Quartz #27—>Three Big Questions for Larry Summers, Janet Yellen, and Anyone Else Who Wants to Head the Fed

September 01, 2013 by Miles Kimball

Here is the full text of my 27th Quartz column, "Three big questions for Larry Summers, Janet Yellen, and anyone else who wants to head the Fed,“ now brought home to supplysideliberal.com. It was first published on July 31, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© July 31, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The financial crisis of 2008 and the miserable performance of the US economy since then made the Federal Reserve look bad. And almost everything the Federal Reserve has done since then to try to get the economy back on track—from the role it took in the Wall Street bailouts (detailed in David Wessel’s book In Fed We Trust), to dramatically increasing the money supply, to quantitative easing—has also made the Fed look bad.

Despite how bad the Fed’s performance looks, things could have been worse—much worse—and I have argued that Ben Bernanke, who led the Fed through this difficult time, should be given a third term as head of the Fed. But as President Obama has made very clear, that is not going to happen.

Now there are rival campaigns for who will follow Bernanke as Fed chief, with former Treasury Secretary Larry Summers and Fed Vice Chairman Janet Yellen as the leading candidates. Ezra Klein has repeatedly written on Wonkblog that Obama’s inner circle favors Summers, and Senate Democrats were galvanized by the prospect to write a letter favoring Yellen, followed a few days later by a New York Times editorial board weighing in strongly for Yellen. Much of the discussion has focused on personality differences that I can verify: Larry Summers was one of my professors in economics graduate school and I had a memorable dinner talking about the economics of happiness with Janet Yellen and her Nobel-laureate-to-be husband George Akerlof when I gave a talk at Berkeley in 2006.

I distilled my own observations into tweets saying on the one hand that “Larry Summers can dominate a room full of very smart economists” while “Janet Yellen, like her husband George Akerlof, is one of the nicest economists I have ever met.” Despite that personal knowledge, and the same publicly available information as everyone else, I had to confess on a HuffPost Live segment on July 25, 2013, that my own views on the relative merits of Summers and Yellen go back and forth on an hourly basis. The source of my trouble is this: there are many questions Larry Summers has studiously avoided addressing about monetary policy (Neil Irwin in Wonkblog thinks this is a deliberate, but flawed strategy) and even Yellen, who has an extensive and laudable record on past and current monetary policy and financial stability policy, hasn’t answered all the questions I have about the future of monetary policy and policy to enhance financial stability. On financial stability, Summers has made mistakes in the past (helpfully listed by Erika Eichelberger at motherjones.com), so I especially want to know where he would go in the future in this important function of the Fed.

The questions I would like to ask Larry Summers and Janet Yellen are many, but let’s focus on three big ones:

Eliminating the “Zero Lower Bound” on Interest Rates. Given all of the problems that a floor of zero on short-term interest rates causes for monetary policy, what do you think of going to negative short-term interest rates, as I have argued for here and here and here? If we repealed the “zero lower bound” that prevents interest rates from going below zero, there would be no need to rely on the large scale purchases of long-term government debt that are a mainstay of “quantitative easing,” the quasi-promises of zero interest rates for years and years that go by the name of “forward guidance,” or inflation to make those zero rates more potent. Repealing the “zero lower bound” would require dramatic changes in monetary policy (and in particular, a dramatic change in the way we handle paper currency), but wouldn’t that be worth it?
Nominal GDP Targeting. What do you think of clarifying monetary policy by guiding short-term interest rates by the velocity-adjusted-money-supply (nominal GDP) targets recommended by the Market Monetarists, combined with regular, explicit forecasts for how high GDP can go without raising inflation? (See “This Economic Theory was Born in the Blogosphere and Could Save the Markets from Collapse.”) In hindsight, it is clear that the Fed should have acted more quickly, and done more, to get the US economy out of the slump the financial crisis put it in. During that time, the behavior of the velocity-adjusted money supply clearly indicated that more monetary stimulus was needed. Wouldn’t it make sense to pay more attention to an indicator that does well both in ordinary times and when the economy faces a crisis the likes of which we haven’t seen since the Great Depression—and move away from the faulty reliance some of those who vote in the Fed’s monetary policy committee put on non-velocity-adjusted money supply numbers?
High Equity Requirements for Banks and Other Financial Firms.What do you think of what Anat Admati and Martin Hellwig have to say about financial regulation in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It? Their argument comes down to this: despite all of the efforts of bankers and the rest of the financial industry to obscure the issues, it all comes down to making sure banks are taking risks with their own money—that is, funds provided by stockholders—rather than with taxpayers’ or depositors’ money. For that purpose, there is no good substitute to requiring that a large share of the funds banks and other financial firms work with come from stockholders. (For follow-up questions on financial regulation, Admati and Hellwig have an invaluable cheatsheet.)

Any serious candidate for the Fed who gives positive answers to these three questions will have my enthusiastic support, and I hope, the enthusiastic support of all those who have a deep understanding of monetary policy and financial stability. But any candidate for the Fed who gives negative answers to these three questions will be indicating a monetary policy and financial stability philosophy that would leave the economy in continued danger of slow growth (with little room for error) and high unemployment in the short run, and the virtual certainty of another serious financial crisis a decade or two down the road.

Update: I am delighted that Gerald Seib and David Wessel flagged this column in their August 2, 2013 Wall Street Journal “What We’re Reading”feature. They write

University of Michigan economist Miles Kimball says the best candidate to take over as leader of the Fed will back negative short-term interest rates, nominal GDP targeting, and high equity requirements for banks and financial firms. If a candidate is chosen who opposes any of these three, Mr. Kimball predicts another serious financial crisis in the next two decades. [Emphasis added.]

In their last sentence, they go beyond what I intend when I write

But any candidate for the Fed who gives negative answers to these three questions will be indicating a monetary policy and financial stability philosophy that would leave the economy in continued danger of slow growth (with little room for error) and high unemployment in the short run, and the virtual certainty of another serious financial crisis a decade or two down the road.

Let me clarify. First, it is not these beliefs by the Fed Chief alone that would lead to a financial crisis, but the philosophy that would answer my three questions in the negative, held more generally—by the Fed Chief and other important players around the world. But of course, the Fed Chief is a hugely important player on the world stage. Second, I write “who gives negative answers to these three questions” meaning negative answers to all three. To separate out the causality more carefully, what I have in mind with the parallel structure of my final sentence in the column (quoted just above) is

Rejection of both negative interest rates and nominal GDP targeting—and perhaps rejection of negative interest rates alone—“would leave the economy in continued danger of slow growth (with little room for error) and high unemployment in the short run.”
Rejection of high equity requirements for banks and other financial firms would lead to “the virtual certainty of another serious financial crisis a decade or two down the road.”

Outtakes: Here are two passages that I had to cut to tighten things up, but that you may find of some interest:

In brief, the Fed put itself in the position of getting bad results using unpopular methods. By July 2009, the Fed’s job approval rating in a Gallup poll was down to 30%, below the job approval rating for the IRS . By the time of the 2012 presidential election campaign, Republican crowds enthusiastically chanted the title of Republican candidate Ron Paul’s book End the Fed.

…in a 32-second exchange with Charlie Rose that is well worth watching for the nuances, President Obama said “He’s already stayed a lot longer than he wanted, or he was supposed to.” The praise for Bernanke in the Charlie Rose interview is so tepid and ungenerous that my interpretation is the same as US News and World Report editor-in-chief Mortimer Zuckerman’s in his July 25, 2013 Wall Street Journal op-ed “Mistreating Ben Bernanke, the Man Who Saved the Economy”: “This comment made it clear that Mr. Bernanke’s days were numbered.”

Quartz #26—>The Government and the Mob

August 08, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 26th Quartz column, “The US government’s spying is straight out of the mob’s playbook,” now brought home to supplysideliberal.com. It was first published on July 4, 2013. Links to all my other columns can be found here. My preferred title above better represents my broader theme: what governments need to do to foster economic growth.

I pitched this column to my editors as an Independence Day column. I am proud of our American experiment: attempting government of the people, by the people, and for the people. This column is about the principles behind that American experiment, from an economic perspective.

© July 4, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Reading Ben Zimmer’s “How to talk like Whitey Bulger: Mobster lingo gets its day in court“ in the International Herald Tribune provided by the hotel during my recent stay in Tokyo reminded me of my litany of the basics the government must provide to make anything close to market efficiency possible:

blocking theft,
blocking deception,
blocking threats of violence.

Let me give two examples of what I have written in this vein. The first is from “So You Want to Save the World“:

If someone’s overall objective is evil or self-serving, the only way what they do will have a good effect on the world is if all their attempts to get their way by harming others are forestalled by careful social engineering. It is exactly such social engineering to prevent people from stealing, deceiving, or threatening violence that yields the good results from free markets that Adam Smith talks about in The Wealth of Nations—the book that got modern economics off the ground.

The second is from ”Leveling Up: Making the Transition from Poor Country to Rich Country“:

The entry levels in the quest to become a rich country are the hardest. The basic problem is that any government strong enough to stop people from stealing from each other, deceiving each other, and threatening each other with violence, is itself strong enough to steal, deceive, and threaten with violence. Designing strong but limited government that will prevent theft, deceit, and threats of violence, without perpetrating theft, deceit, and threats of violence at a horrific level is quite a difficult trick that most countries throughout history have not managed to perform.

“How to talk like Whitey Bulger: Mobster lingo gets its day in court“ describes the example I have in mind when I write about “threats of violence”:

Charging “rent” is extorting money from business owners under the threat of violence.

I have thought about whether I should include actual violence in the list, but decided that, with only a few exceptions, the motivations for violence boil down to either theft or being able to provide some credibility for one’s threats of violence.

Deception covers a wide range of destructive activities. The idea that the free market requires tolerance of corporate deception is itself a big lie. Even routine secrets have a measure of deception to them, and as Sissela Bok demonstrates in her book Secrets: On the Ethics of Concealment and Revelation, the ethical justification for keeping secrets is much trickier than many people think.

Blackmail presents an interesting case that doesn’t quite fit my litany: the threat to reveal deception is used to distort the deceiver’s behavior. But there is an element of deception in such a revelation, since the selective revelation of one person’s secrets and not the secrets of others makes the person whose secret is revealed look much worse than if all secrets were revealed. I think I would fare very well if the day ever came that Jesus predicted when he said:

For there is nothing hidden that will not be disclosed, and nothing concealed that will not be known or brought out into the open. (Luke 8:17)

But I have no doubt that if someone revealed all of my secrets, while everyone else got to keep theirs, I could be made to look very bad.

The possibility that threats of selective revelation of secrets could be used by members of the government to blackmail others—or to deceive the public about the relative merits of different individuals—is the most serious concern raised by government spying. That is why I join Max Frankel in advocating that government spying be overseen not by judges in their spare time, but by a dedicated court whose judges can develop special expertise, with lawyers who have high-level security clearance given the task of representing the interests of those whose communications are being monitored, whether directly or indirectly. Frankel said it this way in his New York Times editorial ”Where did our ‘inalienable rights’ go?“:

Despite the predilections of federal judges to defer to the executive branch, I think in the long run we have no choice but to entrust our freedom to them. But the secret world of intelligence demands its own special, permanent court, like the United States Tax Court, whose members are confirmed by the Senate for terms that allow them to become real experts in the subject. Such a court should inform the public about the nature of its cases and its record of approvals and denials. Most important, it should summon special attorneys to test the government’s secret evidence in every case, so that a full court hears a genuine adversarial debate before intruding on a citizen’s civil rights. That, too, might cost a little time in some crisis. There’s no escaping the fact that freedom is expensive.

If modern technology makes it harder to keep secrets in general, I think that is all to the good. People usually behave better when they believe that their actions could become known. (See for example this TedEducation talk by Jeff Hancock, “The Future of Lying,” which reports evidence that people are more honest online than offline.) Those overthrowing tyrants may benefit from secrecy in putting together their revolutions, but tyrants need secrecy even more. So a general decline in the ability to keep secrets is likely to be a net plus even there.

Above, I pointed out the fundamental problem of political economy:

… any government strong enough to stop people from stealing from each other, deceiving each other, and threatening each other with violence, is itself strong enough to steal, deceive, and threaten with violence.

Although it pains me to say so, the literature on economic growth (see for example Pranab Bardhan’s Journal of Economic Literature survey article ”Corruption and Development: A Review of the Issues“) argues that centralized corruption by a strong but evil state can yield better economic outcomes than decentralized corruption by many local mob bosses or warlords. Nevertheless, I believe the elimination of tyrants and the progress of democracy throughout the world will be one of the most important contributors to human welfare in the coming decades. May those of us who enjoy the blessings of democracy be willing to make the sacrifices that could be necessary to help others enjoy that blessing. And may all nations add to democracy all of the other restraints on government necessary to make government our servant rather than our master.

Quartz #25—>Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data?

July 14, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 25th Quartz column, that I coauthored with Yichuan Wang, “Autopsy: Economists looked even closer at Reinhart and Rogoff’s data–and the results might surprise you.” It is now brought home to supplysideliberal.com (and soon to Yichuan’s Synthenomics). It was first published on May 14, 2013. Links to all my other columns can be found here.

© June 12, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

(Yichuan has agreed to extend permission on the same terms that I do.)

In order to predict the future, the ancient Romans would often sacrifice an animal, open up its guts and look closely at its entrails. Since the discovery of an Excel spreadsheet error in Carmen Reinhart and Ken Rogoff’s analysis of debt and growth by University of Massachusetts at Amherst graduate student Thomas Herndon and his professors Michael Ash and Robert Pollin, many economists have taken a cue from the Romans with the Reinhart and Rogoff data to see if there is any hint of an effect of high levels of national debt on economic growth. The two of us gave our first take in analyzing the Reinhart and Rogoff data in our May 29, 2013 column. We wrote that “…we could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.”

Our further analysis since then (here, and here), and University of Massachusetts at Amherst Professor Arindrajit Dube’s analysis since then and full release of his previous work (here, here, and here) in response to our column have only confirmed that view. (Links to other reactions to our earlier column can be found here.) Indeed, although we have found no shred of evidence for a negative effect of government debt on growth in the Reinhart and Rogoff data, the two of us have found at least a mirage of a positive effect of debt on growth, as shown in the graph above.

The point of the graph at the top is to find out if the ratio of debt has any relationship to GDP growth, after isolating the part of GDP growth that can’t be predicted by past GDP growth alone. Let us give two examples of why it might be important to adjust for past growth rates when looking at the effect of debt on growth. First, if a country is run badly in other ways, is likely to grow slowly whatever its level of debt. In order to see if debt makes things worse, it is crucial to adjust for the fact that it was growing slowly to begin with. Second, if a country is run well, it is likely to grow fast while it is in the “catch-up” phase of copying proven techniques from other countries. Then as it gets closer to the technological frontier, its growth will naturally slow down. If getting richer in this way also tends to lead through typical political dynamics to a larger welfare state with higher levels of debt, one would see high levels of debt during that later mature phase of slower growth. This is not debt causing slow growth, but economic development having two separate effects: the slowdown in growth as a country nears the technological frontier, and the development of a welfare state. Adjusting for past growth helps us adjust for how far along a country is in its growth trajectory.

In the graph, if “GDP Growth Relative to Par” is positive, it means GDP growth is higher in the next 10 years than would be predicted by past GDP growth alone. If “GDP Growth Relative to Par” is negative, it means GDP growth is lower in the next 10 years than would be predicted by past GDP growth. (Here, in accounting for the effect of past GDP growth, we use data on the most recent five past years individually, and the average growth rate over the period from 10 years in the past to five years in the past.) The thick red line shows that, overall, high debt is associated with GDP growth just a little higher than what one would guess from looking at the past record of GDP growth alone. The thick blue curve gives more detail by showing in a flexible way what levels of debt are associated with above par growth and what levels of debt are associated with below par growth. We generated it with standard scatterplot smoothing techniques. The thick blue curve shows that, in particular, GDP growth seems surprisingly high in the range from debt about 60% of GDP to debt about 120% of GDP. Higher and lower debt levels are associated with future growth that is somewhat lower than would be predicted by looking at past growth alone. Interestingly, debt at 90% of GDP, instead of being a cliff beyond which the growth performance looks much worse, looks like the top of a gently rounded hill. If one took the tiny bit of evidence here much, much more seriously than we do, it would suggest that debt below 90% of GDP is just as bad as debt above 90% of GDP, but that neither is very bad.

Where does the evidence of above par growth in the range from 60% to 120% of GDP come from? Part of the answer is Ireland. In particular, all but one of the cases when GDP growth was more than 2.5% per year above what would be expected from looking at past growth occurred in a 10-year period after Ireland had a debt to GDP ratio in the range from 60% to 120% of GDP. It is well-known that Ireland has recently gotten into trouble because of its debt, but what does the overall picture of its growth performance over the last few decades look like? Here is a graph of Ireland’s per capita GDP from the Federal Reserve Bank of St. Louis data base:

The consequences of debt have reversed some of Ireland’s previous growth, but it is still a growth success story, despite the high levels of debt it had in the 1980s and ’90s.

In addition to Ireland, a bit of the evidence for good growth performance following high levels of debt comes from Greece. As the graph below shows, Greece has had more impressive growth in the last two decades than many people realize, despite the hit it has taken recently because of its debt troubles.

