly, those jumping at the correlation between student loans and home ownership over a few years of data are not paying enough attention to large, structural shifts in economic geography over the past fifty years. For nearly a century, suburban growth eclipsed urban. Millenials, the fraught group in question, are changing that. Two-thirds of young graduates now want to move to cities for a better job, compared to a fraction not too long ago. Not to mention the more than 80% that are willing to move to any city if needed.

Dad is no longer a company man, nor mom a housewife. Rather, graduates are likely to vie for shorter commitments focused on training and, in a number of cases, with a higher probability of relocation in the future. Not to mention the logistical, locational difficulty of maintaining a dual-income family (specifically outside of urban centers).

And that’s the demand side. Jobs that cater to college graduates are slowly disappearing from middle America toward coastal centers that capitalize on economies of scale and network effects. Vox notes that the age at which graduates first purchase a house is becoming later. True, but not necessarily relative to household formation itself – something happening later across the country driven by graduates. (Not to mention, as a commenter on Twitter mentions, the increasing necessity of a post-Baccalaureate degree).

Here’s the thing about those with “student debt” – they are much more likely to be “students” than those “without student debt”. In the latter group, you either don’t have a degree – in which case none of the above qualifications apply – or you’re wealthy enough to go through college without any debt. Neither is a representative group.

The bottom line is students increasingly want to live in areas where homeownership is unaffordable. (And it’s not like twenty-somethings even should be able to afford a place in New York City). There is increasing evidence that homeownership is probably not the best investment for many people. The returns on real estate are dwarfed by the stock market, and other carefully-orchestrated investment plans, especially without the (clearly excessive) boom years of the past decade. Maybe millenials are paying more attention and making smarter investments.

Of course, jubilees are almost always a good thing (and it’s not clear that lower rates as Elizabeth Warren wants, would even achieve lower debt – it may just encourage poorer people, or those who otherwise would not have, to borrow more). Deleveraging, especially in a time of low inflation, will improve the economy through simple wealth effects and encourage capital formation via higher savings rate (and perhaps investment in domestic equity).

But it does not strike me as a particularly equitable, or necessarily economically-optimal, use of our budget to help those who were, are, or would-be students. Or, in other words, near the top of the income distribution. An expansion of the EITC with the same money would be more equitable, more directly encourage job creation, and give more bang for the buck.

Of course, the best thing for debtors and the economy would be a inflation above expectations.

 

Brad DeLong notes that lack of consumption is not especially responsible for currently low levels of aggregate demand. I am not so sanguine. At first approximation, this is hardly surprising. There is some truth to the Austrian principle that recessions arise from a decline  in investment during the boom. (There are many flaws to this theory, not the least that spending on consumption goods increases only in relative, not absolute, terms). Since most consumers smooth their spending over time, to the extent liquidity is not a problem (and it was), what happened is exactly what you would expect.

Unfortunately, to the extent this stagnation is secular, we can’t ignore consumption. Take a stylized accelerator model which says that I/Y_r = (K/Y)g_r, where I/Y and K/Y are the investment and capital stock to potential income ratio respectively and g is the potential growth rate. Let’s state secular stagnation as the state where an economy is (for the foreseeable future) demand constrained and g as a function of r drops by some constant amount. (That is, the real interest rate necessary to maintain some level of growth is lower than it used to be).

So, for whatever reason, when the long-run potential growth of the economy falls, firms are not as driven to invest in future profits and therefore the level of investment has to fall. This must either be accompanied by a corresponding increase in consumption or decrease in total income.

The question we should be answering then isn’t whether consumption has increased as a share of GDP, but whether it has increased enough given a lower potential growth rate. Even under generous assumptions, this is probably not the case:

Image

The growth in consumption as a share of GDP – which we will generously define as 1 – max_t(C)/min_t(C) – is just over 18%. Over the same period, real income grew by an average of 3.2%. Taking this as the former potential, and 2% as the new normal g has fallen by around 60%. Even with an optimistic assumption that the economy will grow at 2.5%, the fall in potential g still outweighs the increase in consumption. (This is all under the assumption that K/Y has and will remain fairly constant. Piketty says no. I don’t buy that this will be significant enough to outweigh everything else, but that is for another post). 

