Brain teasers from monetary theory and Scott Sumner

by  Tyler Cowen in

First, here is Scott Sumner's ideal world:

In an ideal world, we’d remove all discretion from central bankers. The Fed would simply define the dollar as a given fraction of 12- or 24-month forward nominal GDP, and make dollars convertible into futures contracts at the target price. If the public expected NGDP to veer off target, purchases and sales of these contracts would automatically adjust the money supply and interest rates in such a way as to move expected NGDP back on target. It would be something like the classical gold standard, but with the dollar defined in terms of a specific NGDP futures contract, instead of a given weight of gold. The public, not policymakers in Washington, would determine the level of the money supply and interest rates most consistent with a stable economy.

To proceed, not everyone will understand this post, which is DeLong on Scott Sumner:

As I understand Scott's proposal, it is this: Nominal GDP in the fourth quarter of 2007 was $14.291 trillion. A 5% growth rate from that base would give us a value of $17.455 trillion for the fourth quarter of 2011. Add on another 3% for the average short-term nominal interest rate we would like to see, and we have $18.153 trillion. Therefore the Federal Reserve would, today, announce that it stands ready to buy and sell dollar deposits to qualified customers at a price of $1 = 1/18,155,000,000,000 of 2011Q4 GDP.

If investors thought that nominal GDP in the fourth quarter of 2011 was likely to be lower than $18.15 trillion, they would take the Fed up on its offer: demand the cash now, pay off the contract in a year by then paying 1/18,155,000,000,000 of 2011Q4 GDP, and (hopefully, if they were right) make money–thus the money stock would increase. If investors thought that nominal GDP in the fourth quarter of 2011 was likely to be greater than $18.155 trillion, they would take the Fed up on its offer: give cash to the Fed now, collect the contract in a year by receiving 1/18,155,000,000,000 of 2011Q4 GDP, and (hopefully, if they were right) make money–thus the money stock would fall.

If nominal GDP were expected to fall, the Federal Reserve would be shoveling money out the door at negative expected nominal interest rates. If his scheme were applied today it would be quantitative easing on a pan-galactic scale, as everybody would run to the Fed with bonds to use as collateral for their promises to pay the expected futures contract in a year in exchange for the cash now.

The Federal Reserve would then become truly the lender of not just last but first resort. Why would anybody borrow on the private market even at 0% per year when they could borrow from the Fed at -3%/year? Savers would simply hold cash rather than try to match the terms that the Fed was offering borrowers. Borrowing firms would borrow from the Fed exclusively. The Fed would thus create a wedge between the minimum nominal interest rate that savers would accept (zero, determined by the alternative of stuffing cash in your mattress) and the nominal interest rate open to borrowers.

I expressed related reservations about a related version of the idea in the 1997 JMCB.  I am all for (rough) nominal GDP targeting, and considering the forecast, and for Scott's work in general, but I don't think the "automaticity" versions of it work.  NGDP targeting does best as a general guideline for the central bank, which the central bank follows to make the world a better place, but without renouncing some ultimate degree of discretion with regard to timing and targeting and how good a deal they offer everyone at this new and somewhat unusual version of the discount window.

It's a general problem with strict pegging schemes that some prices (or pxq variables) adjust more quickly than others, or are better and more quickly forecast than others, and that means arbitrage opportunities against the pegger and/or very dramatic swings in nominal interest rates.

So on this question I agree with Brad and not with Scott.

Still, there is a general rule: when Scott Sumner says you are wrong, you are wrong (this is somewhat distinct from the claim that "Scott Sumner is always right," though if he worded all his pronouncements in a particular way I suppose it would not be).

So perhaps Scott will say that Brad and I are wrong.  Or perhaps he will say that I am wrong about the general rule in the first place.  Or perhaps he will say that we have misunderstood him.

The broader underlying question is how strict a nominal GDP target or NGDP forecast target can be and that question is not very well understood.

David Alexander on Australia

by  Tyler Cowen in

Australia is one of the most economically free countries in the world, and has for some time been among the smallest governments in the developed world, with low levels of tax and spending. Last year, according to the OECD’s Economic Outlook, Australia was the Thatcherite’s number one performer, with not only the lowest level of government spending of all developed countries but also the lowest level of taxes of all developed countries equal with South Korea).

