A Proposal for the supplysideliberal Community's First Public Service Project: a wikipedia Entry on "Wallace Neutrality"

Although I plan to keep tight editorial–and for the most part, authorial–control over this blog itself, in a broader sense I view supplysideliberal as a collective enterprise.  I hope readers of this blog will gel into an online community that goes beyond this blog.  This will be a community of thoughtful people who do not all think alike; they need not be “Supply-Side Liberals” by the definition given in my first post “What is a Supply-Side Liberal?  Anyone who comes to this website frequently belongs to the supplysideliberal community (which means, for example, that the 535 people who have put this blog on their RSS feeds automatically qualify). 

It is my hope that in some way, the supplysideliberal community becomes something more than just this blog.  But it is good to take things in small steps, even if the small steps follow each other in quick succession.  So I have a proposal for a medium-sized undertaking as our first collective project outside of this blog: bringing into existence a wikipedia entry on "Wallace Neutrality.”

If you think this is a good idea, the key step will be to get the entry started, which I think can be done based on Noah Smith´s post “Does Steve Williamson Think Printing Money Can´t Cause Inflation?” and the comments on my post“Is Monetary Policy Thinking in Thrall to Wallace Neutrality?” Once the entry is started, it can be revised in the light of further comments on this blog, reading of one or more of Wallace´s papers, etc. Because of the importance of highlighting the assumption of Wallace Neutrality behind much of the discussion of monetary policy during our current economic troubles, I believe this would be a great service to the world.

Could one of you take the lead on this?

I definitely can´t do it all myself.  In terms of my personal priorities in relation to monetary policy, in the next while I will be writing about how people’s views on Wallace neutrality inform their views on current monetary policy debates, and what I think should be done given my belief in departures from Wallace neutrality.  In setting out the nature of Wallace neutrality itself, I need help.  I think a wikipedia entry would be a great way to collate our collective wisdom on this. And I think it would be a great start toward our becoming something more than just this blog.

supplysideliberal.com Takes on a Math Columnist: Gary Cornell on the Financial Crisis

Mathematics is a crucial tool for economics.  In my view, it is good for all economists to try to understand better what is going on in mathematics.  So I have decided to host an occasional math column in this blog.  

Those of you who have been following this blog closely have seen the very interesting posts based on Gary Cornell’s emails to me.  Gary has agreed to be this blog’s math columnist!  For now, the math column will always be headed by a title that begins “Gary Cornell on …”  or a title that has the word “math” or “mathematics” somewhere in it.  

Here is Gary’s post for today:

One thing I noticed when I was watching the whole financial crisis at work which I never saw mentioned in the econ blogs was this. Consider the following model for a financial firm. You work for a firm on wall street worth 50 billion dollars. Your part of the business actually consists of once a year spinning a roulette wheel with 100 numbers marked zero to 99.  If 1-99 comes up you get a 1 million dollar bonus and your firm makes 10 million from some third party.  If the 0 comes up your firm goes bankrupt wiping out 50 billion dollars in its market cap.

Question:  How many spins before there is even a 50% chance of my company blowing up?

The elementary probability calculation needed for the answer in turn leads to the problem that while the expected value is hugely negative, the most likely scenario is that I and all my bosses and their bosses will be long since retired and very rich before my company goes under, so I would have to be a fool not to play.

Is Monetary Policy Thinking in Thrall to Wallace Neutrality?

Economics (or even just the combination of stabilization policy and macro public finance that I laid out as a core focus for this blog in its original Prospectus, “What is a Supply-Side Liberal?”) is too vast for me to have the crystallized intelligence necessary to do this blog with the care it deserves on my own.  So I need your help.  And I spent some time yesterday working with my daughter Diana Kimball to set up comments with disqus to get your help directly on this blog.  

Currently, I am trying to prepare for more posts on monetary policy.  Following @justinwolfers and @tylercowen on twitter yesterday, including clicking on Brad DeLong’s post A Fragment on the Interaction of Expansionary Monetary and Fiscal Policy at the Zero Nominal Lower Bound to Interest Rates, I was struck again by how dominant the view is that Wallace neutrality as defined by Noah Smith is descriptive of the real world.  Let me try setting out a definition of Wallace neutrality to see if you think the definition is a fair one.  Also, I want to see if you think Wallace neutrality is an appropriate name.