We did a simple exercise to see if the bump up in the thick blue curve in the graph at the top is entirely due to Ireland’s and Greece’s growth that has been reversed recently because of their debt troubles. To be sure that the bad consequences of Ireland’s and Greece’s debt for GDP in the last few years were accounted for when looking at the effect of debt on growth, we pretended that the recent declines in GDP had been spread out as a drag on growth over the period from 1990 to 2007 instead of happening in the last few years. Then we redid our analysis. Making this adjustment to the growth data is a simple, if ad hoc, way of trying to make sure that the consequences of Irish and Greek debt are not missed by the analysis.

Imagining slower growth earlier on to account for Ireland’s and Greece’s recent GDP declines makes the performance of Ireland and Greece in that period from 1990 to 2007 look less stellar. The key effect is on the thick blue curve estimating the effect of debt on growth. Looking closely at the graph below after adjusting Ireland’s and Greece’s growth rates, you can see that the bump up in the thick blue curve in the range where debt is between 60% and 120% of GDP has been cut down to size, but it is still there. So the bump cannot be attributed entirely to Ireland and Greece “stealing growth from the future” with their high levels of debt.

We want to stress that there is no real justification for making the adjustment for Ireland and Greece that we made except as a way of showing that the argument that Ireland and Greece had high growth in the 1990s and early 2000s, but now have had to pay the piper is not enough to turn the story about the effects of debt on growth around.

There are three broader points to make from this discussion of Ireland and Greece.

We still don’t recommend taking the upward bump in growth predicted by the thick blue curves in the 60% to 120% ranges for debt seriously.
The fact that looking at the experience of two countries in two decades can account for a good share of the bump up in the 60% to 120% ranges illustrates just how little there is to go on from the Reinhart and Rogoff data set. Our scatter plots with the thick blue curves give the impression of more than there really is, because we have dots for growth from 1970 to 1980 and 1971 to 1981 and 1972 to 1982, and so on. And there is no way to escape this kind of issue when the economic forces one is interested have both short-run and long-run effects, and change as slowly over time as levels of national debt do. There are advanced statistical methods for correcting for such issues; the corrections almost always go in the direction of saying that there is less evidence in a set of data than it might seem. Even without being experts ourselves in making those statistical corrections, we feel reasonably confident in saying that the Reinhart and Rogoff data speak very softly about any positive or negative effect of debt on growth at all: barely a whisper.
Third, the inclusion of Ireland and Greece and the fact that the basic story survives after pretending their GDP declines were a drag on growth earlier contradicts to some extent the claim of economics blogger and blog critic Paul Andrews in his post “None the Wiser After Reinhart, Rogoff, et al.” that Reinhart and Rogoff’s data focus on “20 or so of the most healthy economies the world has ever seen.” After adjusting for the hit their economies have taken recently, the inclusion of Ireland and Greece gives some perspective on the effects of debt on the growth of economies that havesubsequently had problems paying for their debt. There could certainly be other economies whose growth is more vulnerable to debt than Ireland and Greece, but to us these seem like exactly the kinds of cases people would have in mind when they argue that one should expect debt to have a negative effect on growth.

Understanding all of this matters because, as Mark Gongloff of Huffington Postwrites:

Reinhart and Rogoff’s 2010 paper, “Growth in a Time of Debt,” … has been used to justify austerity programs around the world. In that paper, and in many other papers, op-ed pieces and congressional testimony over the years, Reinhart and Rogoff have warned that high debt slows down growth, making it a huge problem to be dealt with immediately. The human costs of this error have been enormous.

Even though there are many effective ways to stimulate economies without adding much to their national debt, the primary remedies for sluggish economies that are actually on the table politically are those that do increase national debt, so it matters whether people think debt is damning or think debt is just debt. It is painful enough that debt has to be paid back (with some combination of interest and principal), and high levels of debt may help cause debt crises like those we have seen for Ireland and Greece. But the bottom line from our examination of the entrails is that the omens and portents in the Reinhart and Rogoff data do not back up the argument that debt has a negative effect on economic growth.

Quartz #24—>After Crunching Reinhart and Rogoff's Data, We Found No Evidence High Debt Slows Growth

June 30, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 24th Quartz column, that I coauthored with Yichuan Wang, “After crunching Reinhart and Rogoff’s data, we’ve concluded that high debt does not slow growth.” It is now brought home to supplysideliberal.com (and soon to Yichuan's Synthenomics). It was first published on May 29, 2013. Links to all my other columns can be found here. In particular, don’t miss the follow-up column “Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data?”

© May 29, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

(Yichuan has agreed to extend permission on the same terms that I do.)

This column had a strong response. I have included the text of my companion column, with links to many of the responses after the text of the column itself. (For the comments attached to that companion post, you will still have to go to the original posting.) Other followup posts can be found in my “Short-Run Fiscal Policy” sub-blog.

Leaving aside monetary policy, the textbook Keynesian remedy for recession is to increase government spending or cut taxes. The obvious problem with that is that higher government spending and lower taxes tend to put the government deeper in debt. So the announcement on April 15, 2013 by University of Massachusetts at Amherst economists Thomas Herndon, Michael Ash and Robert Pollin that Carmen Reinhart and Ken Rogoff had made a mistake in their analysis claiming that debt leads to lower economic growth has been big news. Remarkably for a story so wonkish, the tale of Reinhart and Rogoff’s errors even made it onto the Colbert Report. Six weeks later, discussions of Herndon, Ash and Pollin’s challenge to Reinhart and Rogoff continue in earnest in the economics blogosphere, in the Wall Street Journal, and in the New York Times.

In defending the main conclusions of their work, while conceding some errors, Reinhart and Rogoff point out that even after the errors are corrected, there is a substantial negative correlation between debt levels and economic growth. That is a fair description of what Herndon, Ash and Pollin find, as discussed in an earlier Quartz column, “An Economist’s Mea Culpa: I relied on Reinhardt and Rogoff.” But, as mentioned there, and as Reinhart and Rogoff point out in their response to Herndon, Ash and Pollin, there is a key remaining issue of what causes what. It is well known among economists that low growth leads to extra debt because tax revenues go down and spending goes up in a recession. But does debt also cause low growth in a vicious cycle? That is the question.

We wanted to see for ourselves what Reinhart and Rogoff’s data could say about whether high national debt seems to cause low growth. In particular, we wanted to separate the effect of low growth in causing higher debt from any effect of higher debt in causing low growth. There is no way to do this perfectly. But we wanted to make the attempt. We had one key difference in our approach from many of the other analyses of Reinhart and Rogoff’s data: we decided to focus only on long-run effects. This is a way to avoid getting confused by the effects of business cycles such as the Great Recession that we are still recovering from. But one limitation of focusing on long-run effects is that it might leave out one of the more obvious problems with debt: the bond markets might at any time refuse to continue lending except at punitively high interest rates, causing debt crises like that have been faced by Greece, Ireland, and Cyprus, and to a lesser degree Spain and Italy. So far, debt crises like this have been rare for countries that have borrowed in their own currency, but are a serious danger for countries that borrow in a foreign currency or share a currency with many other countries in the euro zone.

Here is what we did to focus on long-run effects: to avoid being confused by business-cycle effects, we looked at the relationship between national debt and growth in the period of time from five to 10 years later. In their paper “Debt Overhangs, Past and Present,” Carmen Reinhart and Ken Rogoff, along with Vincent Reinhart, emphasize that most episodes of high national debt last a long time. That means that if high debt really causes low growth in a slow, corrosive way, we should be able to see high debt now associated with low growth far into the future for the simple reason that high debt now tends to be associated with high debt for quite some time into the future.

Here is the bottom line. Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

The graphs at the top show show our first take at analyzing the Reinhardt and Rogoff data. This first take seemed to indicate a large effect of low economic growth in the past in raising debt combined with a smaller, but still very important effect of high debt in lowering later economic growth. On the right panel of the graph above, you can see the strong downward slope that indicates a strong correlation between low growth rates in the period from ten years ago to five years ago with more debt, suggesting that low growth in the past causes high debt. On the left panel of the graph above, you can see the mild downward slope that indicates a weaker correlation between debt and lower growth in the period from five years later to ten years later, suggesting that debt might have some negative effect on growth in the long run. In order to avoid overstating the amount of data available, these graphs have only one dot for each five-year period in the data set. If our further analysis had confirmed these results, we were prepared to argue that the evidence suggested a serious worry about the effects of debt on growth. But the story the graphs above seem to tell dissolves on closer examination.

Given the strong effect past low growth seemed to have on debt, we felt that we needed to take into account the effect of past economic growth rates on debt more carefully when trying to tease out the effects in the other direction, of debt on later growth. Economists often use a technique called multiple regression analysis (or “ordinary least squares”) to take into account the effect of one thing when looking at the effect of something else. Here we are doing something that is quite close both in spirit and the numbers it generates for our analysis, but allows us to use graphs to show what is going on a little better.

The effects of low economic growth in the past may not all come from business cycle effects. It is possible that there are political effects as well, in which a slowly growing pie to be divided makes it harder for different political factions to agree, resulting in deficits. Low growth in the past may also be a sign that a government is incompetent or dysfunctional in some other way that also causes high debt. So the way we took into account the effects of economic growth in the past on debt—and the effects on debt of the level of government competence that past growth may signify—was to look at what level of debt could be predicted by knowing the rates of economic growth from the past year, and in the three-year periods from 10 to 7 years ago, 7 to 4 years ago and 4 to 1 years ago. The graph below, labeled “Prediction of Debt Based on Past Growth” shows that knowing these various economic growth rates over the past 10 years helps a lot in predicting how high the ratio of national debt to GDP will be on a year by year basis. (Doing things on a year by year basis gives the best prediction, but means the graph has five times as many dots as the other scatter plots.) The “Prediction of Debt Based on Past Growth” graph shows that some countries, at some times, have debt above what one would expect based on past growth and some countries have debt below what one would expect based on past growth. If higher debt causes lower growth, then national debt beyond what could be predicted by past economic growth should be bad for future growth.

Our next graph below, labeled “Relationship Between Future Growth and Excess Debt to GDP” shows the relationship between a debt to GDP ratio beyond what would be predicted by past growth and economic growth 5 to 10 years later. Here there is no downward slope at all. In fact there is a small upward slope. This was surprising enough that we asked others we knew to see what they found when trying our basic approach. They bear no responsibility for our interpretation of the analysis here, but Owen Zidar, an economics graduate student at the University of California, Berkeley, and Daniel Weagley, graduate student in finance at the University of Michigan were generous enough to analyze the data from our angle to help alert us if they found we were dramatically off course and to suggest various ways to handle details. (In addition, Yu She, a student in the master’s of applied economics program at the University of Michigan proofread our computer code.) We have no doubt that someone could use a slightly different data set or tweak the analysis enough to make the small upward slope into a small downward slope. But the fact that we got a small upward slope so easily (on our first try with this approach of controlling for past growth more carefully) means that there is no robust evidence in the Reinhart and Rogoff data set for a negative long-run effect of debt on future growth once the effects of past growth on debt are taken into account. (We still get an upward slope when we do things on a year-by-year basis instead of looking at non-overlapping five-year growth periods.)

Daniel Weagley raised a very interesting issue that the very slight upward slope shown for the “Relationship Between Future Growth and Excess Debt to GDP” is composed of two different kinds of evidence. Times when countries in the data set, on average, have higher debt than would be predicted tend to be associated with higher growth in the period from five to 10 years later. But at any time, countries that have debt that is unexpectedly high not only compared to their own past growth, but also compared to the unexpected debt of other countries at that time, do indeed tend to have lower growth five to 10 years later. It is only speculating, but this is what one might expect if the main mechanism for long-run effects of debt on growth is more of the short-run effect we mentioned above: the danger that the “bond market vigilantes” will start demanding high interest rates. It is hard for the bond market vigilantes to take their money out of all government bonds everywhere in the world, so having debt that looks high compared to other countries at any given time might be what matters most.

Our view is that evidence from trends in the average level of debt around the world over time are just as instructive as evidence from the cross-national evidence from debt in one country being higher than in other countries at a given time. Our last graph (just above) shows what the evidence from trends in average levels over time looks like. High debt levels in the late 1940s and the 1950s were followed five to 10 years later with relatively high growth. Low debt levels in the 1960s and 1970s were followed five to 10 years later by relatively low growth. High debt levels in the 1980s and 1990s were followed five to 10 years later by relatively high growth. If anyone can come up with a good argument for why this evidence from trends in the average levels over time should be dismissed, then only the cross-national evidence about debt in one country compared to another would remain, which by itself makes debt look bad for growth. But we argue that there is not enough justification to say that special occurrences each year make the evidence from trends in the average levels over time worthless. (Technically, we don’t think it is appropriate to use “year fixed effects” to soak up and throw away evidence from those trends over time in the average level of debt around the world.)

We don’t want anyone to take away the message that high levels of national debt are a matter of no concern. As discussed in “Why Austerity Budgets Won’t Save Your Economy,” the big problem with debt is that the only ways to avoid paying it back or paying interest on it forever are national bankruptcy or hyper-inflation. And unless the borrowed money is spent in ways that foster economic growth in a big way, paying it back or paying interest on it forever will mean future pain in the form of higher taxes or lower spending.

There is very little evidence that spending borrowed money on conventional Keynesian stimulus—spent in the ways dictated by what has become normal politics in the US, Europe and Japan—(or the kinds of tax cuts typically proposed) can stimulate the economy enough to avoid having to raise taxes or cut spending in the future to pay the debt back. There are three main ways to use debt to increase growth enough to avoid having to raise taxes or cut spending later:

1. Spending on national investments that have a very high return, such as in scientific research, fixing roads or bridges that have been sorely neglected.
2. Using government support to catalyze private borrowing by firms and households, such as government support for student loans, and temporary investment tax credits or Federal Lines of Credit to households used as a stimulus measure.
3. Issuing debt to create a sovereign wealth fund—that is, putting the money into the corporate stock and bond markets instead of spending it, as discussed in “Why the US needs its own sovereign wealth fund.” For anyone who thinks government debt is important as a form of collateral for private firms (see “How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets”), this is the way to get those benefits of debt, while earning more interest and dividends for tax payers than the extra debt costs. And a sovereign wealth fund (like breaking through the zero lower bound with electronic money) makes the tilt of governments toward short-term financing caused by current quantitative easing policies unnecessary.

But even if debt is used in ways that do require higher taxes or lower spending in the future, it may sometimes be worth it. If a country has its own currency, and borrows using appropriate long-term debt (so it only has to refinance a small fraction of the debt each year) the danger from bond market vigilantes can be kept to a minimum. And other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt. We look forward to further evidence and further thinking on the effects of debt. But our bottom line from this analysis, and the thinking we have been able to articulate above, is this: Done carefully, debt is not damning. Debt is just debt.

Companion Post

The title chosen by our editor is too strong, but not so much so that I objected to it; the title of this post is more accurate.

Yichuan only recently finished his first year at the University of Michigan. Yichuan’s blog is Synthenomics. You can see Yichuan on Twitter here. Let me say already that from reading Yichuan’s blog and working with him on this column, I know enough to strongly recommend Yichuan for admission to any Ph.D. program in economics in the world. He should finish has bachelor’s degree first, though.

I genuinely went into our analysis expecting to find evidence that high debt does cause low growth, though of course, to a much smaller extent than low growth causes high debt. I was fully prepared to argue (first to Yichuan and then to the world) that even a statistically insignificant negative effect of debt on growth that was plausibly causal had to be taken seriously from a Bayesian perspective. Our analysis set out the minimal hurdles I felt had to be jumped over to convince me that there was some solid evidence that high debt causes low growth. A key jump was not completed. That shifted my views.

I hope others will try to replicate our findings. That should let me rest easier.

From a theoretical point of view, I am especially intrigued by the possibility that any effect on growth from refinancing difficulties might depend on a country’s debt to GDP ratio compared to that of other countries. What I find remarkable is that despite the likely negative effect of debt on growth from refinancing difficulties, we found no overall negative effect of debt on growth. It is as if there is some other, positive effect of debt on growth to the extent a country’s relative debt position stays the same. Besides the obvious, but uncommonly realized, possibility of very wisely deployed deficit spending, I can think of two intriguing mechanisms that could generate such an effect. First, from a supply-side point of view, lower tax rates now could make growth look higher now, perhaps at the expense of growth at some future date when taxes have to be raised to pay off the debt, with interest. Second, government debt increases the supply of liquid (and often relatively safe) assets in the economy that can serve as good collateral. Any such effect could be achieved without creating a need for higher future taxes or lower future spending by investing the money raised in corporate stocks and bonds through a sovereign wealth fund.

I have thought a little about why borrowing in a currency one can print unilaterally makes such a difference to the reactions of the bond market to debt. One might think that the danger of repudiating the implied real debt repayment promises by inflation would mean the risks to bondholders for debt in one’s own currency would be almost the same as for debt in a foreign currency or a shared currency like the euro. But it is one thing to fear actual disappointing real repayment spread over some time and another thing to have to fear that the fear of other bondholders will cause a sudden inability of a government to make the next payment at all.

Note: Brad Delong writes:

Miles Kimball and Yichuan Wang confirm Arin Dube: Guest Post: Reinhart/Rogoff and Growth in a Time Before Debt | Next New Deal:

As I tweeted,

.@delong undersells our results. I would have read Arin Dube’s results alone as saying high debt *does* slow growth.
*Of course* low growth causes debt in a big way. But we need to know if high debt causes low growth, too. No ev it does!