Alexander also stresses that Australia both is and feels relatively egalitarian, while having a high level of ethnic diversity.  He writes to me:

One key to this is that Australia is the means-testing capital of the world, with the lowest proportion of transfers to high earners of any country; The second key is the very low taxes on low earners; This highly progressive tax and transfer system produces small and dynamic government – I call it egalitoryan – but it turns Hayek and Buchanan upside down.

There is much more here.

The inequality that matters

by  Tyler Cowen in

Here is a new and longish piece by me, on the inequality debates, in The American Interest.  It's about which kinds of inequality matter and which do not.  Most of them do not:

A neglected observation, too, is that envy is usually local. At least in the United States, most economic resentment is not directed toward billionaires or high-roller financiers–not even corrupt ones. It’s directed at the guy down the hall who got a bigger raise. It’s directed at the husband of your wife’s sister, because the brand of beer he stocks costs $3 a case more than yours, and so on.

Furthermore there is a natural rising inequality in a world of strivers and slackers.  But some forms of inequality are more dramatic and are associated with unstable incentives:

If we are looking for objectionable problems in the top 1 percent of income earners, much of it boils down to finance and activities related to financial markets…The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

An understanding of the Black-Scholes idea of synthetic positions drives home the point that such strategies are very hard to stop by regulatory means.  Furthermore politicians have incentives to play the very same socially risky strategies; if things are "good now" they will get reelected and they pay few penalties for the severity of their eventual mistakes.  The fight against excess leverage is probably a non-starter (who now wishes to "slow down" the recovery?).  It is possible that our current system of state capitalism is "Arrow-Hahn-Debreu gameable" and that the financial sector has opened a hole in the proverbial bathtub and is sucking on a very large straw.

There are many other points about inequality in this piece which I have not presented on MR.

*The New Lombard Street*

by  Tyler Cowen in

The subtitle is How the Fed Became the Dealer of Last Resort (home page here) and the author is Perry Mehrling.  The entire book is good but the paydirt comes in the last two chapters, where we are treated to a persuasive and original account of what the crash- and post-crash Fed is all about.

Mehrling tells us that the Fed is now committed to supplying liquidity in money markets through its role as a dealer, on both sides of its balance sheet, and that is a critical shift in the nature of central banking.  He discusses (pp.126-127) how the collateral behind the shadow banking system relied on CDS markets for its pricing.  In Mehrling's account, insurance companies (including AIG) were indirectly serving as dealers of last resort, believing that they held invulnerable positions but nonetheless exposed.  Investment banks, on their side, thought they held matched books but the higher and lower CDO tranches turned out to be less similar than they had been expecting, based on historical price risk.  None of these expectations survived contact with the reality of the crash.

Now it's the central bank which sells AAA protection because eventually, in Mehrling's view, this activity cannot forever remain a private function (for a start, which insurer is itself safer than AAA?).  A good and indeed central question to ask anyone who is proposing a financial system is to ask who will sell AAA insurance.  

To quote Perry, the new Fed principle seems to be: "insure freely but at a high premium."

Mehrling also suggests that looking at the Fed's balance sheet, or its transactions, is misleading.  The key question is what kind of liquidity dealing option the Fed is promising to the market.

I continue to ponder Mehrling's main claims, but in any case this is an important book about the new Fed.

Assorted links

by  Tyler Cowen in

1. Update on Arizona Medicaid transplant rationing.

2. Fear of one's own glance, from Japan.

3. Read both Pirrong and Steve Waldman here, on OTC clearinghouses.  And Felix Salmon.

4. The world's best presentations?

5. Occasionally obscene, NSFW cartoon video on Becker-Murphy rational choice theory of addiction.  It's funny.

6. David Epstein, Columbia scholar of political economy, is charged under the law.  It's not funny.

Sentences to ponder

by  Tyler Cowen in

In 1902, European nations responded to a Venezuelan government debt default with military force. German, Italian and British gunboats blockaded ports, seized customs houses and bombarded a Venezuelan fort. Venezuela caved, agreeing to restructure and pay its debts.

These days, when European leaders see Greece and Ireland on the brink of default, they don't send gunboats–they send money.

That's from Kevin Hassett.