Wallace neutrality:  a property of monetary economic models in which differences in the government’s overall balance sheet at moments in time when the nominal interest rate is zero have no general equilibrium effect on interest rates, prices, or non-financial economic activity, as long as the pattern of government purchases and marginal tax rates is held fixed.  

The first question I am asking readers of this blog is “Do you see a flaw in this definition?”

As Noah points out in his post Does Steve Williamson think printing money can’t cause inflation? the blogosphere has been calling Wallace neutrality the Modigliani-Miller theorem.  And there is no question that it is a Modigliani-Miller-like result, since the proof relies on private agents adjusting their portfolios in a way that counteracts any change in the government’s balance sheet.  But I think it will clarify things a great deal to follow Noah (subliminal message alert) in calling this Wallace neutrality.  

One reason I think that Wallace neutrality deserves its own name is that we find it useful to call Ricardian neutrality “Ricardian neutrality” instead of “the Modigliani-Miller theorem” even though (I think) Ricardian neutrality is more or less an application of the Modigliani-Miller theorem.  In Ricardian neutrality results, the government is typically exchanging bonds (a receive-interest-payments-and-principal-later asset) for cash on the one hand and exchanging an implicit receive-tax-payments-now asset for a receive-tax-payments-later asset.  So it seems like an application of the Modigliani-Miller theorem to me.  

With that definition of Wallace neutrality in hand, or with whatever modified definition you think is the right one, here are my other questions:

  • Is it correct to say that Ben Bernanke does not believe that Wallace neutrality is a good description of the real world?
  • Aside from Ben Bernanke, Noah Smith, and yours truly, who else does not seem to believe that Wallace neutrality is an adequate description of the real world to guide the conduct of monetary policy in our current situation?  
  • What do you think are the best monetary models out there (where “best” includes both technical virtues and real-world plausibility of mechanisms) that exhibit departures from Wallace neutrality that could be used to get oomph from monetary policy in the current economic situation?  When I say “get oomph from monetary policy in the current situation” I mean the kind of thing I was talking about in my posts “Balance Sheet Monetary Policy: A Primer” and “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy.”
  • Is it accurate to say that almost all of the formal models of optimal monetary policy by Michael Woodford and Lars Svensson and their students exhibit Wallace neutrality?   What are the exceptions?  What about formal models of optimal monetary policy by other authors?

Use the comment window at the bottom of this post to reply if you feel you have an answer to one of these questions.   (It will not show up on the blog right away because I need to approve comments for them to appear.)  I appreciate the help.  3696 heads are smarter than one.

Comments on supplysideliberal.com

Update, April 21, 2013: I want to encourage more commentary on my blog. I need to approve each comment unless you are whitelisted. But if you send me a tweet to let me know you need a comment approved, I will get to it quicker, and normally approve it and whitelist you. I do try to enforce a certain level of civility and decorum (including a language filter), but on substance, I want a robust debate. For Quartz columns, the link I post on my blog (usually the day after the column appears) is a good place to make comments. 

I appreciate all of you who are reading my blog.  Let me remind you that I have a companion twitter site @mileskimball.   

I am going to experiment with having tightly moderated comments on this blog.  The way I have comments set up using disqus, I can see all comments, but you will only be able to see the comments that I approve.  I am going to handle comments as a newspaper or magazine would handle letters to the editor.   But so far, comments have been of very high quality, so I have approved them all.  

I will have some posts in which I will pose a question and actively invite comments in order to take advantage of the collective wisdom of my readers.  On those posts, I will be especially diligent about checking out all of the comments, and I will publish more of the comments.  The first such crowd-sourcing post is my post “Is Monetary Policy Thinking in Thrall to Wallace Neutrality?”  The high level of the collective wisdom of my readers is apparent from the comments to this post.  

Two notes:

  1. If you want to see comments, you have to go to the post itself.  You can’t see them on the home page of the blog.  
  2. I have to approve each comment individually in disqus for it to appear, so if I am away from my computer or from internet access (as I often am for substantial periods of time), there may be a significant delay before your comment appears.