In tweeting this, I mean,if I were convinced Arin Dube’s left graph were causal, the left graph seems to suggest that higher debt causes low growth in a very important way, though of course not in as big a way as slow growth causes higher debt. If it were causal, the left graph suggests it is the first 30% on the debt to GDP ratio that has the biggest effect on growth, not any 90% threshold. Yichuan and I are saying that the seeming effect of the first 30% on the debt to GDP ratio could be due in important measure to the effect of growth on debt, plus some serial correlation in growth rates. The nonlinearity could come from the fact that it takes quite high growth rates to keep a country from have some significant amounts of debt—as indicated by Arin Dube’s right graph, which is more likely to be primarily causal.

By the way, I should say that Yichuan and I had seen the Rortybomb piece on Arin Dube’s analysis, but we were not satisfied with it. But I want to give credit for this as a starting place for Yichuan and me in our thinking.

Brad Delong’s Reply: Thanks to Brad DeLong for posting the note above as part of his post “DeLong Smackdown Watch: Miles Kimball Says That Kimball and Wang is Much Stronger than Dube.”

Brad replies:

From my perspective, I tend to say that of course high debt causes low growth—if high debt makes people fearful, and leads to low equity valuations and high interest rates. The question is: what happens in the case of high debt when it comes accompanied by low interest rates and high equity values, whether on its own or via financial repression?
Thus I find Kimball and Wang’s results a little too strong on the high-debt-doesn’t-matter side for me to be entirely comfortable…

My Thoughts about What Brad Says in the Quote Just Above: As I noted above, my reaction is to what we Yichuan and I found is similar to Brad’s. There must be a negative effective of debt on growth through the bond vigilante channel, as Yichuan and I emphasize in our interpretation. For example, in our final paragraph, Yichuan and I write:

…other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt.

The surprise is the pattern that when countries around the world shifted toward higher debt than would be predicted by past growth, that later growth turned out to be somewhat higher than after countries around the world shifted to lower debt. It may be possible to explain why that evidence from trends in the average level of debt around the world over time should be dismissed, but if not, we should try to understand those time series patterns. It is hard to get definitive answers from the relatively small amount of evidence in macroeconomic time series, or even macroeconomic panels across countries, but given the importance of the issues, I think it is worth pondering the meaning of what limited evidence there is from trends in the average level of debt around the world over time. That is particularly true since in the current crisis, many people have, recommended precisely the kind of worldwide increase deficit spending—and therefore debt levels—that this limited evidence speaks to.

I am perfectly comfortable with the idea that the evidence from trends in the average level of debt around the world over time is limited enough so theoretical reasoning that shifts our priors could overwhelm the signal from the data. But I want to see that theoretical reasoning. And I would like to get reactions to my theoretical speculations above, about (1) supply-side benefits of lower taxes that reverse in sign in the future when the debt is paid for and (2) liquidity effects of government debt (which may also have a price later because of financial cycle dynamics).

Matt Yglesias’s Reaction: On MoneyBox, you can see Matthew Yglesias’s piece “After Running the Numbers Carefully There’s No Evidence that High Debt Levels Cause Slow Growth.” As I tweeted:

Don’t miss this excellent piece by @mattyglesias about my column with @yichuanw on debt and growth. Matt gets it.

In the preamble of my post bringing the full text of “An Economist’s Mea Culpa: I Relied on Reihnart and Rogoff" home to supplysideliberal.com, I write:

In terms of what Carmen Reinhart and Ken Rogoff should have done that they didn’t do, “Be very careful to double-check for mistakes” is obvious. But on consideration, I also felt dismayed that they didn’t do a bit more analysis on their data early on to make a rudimentary attempt to answer the question of causality. I wouldn’t have said it quite as strongly as Matthew Yglesias, but the sentiment is basically the same.

Paul Krugman’s Reaction: On his blog, Paul Krugman characterized our findings this way:

There is pretty good evidence that the relationship is not, in fact, causal, that low growth mainly causes high debt rather than the other way around.

Kevin Drum’s Reaction: On the Mother Jones blog, Kevin Drum gives a good take on our findings in his post “Debt Doesn’t Cause Low Growth. Low Growth Causes Low Growth.” He notices that we are not fans of debt. I like his version of one of our graphs:

Mark Gongloff’s Reaction: On Huffington Post, Mark Gongloff’s“Reinhart and Rogoff’s Pro-Austerity Research Now Even More Thoroughly Debunked by Studies” writes:

…University of Michigan economics professor Miles Kimball and University of Michigan undergraduate student Yichuan Wang write that they have crunched Reinhart and Rogoff’s data and found “not even a shred of evidence" that high debt levels lead to slower economic growth.
And a new paper by University of Massachusetts professor Arindrajit Dube finds evidence that Reinhart and Rogoff had the relationship between growth and debt backwards: Slow growth appears to cause higher debt, if anything….
This contradicts the conclusion of Reinhart and Rogoff’s 2010 paper, “Growth in a Time of Debt,” which has been used to justify austerity programs around the world. In that paper, and in many other papers, op-ed pieces and congressional testimony over the years, Reinhart And Rogoff have warned that high debt slows down growth, making it a huge problem to be dealt with immediately. The human costs of this error have been enormous….
At the same time, they have tried to distance themselves a bit from the chicken-and-egg problem of whether debt causes slow growth, or vice-versa. "The frontier question for research is the issue of causality,“ [Reinhart and Rogoff] said in their lengthy New York Times piece responding to Herndon. It looks like they should have thought a little harder about that frontier question three years ago.

There is an accompanying video by Zach Carter.

Paul Andrews Raises the Issue of Selection Bias: The most important response to our column that I have seen so far is Paul Andrews’s post "None the Wiser After Reinhart, Rogoff, et al.” This is the kind of response we were hoping for when we wrote “We look forward to further evidence and further thinking on the effects of debt.” Paul trenchantly points out the potential importance of selection bias:

What has not been highlighted though is that the Reinhart and Rogoff correlation as it stands now is potentially massively understated. Why? Due to selection bias, and the lack of a proper treatment of the nastiest effects of high debt: debt defaults and currency crises.
The Reinhart and Rogoff correlation is potentially artificially low due to selection bias. The core of their study focuses on 20 or so of the most healthy economies the world has ever seen. A random sampling of all economies would produce a more realistic correlation. Even this would entail a significant selection bias as there is likely to be a high correlation between countries who default on their debt and countries who fail to keep proper statistics.
Furthermore Reinhart and Rogoff’s study does not contain adjustments for debt defaults or currency crises. Any examples of debt defaults just show in the data as reductions in debt. So, if a country ran up massive debt, could’t pay it back, and defaulted, no problem! Debt goes to a lower figure, the ruinous effects of the run-up in debt is ignored. Any low growth ensuing from the default doesn’t look like it was caused by debt, because the debt no longer exists!

I think this issue needs to be taken very seriously. It would be a great public service for someone to put together the needed data set.

Note that Paul Andrews views are in line with our interpretation of our findings. Let me repeat our interpretation, with added emphasis:

…other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt.

Of course, it is disruptive to have a national bankruptcy. And national bankruptcies are more likely to happen at high levels of debt than low levels of debt (though other things matter as well, such as the efficiency of a nation’s tax system). And the fear by bondholders of a national bankruptcy can raise interest rates on government bonds in a way that can be very costly for a country. The key question for which the existing Reinhart and Rogoff data set is reasonably appropriate is the question of whether an advanced country has anything to fear from debt even if, for that particular country, no one ever seriously doubts that country will continue to pay on its debts.

Quartz #23—>QE or Not QE: Even Economists Need Lessons in Quantitative Easing, Bernanke Style

June 18, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 23d Quartz column, “QE or Not QE: Even Economists need lessons in quantitative easing, Bernanke style,” now brought home to supplysideliberal.com. It was first published on May 14, 2013. Links to all my other columns can be found here.

© May 14, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Martin Feldstein is an eminent economist. In addition to being a prolific researcher, he served as head of US president Ronald Reagan’s Council of Economic Advisors, and made the National Bureau of Economic Research (NBER) what it is today—an institution that Paul Krugman called “the old-boy network of economics made flesh.” (I am one of the many economists who belongs to the NBER.) But Feldstein was wrong when he wrote in the Wall Street Journal last week, “The time has come for the Fed to recognize that it cannot stimulate growth,” in an op-ed headlined “The Federal Reserve’s Policy Dead End: Quantitative easing hasn’t led to faster growth. A better recovery depends on the White House and Congress.”

“Quantitative easing” or “QE” is when a central bank buys long-term or risky assets instead of purchasing short-term safe assets. One possible spark for Feldstein’s tirade against quantitative easing was the Fed’s announcement on May 1 that it “is prepared to increase or reduce the pace of its purchases” of long-term government bonds and mortgage-backed securities depending on the economic situation. This contrasts with the Fed’s announcement on March 20 that had only pledged as if the Fed would either keep the rate of purchases the same or scale them back, depending on circumstances. Philadelphia Fed Chief Charles Plosser described this as the Fed trying “to remind everybody” that it “has a dial that can move either way.”

So the Fed sounds more ready to turn to QE when needed than it did before.

Feldstein’s argument boils down to saying, “The Fed has done a lot of QE, but we are still hurting, economically. Therefore, QE has failed.” But here he misunderstands the way QE works. The special nature of QE means that the headline dollar figures for quantitative easing overstate how big a hammer any given program of QE is. Once one adjusts for the optical illusion that the headline dollar figures create for QE, there is no reason to think QE has a different effect than one should have expected. To explain why, let me lay out again the logic of one of the very first posts on my blog, “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy.” In that post I responded to Stephen Williamson, who misunderstood QE (or “balance sheet monetary policy,” as I call it there) in a way similar to Martin Feldstein.

To understand QE, it helps to focus on interest rates rather than quantities of assets purchased. Regular monetary policy operates by lowering safe short-term interest rates, and so pulling down the whole structure of interest rates: short-term, long-term, safe and risky. The trouble is that there is one safe interest rate that can’t be pulled down without a substantial reform to our monetary system: the zero interest rate on paper currency. (See “E-Money: How Paper Currency is Holding the US Recovery Back.”) There is no problem pulling other short-term safe interest rates (say on overnight loans between banks or on 3-month Treasury bills) down to that level of zero, but trying to lower other short-term safe rates below zero would just cause people to keep piles of paper currency to take advantage of the current government guarantee that you can get a zero interest rate on paper currency, which is higher than a negative interest rate.

As long as the zero interest rate on paper currency is left in place by the way we handle paper currency, the Fed’s inability to lower safe, short-term interest rates much below zero means that beyond a certain point it can’t use regular monetary policy to stimulate the economy any more. Once the Fed has hit the “zero lower bound,” it has to get more creative. What quantitative easing does is to compress—that is, squish down—the degree to which long-term and risky interest rates are higher than safe, short-term interest rates. The degree to which one interest rate is above another is called a “spread.” So what quantitative easing does is to squish down spreads. Since all interest rates matter for economic activity, if safe short-term interest rates stay at about zero, while long-term and risky interest rates get pushed down closer to zero, it will stimulate the economy. When firms and households borrow, the markets treat their debt as risky. And firms and households often want to borrow long term. So reducing risky and long-term interest rates makes it less expensive to borrow to buy equipment, hire coders to write software, build a factory, or build a house.

Some of the confusion around quantitative easing comes from the fact that in the kind of economic models that come most naturally to economists, in which everyone in sight is making perfect, deeply-insightful decisions given their situation, and financial traders can easily borrow as much as they want to, quantitative easing would have no effect. In those “frictionless” models, financial traders would just do the opposite of whatever the Fed does with quantitative easing, and cancel out all the effects. But it is important to understand that in these frictionless models where quantitative easing gets cancelled out, it has no important effects. Because in the frictionless models quantitative easing gets canceled out, it doesn’t stimulate the economy. But because in the frictionless models quantitative easing gets cancelled out it has no important effects. In the world where quantitative easing does nothing, it also has no side effects and no dangers. Any possible dangers of quantitative easing only occur in a world where quantitative easing actually works to stimulate the economy!

Now it should not surprise anyone that the world we live in does have frictions. People in financial markets do not always make perfect, deeply-insightful decisions: they often do nothing when they should have done something, and something when they should have done nothing. And financial traders cannot always borrow as much as they want, for as long as they want, to execute their bets against the Fed, as Berkeley professor and prominent economics blogger Brad DeLong explains entertainingly and effectively in “Moby Ben, or, the Washington Super-Whale: Hedge Fundies, the Federal Reserve, and Bernanke-Hatred.” But there is an important message in the way quantitative easing gets canceled out in frictionless economic models. Even in the real world, large doses of quantitative easing are needed to get the job done, since real-world financial traders do manage to counteract some of the effects of quantitative easing as they go about their normal business of trying to make good returns. And “large doses” means Fed purchases of long-term government bonds and mortgage-backed bonds that run into trillions and trillions of dollars. (As I discuss in “Why the US Needs Its Own Sovereign Wealth Fund,” quantitative easing would be more powerful if it involved buying corporate stocks and bonds instead of only long-term government bonds and mortgage-backed bonds.) It would have been a good idea for the Fed to do two or three times as much quantitative easing as it did early on in the recession, though there are currently enough signs of economic revival that it is unclear how much bigger the appropriate dosage is now.

Does QE work? Most academic and central bank analyses argue that it does. (See for example, work by Arvind Krishnamurthy and Annette Vising-Jorgenson of Northwestern University, and work by Signe Krogstrup, Samuel Reynard and Barbara Sutter of the Swiss National Bank. ) But I am also impressed by the decline in the yen since people began to believe that Japan would undertake an aggressive new round of QE. One yen is an aluminum coin that can float on the surface tension of water. Since September, it has floated down from being worth 1.25 cents (US) to less than a penny now. Exchange rates respond to interest rates, so the large fall in the yen is a strong hint that QE is working for Japan, as I predicted it would when I advocated massive QE for Japan back in June 2012.

Sometimes friction is a negative thing—something that engineers fight with grease and ball bearings. But if you are walking on ice across a frozen river, the little bit of friction still there between your boots and the ice allow you to get to the other side. It takes a lot of doing, but quantitative easing uses what friction there is in financial markets to help get us past our economic troubles. The folks at the Fed are not perfect, but they know how quantitative easing works better than Martin Feldstein does. If we had to depend on the White House and Congress for economic recovery, we would be in deep, deep trouble. It is a good thing we have the Fed.

Quartz #22—>An Economist's Mea Culpa: I Relied on Reinhart and Rogoff

June 02, 2013 by Miles Kimball

blog.supplysideliberal.com tumblr_inline_mnskj3mUg61qz4rgp.png

Link to the Column on Quartz

Here is the full text of my 22d Quartz column, “An Economist’s Mea Culpa: I Relied on Reinhart and Rogoff," now brought home to supplysideliberal.com. The comments I made when I first flagged this column on my blog now seem outdated. You would be better advised to read my post "After Crunching Reinhart and Rogoff’s Data, We Found No Evidence that High Debt Slows Growth” and the Quartz column I wrote with Yichuan Wang that it links to. Yichuan and I plan another follow-up post to that very soon. Note that the argument below about debt raising interest rates for countries that do not have their own currency still stands, and has been amplified by Paul Andrews here, though the other worries I mention based on the Reinhart and Rogoff data set have been allayed.

I hope you notice the allusions to incentives and mechanism design below. In terms of what Carmen Reinhart and Ken Rogoff should have done that they didn’t do, “Be very careful to double-check for mistakes” is obvious. But on consideration, I also felt dismayed that they didn’t do a bit more analysis on their data early on to make a rudimentary attempt to answer the question of causality. I wouldn’t have said it quite as strongly as Matthew Yglesias, but the sentiment is basically the same.

© April 20, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Ken Rogoff is an economist who has always been kind to me, and for whom I have deep respect. And I have no animus toward Carmen Reinhart. Nevertheless, I hope there has been a nightmarish quality to the last few days of what Quartz writer Matt Phillips called a “bone-crunching social media pile-on that Harvard economists Ken Rogoff and Carmen Reinhart received in recent days after some other researchers questioned their influential findings that high government debt is a drag on economic growth.” I say this because I know from my own experience as a researcher how powerfully the hint of such an embarrassment motivates economists and other researchers to sweat the details to get things right. Some errors will always slip through the cracks, but a researcher ought to live in mortal fear of a contretemps like that Reinhart and Rogoff have found themselves in this week.

Reinhart and Rogoff have not only caused embarrassment for themselves, but also for all those who have in any way relied on their results. Those who made their case by overinterpreting the particular results that have now been discredited should be the most embarrassed. Quartz’s Tim Fernholz gives a rundown of politicians and other policy makers who relied heavily on Reinhart and Rogoff’s results in “How influential was the Reinhart and Rogoff study warning that high debt kills growth?”

