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The Minimum Wage, Rent Control, and Vacancies or Who Searches?
In an interesting new paper Federal Reserve economists Marianna Kudlyak, Murat Tasci and Didem Tüzemen look at what happens to job vacancy postings when the minimum wage increases.
The vacancy data in our analysis come from the job openings data from the Conference Board as a part of its Help Wanted OnLine (HWOL) data series. HWOL provides monthly data on vacancies at detailed geographical (state, metropolitan statistical area, and county) and occupational (six-digit SOC and eight-digit O*Net) levels starting from May 2005. HWOL covers around 16,000 online job boards.
…Our identification strategy exploits the idea that different occupations can be differently impacted by minimum wage hikes due to differential mass of occupation-specific wage distributions concentrated around the prevailing minimum wage. We formalize this idea by analyzing wage distributions by occupation at the state level using micro data from the Current Population Survey (CPS). We identify occupations with large shares of employed workers at or near the state-level effective minimum wage and we refer to these occupations as “at-risk occupations.” We then estimate vacancy growth in at-risk occupations relative to vacancy growth in other occupations around the time when minimum wage increase takes place in the state, and relative to growth in vacancies in at-risk occupations at the national level.
…We find a statistically significant and economically sizeable negative effect of the minimum wage increase on vacancies. Specifically, a 10 percent increase in the level of the effective minimum wage reduces the stock of vacancies in at-risk occupations by 2.4 percent and reduces the flow of vacancies in at-risk occupations by about 2.2 percent.
…We find that firms cut vacancies up to three quarters in advance of the actual minimum wage increase. This finding is consistent with the firms’ desire to cut employment and vacancies being a forward-looking tool to achieve it. This finding is also consistent with a typical announcement effect of a policy change. Formally testing for the parallel trends assumption in our triple-difference identification, we find that at-risk and not-at-risk occupations do not have statistically significant differences in their vacancy trends prior to the typical announcement period. But the negative effect persists even four quarters after the minimum wage increase. The cumulative negative effect of a 10 percent increase in the minimum wage on total vacancies is as large as 4.5 percent a year later.
…We find that vacancies in occupations that typically employ workers with lower educational attainment (high school or less) are affected more negatively than vacancies in other occupations. The negative effect on vacancy posting is exacerbated in counties with higher poverty rates, which highlights another trade-off that policymakers might want to take into account.
This reminded me of a similar paper on rent controls (ungated) by Are Oust that Tyler and I mention in the forthcoming edition of Modern Principles of Economics.
Are Oust studied rent controls in Oslo, Norway and found that during the rent control era it was common for landlords to require their tenants to be of a certain gender, age, occupation and even religion (which would be illegal in the United States). Landlords would also find ways to charge extra by asking renters for extra services such as baby-sitting, garden work or snow-clearing. When rent control was eliminated, however, the number of apartments increased and landlords no longer advertised these kinds of requirements. Perhaps most telling, in the rent-control era it was common for renters to advertise “Apartment Wanted” but when rent controls were lifted it became much more common for landlords to advertise “Apartments for Rent!”
In other words, in a free market firms search for employees and landlords search for renters but under the minimum wage and rent control, workers must search for jobs and renters must search for apartments to a much greater extent.
Nellie Bowles interviews me on inflation
So I called someone smart (Tyler Cowen, an economist, author, and professor at George Mason University) to explain the dynamics to me.
“Inflation right now is still transitory in that we can choose to end it,” Cowen told me. The Federal Reserve could disinflate and raise interest rates—mortgage interest rates today remain well below 3%—though that risks starting a recession.
Cowen explained that the reason the inflation-wary are still pretty quiet is that all the anti-Obama Republicans were so wrong in 2008. After the Obama-era bailout during the Great Recession, Republicans were convinced inflation would run rampant. And they said so. A lot. But inflation stayed mostly in control. “They all got egg on their faces after that,” Cowen said. “So the crowd that would complain now, they’re whispering about it but not shouting yet.” (Larry Summers and Steve Rattner have sounded the alarm.)
“I think the inflation will last two to three years, and it will be bad,” Cowen said. But really grim hyper-inflation à la Carter-era, he thinks is unlikely. It could only happen if the Federal Reserve decides it’s too risky to trim the sails of cheap money. “I’d put it at 20% chance that the Fed will think, ‘Trump might run again, and we don’t want Biden to lose . . . history’s in our hands, so we’ll wait to tighten.’ And then it just goes on, and then it’s very bad.”
But a recession is also bad. It’s hard to sort it all out. “As the saying goes, ‘If you’re not confused, you don’t know what’s going on,’” Cowen told me.
That is from the Bari Weiss Substack, other topics are considerd (not by me) at the link.