Gary Cornell on Intergenerational Mobility

Mathematician Gary Cornell has a theory I like about perceptions of intergenerational mobility in different countries and an empirical question the theory depends on.  Please send replies to him at gary@thecornells.com . I will find out from him what answers he got.  Here is his email I reprint with his permission with his theory and question:

Hi Miles, thanks for the post.

I wonder if you know anything about the following conjecture of mine:

The background is that I’ve long puzzled about people believe that America is the land of opportunity even though intergenerational mobility  is actually lower here than in many other countries. I  have a conjecture  that seems to have some  evidence to sustain it. (Basically I scanned the equivalent of the Forbes rich lists here and in other countries).

Namely:  While moving from upwards from one quintile to another  is less likely in the united states, moving  to the top .01% of wealth (assets of about $30 million roughly) is far more likely in the United States than in other countries or even moving into the top .1% (about 7 million in assets)  (For these people think of the first 1,000 people hired at Google or the first few hundred at Facebook  for example… )  In other countries I am pretty sure that the probability  that someone born  middle class or even upper middle class can become really really rich is a small fraction of what it is here.  So more precisely my conjecture is that, for example, because the ratio:

P(getting rich in the US)/P(getting rich in Europe)  

is so large people (and the media) tend to believe and the media tends to report that America is a land of opportunity compared to other countries and to forget that

P(getting really  rich in the US)

is almost vanishingly small in absolute terms… (If you look at the equivalent of the Forbes list in other countries it sure looks like the american list has fewer examples of people getting their place through the lucky sperm derby than in England, France. Or Germany.) Do you know of any papers on this?

 

Gary Cornell on Andrew Wiles

With Gary Cornell’s permission, I reprint here an email he sent me with a correction to the wikipedia  quotation in my post “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy.”

By the way, Gary was alluding to Alan Blinder’s book Hard Heads, Soft Hearts: Tough-Minded Economics for a Just Society, which in fact has been a book that influenced my thinking about economic policy.  Because Alan Blinder was Greg Mankiw’s professor when Greg was an undergraduate at Princeton doing graduate-level work, I think of Alan as my grand-advisor.   

Dear Miles,

Ihave very much enjoyed your recent blog entries which I was turned on to by the continuously interesting posts of your students Noah Smith. (Having such a brilliant student must be quite a lot of fun!) Anyway, I am glad you have started blogging because we definitely need more economists with “soft hearts and hard heads” like you seem to have.  

That having been said, in one of your recent posts you quoted the Wikipedia article on Wileswhich said this:

“Starting in the summer of 1986, based on successive progress of the previous few years of Gerhard Frey, Jean-Pierre Serre and Ken Ribet, Wiles realized that a proof of a limited form of the modularity theorem might then be in reach.”

Since I actually helped organize the  big conference on the proof that Wiles for example spoke at, I remember the time very well!  And unfortunately this sentence is, I believe subtly but still quite wrong and so gives the wrong idea of what was going on at the time and I dare say of what Wiles himself was thinking when he took the leap into the unknown. As I read it, it says Wiles thought the that the work done on proving the amazing  implication (what we call Ribet’s theorem now) that: “Modularity (Shimura-Taniyama-Weil)  for semi stable elliptic curves implies Fermat” led Wiles to think that modularity was in reach. My understanding, based on what Wiles has said numerous times and also because of what was being done in the field of modular forms at that time (such as the then relatively recent proof of the main conjecture etc.) was rather that Wiles was willing to try so hard to prove modularity, even though nobody thought it was possible at the time *because* of Ribet’s theorem. In other words, he was willing to make the effort because Ribet’s theorem told him Fermat would fall *if* he could prove modularity. And since nobody really thought modularity was in reach at the time, it was truly amazing that Wiles believed he could prove even a special case of it and his willingness to basically risk all on the attempt remains so amazing. (Wiles himself is often quoted as saying that proving Fermat was a lifelong dream of his from the time he was a young student and thus provided the motivation once Ribet had shown the implication.)