This is, of course, a simplistic assumption. The accelerator model is naturally stylized and investment may not fall nearly as much as suggested. Increased consumption of capital (“wear and tear”) may be one such reason, though that seems ever unlikely in an economy increasingly-oriented towards investments in intellectual property and information rather than coal mines. So if it is not the case that increasing consumption is necessary to maintain a certain level of income, it is certainly interesting to see the assumptions and model under which that is so.

The United States is simultaneously too much like China, and not enough like China. On the one hand, falling potential growth in both countries necessitate a decreasing reliance on private investment. On the other hand, unlike China, there is much the United States can and should do to increase public investment in green technology, basic research, and stronger infrastructure. 

Earlier today Matt Yglesias borrowed a chart from Thomas Piketty’s new book noting that public assets remain above public debt. This chart actually underestimates the strength of our balance sheet.  A more striking image is the ratio of our gross national product (GNP) to our gross domestic product (GDP).
 
Image 
 
 
The left axis here is a pretty narrow range, so the dynamics aren’t as extreme as they first seem, but what you’re seeing is that the GDP-GNP ratio is at it’s highest pint in history and continues to rise. What does that mean? Remember from Econ 101 that the GNP = GDP + American income on foreign assets – foreign income on American assets. In essence, the ratio I’m graphing shows that over the past decade net inflows have grown substantially faster than GDP, despite the skyrocketing debt. (Since GNP/GDP = 1 + (net payments)/GDP In fact, you would expect precisely the opposite phenomenon, more so than ever before as our deficits are increasingly financed by foreign savings (interest payments to domestic pension funds cancel out). As Wikipedia recites basic economic wisdom:
 
Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make the use of GDP more attractive for politicians in countries with increasing national debt and decreasing assets.,
 
It’s worthwhile asking yourself what exactly national debt represents – a claim on future income. This graph suggests that our claim on everybody else’s future income is way higher than their claim on our income. You should be scratching your head – why are emerging markets throwing money at us when the domestic return on capital is far more attractive? They are lending us really cheap credit so that we can recycle that to our firms which then invest in foreign equities earning a huge premium. That should sound pretty familiar to you, because it’s basically how Wall Street made all of its money. America, basically, is a huge hedge fund.
 
But for the Federal Government, this isn’t a problem. We can always roll over our debt since the dollar is sovereign. We can actually make some pretty insightful observations taking the perspective that the government is a big bank. We could theoretically sell our foreign assets to repurchase our own debt (or, since we don’t have a sovereign wealth fund, tax our citizens more, which is the same thing) which is less volatile than emerging market equities (and isn’t subject to any currency risk). But we’d then be short emerging market, which means we would pay the risk premium rather than earn it. 
 
The in-built short term volatility isn’t actually a big deal, either. In the long-run, equity indices are pretty well correlated with economic growth, and everybody else will grow faster than us on average. That leaves liquidity risk, but because the Federal Reserve exists even that is negligible. The currency implications of this are even more mind bending still. For most countries, a depreciation has a negative wealth effect – that is we can buy less on the international market than before in real terms. But the more our own inflows are denominated in foreign currencies, the less obvious this link becomes. That gives monetary policy more space as higher inflation would be a lot less detrimental for us than any other country.
 
People are happy to pay a premium for safety. We should be happy to earn that spread. 

The recent emerging markets crisis – one a long time coming, depending on who you ask – started on cue from Ben Bernanke that the Fed would “taper” its unprecedented injection of liquidity into international markets. That emerging markets responded so poorly tells us something important: they expect the taper to come much too soon.

In principle, the Fed wants to continue with its “expansionary” program until the United States is growing quickly again. The “Evans Rule” ensures we will keep a zero interest rate policy until unemployment has fallen below 6.5%, though no such forward guidance exists for QE. 

In reality, if emerging markets expected QE to come only after the US economy was healthy again, this kind of depreciation of currency and fall of stock would be very unlikely. A robust US economy implies a growing demand for exports denominated in EM currencies: boosting both the currency and stock market. While the expectation of future growth probably wouldn’t offset entirely the effect of curtailed liquidity, it would have likely contained much of the depreciation.

Emerging markets are a more informative tool to this effect than American stocks. While  we can infer the same conclusion – that tightening will be premature – from our stocks’ sensitivity to QE, US markets are too closely connected with QE’s direct wealth effect, obscuring observation of expectations.