*The Big Ditch*

by  Tyler Cowen in

The authors are Noel Maurer and Carlos Yu and the subtitle of this excellent book is How American Took, Built, Ran, and Ultimately Gave Away the Panama Canal.  In the old days they might have called this book The Panama Canal.  Excerpt:

In 1920, when the Panama Canal first opened to commercial traffic, real freight rates between Britain (Liverpool) and the West Coast of the United States (Portland, Oregon) dropped 27 percent.  In 1921, the canal's first year of operation, real shipping costs dropped another 35 percent…by 1922, shipping costs had fallen 31 percent below their prewar average.

Within a few years, oil prices in California and Texas had converged.  The authors estimate a social rate of return of nine percent for the first two decades of the canal's existence and they do include the costs of defending it.

In my view, whether as tourists, economists, or historians, people do not spend enough time thinking about the Panama Canal.  Here is the book's home page.

Device Lag at the FDA

by  Alex Tabarrok in

A new survey of the FDAs impact on medical technology innovation reports that the FDA is slow, inefficient and costly.  The survey is from the Medical Device Manufacturers Association so take it with a grain of salt (but see below). What is most telling, however, is how manufacturers rate the FDA compared to its European counterpart(s).

Overall Experience: 75 percent of respondents rated their regulatory experience in the EU excellent or very good. Only 16 percent gave the same ratings to the FDA…

Respondents also cite specific concerns with the FDA process (not just a general complaint of slowness which could be efficient) such as:

…44 percent of participants indicated that part-way through the regulatory process they experienced untimely changes in key personnel, including the lead reviewer and/or branch chief responsible for the product’s evaluation.

As a result:

On average, the products represented in the survey were available to patients in the U.S. a full two years after they were available to patients in Europe (range = 3 to 70 months later).

In some cases, respondents said they initiated their regulatory processes within and outside the U.S. at the same time, but received clearance/approval in the U.S. much later. In anticipation of long, expensive FDA reviews, others said they decided to seek or obtain European approval first in an effort to generate sales overseas that could help fund their U.S. regulatory efforts.

The survey has a good discussion of potential biases. To those not familiar with the industry it might seem obvious that the MDMA would want to bash the FDA but my experience is that companies in the business don't like to complain. Indeed, the survey notes:

A number of companies indicated that they would not respond due to fear of retribution from the FDA (despite assurances we would maintain their confidentiality).

See FDAReview for more on the FDA. Hat tip: Mike Mandel.

Addendum: Loyal reader Josh Turnage has produced a video plea to the FDA on behalf of his mother to leave Avastin approved for breast cancer.

China fact of the day

by  Tyler Cowen in

“The money supply is too large,” said Andy Xie, an economist based in Shanghai who formerly worked at Morgan Stanley. “They increased the money supply to stimulate the economy. Now land prices have jumped 20 times in some places, 100 times in others. Inflation is broad-based. Go into a supermarket. Milk is more expensive in China than it is in the U.S.”

In Shanghai, where the average monthly wage is about $350, a gallon of milk now costs about $5.50.

The article is a good survey of some Johnny-come-lately China skeptics.

Are we out of the liquidity trap yet?

by  Tyler Cowen in

Retail sales probably climbed in November for a fifth consecutive month as Americans began their holiday shopping, showing consumers are playing a bigger role in the U.S. recovery, economists said before a report this week.

The story is here.  As D.H. Robertson insisted, there is the money-goods margin and not just the money-bonds margin (Richard Ebeling taught me that point).  On the money-goods margin we seem to be experiencing an ongoing rise in aggregate demand.  Is the claim that retail spending went up this much, for months, but could not possibly have gone up any higher?  If so, I do not believe that claim.

Are we out of the liquidity trap yet?

Assorted links

by  Tyler Cowen in

1. As I've been saying, derivatives clearinghouse regulation isn't working.  And that was supposed to be one of the best, least controversial, and most non-partisan parts of Dodd-Frank.

2. Arnold Kling, China, labor markets, Hayek, Hilferding.  Uh-oh.

3. Are people backing away from the school choice movement?

4. Can you tell if someone is Mormon by looking at him?

5. What (some white) progressives don't understand about Obama.

6. The culture that is Mecklenburg-Western Pomerania.