Anyway if I was going to rewrite the Wikipedia article, here’s what I think it should say:

“Starting in the summer of 1986, based on the work of the previous few years including Gerhard Frey’s on the importance of what is now called the Frey curve, Jean-Pierre Serre who showed that the properties of the Frey curve plus what became known as the epsilon conjecture would contradict a weak form of the modularity conjecture and then finally Ken Ribet with his deep and difficult proof of the epsilon conjecture, everyone now knew  that a proof of a limited form of the modularity theorem meantFermat would fall. Of course, at that point even a weakened form of the modularity conjecture was thought of as being totally beyond reach, so Ribet’s theorem was thought of as simply being a really cool result and hey maybe in a hundred years or so we would finally knew enough to prove modularity, and therefore Fermat itself would be a corollary! Somehow, Wiles started to believe that by combining many of the techniques developed in the 70’s and 80’s in Modular Forms specifically and Arithmetic Geometry more generally, along with techniques that he had only glimmerings of at that point, maybe, just maybe he could prove modularity and thus his lifelong dream of proving Fermat might actually be possible. So he was willing to devote all his efforts for so many years to the proof of the modularity conjecture.”

Finally, for those who want to go further into the details of the proof we turned that conference into what has become one of the more practical ways to “get into the proof” – well  “practical” if you have two or three years of graduate math courses of course.

http://www.amazon.com/Modular-Forms-Fermats-Last-Theorem/dp/0387989986/ref=sr_1_5?s=books&ie=UTF8&qid=1338802037&sr=1-5

Otherwise, I strongly recommend

http://www.amazon.com/Fearless-Symmetry-Exposing-Patterns-Numbers/dp/0691138710/ref=sr_1_3?s=books&ie=UTF8&qid=1338896372&sr=1-3

as the best possible treatment of the circle of ideas around Wiles work for  a mathematically literate reader-any grad student in economics should have enough background to read this I think.

Best regards,

Gary Cornell

Henry George and the Carbon Tax: A Quick Response to Noah Smith →

The title is a link to Noah Smith’s post “Carbon Taxes Won’t Work.  Here’s What Will.”  

I have to be quick because I have proofs to read for my new AER paper with Dan Benjamin, Ori Heffetz and Alex Rees-Jones.  One downside of blogging is that your coauthors know what you are doing instead of working on your joint paper with them.  

Forgive me, Noah, if I am missing something in only skimming your post, but I wanted to say that a carbon tax or a gasoline tax isn’t just about global warming.  I like the national security argument for lowering the price of oil that, say, Iran gets, as well as the global warming argument.  I second you in advocating scientific research as the most effective way to address global warming.  But the revenue from the carbon tax can help pay for this research and other important government functions.    

To the extent that oil or coal in the ground is in inelastic supply, increasing taxes on oil and coal in many countries around the world at the same time is somewhat like Henry George’s land tax that came up in the conversation when Clive Crook told Michael Kinsley about this blog, as reported in Clive Crook’s post “Supply-Side Liberals.”  Note that if oil or coal is in inelastic supply like this, the before-tax price of oil and coal might go down so much that the after-tax price of oil and coal doesn’t change that much.  If so, the quantity used might not change that much either.*  So the direct benefit on the global warming front of a carbon tax might be small.  But the benefit in raising revenue to pay for research to solve the global warming problem could be huge.  

Overall, relative ineffectiveness at slowing global warming would lead to a smaller optimal level of a carbon tax, but the revenue side alone is pretty favorable, as long as the government doesn’t give away all of the potential revenue by using “Cap and Trade.”

*Note:  I have to give credit where it is due for this idea that worldwide carbon taxes will push down the price of oil or coal enough that there might not be much effect on use.  When I was a visitor at the Center for Economic Studies in Munich last Summer, I learned this at lunch from one of the other visitors there, who was unsuccessfully (I think) trying to persuade one of the graduate students in Munich to work on it.  I hope that someone has worked on this idea or plans to work on it.

A Supply-Side Liberal Joins the Pigou Club

I try not to oversimplify in my posts, but I confess to oversimplifying on occasion in the titles of my posts.  The number of words it is reasonable to put into a title–and a title’s function of intriguing people enough that they might actually read a post–make me willing to make that compromise.  