Of course, the massive liquidity from QE also plays a direct effect on emerging market currencies, but it’s fair to guess the relative sensitivity of EM currencies is lower than that of American stocks. (For example, a good jobs report might actually freak Wall Street out, whereas emerging markets are relatively insulated from that).

This is a somewhat contrived argument, still, the magnitude of currency deterioration across Asia should somewhat revise our beliefs that tapering is coming sooner than it should. 

The interesting story of the day is definitely a rapidly “collapsing” Rupee haunted by abnormally high volatility over the past month. I scare quote “collapse” because it’s a term that reflects the Western bias of this conversation. If you’re an American who has invested in emerging market funds hoping for real gains intended for domestic consumption that beat an index well, then, you’ve been screwed. As far as India is concerned the depreciation is  of less concern. Still, Raghuram Rajan has his job cut for him, and I’ve discussed the Indian Rupee in this context before. However, since Paul Krugman blegs to learn what he is missing, I’ll offer a few things that worry me at the moment.

Primarily, like any other developing country with rentier bureaucrats, fuel subsidies are important to India twofold. First as a stimulant for middle class growth that demands transportation and electricity (generators are big); second as a key ingredient to important fertilizers without which the Indian farming model would fail.

Fuel subsidies pose an interesting problem for a country that will meet 90% of its oil needs through imports. (I mistakenly noted that 90% of oil is currently imported. That said, the greater the difference between the current figure and the future one, the worse one unit of depreciation will be). Basically all growth in India’s most important market will be financed from imports henceforth. On the one hand, the decisive role government plays in the energy market almost guarantees that deficits will face an upward pressure, in a time when yields are already rising. The sensible solution would unfortunately involve curtailing the provision of a good necessary for political success.

More importantly, as energy becomes the dominant theme in Indian trade – as it undoubtedly will – India looses the primary benefit of depreciation: exports. When trade structure is such that the cost effect (price of imports) of depreciation trumps the quantity effect (quantity of imports) the beneficial nature of depreciation is removed entirely. Known as the Marshall-Lerner condition, a country technically faces this dilemma when the summed price elasticity of imports and exports falls below one.

Usually, since goods tend to be price inelastic in the short-run, devaluations are not always immediately successful but work over time. Not so for dollar-priced oil. As the value of oil is already buoyed by demand from emerging markets, each point of depreciation for the Rupee is that much worse for its balance and budget. Using data from the International Financial Statistics and Direction of Trade Statistics from the IMF, Yu Hsing estimates that India may not significantly meet the Marshall-Lerner condition. Since the paper might be gated for some of you, I’ll copy the relevant result:

As the US real income declines due to the global financial crisis, the trade balance for Japan, Korea, Malaysia, Pakistan, Singapore, or Thailand will deteriorate whereas the trade balance for Hong Kong or India may or may not deteriorate depending upon whether the relative CPI or PPI is used in deriving the real exchange rate.

India – to my surprise – weathered a depreciation better than some of the other countries studied, but a statistically significant success was predicated on the deflator of choice to determine real interest rates.

While I am not confident that India fails to meet the condition, rising oil prices and domestic demand guarantees the cost and quantity effects may be a little too close for comfort.

That, of course, only considers the total trade balance. As mentioned, government is unlikely to weather the necessary inflation well, especially if Raghuram Rajan decreases liquidity reserve ratios (as he has wanted to do for a while) which would light an upward pressure on already rising yields. The feedback loops formed from a rising deficit, stalling growth, and decreased demand for Rupee bonds will result in unfortunately high interest payments.

A tangential point concerns rentiers like Reliance – owner of the world’s largest refinery – which benefit from rapidly rising prices in an inelastic-demand environment. Its influence in government, along with political concerns will make handling these ridiculously useless subsidies hell for any Democratic government predicated on shaky coalitions.

India has a lot going for it. A falling Rupee hardly highlights any structural problem insofar as its own domestic economy is concerned (but brings to bear important questions about international monetary systems, a discussion for another day). I am largely with Paul Krugman that this is nothing to fret about – we are still talking about a country where people cry about 5% growth – but am only cautiously optimistic regarding the political ramifications from such rapid depreciation. Krugman is right in principle, and sometimes that is not enough.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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