But I, like many others, have relied on Reinhart and Rogoff’s results in smaller ways—and wish this embarrassment on myself as a warning for the future. No one is perfect, but it is important not to undercut the motivation to be careful by softening the penalty for error too much. I am lucky I can heal the damage; I have fully updated the argument I made based on Reinhart and Rogoff’s results in my column “What Paul Krugman got wrong about Italy’s economy” in a way that I think leaves the force of the overall argument in that column intact. Here in full, is the new passage, which also gives my view of the substantive issue that Reinhart and Rogoff have now occasioned so much confusion about:

And despite the recent revelation of errors in Carmen Reinhart and Ken Rogoff’s famous study of debt levels and economic growth, which I discuss here and which motivated the update you are reading (the original passage can be found here), there are reasons to think that high levels of debt are worth worrying about.
First, for a country like Italy that does not have its own currency (since it shares the euro with many other countries), Paul Krugman’s own graph shows a correlation between national debt as a percentage of GDP and the interest rate that a country pays.
Second, the paper by Thomas Herndon, Michael Ash and Robert Pollin that criticizes Reinhart and Rogoff finds that, on average, growth rates do decline with debt levels. Divide debt levels into medium high (60% to 90% of GDP), high (90% to 120% of GDP), and very high (above 120% of GDP). Then the growth rates are 3.2% with medium-high debt, 2.4% with high debt, and 1.4% with very high debt. (I got these numbers by combining the 4.2% growth rate for countries in the 0 to 30% debt-to-GDP ratio range from Table 3 with the estimates in Table 4 for how things are different at higher debt levels.) Moreover, contrary to the impression one would get from the column here, Herndon, Ash and Pollin’s Table 4 indicates that the differences between low levels of debt and high levels of debt are not just due to chance, though what Herndon, Ash and Pollin emphasize is that very low levels of debt, below 30% of GDP, have a strong association with higher growth rates. Overall, with the data we have, we don’t know what causes what, so there is no definitive answer to how much we should worry about debt, but ample reason not to treat debt as if it were a nothing. [For a more recent reassessment of that evidence, see my post “After Crunching Reinhart and Rogoff’s Data, We Found No Evidence that High Debt Slows Growth” and the Quartz column I wrote with Yichuan Wang that it links to.]

There is definitely a reasonable case to be made that if additional spending or tax cuts are the only way to stimulate the economy, then we should do it even at the cost of additional debt. But as I argue both in “What Paul Krugman got wrong about Italy’s economy” and in “Why austerity budgets won’t save your economy,” there are ways to stimulate the economy without adding to its debt burden, and stimulating the economy in a way that doesn’t add substantially to the national debt is better than stimulating the economy in a way that does.

Unlike what many politicians would do in similar circumstances, Reinhart and Rogoff have been forthright in admitting their errors. (See Chris Cook’s Financial Times post, “Reinhart and Rogoff Recrunch the Numbers.”) They also used their response to put forward their best argument that correcting the errors does not change their bottom line. Given the number of bloggers arguing the opposite case—that Reinhart and Rogoff’s bottom line has been destroyed—it is actually helpful for them to make their case in what has become an adversarial situation, despite their self-justifying motivation for doing so. And though I see a self-justifying motivation, I find it credible that Reinhart and Rogoff’s original error did not arise from political motivations, since as they note in their response, of their two major claims—(1) debt hurts growth and (2) economic slumps typically last a long time after a financial crisis—the claim that debt hurts growth is congenial to Republicans, while the claim that it is normal for slumps to last a long time after a financial crisis is congenial to Democrats. But it hurt the nation’s decision-making process when the true statement, that we should be worried high levels of national debt might have a negative effect on growth, was mangled into the idea that a debt-to-GDP ratio of 90% is a critical threshold for the effects of debt on the economy—an idea that gained the traction it did because of Reinhart and Rogoff’s mistake.

Quartz #21—>Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere?

May 17, 2013 by Miles Kimball

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Link to the Column on Quartz

Here is the full text of my 21st Quartz column, “This economic theory was born in the blogosphere and could save markets from collapse,” now brought home to supplysideliberal.com and given my preferred title. (I am now up-to-date bringing home to supplysideliberal.com all of my columns that are past the 30-day exclusive I give Quartz by contract.)

Even before I started blogging, Noah Smith told me I should write a post about NGDP targeting. This is that post. And it is also the post on “Optimal Monetary Policy” that I have been promising for some time. It was first published on February 22, 2013. Links to all my other columns can be found here.

© February 22, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The most important equation in economics

Much of the history of economics can be traced by the contents of its best-selling textbooks. In 1848, John Stuart Mill published the blockbuster economics textbook of the 19th century: Principles of Political Economy. A century later, in 1948, Paul Samuelson—the very first American Nobel laureate in economics, who more than anyone else made economics the mathematical subject it is today—popularized Keynesian economics in the best-selling economics textbook of all time, Economics: An Introductory Analysis. This past year, in my classroom, I taught from one of the two best and most popular introductory economics textbooks, Brief Principles of Macroeconomics authored by Greg Mankiw—chair of the economics department at Harvard, former chair of the president’s Council of Economic Advisors, and my graduate school advisor.

One constant in all of these textbooks is an equation as famous for economics as E=MC2 is for physics—an equation suitable for an economist’s vanity license plate: MV=PY.

As E=MC2 is the key to understanding nuclear weapons and nuclear power, the “equation of exchange” MV=PY is the key to understanding monetary policy. And for the first major school of economic thought born in the blogosphere, I know of no way to explain their views without invoking this equation. Nerdily charismatic, they call themselves “market monetarists,” but it is easier to identify them by their attribution of almost mystical powers to maintaining a steady growth rate of both sides of this equation. Let me try to explain why the equation MV=PY is so important.

One way to read MV=PY is: Velocity adjusted money equals nominal GDP.

M is the money supply.
V is the “velocity” of money or how hard money works.
So M times V is velocity-adjusted money.
P is the price level: think of the consumer price index, though P would include the prices of other things as well, such as equipment bought by businesses.
Y is real GDP, the amount of goods and services produced by the economy that really matter for our material well-being.
But P times Y is GDP at current prices before adjusting for inflation. GDP before adjusting for inflation is called nominal GDP. PY, that is nominal GDP, can go up either because real GDP goes up (an increase in Y) or because prices go up (an increase in P).

So what the equation of exchange says is: if there is a lot of money in the economy and that money is working hard, then either the economy will have high real GDP (=Y) or high prices (P). On the other hand, if there is not enough money or money is not working very hard, then either real GDP will be low or prices will be low.

Milton Friedman, one of the dominant economists of the 20th century, didn’t write a best-selling economics textbook, but had an enormous influence on policy as a public intellectual. (To celebrate what would have been his 100th birthday last year, I annotated links to many of his best YouTube videos here on my blog. They are still well worth watching.) Friedman played a key role in the US’s switch from a draft to a volunteer military and was the intellectual mastermind behind the school choice movement. As an adviser to president Ronald Reagan, he was the gray eminence of Reaganomics. In monetary policy, Friedman proposed having the money supply (M) grow at a constant rate. Since he thought velocity (V) wouldn’t change much, Friedman was, in effect, advocating a constant growth rate of the velocity-adjusted money supply—and therefore a constant growth rate of nominal GDP. The trouble with this idea is that velocity turned out in later years not to be constant—both because it is affected by interest rates and because it is affected by innovations such as ATM’s. So keeping the money supply (M) growing at a constant rate would cause erratic swings in the velocity-adjusted money supply (MV), and therefore in nominal GDP.

Enter: the market monetarists

So the spirit of Milton Friedman’s proposal is the idea of keeping velocity-adjusted money, and therefore nominal GDP, growing at a constant rate. In a movement that should make Milton Friedman proud (if he can get internet access in heaven), that is exactly what the “market monetarists” advocate. The importance market monetarists put on the idea of keeping nominal GDP growing at a constant rate is readily apparent from the frequency of the abbreviation NGDP for nominal GDP in some of the posts and tweets by Scott Sumner, David Beckworth, and Lars Christensen. One of the best ways to see the value of paying attention to nominal GDP is to look at a graph of nominal GDP over time in the US, using data from the Federal Reserve Bank of St. Louis.

In all the years since 1955, the most striking feature of the graph is the jog down in nominal GDP since the financial crisis in late 2008. Market monetarists take this jog down in GDP since the financial crisis as an indication that monetary policy has not been anywhere near stimulative enough in the aftermath of the financial crisis. In this, they are absolutely right. The reason the graph of nominal GDP shows the stance of monetary policy so well is that too-tight monetary policy drags down both prices (=P) and real GDP (=Y), which both contribute to nominal GDP (=PY) that is low relative to its trend. Conversely, too-loose monetary policy pushes up both prices and real GDP, which both contribute to nominal GDP that is high relative to its trend.

Here is a corresponding graph for the euro zone minus Germany from wunderkind and Wonkbook blogger Evan Soltas:

This graph for Europe focuses on recent years (the trend is shown by the dashed line) and indicates that, while it might have been more nearly okay for Germany, the European Central Bank’s monetary policy has been too tight for the rest of the euro zone.

The graphs show one of the big attractions of market monetarism: with graphs like these it is easy to get a handle on whether monetary policy has been too loose or too tight. Market monetarists go further to say that if the US Federal Reserve and other central banks committed to do whatever it takes to keep nominal GDP on track, then the financial markets listening to that commitment would react in a way that would help to make it happen. In Fed-speak, the market monetarists emphasize communication policy in the form of forward guidance on the track of nominal GDP the Fed or other central bank is aiming for. To know whether the financial markets are getting the message, market monetarists advocate the creation of assets that would provide a market prediction for nominal GDP much as TIPS (Treasury Inflation Protected Securities) provide a market prediction for inflation.

So far, I have emphasized the positive aspects of market monetarism, because I think market monetarism has, in fact, been an important force for good in our current economic troubles. When a crisis scares people into holding back on spending, the best remedy is monetary stimulus, and graphs of nominal GDP, interpreted as a market monetarist would, speak loudly for exactly the needed monetary stimulus.

Evaluating market monetarism

But now I want to step back and question whether market monetarism is the final answer for monetary policy. There are three things that matter for monetary policy: the temptation, the objective if a central bank can resist the temptation, and the toolkit.

The Temptation. The temptation for monetary policy is that, absent a concern about inflation, GDP is chronically too low for at least three reasons: imperfect competition, taxes, and labor market frictions. The trouble is that raising GDP beyond a certain point—a point called the natural level of GDP—does raise inflation. And not only does raising GDP beyond a certain point raise inflation, pushing GDP above the natural level for even a year or two raises the level of inflation permanently. The one way to get rid of that extra inflation is to push GDP below the natural rate for a while. To put things starkly, after the above-natural GDP of the 1960s, we would still have the double-digit inflation of the 1970s if Americans hadn’t suffered through a big recession that put GDP below its natural level during Reagan’s first term in the early 1980’s. We have low inflation today in large measure thanks to the suffering of Americans in the early 1980s.

The objective. “Sinning” by having GDP above the natural level is no fun if it has to be coupled with “repenting” by having GDP below the natural level to avoid having inflation forever higher. There are two reasons the combination of above-natural GDP one year and below-natural GDP another year is a bad deal. First, the pleasure from higher output and employment to workers, to the taxman, and to firms, is not as big as the pain from lower employment. Second, higher output makes inflation go up more readily than lower output brings inflation back down. Put all this together, and the objective is clear: stay at the natural level of output to avoid the bad deals from any other combination of output in different years that keeps inflation from being higher in the end.

Now, let’s translate the objective of staying at the natural level of output into nominal GDP terms. (It is important in the discussion above that I am thinking of inflation primarily in terms of otherwise slow-to-adjust prices going up faster, rather than in terms of slow-to-adjust wages going up faster. My argument for doing that can be found here.) As long as the natural level of output is growing at a steady rate, keeping real GDP on that steady track will also keep inflation and so the rate of increase of prices steady. If both real GDP and prices are growing at a steady rate, then nominal GDP will be growing at a steady rate. So a steady growth rate of nominal GDP is exactly the right target as long as the natural level of output is growing steadily.

But what if new technology makes the natural level of output go up faster, as the digital revolution did from at least 1995 to 2003? Then real GDP should be going up faster to keep inflation steady. And that means that nominal GDP should also be going up faster. Historically, the Fed has not handled its response to unexpected technology improvements very well, as I discuss in another column, but that doesn’t change the fact that the Fed should have had nominal GDP go up faster after unexpectedly large improvements in technology. (Because the Fed actually let nominal GDP go below trend after technology improvements—instead of above trend as it should have—many people ended up not being able to get jobs after technology improvements.)

By the same token, if technology improves more slowly than it normally does, then both real and nominal GDP should be on a lower track to keep inflation steady and avoid the bad deals from pushing inflation up and then having to bring it back down. Some people have claimed that our current economic slump is a reflection of technology growing more slowly, but careful measures of the behavior of technology and a growing body of research by economists show that is at most a small part of what has been going on since the financial crisis that hit in late 2008. Indeed, if all of the below-trend output we have seen in the last few years were due to more slowly improving technology, we would not have seen inflation fall the way it did after the financial crisis.

The toolkit. Even if I can bring my market monetarist friends around to adjusting the nominal GDP target for what is happening with technological progress, I differ from them in thinking that the tools currently at the Fed’s disposal plus clearly communicating a nominal GDP target are not enough to get the desired result. The argument goes as follows. Interest rates are the price of getting stuff—goods and services—now instead of later. If people are out of work, we want customers to buy stuff now by having low interest rates. Thinking about short-term interest rates like the usual federal funds rate target that the Fed uses, the timing of the low interest rates matters. If everyone knows we are going to have low short-term interest rates in 2016, then it encourages buying in the whole period between now and 2016 in preference to buying after 2016. But to get the economy out of the dumps, we really want people to buy right now, not spread out their purchases over 2013, 2014, and 2015. The lower we can push short-term interest rates, the more we can focus the extra spending on 2013, so that we can have full recovery by 2014, without overshooting and having too much spending in 2015. This is an issue that economist and New York Times columnist Paul Krugman alludes to recently in a column about Japanese monetary policy.

There is only one problem with pushing the short-term interest rate down far enough to focus extra spending right now when we need it most: the way we handle paper currency. The Fed doesn’t dare try to lower the interest rate it targets below zero for fear of causing people to store massive amounts of currency (which effectively earns a zero interest rate). Indeed, most economists, like the Fed, are so convinced that massive currency storage would block the interest rate from going more than a hair below zero that they talk regularly about a zero lower bound on interest rates. The solution is to treat paper currency as a different creature than electronic money in bank accounts, as I discuss in many other columns. (“What Paul Krugman got wrong about Italy’s economy” gives links to other columns on electronic money as well.) If instead of being on a par with electronic money in bank accounts, paper currency is allowed to depreciate in value when necessary, the Fed can lower the short-term interest as far as needed, even if that means it has to push the short-term interest rate below zero.

Keeping the economy on target

In the current economic doldrums, breaking through the zero lower bound with electronic money is the first step in ensuring that monetary policy can quickly get output back to its natural level. A better paper currency policy puts the ability to lower the Fed’s target interest rate back in the toolkit. That makes it possible for the Fed to get the timing of extra spending by firms and households right to meet a nominal GDP target—hopefully one that has been appropriately adjusted for the rate of technological progress.

Despite the differences I have with the market monetarists, I am impressed with what they have gotten right in clarifying the confusing and disheartening economic situation we have faced ever since the financial crisis triggered by the collapse of Lehman Brothers on September 15, 2008. If market monetarists had been at the helm of central banks around the world at that time, we might have avoided the worst of the worldwide Great Recession. If the Fed and other central banks learn from them, but take what the market monetarists say with a grain of salt, the Fed can not only pull us out of the lingering after-effects of the Great Recession more quickly, but also better avoid or better tame future recessions as well.

Quartz #20—>Why Austerity Budgets Won't Save Your Economy

May 13, 2013 by Miles Kimball

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Link to the Column on Quartz

Here is the full text of my 20th Quartz column, Here is a link to my 20th column on Quartz: “Why Austerity Budgets Won’t Save Your Economy.” now brought home to supplysideliberal.com. It was first published on April 1, 2013. Links to all my other columns can be found here.

© April 1, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

“Austerity” in the title means “Naked Austerity,” in line with the hashtag #nakedausterity that I introduced on Twitter:

Definition for #nakedausterity : Tax increases and/or government spending cuts unaccompanied by other measures to maintain aggregate demand.

The point of the hashtag is this:

When you are worried about debt, #nakedausterity is not the answer.

Don’t miss the discussion of the costs of national debt toward the end of the column.

Austerity is in vogue. For some time now, countries in Europe have been raising taxes and cutting government spending because they are worried about their national debt. They have hit on the word austerity to describe these tax increases and government spending cuts. The US is now following suit.

But the trouble with austerity is that it is contractionary—that is, austerity tends to slow down the economy. In bad economic times, people can’t get jobs because businesses aren’t hiring, and businesses are not hiring because people aren’t spending. So in bad economic times, it adds insult to injury when the government does less spending, less hiring, and taxes more money out of the pockets of those who would otherwise spend.

The contractionary effect of austerity creates a dilemma, not only because a slower economy is painful for the people involved—that is, just about everyone—but also because tax revenue falls when the economy slows down, making it harder to rein in government debt. This dilemma has fueled a big debate. There are four basic positions:

1. Arguing that austerity can actually stimulate the economy, as long as it is implemented gradually. That is the position John Cogan and John Taylor take in their Wall Street Journal op-ed, “How the House Budget Would Boost the Economy,” which I questioned in my column, “The Stanford economists are so wrong: A tighter budget won’t be accompanied by tighter monetary policy.”