In the title to my last post “Why Taxes are Bad,” I am referring to income, earnings and consumption taxes.  There is a big exception to the rule that most taxes have bad side-effects: Pigou taxes.  Pigou taxes are taxes that discourage people from doing too much of things that have bad consequences for the world that don’t fall entirely on the person making the decision.  Pigou taxes are one of the closest things there is to a free lunch in economic policy: a way to finance the many important things the government does–including enabling the government to defend our country and help the poor, build roads and bridges and foster scientific research–while discouraging things that should be discouraged (at least discouraged a little bit).   

The most important Pigou tax on the table (at least among economists) is a carbon tax.  Because one of the big benefits of Pigou taxes is to finance important government functions without causing harmful distortions, I am unwilling to consider “Cap and Trade” as an equivalent to a Pigou tax on carbon emissions.   In theory, if the carbon emissions rights in “Cap and Trade” were auctioned off, it would be equivalent to a carbon tax at some level (though I think less likely to be at the right level than if the carbon tax rate is set directly), but in practice, most of the potential government revenue would be given away to carbon-emitting companies.  That would mean either that important government functions would suffer, or that we would have to use distortionary taxes–with all the attendant costs detailed in "Why Taxes are Bad“–in order to finance those government functions.  The best can be the enemy of the good, but for now I am holding out for an actual carbon tax.  (If a comprehensive carbon tax is not politically possible, an increase in the gasoline tax would be a reasonable start, but I am not at all convinced that an increase in the gasoline tax is any easier politically than a comprehensive carbon tax.)   

In any case, I am hereby officially joining the Pigou Club.  For more about the Pigou Club and the logic behind Pigou taxes, see Greg Mankiw’s post ”The Pigou Club Manifesto.“    


Why Taxes are Bad

In “Miles Kimball, the Supply-Side Liberal,” Noah Smith summarizes my post “Can Taxes Raise GDP?” with this passage:

Many people are familiar with the fact that people work about the same  amount whether taxes are low (as in the 2000s) or high (as in the 1960s). Miles agrees with this, but points out that high taxes hurt people in a different way, by making them feel so poor that they have to work more, and thus depriving them of leisure.

This makes it clear to me that I didn’t get some of my point across in “Can Taxes Raise GDP?” since what Noah is saying only applies to the case when the government is wasting the money.  What if the government isn't wasting the money?  Let’s take the case of the government redistributing money from the rich to the poor (which is a big element of what is going on in Medicaid and Medicare, for example).  The first thing that happens, as Karl Smith emphasizes in “Welcome Miles Kimball: Now Set the Record Straight on Taxes” is that the poor receiving the money work less:

benefits lead people to work less, a point I have long tried to make. 

This is a big effect.  And if it means that fathers and mothers don’t have to work second jobs to make ends meet and can spend more time with their children, this is a good thing, even though it makes GDP go down.  (One of the many problems with using GDP as if it were the measure of how well a society is doing is that child-rearing by parents doesn’t get counted in GDP.)

So far so good, but what about the side effects of taking the money from the rich to give to the poor?  The “Occupy Wall Street” movement and its spinoffs paint a picture of rich people who got rich by some kind of chicanery or evil–a picture embedded in the negative connotation now carried by the phrase “the 1%.”  But the typical case is someone who got rich–or whose parents got rich–by providing a useful service.  And I am not just talking about the wonderful services provided by someone like Steve Jobs or Oprah Winfrey. For vividness I need to use famous people as examples, but before their current fame, in the relative anonymity that most rich people live in, Duchess Kate’s parents rose to become part of the “the 1%” in England by providing people with party supplies and decorations.   There were many parties that were better because Carole and Michael Middleton provided these supplies and decorations.  Aside from the rare cases (think Bernie Madoff) in which someone gets rich by pretending to provide a service they are not really providing, or by means of some other evil–we all benefit from having the rich work hard to provide us with those services. Also, many of the rich provide jobs to employees.  

Now let’s look at the bad side-effects of tax distortions. To do this, we need to compare distortionary taxes (such as income taxes, labor earnings taxes or consumption taxes) to taxes on the rich that do not depend on the level of their income, earnings or consumption.  If we could tax the rich in a way that did not depend on their income, earnings or consumption, they would fulfill their obligation to contribute toward helping the poor in part by working harder to make more money to pay the taxes.  This would benefit all of the people who receive the services they provide.   And they might hire additional employees to work with them in the extra time they are devoting to work.  

By contrast, distortionary taxes such as income, earnings or consumption taxes push the rich toward getting the money to pay their taxes out of their existing income rather than in part by raising their before-tax income to soften some of the hit to their after-tax income.  We are all then worse off as a result: the rich because they would rather work harder than take the tax hit entirely as a reduction in after-tax income, and everyone else who would have benefitted as a customer or employee from the extra services and jobs they would have provided.  

So why don’t we use non-distortionary taxes that don’t depend on income, earnings or consumption to raise the taxes to help the poor?  It is because it is not easy to tell the rich and the poor apart without looking at income, earnings or consumption.  

In principle, if we could look at genes, say, to figure out who is inherently blessed with the talents to be rich, we could avoid distortions.  This approach raises a host of troubling philosophical issues.  But it is taken seriously in the academic literature.  See for example my University of Michigan colleague Joel Slemrod’s paper with Kyle Logue: Genes as Tags: The Tax Implications of Widely Available Genetic Information.  At this point, I am not willing to recommend such a gene-based approach.  But without some new approach, we are stuck with identifying who is rich by looking at income, earnings or consumption.  So we use taxes that depend on income, earnings or consumption, with all their attendant distortions. 

My overall message in this post is given well by Noah’s summary of my first post “What is a Supply-Side Liberal”:

Taxes bad, redistribution good.  

Some messages are worth repeating.

Scott Sumner: "'What Should The Fed Do?' Is The Wrong Question" →

Scott Sumner writes:

Several commenters asked me for a critique of Miles Kimball’s new post on monetary policy. I like him a lot, but I’m afraid this post will be mostly negative. Of course that’s not surprising, as Kimball is like 99.99% of other economists; he looks at monetary policy through the wrong end of the telescope.

I will definitely talk about nominal GDP targeting and the other issues Scott raises in future posts, probably not all at once, since there is a lot of meat there.

Here is my favorite passage in Scott’s post:

He also does the reductio ad absurdum of the Fed buying up all of planet Earth. I like that example, but (unlike Kimball) I’d characterize it is a success if it failed to boost NGDP. After all, wouldn’t it be nice if America owned the whole planet, and we could all kick back and live off the work effort of others?

Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy

blog.supplysideliberal.com tumblr_m51wyl95O61r57lmx.jpg

There is something wonderful about having earned one’s first big critic in the blogosphere, so I do want to answer Stephen Williamson’s post “Quantitative Easing, the Conventional View."   But before the end of this post I promise to also make two important points that go beyond this small dustup with Stephen.  I will talk about:

  1. the role of economic models in informing economic policy and 
  2. why effective use of balance sheet monetary policy can involve open market asset purchases that are in the trillions of dollars.

Stephen’s objection 1  is to my statement from "Balance Sheet Monetary Policy: A Primer”

Above the natural level of output, core inflation rises.  Below the natural level of output, core inflation falls. 

He then criticizes this statement by saying two closely related things I heartily agree with:  (a) the current situation is hard to interpret and (b) in general, at any given time it is hard to know what the natural level of output is at that moment.  He also characterizes the theoretical provenance of this statement as New Keynesian.  That is also true.  I take the idea that inflation adjusts gradually from my main graduate school advisor Greg Mankiw, one of the most eminent New Keynesians: both from his textbook where he gives his view of the facts and from his theoretical 2002 paper with Ricardo Reis trying to explain those facts: “Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve.”Michael Kiley anticipated Mankiw and Reis in his 1995 job market paper.  He used the nice phrase “sluggish inflation” to describe what he was explaining with his model.      

In criticizing this view, Stephen is presumably alluding to the fact that in other models the price level jumps up instantly above the natural level of output, and in others, the inflation rate jumps up instantly above the natural level of output and then gradually returns to normal.  But I don’t need sluggish inflation for the thread of my argument in “Balance Sheet Monetary Policy: A Primer”.  The key points in that section were only 

  • It is possible in some circumstances for monetary policy to be too expansionary.
  • It is possible in some circumstances for monetary policy to be too contractionary.  
  • Monetary policy does not have the power to permanently raise the level of output. 