2. Arguing that debt is so terrible that austerity is necessary even if it tanks the economy. This is seldom argued in so many words, but is the implicit position of many government officials, both in Europe and the US.

3. Arguing that the economy is in such terrible shape that we have to be willing to increase spending (and perhaps cut taxes) even if it increases the debt. This is the position taken by economist and New York Times columnist Paul Krugman. Indeed, Krugman is so intent on arguing that the government should spend more, despite the effect on the debt, that in many individual columns he appears to be denying that debt is a serious problem. A case in point is his reply, “Another Attack of the 90% Zombie,” to my column emphasizing the dangers of Italy’s national debt, “What Paul Krugman got wrong about Italy’s economy.” (In addition to this column, I responded on my blog.)

4. Arguing that there are ways to stimulate the economy without running up the national debt. This is what I also argue in my column on Krugman. For the US, the most important point is that using monetary policy to stimulate the economy does not add to the national debt and that even when interest rates are near zero, the full effectiveness of monetary policy can be restored if we are willing to make a legal distinction between paper currency and electronic money in bank accounts—treating electronic money as the real thing, and putting paper currency in a subordinate role. (See my columns, “How paper currency is holding the US recovery back” and “What the heck is happening to the US economy? How to get the recovery back on track.”) As things are now, Ben Bernanke is all too familiar with the limitation on monetary policy that comes from treating paper currency as equivalent to electronic money in bank accounts. He said in his Sept. 13, 2012 press conference:

If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.

Without the limitations on monetary policy that come from our current paper currency policy, the Fed could lower interest rates enough (even into negative territory for a few quarters if necessary) to offset the effects of even major tax increases and government spending cuts.

The price of debt

Since I see a way to stimulate the economy without adding to the national debt—and even in the face of measures to rein in the national debt—I face no temptation to downplay the costs of high levels of national debt. What are those costs? The most obvious cost of high levels of national debt is that at some point, lenders start worrying about whether a country can ever pay back its debts and raise the interest rates they charge. (This all works through the bond market, giving rise to James Carville’s famous quip: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”) One can disagree with their judgment, but lenders are showing no signs of doubting the ability of the US government to pay its debts. But there can be costs to debt even if no one ever doubts that the US government can pay it back.

To understand the other costs of debt, think of an individual going into debt. There are many appropriate reasons to take on debt, despite the burden of paying off the debt:

To deal with an emergency—such as unexpected medical expenses—when it was impossible to be prepared by saving in advance.
To invest in an education or tools needed for a better job.
To buy an affordable house or car that will provide benefits for many years.

There is one more logically coherent reason to take on debt—logically coherent but seldom seen in the real world:

To be able to say with contentment and satisfaction in one’s impoverished old age, “What fun I had when I was young!”

In theory, this could happen if when young, one had a unique opportunity for a wonderful experience—an opportunity that is very rare, worth sacrificing for later on. Another way it could happen is if one simply cared more in general about what happened in one’s youth than about what happened in one’s old age.

Tax increases and government spending cuts are painful. Running up the national debt concentrates and intensifies that pain in the future. Since our budget deficits are not giving us a uniquely wonderful experience now, to justify running up debt, that debt should be either (i) necessary to avoid great pain now, or (ii) necessary to make the future better in a big enough way to make up for the extra debt burden. The idea that running up debt is the only way to stimulate an economic recovery when interest rates are near zero is exactly what I question in my previous column about Italy’s economy. If reforming the way we handle paper currency made it clear that running up the debt is not necessary to stimulate the economy, what else could justify increasing our national debt? In that case, only true investments in the future would justify more debt: things like roads, bridges, and scientific knowledge that would still be there in the future yielding benefits—benefits for which our children and we ourselves in the future will be glad to shoulder the burden of debt.

Quartz #19—>Four More Years! The US Economy Needs a Third Term of Ben Bernanke

May 09, 2013 by Miles Kimball

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Link to the Column on Quartz

Here is the full text of my 19th Quartz column, Here is a link to my 19th column on Quartz: “Four More Years: The US economy needs a third term of Ben Bernanke,” now brought home to supplysideliberal.com. It was first published on March 22, 2013. Links to all my other columns can be found here.

© March 22, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Ben Bernanke’s second term as chairman of the US Federal Reserve ends at the end of January 2014. Speculation has begun about whether President Obama leans toward reappointing him and whether Ben Bernanke would accept reappointment. At his March 20 press conference, Bernanke said he had spoken to Obama “a bit” about his own future without directly addressing the question of whether he would be willing to serve a third term if asked. But he emphasized that he did not see himself as indispensable, saying “I don’t think that I’m the only person in the world who can manage the exit [strategy]” from the stimulus the Fed has been providing to the economy. Given Bernanke’s reticence, the Wall Street Journal provides an important tea leafwhen it reports that “Many of [Bernanke’s] friends and associates believe he will want to leave after his current term expires.”

Though the stresses Ben Bernanke has faced during his time as chairman of the Fed—and the princely speaker fees and book advances available to former Fed chiefs—would make a desire to retire at the end of his current term understandable, I hope that Obama will ask him to serve a third term and that Ben Bernanke will accept—and that the Senate will confirm him by a wider margin than it did for his second term. Of these decision-makers, the hardest to persuade might be Ben Bernanke himself.

As Bernanke said, if all goes well, and the economy is firmly on the road to full recovery, many possible Fed chiefs could manage a reasonably graceful exit from quantitative easing and interest rates hovering around zero. But I do not think the economy will be out of the woods by January 2014. Many dangers will remain, particularly dangers to the US economy from troubles in the rest of the world and from the difficulties of reining in the US national debt without bringing the US economy to a halt.

Though not by any means a close confidant, I have known Ben Bernanke for a long time from meetings of the Monetary Economics group in the National Bureau of Economic Research. We economists are quick to take the measure of one another, and I have always had the highest respect for Ben Bernanke’s thoughtful approach to economics. Through the news, and from reading David Wessel’s wonderful book about the Fed’s response to the financial crisis, In Fed We Trust, I have studied with interest each official move that Ben Bernanke has made as chairman of the Fed. Instead of Monday morning quarterbacking, I have asked myself at each point what I thought should be done, given what I knew at the time, and compared it to the decisions that Bernanke made at that time. I know I could not have done better than Bernanke. And Greg Mankiw, former chairman of the Council of Economic Advisors, who was on the same short list for appointment as Fed chairman as Bernanke, has similarly said that “he very much agreed with Bernanke’s policy decisions over his tenure.”

I can say with clarity that Bernanke’s biggest failure—not foreseeing the gravity of the coming financial crisis—was a failure of the entire economics profession and hardly his alone. Economists did see the housing bubble and worried in advance about a collapse in housing prices. But what we didn’t know—in large part because the needed data was not collected from them—is what huge bets the big banks and other big financial firms had taken on the overall level of house prices in the US. So when housing prices fell all across the US, the big banks and other financial firms got into trouble, and dragged the world economy down with them. Ever since, Ben Bernanke has been laboring mightily to get the US economy and the world economy out of the hole that the financial crisis put them in.

In addition to wielding the emergency powers of the Fed to prevent an even worse financial meltdown, Bernanke has played a central role in adding quantitative easing to the standard toolkit of monetary policy in the US. In other words, Bernanke did a lot to help convince his colleagues in the Fed, and some fraction of the public, that when the interest rate on three-month Treasury bills has fallen to zero, the Fed can and should still stimulate the economy by buying other assets instead of three-month Treasury bills. Bernanke has acted according to the slogan I use in my blog post “Balance Sheet Monetary Policy: A Primer,”

When below natural output: print money and buy assets!

And when one kind of asset already has a zero interest rate, buy some other type of asset. Bernanke has done so, in the face of often-savage criticism. (It is only in the last few years that “End the Fed!” has become a slogan for a substantial minority of the US population—many of whom reliably show up as energetic commentators on websites.) In all of this, the Bernanke Fed has been significantly more vigorous than other major central banks, and as a result, the US has done better economically than Japan, the UK or the euro zone as a whole. (China is a whole different story.)

Although there are a few other economists who might match Bernanke in their monetary policy judgments, through his years at the helm of the Fed, Bernanke has developed an unparalleled skill in explaining and defending controversial monetary policy measures to Congress and to the public. The most important ways in which US monetary policy has fallen short in the last few years are because of the limits Congress has implicitly and explicitly placed on the Fed. Negative interest rates could be much more powerful than quantitative easing, but require a legal differentiation between paper currency and electronic money in bank accounts to avoid massive currency storage that would short-circuit the intended stimulus to the economy. (See my column: “How Paper Currency is Holding the US Recovery Back.”) That would require legislation. Lending directly to households would require legislation. (See my column: “More Muscle than QE3: With an extra $2,000 in their pockets, could Americans restart the US economy?”) And creating a US Sovereign Wealth Fund as a sister institution to the Fed to give the Fed running room and help stabilize the financial system would require legislation. (See my column: “Why the US needs its own sovereign wealth fund” and also: “How to stabilize the financial system and make money for US taxpayers.”)

If we are to have a hope of adding these tools to the monetary policy toolkit—tools that one way or another, we will need someday—we need a Fed chief who not only has the skill that Bernanke has gained at explaining monetary policy to Congress and the public, but also the prestige that will come when we finally get out of the economic mess we are in and people realize that, in important measure, it was Ben Bernanke who got us out of that mess. But the biggest reason we need a third Bernanke term is that nasty economic shocks may not be through with us yet. And no other potential head of the Fed has as much experience in responding to nasty shocks with solidly creative monetary policy as Ben Bernanke.

I join Greg Mankiw, who happened to be my graduate adviser, in calling Ben Bernanke a hero. Though he might be tempted to cut it short, I don’t see any way that Ben Bernanke can complete the hero’s journey that history has appointed him without a third term.

Quartz #18—>Show Me the Money!

May 07, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 18th Quartz column, “The Stanford economists are so wrong: A tighter budget won’t be accompanied by tighter monetary policy.”I honestly couldn’t think of a good working title of my own before my editor Mitra Kalita gave it the title it has on Quartz. But it finally came to me what I wanted my version of the title to be: the main theme is short-run monetary policy dominance, so my title is “Show Me the Money!”

The heart of this column is a discussion of the paper I wrote with Susanto Basu and John Fernald:“Are Technology Improvements Contractionary?” It was first published on March 19, 2013. Links to all my other columns can be found here.

© March 19, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Until the election last year, Stanford economics professor John Taylor was one of Mitt Romney’s chief campaign economists. This morning, he joins his Stanford colleague John Cogan in a Wall Street Journal opinion piece, “How the House Budget Would Boost the Economy.” Cogan and Taylor write:

According to our research, the spending restraint and balanced-budget parts of the House Budget Committee plan would boost the economy immediately.

Leaving aside the long-run merits of the House Budget, let’s evaluate Cogan and Taylor’s argument about what its short-run effects would be. The key to any hope that cutting spending would stimulate the economy is that the spending cuts are all in the future—hopefully after the economy has already fully recovered:

The House budget plan keeps total federal outlays at their current level for two years. Thereafter, spending would rise each year, but more slowly than if present policies continue.

If government spending doesn’t change for the next two years, why might the budget being put forward by the US House of Representatives boost the economy now? Put plainly, their argument is that companies sitting on big piles of cash will invest more and individuals who have money to spend because they have funds in stocks, bonds and bank accounts will spend more now because of reduced concerns about higher future business and personal taxes.

The thing that Cogan and Taylor leave obscure in their argument is that the short-run effect of the House Budget would depend critically on the Federal Reserve’s reaction to it. Let me illustrate the importance of what the Fed does by pointing to the short-run effects of technology shocks. All economists agree that, in the long run, technological progress raises GDP—more than anything else. Yet, in our paper “Are Technology Improvements Contractionary?” which appeared in the scholarly journal American Economic Review, Susanto Basu, John Fernald and I showed that, historically, technology improvements have led to short-run reductions in investment and employment that were enough to prevent any short-run boost to GDP, despite improved productivity. (Independently, using very different methods, many other economists, starting with Jordi Gali, had found the negative short-run effect of technology improvements on how much people work.)

How can something that stimulates the economy in the long run lead people to work and invest less? It is all about the monetary policy reaction. Historically, in the wake of technology improvements, the Fed has cut interest rates somewhat, but has failed to do enough to keep the price level on track and accommodate in the short run the higher level of GDP that eventually follows from a technological improvement in the long run.

So what monetary policy do Cogan and Taylor envision to go along with the House Budget’s proposed cuts in future government spending? Arguing that the results of the House Budget would be even better than predicted by the model they are relying on, Cogan and Taylor write:

Nor does the model account for beneficial changes in monetary policy that could accompany enactment of the budget plan. Lower deficits and national debt would reduce pressure on the Federal Reserve to continue buying long-term Treasury bonds.

To translate, Cogan and Taylor are envisioning tighter monetary policy to go along with the House Budget. But, to the extent that their arguments about the stimulative effects of cutting future government spending have any merit, it would be in conjunction with continued—and likely accelerated–Fed purchases of long-term government bonds and mortgage bonds. As I discussed in an earlier column and at much greater length on my blog, John Taylor is so strongly opposed to even what the Fed is currently doing to support the economy that he is willing to resort to specious arguments to argue for Fed tightening. There is no hope that the House Budget will stimulate the economy as Cogan and Taylor claim unless John Taylor gives up his misguided wish for tighter monetary policy.

Quartz #17—>How Italy and the UK Can Stimulate Their Economies Without Further Damaging Their Credit Ratings

May 03, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 17th Quartz column, “What Paul Krugman Got Wrong About Italy’s Economy,” now brought home to supplysideliberal.com and given my preferred title. It was first published on February 26, 2013. Links to all my other columns can be found here.

© February 26, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The combative title my editor gave this column attracted Paul Krugman’s attention in one of his columns, linked in my reply “Noah Smith Joins My Debate with Paul Krugman: Debt, National Lines of Credit and Politics.”

Note that I have a nuanced position toward national debt, which is also articulated in my columns “Why austerity budgets won’t save your economy” and “An economist’s mea culpa: I relied on Reinhart and Rogoff." On Twitter, I have encapsulated this nuanced view into the hashtag #nakedausterity–

Definition for #nakedausterity : Tax increases and/or government spending cuts unaccompanied by other measures to maintain aggregate demand.

The point of the hashtag is this:

When you are worried about debt, #nakedausterity is not the answer.

Update: More recently, Yichuan Wang and I examined what the Reinhart and Rogoff data set suggests about the effects of debt on growth and found no evidence for such an effect. Links to all our analysis can be found in our Quartz column "Autopsy: Economists looked even closer at Reinhart and Rogoff’s Data–and the results might surprise you.” Our earlier Quartz column “After crunching Reinhart and Rogoff’s data, we’ve concluded that high debt does not slow growth”, my companion post “After Crunching Reinhart and Rogoff’s Data, We Found No Evidence That High Debt Slows Growth,” and my post “Why Austerity Budgets Won’t Save Your Economy” discuss other reasons one might be concerned about high levels of national debt.

Editor’s note: This post was updated on April 19, 2013, to reflect an error in the referenced study on debt levels by Carmen Reinhart and Ken Rogoff.

In the last few days, while the US political debate centers on ways to deal with burgeoning debt, UK government debt has been downgraded and investors are demanding much higher yields on Italian debt in the wake of the Italian election results (paywall). As concerns about national credit ratings push economies around the world toward austerity–government spending cuts and tax hikes–some commentators are still calling for economic stimulus at any cost. Joe Weisenthal wrote that David Cameron must spend more money in order to save the British economy. Paul Krugman wrote in “Austerity, Italian Style” that austerity policies simply don’t work. The downside of their prescription of more spending—and perhaps lower taxes—is that it would add to the United Kingdom’s and to Italy’s national debt.

And despite the recent revelation of errors in Carmen Reinhart and Ken Rogoff’s famous study of debt levels and economic growth, which I discuss here and which motivated the update you are reading (the original passage can be found here), there are reasons to think that high levels of debt are worth worrying about.

First, for a country like Italy that does not have its own currency (since it shares the euro with many other countries), Paul Krugman’s own graph shows a correlation between national debt as a percentage of GDP and the interest rate that a country pays.

Second, the paper by Thomas Herndon, Michael Ash and Robert Pollin that criticizes Reinhart and Rogoff finds that, on average, growth rates do decline with debt levels. Divide debt levels into medium high (60% to 90% of GDP), high (90% to 120% of GDP), and very high (above 120% of GDP). Then the growth rates are 3.2% with medium-high debt, 2.4% with high debt, and 1.4% with very high debt. (I got these numbers by combining the 4.2% growth rate for countries in the 0 to 30% debt-to-GDP ratio range from Table 3 with the estimates in Table 4 for how things are different at higher debt levels.) Moreover, contrary to the impression one would get from the column here, Herndon, Ash and Pollin’s Table 4 indicates that the differences between low levels of debt and high levels of debt are not just due to chance, though what Herndon, Ash and Pollin emphasize is that very low levels of debt, below 30% of GDP, have a strong association with higher growth rates. Overall, with the data we have, we don’t know what causes what, so there is no definitive answer to how much we should worry about debt, but ample reason not to treat debt as if it were a nothing.