(The history of thought for macroeconomics makes the phrase “the natural level of output” a reference to the third bullet.)   I would be shocked if Stephen disagrees with any of these statements.  

I actually began addressing Stephen’s objection 2, even before he made it, when I wrote:

It is logically possible that sellers might sell all of a particular asset to the Fed before its interest rate gets down to zero.  Then it has to find some other asset to buy that it doesn’t already have all of.  Notice that this only happens when people don’t feel they really need that particular asset very badly, otherwise they wouldn’t sell it to the Fed so cheaply.  So nothing bad happens as a result of the Fed buying all of an asset that people are willing to let go of that easily.  (Remember that an interest rate above zero has to be associated with a lower price than what the asset would have at an interest rate equal to zero.)  

Stephen’s objection 2 boils down to saying that, because of the Modigliani-Miller theorem, this logical possibility is what would actually happen: no matter how much the Fed buys of an asset, the price and interest rate of the asset will not change.  I have several responses:  

A. Scientifically, the best way to find out would be: try balance sheet monetary policy on a massive scale and see what happens.  If you really believed in this strong version of Modigliani-Miller as applicable to the real world, there would be no policy downside to such an experiment, since what the Fed does in terms of balance sheet monetary policy would have no effect on anything that matters.  

B. As Noah Smith points out in a recent post, the Modigliani-Miller theorem was originally applied to corporations.   But Stephen needs a version of the Modigliani-Miller theorem that applies to the government (the Wallace theorem), which is tougher to justify than the version that applies to corporations.   I want to clarify one thing about Noah’s post.  Stephen clearly does think that the money supply can have an affect on the economy as long as the Fed funds rate is above zero.  But Noah is right that Stephen is implicitly claiming that “quantitative easing" cannot cause inflation.

("Quantitative easing" is the very confusing phrase that the press has decided to use to refer to what I am more accurately calling balance sheet monetary policy.   Explaining why I think "quantitative easing” is such a misleading term requires explaining the difference between the history of Japanese monetary policy and what the Bernanke Fed has been doing, something I will save for another post someday.)

C. The original corporate version of the Modigliani-Miller theorem serves as the “frictionless case” of Corporate Finance.  As in Physics, the frictionless case is of great value as a starting point for teaching Corporate Finance.   But I don’t know of any real-world application of the Modigliani-Miller theorem where it applies as well as the the frictionless case in Physics applies to, say, planetary orbits.  It would be giving the frictionless case of the Modigliani-Miller theorem its due (and maybe more than its due) as a useful approximation if we think of the real world economy as being like the case of a golf ball sailing through the air.  Thinking about how the golf ball would behave in a vacuum is a good start for understanding its trajectory, but a golfer who ignores the wind is unlikely to win the U.S. Open.   

Stephen’s objection 3 has several elements.  He seems to assert even more forcefully that the assumptions needed for a Modigliani-Miller result–or Wallace result–to apply to the real world.   He indicates using technical language that he believes that what the Fed does matters as long as the Fed funds rate is above zero.  At least that is my interpretation of this passage:

A central bank is a financial intermediary. Its power to alter the allocation of resources and economic welfare derives from its monopoly over the issue of some special kinds of liabilities (currency and reserves) which are used in retail transactions and large-value financial transactions. 

But most important is what Stephen is suggesting in his objection 3 about the proper role of economic models in informing economic policy.  He is saying that (at least in advance of solid empirical evidence) we should use either the frictionless model to guess what will happen in the real world if we use balance sheet monetary policy or, a formal model with the relevant friction spelled out.   It is easy to see the attraction of this view.  In the next few years, young economists will make their mark–or older economists will burnish their reputations–by laying out many different formal models of frictions that could make balance sheet monetary policy work in those theoretical models.  (Perhaps someone has  the killer model in this category already, but if so, they clearly haven’t convinced Stephen.)  It would be better if we had all of those models in hand now, instead of a few years from now.  But the European debt crisis could send the U.S. economy into another full-scale recession before economists have all of those models worked out.  

In the meantime, the key question for economic policy making is “Do we believe that the real world is like the frictionless case or not?”  To make an analogy to math, the judgment involved is less like the judgment of whether something is proven than it is like the question of whether a mathematician believes strongly enough that something is true–and that she understands well enough what is going on–that it is worth betting a substantial chunk of time on trying to prove it.  Andrew Wiles made a judgment of exactly this sort when he set out to prove Fermat’s last theorem.  According to the current text of the wikipedia article on Andrew Wiles: 

Starting in the summer of 1986, based on successive progress of the previous few years of Gerhard Frey, Jean-Pierre Serre and Ken Ribet, Wiles realised that a proof of a limited form of the modularity theorem might then be in reach.

Based on his intuition that he understood what was going on in relation to Fermat’s last theorem, Andrew Wiles proceeded to spend the next 7 years working on the theorem.  The corresponding kind of judgment in Economics involves trying to read tentative bits of early empirical evidence (as well as thinking about possible theorems and approaches) in a way that Mathematics does not, but the kind of judgment involved is similar in spirit.  All of the theoretical models and all of the data analysis we have in hand goes into making that judgment, as well as our ability to extrapolate from what we know to guesses about what we don’t know.  In particular, Ben Bernanke and his fellow decision-makers about monetary policy have to make decisions based on available theory and evidence and their best judgments if proven results are unavailable in time of crisis.  

So for now, in the absence of a formal model of frictions that I am willing to point to as decisive for understanding balance sheet monetary policy, let me state as my carefully considered judgment (revisable in the light of further evidence and theory, but a bet on the truth with reputation at stake nevertheless) that there is enough friction modifying the Modigliani-Miller logic in relation to balance sheet monetary policy to be like the case of wind resistance.  In other words, there is some friction, but not much.  Balance sheet monetary policy is like moving the economy with a giant fan.  It can be done, but it takes huge open market purchases of assets to move the economy much once the Fed funds rate is more or less at zero.  

The key insight is that it is perfectly possible for the Fed to buy trillions and trillions of dollars of assets other than Treasury bills–or for other central banks to take corresponding actions–if that is what it takes.  The key issues are about the side effects and dangers of doing so.  Balance sheet monetary policy can powerfully stimulate the economy if the Fed does enough.  But we might have to get used to open market purchases in the trillions and trillions.

Stephen Williamson: "Quantitative Easing: The Conventional View" →

This is a critical post about my third post “Balance Sheet Monetary Policy: A Primer.”  Stephen makes serious points that cannot be answered quickly and will have to be answered in the course of major posts sometime down the line.  For now let me just welcome his characterization of my viewpoint as “The Conventional View.”  What I said in my post may be controversial–as it should be given how new it is to use balance sheet monetary policy in a big way.  And I explain balance sheet monetary policy without pulling any punches.  But my views on this are fundamentally mainstream views about how the world works.  I am not out on the fringe in how I am looking at things.  

National Rainy Day Accounts →

To back up the idea that there may be even better policies than FLOC’s, here is another proposal from my paper “Getting the Biggest Bang for the Buck in Fiscal Policy” in the  section: “3. Household Finance Considerations.”  

… in principle, national lines of credit in times of low demand could be superseded in the long run (at least in part) by a modest level of forced saving in times of high demand, with the funds from these “national rainy day accounts” released to households in time of recession (and also perhaps in the case of one of a well-defined list of documentable personal financial emergencies).  

In the long run, I like National Rainy Day Accounts much better than FLOCs.  But National Rainy Day Accounts seem politically harder to me than FLOCs, because National Rainy Day Accounts require action in advance of a crisis instead of after the crisis hits.  

The title of this post is a link to the paper.  

Reihan Salam: "Miles Kimball on Federal Lines of Credit" →

I want to endorse Reihan Salam’s statement that “FLOCs are best understood as a second-best alternative to counter-cyclical transfers, not as an ideal solution.”  There are probably better ways to stimulate the economy, but I think issuing FLOCs at the appropriate time is a feasible policy–well within the range of political possibility–that is much better than many things we have done in the past to stimulate the economy.