In an environment in which stimulus is needed, but extra debt is a problem, there should be a laser-like focus on the ratio of stimulus any measure provides relative to the amount of debt it adds. In every one of my proposals for stimulating the economy, I have been careful to avoid proposals that would make a large addition to national debt. So I do not follow Joe Weisenthal and Paul Krugman in their recommendations.

First, instead of raising spending or cutting taxes, the Italian and UK governments can directly provide lines of credit to households, as I have proposed for troubled euro-zone countries and for the UK, as well as for the US. Although there would be some loan losses, the better ratio of stimulus to the addition to the national debt would lead to a much better outcome. In particular, after full economic recovery in the short run, there would be much less debt overhang to cause long-run problems after such a national lines of credit policy than under Weisenthal’s or Krugman’s prescriptions.

But for the UK, it is an even more important mistake to think that monetary policy can’t cut short-term interest rates below zero. Weisenthal quotes a post on Barnejek’s blog, “Has Britain Finally Cornered Itself?” that illustrates the faulty thinking I’m talking about:

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

“Liquidity trap” is code for the inability of the Bank of England to lower interest rates below zero. The faulty thinking is to treat the “liquidity trap” or the “Zero Lower Bound,” as modern macroeconomists are more likely to call it, as if it were a law of nature. The Zero Lower Bound is not a law of nature! It is a consequence of treating money in bank accounts and paper currency as interchangeable. As I explain in a series of Quartz columns (1, 2, 3 and 4) and posts on my blog—that is a matter of economic policy and law that can easily be changed. As soon as paper pounds are treated as different creatures from electronic pounds in bank accounts, it is easy to keep paper pounds from interfering with the conduct of monetary policy. In times when the Bank of England needs to lower short-term interest rates below zero, the effective rate of return on paper pounds can be kept below zero by announcing a crawling peg “exchange rate” between paper pounds and electronic pounds that has the paper pounds gradually depreciating relative to electronic pounds.

In his advice for the UK, Weisenthal should either explain why having an exchange rate between paper pounds and pounds in bank accounts is worse than a massive explosion of debt or join me in tilting against a windmill less tilted against. And for those who read Krugman’s columns, it would take a bad memory indeed not to recall that he gives the corresponding advice of stimulus by additional government spending for the US, which faces its own debt problem. I hope Paul Krugman will join me too in attacking the Zero Lower Bound.

In 1896 William Jennings Bryan famously declared: “… you shall not crucify mankind on a cross of gold.”

In our time it is not gold that is crucifying the world economy (though some would return us to the problems that were caused by the gold standard), but the unthinking worldwide policy of treating paper currency as interchangeable with money in bank accounts. So for our era, let us say: You shall not crucify humankind on a paper cross.

Quartz #16—>Monetary Policy and Financial Stability

May 01, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 16th Quartz column, “Queasy Money: We should stop expecting monetary policy alone to save the US economy” now brought home to supplysideliberal.com and given my preferred title. It was first published on February 22, 2013. Links to all my other columns can be found here.

© February 22, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Minutes of the US Federal Reserve’s monetary policy committee meeting on Jan. 29 and 30 and other recent statements by Fed officials reveal a vigorous debate within the central bank about the effects of monetary policy stimulus on financial markets. Most strikingly, the minutes indicate that Kansas City Federal Reserve Bank president Esther George “…dissented from the committee’s policy decision, expressing concern that loose credit increased the risks of future economic and financial imbalances….” In the same vein, Cleveland Fed president Sandra Pianalto expressed in a Feb. 15 speech her worry that “… financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment.”

These worries are not without some foundation. For example, in a Feb. 20 Wall Street Journal article “Fed Split Over How Long to Keep Cash Spigot Open,” reporters Jon Hilsenrath and Victoria McGrane show graphs of dramatic flows of money into junk bonds, junk loans, and real estate investment trusts. Nevertheless, Boston Fed president Eric Rosengren is quoted as saying:

…that it wasn’t the central bank’s job to halt every episode of financial excess. Individual financial institutions regularly fail without bringing down the economy, and financial bubbles don’t always wreck financial systems. When the tech bubble burst in 2000, for example, the U.S. experienced a relatively brief and shallow recession. It didn’t lead to the same cascade of market collapses and a deep downturn as in 2008.

And they report Dallas Fed president Richard Fisher saying that although he is alert to possible dangers, “These robust markets are part of the Fed’s policy intent.”

In an extended question and answer session at the University of Michigan on Jan. 14, Federal Reserve Board Chairman Ben Bernanke revealed his philosophy about dealing with financial stability: “… we will, obviously, be working very hard in financial stability. We’ll be using our regulatory and supervisory powers. We’ll try to strengthen the financial system. And if necessary, we will adjust monetary policy as well but I don’t think that’s the first line of defense.” Although Bernanke does not want fears about financial stability to constrain monetary policy too much, he is more concerned about the effects of quantitative easing (buying long-term Treasury bonds and mortgage-backed securities) and forward guidance (making announcements about future short-term interest rates) than he would be if the Fed could just push the current short-term interest rate below the near-zero level it is at now:

… we have to pay very close attention to the costs and the risks and the efficacy of these non-standard policies as well as the potential economic benefits. And to the extent that there are costs or risks associated with non-standard policies which do not appear or at least not to the same degree for standard policies then you would, you know, economics tells you when something is more costly, you do a little bit less of it.

I find wisdom in the words of Rosengren, Fisher and Bernanke. In my view:

It is almost impossible for monetary policy to stimulate the economy except by (a) raising asset prices, (b) causing loans to be made to borrowers who were previously seen as too risky, or (c ) stealing aggregate demand from other countries by causing changes in the exchange rate.
Quantitative easing is likely to have unprecedented effects on financial markets—effects that will look unfamiliar to those used to what the standard monetary policy tool of cutting short-term interest rates does.
It is not risk-taking we should be worried about, but efforts to impose risks on others—including taxpayers—without fully paying for that privilege.

1. Monetary Policy Works Through Raising Asset Prices, Loosening Borrowing Constraints, or Affecting the Exchange Rate. It doesn’t make sense for firms to produce things no one wants to buy. Aggregate demand is the willingness to buy goods and services that determines how much is produced in the short run. Aggregate demand is the sum of the willingness of households (meaning families and individuals) to spend and build houses, of firms to buy equipment, build factories, office buildings, and stores, and spend on research and development, of government purchases, and of net exports: how much more foreigners buy from us than we buy from them (an area where the US is now in the hole).

To analyze household spending, it is a useful simplification to think of households as divided into two groups: (i) those who either don’t need to borrow or can borrow all they want at reasonable rates, and (ii) those who are borrowing as much as they can already and can’t borrow more. Economic theory suggests that those who don’t need to borrow or can borrow all they want at reasonable rates will look at the value of their wealth—including the asset value of their future paychecks—and spend a small fraction of that full wealth every year. The size of that fraction depends primarily on long-run factors, and is mostly beyond the Fed’s control. So, by and large, the only way the Fed can get those who don’t need to borrow to spend more is by increasing the value of their full wealth. If the full wealth goes up because they expect fatter paychecks in the future, no one gets worried, but otherwise that increase in wealth has to come from an increase in highly visible asset prices.

Those who are already borrowing as much as they can, will only be able to spend more if they can get their hands on more money in the here and now. Tax policy matters here, but the most recent change—the expiration of the Obama payroll tax cut—goes in the wrong way, reducing what people living from paycheck to paycheck have to spend. My proposal of a $2,000 Federal Line of Credit to every taxpayer would be a way to stimulate the spending of this group without adding much to the national debt. But this is beyond the Federal Reserve’s authority under current law. The way monetary policy now affects the spending of those who face limits on their borrowing is by lowering the cost of funds to banks so much that banks start to think about lending to people they were unwilling to lend to before.

A similar division by ability to borrow helps in understanding business investment as well. For firms who have trouble borrowing, additional investment spending will depend on borrowers-previously-deemed-too-risky getting loans. For firms that don’t need to borrow or can borrow all they want at reasonable rates, the key determinant of business investment is how valuable a firm thinks a new factory, office building, store, piece of equipment, or patent will be. But, by and large, the same factors that affect how valuable a new investment will be affect how valuable existing factories, office buildings, stores, equipment, and patents are. So the prices of the stocks and bonds that would allow one to buy a firm outright—with all of its factories, office buildings, stores, equipment and patents—will have to increase if the Fed is to encourage investment. The same logic holds for houses: it is hard to make it more valuable to build a new house without also making existing houses more valuable and pushing up their prices.

Aside from government purchases—which are the job of the president and the warring Democrats and Republicans in Congress rather than the Fed—that leaves net exports. There the problem is that while any one country can increase its aggregate demand by increasing its net exports, this doesn’t work when all countries try to increase net exports at the same time. The reason that monetary expansion isn’t a zero-sum game across countries is because monetary policy can increase aggregate demand by raising asset prices and encouraging lenders to lend to borrowers they didn’t want to lend to before. The big danger is that those making the decisions within the Federal Reserve will mistake the normal workings of monetary policy—acting through asset prices and risky lending—for financial shenanigans that need to be stamped out by premature monetary tightening.

2. Nonstandard Monetary Policy. That said, nonstandard monetary policy in the form of purchases of long-term Treasury bonds and mortgage-backed securities and “forward guidance” on future short-term interest rates take the economy into uncharted territory. But uncharted territory brings not only the possibility of new monsters but also the near certainty of previously unseen creatures that might look like monsters, but are harmless.

3. Facing the Real Financial Dangers Squarely. So what distinguishes the real monsters from the paper dragons? Eric Rosengren had the key when he pointed to the contrast between the collapse of the internet stock bubble in 2000 and the financial crisis in 2008, that stemmed from the collapse of the housing bubble. The difference was that, by and large, people invested in the internet stock price boom with their own money, and took the hit themselves when the bubble collapsed; people invested in the house price boom—both directly and indirectly—with borrowed money, and so imposed their losses on those they borrowed from and on taxpayers through bailouts. “High capital requirements” is the name of the policy of forcing big banks to put enough of their own money at risk to be able to absorb financial losses without imposing those losses on others. Capital requirements for banks are akin to down payment requirements for individuals buying houses. The financial crisis we are still suffering from arose from too little of both. Needless to say, banks hate capital requirements, since the secret for all too great a share of financial profits is taking the upside while foisting the downside on others (often taxpayers) who don’t know they are taking the downside, and aren’t being compensated for taking that risk.

Beyond pushing for high capital requirements—especially during booms, when financial shenanigans are most likely—the Fed can do a lot to foster financial stability by continuing to make a list of possible macroeconomic risks to use in subjecting financial firms to “stress tests” as it has done in 2009, 2011, 2012 and 2013. But it can do more with this list of possible macroeconomic risks by requiring financial firms to explicitly insure themselves against these risks and imposing very tough capital requirements on those who purport to provide such insurance. Indeed, for deep pockets, the ideal provider of such insurance would be a sovereign wealth fund, as I proposed in “Why the US Needs Its Own Sovereign Wealth Fund.” The problem is not having taxpayers bear these risks, it is having taxpayers bear these risks without being compensated for doing so. The bedrock principle should be to bring as many macroeconomic risks as possible out of the shadows into the light of day, so that prices can be put on those risks. If risks are out in the open, then those who face them will face them knowingly, and won’t be able to shirk the responsibility they have undertaken when those risks materialize.

Fostering financial stability by enforcing high capital requirements during booms and working toward the naming and pricing of macroeconomic risks is its own reward. But it also has the extraordinary benefit of freeing up monetary policy to pursue its main mission of protecting the economy from inflation and high unemployment. The more potential evils we face, the more tools we need. Rather than attempting to use the familiar tool of monetary policy for a task to which it is ill-suited, let us fashion new tools to enhance financial stability.

Quartz #15—>How to Stabilize the Financial System and Make Money for US Taxpayers

April 29, 2013 by Miles Kimball

Here is the full text of my 15th Quartz column, “How to stabilize the financial system and make money for US taxpayers” now brought home to supplysideliberal.com. It was first published on February 8, 2013. Links to all my other columns can be found here.

© February 8, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Note: a version of this column is also slated to be published in FS Focus, the financial services magazine of the ICAEW, an organization of accountants in the UK. In that version, the passage from “In brief, …” to the end of its paragraph was replaced with this passage, which I think you will find interesting as well:

At its inception, a US sovereign wealth fund would be established by issuing $1 trillion worth of low-interest safe Treasury bonds and investing those funds in high-expected-return risky assets. That takes those risky assets off the hands of private investors and puts safe assets in the hands of those private investors instead. Having fewer risky assets on their balance sheets overall would make those private investors readier to back private firms in taking on the additional risks involved in buying equipment, building factories, or starting up new businesses. And having more safe assets in the hands of private investors would provide good collateral for the financial arrangements those projects would need. Thus, the establishment of the sovereign wealth fund encourages investment and stimulates the economy. The Fed has plenty of tools for keeping the economy from being stimulated too much. So the mere existence of the sovereign wealth fund gives the Fed a wider range of stimulus levels to choose from. Moreover, any given level of stimulus would requires a less aggressive course of quantitative easing (QE) on the part of the Fed than it would otherwise need to pursue.

Geopolitically, the world still lives in the shadow of Sept. 11, 2001. Economically, the world still lives in the shadow of Sept. 15, 2008, the day Lehman Brothers collapsed and ushered in a deep financial crisis. The fundamental problem: big banks and other financial firms that pretended to take on huge risks without, in fact, being able to shoulder those risks. Under the guise of taking such risks, these financial firms reaped the reward during the good times. But when the risks came home to roost, only US taxpayers—the US government acting on their behalf—had the wherewithal to absorb those risks.

In the future, shouldn’t US taxpayers get some of the reward from taking on the macroeconomic risks that are too big and too pervasive for banks and financial firms to shoulder? Such risk-bearing is richly rewarded. Indeed, as George Mason University professor Tyler Cowen points out in his American Interest article, “The Inequality that Matters,” a shockingly high fraction of the wealth of the super-rich comes from finance. But more importantly, having US taxpayers rewarded for actually taking on macroeconomic risk—risk that US taxpayers end up bearing in large measure anyway—would crowd out the charade of big banks and financial firms pretending to take on that risk. And it is that pretense that brought the world to the dreadful, long-lasting economic quagmire it is in now.

In my Quartz column a little over a month ago I explained “Why the US needs its own sovereign wealth fund” primarily as a way to give the Federal Reserve more running room in monetary policy. In brief, the mere existence of a US sovereign wealth fund, one that issued through the Treasury $1 trillion worth of low-interest safe bonds and invested it in high-expected-return risky assets, would give the Federal Reserve a lot more room to maneuver. Moreover, it would allow the Fed to pursue a less aggressive course of quantitative easing (QE) than it would otherwise need to pursue. The US fund would draw political controversy to itself, and away from the Fed, thereby preserving the independence of monetary policy that we need in order to avoid inflation in the long run.

But a US sovereign wealth fund can do more if given the independence it needs to focus on (1) making money for the US taxpayer and (2) financial stability, rather than extraneous political objectives. These two goals are consistent, since the same contrarian strategy serves both. Buying assets cheap, relative to their fundamentals, and selling assets that are expensive, relative to their fundamentals, both pushes asset prices toward their fundamentals and, by buying low and selling high, makes profits that we can use to help pay off the national debt. It takes almost inhuman fortitude to withstand the winds of investment fashion. But given appropriate compensation policies, a $1 trillion US sovereign wealth fund would be able to hire the next generation’s Warren Buffett to take care of US taxpayers’ money. They deserve no less.

Update: I discovered in a forgotten email a pdf of a version of this in print (on page 8) and a link to a version on the Economia website. I find those mostly interesting for the visuals:

blog.supplysideliberal.com tumblr_inline_nx5x6a2W5E1r57lmx_500.png

Quartz #14—>Off the Rails: How to Get the Recovery Back on Track

April 26, 2013 by Miles Kimball

blog.supplysideliberal.com tumblr_inline_mlkedka0Pt1qz4rgp.png

Link to the Column on Quartz

Here is the full text of my 14th Quartz column, “Off the Rails: What the heck is happening to the US Economy? How to get the recovery back on track,” now brought home to supplysideliberal.com. It was first published on February 1, 2013. Links to all my other columns can be found here.

© February 1, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

GDP fell in the last quarter of 2012. It was only a fraction of a percent, but it means the recovery is on hiatus. Why? Negative inventory adjustments tend to be short-lived, so let me leave that aside, although it definitely made last quarter’s statistics look worse. Of the longer-lived forces, on the positive side,

consumer spending rose,
home-building rose, and
business investment on buildings and equipment rose.

On the negative side,

exports fell more than imports, and
government purchases fell.

Net exports and government purchases are the big worries going forward as well.

How much the rest of the world buys from the US depends on how other economies are faring. And most of the rest of the world is hurting economically. The Japanese are so fed up with their economic situation that they are on their sixth prime minister in the six and a half years since Junichiro Koizumi left office in 2006. The European debt crisis is in a lull right now, but could still resume full force at any time. In addition to all of its other problems, the United Kingdom is facing a mysterious decline in productivity, explained in Martin Wolf’s Financial Times article “Puzzle of Falling UK Labour Productivity” and the Bank of England analysis by Abigail Hughes and Jumana Saleheen.

The decline in US government spending comes from the struggle of state and local governments with their budgets and at the federal level from the ongoing struggle between the Democrats and Republicans about the long-run future of taxing and spending. Last quarter saw a remarkable decline in military spending that Josh Mitchell explains this way in today’s Wall Street Journal (paywall).

The biggest cuts came in military spending, which tumbled at a rate of 22.2%, the largest drop since 1972. …
Military analysts said the decline likely was a result of pressure on the Pentagon from a number of areas.
Among them: reductions in spending on the war in Afghanistan as it winds down, a downturn in planned military spending, a constraint placed on the Pentagon budget because the federal government is operating on short-term resolutions that limit spending growth, as well as concern that further cuts may be in the pipeline.

The problem is that, absent a big increase in economic growth, balancing the federal budget in the long run requires big increases in taxes or big reductions in spending. But, although opinions differ on which option is worse, tax increases and spending cuts themselves are enemies of economic growth. So the traditional options for balancing the federal budget in the long run all have the potential to make things much worse.

Our problems are so big they need new solutions. In our current situation, the fact that a proposal is “untried” is a plus, since none of the economic approaches we have tried lately have worked very well. In the last few months I have focused my Quartz columns on explaining how the US and the world can get out of the economic mess we are in with new solutions. A recap:

One of the new solutions is really an old one, that Congress and the President might be timidly tiptoeing toward too little of: dramatically more open immigration. Done right, this is guaranteed to add to long-run economic growth, as more workers make more goods, perform more services, and contribute to solving our long-run budget problems. And it isn’t just the US that would benefit from more open immigration. Ryan Avent has a must-read article in The Economist arguing that “Liberalising migration could deliver a huge boost to global output.”
The long-run budget can be balanced in a way that achieves both the core Republican goals of holding down the size of government and the burden of taxation and the core Democratic goal of taking care of the poor, sick and elderly. Here is how: by using the tax system to back up a program of public contributions to expand the non-profit sector instead of taxes and spending to expand government, or brutal cuts with no compensating way to take care of those in need.
For stimulating the economy, the one current approach that has been working at least halfway is “quantitative easing”: the Fed’s large purchases of long-term government bonds and mortgage-backed securities. But quantitative easing is hugely controversial and has an unfortunate side effect of making our long-run government debt problem worse than if we could stimulate the economy some other way. Establishing a US Sovereign Wealth Fund to do the purchasing of long-term and risky assets would give the Fed room to maneuver in monetary policy, and restrict its job to steering the economy rather than making controversial portfolio investment decisions. And a US Sovereign Wealth Fund could stand as a bulwark against wild swings in financial markets. (In addition to the column linked above, I spoke on CNBC’s Squawkbox about a US Sovereign Wealth Fund.)
Although valuable, a US Sovereign Wealth Fund is a poor second best to electronic money. It is the fear of massive storage of paper currency that prevents the US Federal Reserve and other central banks from cutting short-term rates as far below zero as necessary to bring full recovery. (If electronic dollars, yen, euros and pounds are treated as “the real thing”—the yardsticks for prices and contracts—it is OK for people to continue using paper currency as they do now, as long as the value of paper money relative to electronic money goes down fast enough to keep people from storing large amounts of paper money as a way of circumventing negative interest rates on bank accounts.) As I argued in “Could the UK be the first country to adopt electronic money,” the low interest rates that electronic money allows would stimulate not only business investment and home building, but exports as well—something that would lead to a virtuous domino effect as the adoption of an electronic money standard by one country led to its adoption by others to avoid trade deficits. If I were writing that column now, I would be asking if Japan could be the first country to adopt electronic money, since Japan’s new prime minister Shinzo Abe is calling for a new direction in monetary policy. For the Euro zone, I argue in “How the electronic deutsche mark can save Europe” that electronic money is not only the way to achieve full recovery, but the solution to its debt crisis as well.
Finally, if electronic money is too radical, the government can stimulate the economy without adding too much to the national debt by giving consumers extra borrowing-power with a government-issued credit card and a $2,000 credit limit to every taxpayer. These Federal Lines of Credit would stimulate the economy at a fraction of the cost of tax rebates. This is a big advantage for countries deep in debt, which includes most major economies. And Lines of Credit are an affordable way to stimulate the economies of European countries such as Spain and Italy that lack an independent monetary policy because they share the euro with many other European countries.

Franklin Roosevelt famously said:

The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.

We are at such a moment again. The usual remedies have failed. It is time to try something new. Any one of these proposals could make a major difference. In combination, they would transform the world.

Quartz #13—>John Taylor is Wrong: The Fed is Not Causing Another Recession

April 24, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 13th Quartz column, “John Taylor is Wrong: The Fed is not causing another recession,” now brought home to supplysideliberal.com. It was first published on January 29, 2013. Links to all my other columns can be found here.

© January 29, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

In his Wall Street Journal editorial headlined “Fed Policy is a Drag on the Economy“ this morning, Stanford economist John Taylor makes the remarkable claim that the US Federal Reserve’s efforts to keep interest rates down by asset purchases now—and promises of asset purchases in the future—is like rent control. If this were true, then the Fed’s actions to lower interest rates could be contractionary and could cause another recession. But it is just wrong.

The Fed’s actions to lower interest rates are more like encouraging the construction of more apartments—by granting building permits more readily—in an effort to keep rents down. That makes all the difference. The Fed’s actions are stimulative because the Fed is acting within the framework of supply and demand bringing markets to equilibrium. While the Fed is intervening in asset markets, contrary to Taylor’s claim, it is not doing anything to take away the role of interest rates to equate supply and demand. So when the Fed brings interest rates down, people will build more houses and factories, and buy more machines and consumer durables than they otherwise would.

This column is the two-paragraph précis of my post “Contra John Taylor.”

Twitter provided some reviews of these two pieces that I liked. Here are a few:

Noah Smith: Miles Kimball bellows, turns green, shreds his clothes, and hurls John Taylor into low Earth orbit
Daniel Altman:With @TimHarford smacking down Rachman and @mileskimballsmacking down Taylor, I think the Internets are won for today.
Tomas Hirst: An excellent post from @mileskimball explaining why #QE scaremongers are wrong
Jonathan Prober: Thought your elaboration upon your agreement with Taylor on scope of Fed intertwined with your discussion of SWF was top notch
Matthew Yglesias

Paul Krugman cited “Contra John Taylor.” in his column “Calvinist Monetary Economics,” writing

Actually, as Miles Kimball points out, [John Taylor is] committing a basic microeconomic fallacy — a fallacy you usually identify with Econ 101 freshmen early in the semester…

Quartz #12—>Yes, There is an Alternative to Austerity vs. Spending: Reinvigorate America's Nonprofits

April 18, 2013 by Miles Kimball

blog.supplysideliberal.com tumblr_inline_mkvzvh8n041qz4rgp.png

Link to the Column on Quartz

Here is the full text of my 12th Quartz column, “Yes, there is an alternative to austerity vs. spending: Reinvigorate America’s nonprofits,” now brought home to supplysideliberal.com. It was first published on January 15, 2013. Links to all my other columns can be found here.

© January 15, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Despite serving only one term from 1989-1993, US President George H. W. Bush (just released from the hospital yesterday after a bout of fever and other complications) has cast a long shadow over subsequent events. His decision to leave Saddam Hussein in place after the First Iraq War led to his son’s immensely controversial Second Iraq War. And the negative reaction to his decision to compromise with Democrats in raising taxes in 1990 despite his pledge “Read my lips, no new taxes” has set the terms of the tax policy debate ever since. Tax reformer Grover Norquist codified the principle of “no new taxes” into the Taxpayer Protection Pledge, which goes as follows:

I, ____ pledge to the taxpayers of the state of ____, and to the American people that I will:
ONE, oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses; and
TWO, oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.

Republican Speaker of the House John Boehner made a nod toward this pledge two weeks ago, pushing for the temporary resolution of the fiscal cliff, when he reminded his rank and file that, technically, taxes had already gone up, due to the expiration of the younger Bush’s tax cuts at year end. The implication was that members of Congress would really be voting for a tax cut, not a tax increase, and so would not be breaking their pledge. There is no doubt that this matter of interpretation will feature prominently in the GOP primaries in 2014.

The ongoing crisis in long-run US taxing and spending policy is born from the collision of an almost unstoppable force on the spending side with Grover Norquist’s almost immovable object on the taxing side. Former Treasury Secretary Larry Summers ably describes the almost unstoppable force on the spending side in his Washington Post editorial “The Reality of Trying to Shrink Government.” The bottom line is that the explosion of government spending is primarily the result of (1) an aging population, (2) having to pay interest on ballooning government debt, and (3) the increasing cost of medicine that keeps discovering ways to do more with the expensive skilled labor of doctors and other medical professionals. To put it bluntly, the only way to keep government spending constant in the future, let alone reduce it, would be to dramatically reduce benefit levels for Social Security, Medicare and Medicaid, or to gut all the other functions of government, from national defense to the judicial system to scientific research.

It is easy to be misunderstood when mentioning Hitler, but here I want to invoke a comparison solely in his role as an inept commander-in-chief of the German armed forces and in no other capacity. In his book, The Storm of War: A New History of the Second World War, Andrew Roberts argues that Hitler’s no-retreat, “stand-or-die” orders were strategically disastrous for the German forces. German generals had a brilliant record at turning tactical retreats into great German victories. But Hitler’s stand-or-die orders took away the advantage of maneuver and left German troops to be mowed down by the Russians under Stalin. My point is that the “stand-or-die” approach is likely to do no better against the spending juggernaut than it did against Stalin.

In our long-run fiscal situation, the alternatives (of which we may need more than one) are to convince the American people to swallow straight benefit cuts, to directly raise tax rates, to grow the economy to get more revenue through:

1. Increased immigration, done in a way that focuses on economic growth, as I discussed in a previous Quartz piece entitled “Obama could really help the US economy by pushing for more legal immigration”

2. A more efficient tax system that encourages capital formation, as discussed in my “Twitter Round Table on Consumption Taxation”

3. A big push for increased scientific research to accelerate technological progress

But then what? I propose that many of the jobs the government has set for itself actually be done outside the government, by the non-profit sector.

In my recent blog post “No Tax Increase Without Recompense” (there’s a cliff notes version here), I propose a “public contribution system” that goes far beyond the current tax deduction for charitable contributions. In this program:

A public contribution is a donation to a nonprofit organization meeting high quality standards that engages in activities that (a) could be legitimate, high-priority activities of Federal or State governments and (b) can to an important extent substitute for spending these governments would otherwise be likely to do.

My proposal is to raise marginal tax rates above about $75,000 per person—or $150,000 per couple—by 10% (a dime on every extra dollar), but offer a 100% tax credit for public contributions up to the entire amount of the tax surcharge.

In addition to helping the government budget by taking over tasks the government is now doing and by reducing revenue lost to the current charitable deduction, I believe the non-profit sector (with the usual level of regulation) can do many things better than the government, and this program would be much less painful for people than paying the same amount in taxes. It is easy to find fulfillment in philanthropy. There is satisfaction in knowing one has made a difference in the world, in a way of one’s own choosing. And giving can serve as a good opportunity for teaching children to care. No doubt, some would view these contributions to charitable causes as almost as onerous as the taxes to which they would be an alternative. But I don’t think that would be the typical reaction.

Many people talk as if taxes are hateful only because the government is taking our money. But taxes are also hateful because the government is arrogating to itself the choice of what should be done with the money it takes from us. The government is jealous of its power. But let us insist that any resolution of our long-run fiscal crisis reduces, rather than adds to, government power. We do need to take care of those who are poor, sick and elderly. A program of public contributions shrinks government, while getting the job done. And it would be a fitting honor for George H. W. Bush, who said movingly in his inaugural address:

I have spoken of a thousand points of light, of all the community organizations that are spread like stars throughout the Nation, doing good… . The old ideas are new again because they are not old, they are timeless: duty, sacrifice, commitment, and a patriotism that finds its expression in taking part and pitching in.

Quartz #11—>Why the US Needs Its Own Sovereign Wealth Fund

April 11, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 11th Quartz column, “Why the US needs its own sovereign wealth fund,” now brought home to supplysideliberal.com. It was first published on January 3, 2013. Links to all my other columns can be found here.

© January 3, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The fate of the US economy, like that of Japan, the euro zone, and the rest of the world will rest on an important fact: unless private investors or another government counteract central bank asset purchases 100%, central banks can drive asset prices up and interest rates down by buying any asset that has an interest rate above zero. The Fed has committed to continue buying $45 billion of longer-term Treasurys every month and $40 billion a month of mortgage-backed securities until the economy recovers.

But what if longer-term Treasuries and mortgage-backed securities are the wrong assets for the Fed to buy? Most of those rates are already below 3%, so it’s not that easy to push the rates down further. What is worse, when long-term assets already have low interest rates, pushing down those interest rates pushes the prices of those assets up dramatically. So the Fed ends up paying a lot for those assets, and when it later has to turn around and sell them—as it ultimately will need to, to raise interest rates and avoid inflation, it will lose money. Avoiding buying high and selling low is tough when the Fed has to move interest rates to do the job it needs to do. At least economic recovery reduces mortgage defaults and so helps raise the prices of mortgage-backed securities through that channel. But the effects of interest rates on long-term assets cut against the Fed’s bottom line in a way that is never an issue when the Fed buys and sells 3-month Treasury bills in garden-variety monetary policy.

From a technical point of view, once 3-month Treasury bill rates (and overnight federal funds rates) are near zero, the ideal types of assets for “quantitative easing” to work with are assets that (a) have interest rates far above zero and (b) are buoyed up in price when the economy does well. That means the ideal assets for quantitative easing are stock index funds or junk bond funds!

Yet, is the Federal Reserve even the right institution to be making investment decisions like this? University of Chicago finance professor John Cochrane writes in his Wall Street Journal editorial “The Federal Reserve: From Central Bank to Central Planner.”

In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that “we should not rule out the further use of such [nontraditional] policies if economic conditions warrant.”
But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.
This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system.

As Cochrane points out, isn’t it a bit much to expect the Fed to both choose the right amount of stimulus for the economy and decide which financial investments are the most likely to turn a profit for a government that faces remarkably low borrowing costs?

Why not create a separate government agency to run a US sovereign wealth fund? Then the Fed can stick to what it does best—keeping the economy on track—while the sovereign wealth fund takes the political heat, gives the Fed running room, and concentrates on making a profit that can reduce our national debt.

Sovereign wealth funds are already standard for governments that have paid off their national debt and gone into the black. And some countries have both debt and sovereign wealth funds on their balance sheet. In order of holdings, the Monitor Group’s Sovereign Wealth Fund Assets Under Management Table shows that Norway, China, United Arab Emirates, Singapore, and Kuwait have the top sovereign wealth funds. Markets today are so hungry for assets as safe as US Treasurys, and so frightened of risk (pdf), that a US sovereign wealth fund would be paid handsomely to provide safe assets and shoulder some of the risk. But those financial returns are a bonus over and above the primary aim: fostering full economic recovery.

As an adjunct to monetary policy, the details of what a US Sovereign Wealth Fund buys don’t matter. As long as the fund focuses on assets with high rates of return, the effect on the economy will be stimulative, and the Fed can use its normal tools to keep the economy from getting too much stimulus. So there can be a division of labor: the US Sovereign Wealth Fund can focus on making as high a return as possible for the US taxpayer, and hire accordingly, as other sovereign wealth funds do, while the Federal Reserve focuses on getting the amount of stimulus right, which is where its expertise lies. The US Sovereign Wealth Fund needs the same level of independence as the Fed, and a single mandate to earn high returns, given the level of risk it is taking on. Above some minimum, the US Treasury can be given the authority to determine the amount the US Sovereign Wealth Fund is allowed to borrow so that no one institution would have too much power or too much responsibility.

Since it would horn in on their turf, big investment banks on Wall Street are likely to offer a chorus of complaints about a US Sovereign Wealth Fund. But after many years of playing a “heads I win, tails you lose” game with the US Government and the US taxpayers, the big investment banks have no moral standing to object to the US government and the US taxpayers finally getting some of the return that should go along with the risks that they have always had to bear.

Quartz #10—>Read His Lips: Why Ben Bernanke Had to Set Firm Targets for the Economy

April 08, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 10th Quartz column, “Read his lips: Why Ben Bernanke had to set firm targets for the economy,” now brought home to supplysideliberal.com. It was first published on December 13, 2012. Links to all my other columns can be found here.

© December 13, 2012: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The Fed has announced for the first time what levels of unemployment and inflation would lead it to keep short-term interest rates close to zero:

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

There are several remarkable aspects to this sentence. First, the Fed is saying more clearly than ever before that 2% is its long-run inflation target. Second, it is saying it thinks the unemployment rate can be brought down at least as far as 6.5% without causing too much inflation, though it will keep a close watch on where inflation seems to be headed to make sure. Third, the Fed is saying it is willing to tolerate inflation temporarily above 2% if that is what it takes to bring the unemployment rate down that low.

I applaud this move by the Fed. Although the Fed said, “The Committee views these thresholds as consistent with its earlier date-based guidance,” I am not so sure. It is not that easy to know how long it will take for the economy to recover. Specifying the actual economic indicators that the Fed is looking at, and how it is reading them, is much better. Saying specific dates had the danger of suggesting the Fed would keep interest rates low for too long if the economy recovered more quickly than expected. This danger was significant because an important line of thought has suggested that the Fed should promise to overheat the economy in the future to stimulate the economy now. The specific guidepost for unemployment and inflation that the Fed has laid down in yesterday’s statement make it clear that the Fed is not promising to overheat the economy in the future to stimulate the economy now. But those guideposts also make it clear that the Fed intends to continue to do what else it feels it can to return the economy to the lowest level of unemployment consistent with steady inflation.

There are things that the Fed could do to get the economy more quickly to robust health. Most obviously, there is no reason that the Fed should limit its purchases of additional long-term treasury bonds and mortgage bonds to the $85 billion per month rate it has announced. But to take the chains off of monetary policy, the best thing for the Fed to do would be to urge Congress to give it the authority to subordinate paper money to electronic money to eliminate the “zero lower bound” that paper money puts on short-term interest rates, as I discuss in “How paper currency is holding the US Recovery Back” and “Could the UK be the first country to adopt electronic money?”

Quartz #9—>Could the UK Be the First Country to Adopt Electronic Money?

April 05, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 9th Quartz column, “Could the UK Be the First Country to Adopt Electronic Money?“ now brought home to supplysideliberal.com. In draft, this column had the working title “How the Transition to Electronic Money Rewards the First Movers and Punishes the Laggards.” It was first published on December 12, 2012. Links to all my other columns can be found here.

© December 12, 2012: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

The “fiscal cliff” of mandated tax increases and spending at the end of this year is simply the peculiar American version of the struggle of advanced countries around the world to deal with mountains of debt. The euro zone debt crisis can be depended on to provide constant grist for the news mill, as Quartz’s Euro Crunch obsession demonstrates. Japan’s debt is a quieter, but in many respects, larger time bomb, as Anthony Fensom explains in “Forget Europe: Is the Real Debt Crisis in Japan?” backed upby an official International Monetary Fund warning. And our mother country across the pond is not immune.

What people don’t fully appreciate is the extent to which hobbled monetary policy has exacerbated these debt crises. The high levels of unemployment that have dragged down tax revenues and elevated government spending—as well as making it harder for individual households to get out of debt—could have been cut short if monetary policy had more vigorously fought the slumps that have faced the US, the euro zone, Japan and the UK. And whatever the Fed, ECB, Bank of Japan and Bank of England could have done (more Quantitative Easing, anyone?), there is little doubt that they did less than they might have because of their inability to push short-term interest rates more than a hair into negative territory. In his November 2000 academic article “Overcoming the Zero Bound on Interest Rate Policy,” Carnegie-Mellon economist Marvin Goodfriend explained with admirable directness: “No one will lend money at negative nominal interest if cash is costless to carry over time. Therefore, the power of open market operations to lower short-term interest rates to fight deflation and recession is strictly limited when nominal rates are already low on average.” In other words, if a central bank tries to push short-term interest rates very far below zero, people will shift to storing their own massive piles of paper currency, which makes it a lot harder for central banks to do their jobs.

In “How Paper Currency is Holding the US Recovery Back,” I explained how subordinating paper money to electronic money can end recessions and stop inflation. Freeing up monetary policy then makes it possible to raise taxes or cut spending to deal with debt without throwing the economy back into a deep recession. And as Matthew Yglesias points out, with the means to keep the economy at the natural level of output—at the sweet spot between recession and the overheating that accelerates inflation, we “… could happily move on to more interesting topics, such as: How do countries get rich rather than simply escape recession?”

The key is to allow for an exchange rate between paper currency and money that is recorded electronically in bank accounts. I am proposing that in times of economic emergency, the rate at which electronic money could be converted into paper currency would be allowed to vary over time. Let me use the pound as an example, and a 4% per year rate of depreciation of paper money. The exchange rate would start out at par: withdrawing £100 from a UK bank account would yield £100 of paper money, as usual. But after three months, if you withdrew £100 from a UK bank account, you would be handed about £101 in paper money. After six months, you would get about £102 in paper money, and so on. Of course, the exchange rate would apply for deposits as well: after six months, depositing £102 of paper money would add £100 to what was shown in your bank account. Retailers might accept paper money at par for longer than banks, but after a while, they too would ask for more in paper money than would be charged to a debit or credit card. But the extra paper money banks would give for withdrawals would make that a wash. The exchange rate between paper pounds and electronic pounds wouldn’t directly change how far anyone’s paycheck would go. What it would do is allow the Bank of England to set short-term interest rates anywhere above negative 4%. That is, since the value of paper pounds would be shrinking at the rate of 4% per year in relation to electronic pounds, the Bank of England could push interest rates so low that the number of electronic pounds in a bank account would gradually shrink at a somewhat slower rate.

What a negative interest rate means is that there is no way for someone saving money to stay even using a totally safe saving strategy, either in a bank account, or by saving currency. Negative interest rates help to fight recessions, and once the economy recovers, interest rates will soon return to normal. Indeed, even someone living off of interest income is likely to be helped more by the quick recovery of the economy, leading to interest rates above zero, than if interest rates had not been able to go negative, but had stayed at zero for a long time.

Negative interest rates stimulate investment when firms find that building a new factory or buying new equipment in even a wounded economy earns a better return than putting money in the bank or keeping paper money in a safe. Negative interest rates have another powerful effect as well. They cause savers to seek higher returns in foreign stocks, bonds and other assets. For the UK, the purchase of foreign assets would put pounds in the hands of people outside the UK whose only good use for those pounds is to either to buy UK products or to pass off the unwanted pounds to someone else until someone spends them on UK products. So negative interest rates stimulate exports.

Right now, most major economies are struggling to get enough aggregate demand stimulus for their economies. And one nation’s exports—an addition to aggregate demand, are another nation’s imports—a subtraction from aggregate demand. So the powerful effect of negative interest rates on exports means that the first movers in the transition to electronic money gain aggregate demand at the expense of the laggards. But that should just spur the laggards to make the transition to electronic money as well; then the whole world will have all the aggregate demand stimulus it can possibly use (and more, if care isn’t taken not to overdo the stimulus). Or if other nations stubbornly resist the transition to electronic money, the first movers could still come out ahead even if they invited other countries to do exchange rate interventions that would give them less of a boost in exports, but a bigger boost to investment in factories and equipment. (One reason the first movers would come out ahead is that such exchange rate interventions would involve the laggards lending to the first movers at even lower negative interest rates than would otherwise prevail. That means the laggards would, in effect, be paying the first movers an arm and a leg to take the funds.)

The fact that the transition to electronic money rewards the first movers and punishes the laggards makes it much more likely that this transition will actually happen in the near future. Once any major economy gets the ball rolling, others will soon follow. And nations should be vying to be the first. My use of the UK as an example above is not random. The UK could easily be the first nation to make the transition to electronic money. Such a dramatic move would be easier to push through in a parliamentary system of government, with a powerful Chancellor of the Exchequer, than in the American system of government, replete with checks, balances, and gridlock. As Joe Weisenthal writes, the Bank of England has a creative incoming Governor in Mark Carney—who is now Governor of the Bank of Canada—and a Chancellor of the Exchequer willing to go outside the monetary policy box far enough to appoint a Canadian. The economy of the United Kingdom needs help. It is the mother country for modern economics as well as for American politics. There are many UK economists who can fully appreciate the opportunity the transition to electronic money would provide. This transition is in many ways a small one compared to the great monetary transitions of the past: paper money is just a way station on the road between barter and coins and a full embrace of the electronic money that is already a big part of our daily lives.

Quartz #8—>Judging the Nations: Wealth and Happiness Are Not Enough

April 03, 2013 by Miles Kimball

Link to the Column on Quartz

Here is the full text of my 8th Quartz column, “Obama the Libertarian? Americans say they’d be happy if the government got out of their way,“ now brought home to supplysideliberal.com. The title of this post is the original working title of the column. Below the text of the column itself, I have an important outtake from my original draft. This column was first published on December 4, 2012. Links to all my other columns can be found here.

© December 4, 2012: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Four years from now—or 40—how should we evaluate Barack Obama’s presidency? This is not an easy question. For example, when things go badly (or well), a tricky aspect of this question is “To what extent is the president responsible for what happened?” Ruchir Sharma argues that in their judgment of the last four years, voters put the primary blame for our economic troubles on inevitable after-effects of the financial crisis that hit in 2008. Another tricky aspect of judging a presidency is deciding how to sum things up when a policy initiated by the president helps one group while hurting another. But the first question to ask four years from now, in 2016, will be “Are you better off than you were four years ago?”

It’s often assumed that in answering this question people are referring to their financial situation. But what if they took happiness into account as well? As Allison Steed points out in her Nov. 29 article in the Telegraph, “Here’s How Much You Need to Be ‘Happy’ in Different Countries,” financial aspirations can differ a lot across countries. And money is clearly not the only thing that matters for happiness. A Pew Research Center Report on happiness around the world shows that while happiness goes up with per capita GDP, at similar middle-income levels, the Latin American countries do better than expected while Eastern European countries do worse than expected.

In two previous Quartz columns, I discussed evidence that happiness is not enough: people want to be rich, successful, happy and much more. In previous research my co-authors and I found that in both hypothetical situations and the real-world choices young doctors make about which residency to choose, happiness was very important, but so was money and prestige. This would be paradoxical if each of the people we surveyed defined “happiness” as “whatever it is I want,” but in fact, people used the word “happiness” to mean “feeling happy.”

That people want more than money makes GDP an inadequate measure of well-being. That they want more than happiness makes happiness an inadequate measure of well-being. So it won’t work to simply replace GDP with Gross National Happiness as Richard Layard advocates in his book, Happiness. And looking at National Life Satisfaction has a similar problem.

So let’s get serious about what it means for an individual or a nation to be better off. Constructing a solid measure of national well-being requires answering the two questions “What do people want and how much do they want it?” So my coauthors Daniel Benjamin, Ori Heffetz, Nichole Szembrot and I set out to answer exactly those questions in our National Bureau of Economic Research Working Paper “Beyond Happiness and Life Satisfaction: Toward Well-Being Indices Based on Stated Preference.” We gave about 4,600 US adults hard choices to make in computer-generated scenarios where they had to identify both what people wanted for themselves and what they wanted for the nation as a whole. We didn’t want to prejudge, so we started with a list of 136 aspects of life that people might care about, drawing from a wide-ranging scientific and philosophical literature, as well as spirited discussions among the four of us.

The answers we found to “What do people want and how much do they want it?” were at once surprising and the height of common sense. I want to focus on the answers people gave for what they wanted for the nation as a whole, since that is primarily what a president should be judged on. One important finding is that, even across divisions of party, religion, age and sex, people by and large put the same things at the top of the list of what they want for the nation. And the things they want for the nation as a whole are similar to the things they want for themselves.

Let me give my take on the top 25 things we found people want for the nation as a whole. Freedom comes first: freedom from injustice, corruption, emotional abuse and abuse of power; freedom of speech and political participation, freedom to pursue one’s dreams and the freedom of having choices. Besides freedom, people want for the nation goodness, truth, loyalty, respect and justice.

Only after freedom and goodness, do the “bread-and-butter” aspects of people lives start to come in. These bread-and-butter aspects are reflected in 11 of the top 25 aspects of life, including people’s health and freedom from pain, financial security, someone to turn to in time of need, emotional stability, a sense of security and peace, and activities to enjoy. Beyond freedom, goodness, and the practical, bread-and-butter aspects of people’s lives I just listed, people want meaning—the sense that one is making a difference in the world–for themselves and for others.

Freedom, goodness, truth, loyalty, respect, justice, bread-and-butter concerns, meaning: people’s hopes for our nation, and for themselves, extend to a lot more than money and happiness. I believe the breadth of what people want for the nation has implications for the policies our country should pursue, and how we should judge President Obama four years from now. In drawing out those implications, I will leave aside the bread-and-butter concerns, and concerns about “justice,” since I think our leaders understand those better than the other concerns.

One of the best ways to increase the freedom in the world is to allow more people to come to the United States to experience and tell of the freedom we have here, as I advocated in my Quartz column “Obama Could Really Help the US Economy by Pushing for More Legal Immigration.” But there is a lot to be done to preserve and bolster freedom in the US. Taxes represent a loss of freedom that should be mitigated in the kinds of ways I suggest in my post “No Tax Increase Without Recompense.” The conflict between employees’ freedom at work and employers’ freedom to lay down work requirements need to be fairly adjudicated, as discussed in my post “Jobs.” And every government regulation, in addition to whatever other costs and benefits it has, causes a loss of freedom from telling somebody what they must do.

When we do constrain freedom by regulation, it should be in service of something important, such as truth: people’s freedom from being lied to, deceived or betrayed. It is worth remembering that the standard results about the virtues of the free market all depend on deception being effectively neutralized–so there is no fundamental conflict between economic growth and laws that block corporate deception and throw scam artists in jail. Enforcing the basic principle of telling the truth, like enforcing property rights, is an area where government is on the side of the angels.

Meaning, goodness, loyalty and respect are the trickiest for public policy to foster. As a social scientist who does research supported by government grants, I would like to think that there is some sense of meaning for all of us in humanity’s efforts at scientific research, such as medical research and the kind of research to slow global warming advocated by Noah Smith in his Atlantic column “The End of Global Warming: How to Save the Earth in 2 Easy Steps.” But I think a big part of what government needs to do to foster meaning, goodness, loyalty and respect is to stay out of the way. In this regard, I am worried about recent discussion of limiting the charitable deduction. My proposal for a system of “public contributions” is a way to reform and refocus the purpose of the charitable deduction instead, in order to reduce the government deficit, and reduce the footprint of the government, without depriving people of help they need.

From doing this research, I am left with the overwhelming impression that—even in the realm of intangibles—what people hope for and wish for is not one thing, but many things. Our desires are boundless. And that is how it should be. As Robert Browning wrote, ”Ah, but a man’s reach should exceed his grasp, Or what’s a heaven for?”

In early drafts, I related what I say in the Quartz column to Jonathan Haidt’s six moral tastes in his book The Righteous Mind: Why Good People Are Divided by Politics and Religion. Here is a New York Times book review by William Saletan, and here is a good passage from Jonathan Haidt summarizing his theory, chosen by Bill Vallicella, in Bill’s post “Jonathan Haidt on Why Working Class People Vote Conservative.”

There is a key chunk of text making the link to Jonathan Haidt’s theory that was appropriately cut for being too wonkish, but that I think you might find valuable

for making that connection and
for more carefully stating the key findings about people’s preferences in hypothetical policy choices from my paper with Daniel Benjamin, Ori Heffetz and Nichole Szembrot.

Here it is:

The most important boon people want for the nation as a whole is freedom. In the words we used for the choices we gave them, the #1, #2, #10, #13, #18 and #23 things people want for the nation are
freedom from injustice, corruption, and abuse of power in your nation
people having many options and possibilities in their lives and the freedom to choose among them;
freedom of speech and people’s ability to take part in the political process and community life;
the amount of freedom in society;
people’s ability to dream and pursue their dreams; and
people’s freedom from emotional abuse or harassment.
The next most important boons people want for the nation are goodness, truth, loyalty, respect and justice. On our list, the #3, #6, #8, #17, #19 and #21 most highly-valued aspects of the good society are
people being good, moral people and living according to their personal values;
people’s freedom from being lied to, deceived or betrayed
the morality, ethics, and goodness of other people in your nation;and
people having people around them who think well of them and treat them with respect
the quality of people’s family relationships
your nation being a just society.
The exact picture of “goodness” and “justice” might differ from one person to the next, but it is clear that they represent more than just money and happiness. University of Virginia psychologist Jonathan Haidt, in his brilliant book The Righteous Mind: Why Good People Are Divided by Politics and Religion argues that morality comes in six flavors (“The righteous mind is like a tongue with six tastes.”):
liberty vs. oppression,
fairness vs, cheating,
sanctity vs. degradation,
loyalty vs. betrayal,
authority vs subversion, and
care vs. harm.
The first five of Haidt’s flavors of morality are well represented above. The fourth flavor of morality, care vs. harm, is the one many authors focus on, to the exclusion of the others. It is the bread and butter aspects of people’s lives. In our findings, care vs. harm is reflected in 11 of the top 25 (numbers 4, 7, 9, 11, 12, 13, 16, 18, 22, 24, 25), including “the overall well-being of people and their families” in your nation, people’s health, financial security, and freedom from pain; “people having people they can turn to in time of need” and a “sense of security about life and the future in general” and balance, as reflected in the items “people’s mental health and emotional stability,” “how much people enjoy their lives” and “how peaceful, calm and harmonious people’s lives are.”
In addition to all of these, people want meaning, as reflected by #5 and #14 on our list: “people’s sense that they are making a difference, actively contributing to the well-being of other people, and making the world a better place, and “people’s sense that their lives are meaningful and have value.” In addition to his discussion of key dimensions of morality, in The Righteous Mind: Why Good People Are Divided by Politics and Religion, Jonathan Haidt emphasizes the importance of meaning—in particular, the importance of feeling one is a part of a larger whole. One of his central metaphors is “We are 90 percent chimp and 10 percent bee.” That is, Haidt believes that perhaps 90% of the time we are out for ourselves, however gently, but perhaps 10% of the time we are out for a higher cause (like the general good of everyone in our group) to the deepest level of our beings. A sense of “meaning” often comes from making that connection to something greater than ourselves.

You can see my other posts on happiness in the happiness sub-blog linked at my sidebar, and here:

http://blog.supplysideliberal.com/tagged/happiness