The wisdom of Scott Sumner
Meanwhile, young tweeters seem to forget the Great Inflation happened, or perhaps that it was caused by some sort of oil shock. How oil shocks cause double digit NGDP growth has never been explained. Everything we learned about unreliable Phillips Curves and shifting inflation expectations seems to have been forgotten. You simply can’t have too much stimulus.
I suppose their ignorance is understandable. If parents expertly adjust the thermostat to keep the house temperature at 71 to 73 degrees for 20 years, with a 72 degree target, can you blame the kids who grew up in that house for thinking that thermostats don’t have much impact on temps? (Let’s hope Powell knows!)
My views are orthogonal to this intra-Keynesian debate. I don’t think the fiscal stimulus is a good idea, but not because I expect much inflation. The inflation rate will be determined by the Fed. Rather it’s a reckless policy because it will lead to higher tax rates in the future and won’t do much to generate growth beyond Q3. (Deficits do cause higher interest rates, but only slightly higher in a country like the US.)
For 250 years of American history, politicians have held the peacetime budget deficit in check because of fears of either inflation or higher interest rates (or perhaps a loss of confidence in the gold standard.) What would happen if they begin to sniff out that the actual risk is not inflation or much higher interest rates next year, rather the risk is higher taxes in 20 years, after they’ve safely retired? How would they respond to this information?
I fear that we are about to find out.
There is more at the link. As an aside, I am amazed how much “but the job market recovered so slowly last time” is considered a relevant argument here.
Why bitcoin will not take over the world
Yes it is here to stay, and it is not a bubble, but…here is one part of the argument:
If you hold or trade with a stablecoin, you incur several risks. First, the stablecoin peg to the dollar may someday be broken, an old problem with pegged exchange rates that Milton Friedman often warned about. Second, to the extent stablecoins and other crypto assets become a major part of the financial system, they will attract more regulatory interest. That in turn will limit many of their advantages over the traditional bank sector. The U.S. government does not want a financial system that evolves outside the purview of the Federal Reserve, FDIC and other regulatory institutions.
Third, the formal banking sector will improve, for instance by moving to more rapid clearing, or by introducing electronic reserve currencies. With the latter, you could transfer your electronically-based dollars within the accounting system of the central bank, and achieve a non-intermediated transfer without resorting to crypto. It is not obvious that crypto will be the market winner once more mainstream institutions learn some lessons from the success of crypto.
And in sum:
The more utopian scenarios for crypto, whether proponents realize it or not, rely on the notion that crypto remains simultaneously fringe and mainstream. That will be a hard trick to pull off.
Your rebuttals, and more, are considered at the link to my latest Bloomberg column.
Robert B. Wilson, Nobel Laureate
Here is his home page. He has been at Stanford Business School since 1964, and born in Geneva, Nebraska. Here is his personal website. Here is his Wikipedia page. He has a doctorate in business administration from Harvard, but actually no economics Ph.D. (bravo!) Here is the Nobel designation.
Most of all Wilson is an economic theorist, doing much of his most influential work in or around the 1980s. He is a little hard to google (no, he did not work with Philip Glass), but here are his best-cited papers. To be clear, he won mainly for his work in auction theory and practice, covered by Alex here. But here is some information about the rest of his highly illustrious career.
He and David Kreps wrote a very famous paper about deterrence. Basically an incumbent wishes to develop a reputation for being tough with potential entrants, so as to keep them out of the market. This was one of the most influential papers of the 1980s, and it also helped to revive some of the potential intellectual case for antitrust activism. Here is Wilson’s survey article on strategic approaches to entry deterrence.
Wilson has a famous paper with Kreps, Milgrom, and Roberts. They show how a multi-period prisoner’s dilemma might sustain cooperating rather than “Finking” if there is asymmetric information about types and behavior. This paper increased estimates of the stability of tit-for-tat strategies, if only because with uncertainty you might end up in a highly rewarding loop of ongoing cooperation. This combination of authors is referred to as the “Gang of Four,” given their common interests at the time and some common ties to Stanford.
His 1982 piece with David Kreps on “sequential equilibria” was oh so influential on game theory, here is the abstract:
We propose a new criterion for equilibria of extensive games, in the spirit of Selten’s perfectness criteria. This criterion requires that players’ strategies be sequentially rational: Every decision must be part of an optimal strategy for the remainder of the game. This entails specification of players’ beliefs concerning how the game has evolved for each information set, including information sets off the equilibrium path. The properties of sequential equilibria are developed; in particular, we study the topological structure of the set of sequential equilibria. The connections with Selten’s trembling-hand perfect equilibria are given.
Here is a more readable exposition of the idea. This was part of a major effort to figure out how people actually would play in games, and which kinds of solution concepts economists should put into their models. I don’t think the matter ever was settled, and arguably it has been superseded by behavioral and computational and evolutionary approaches, but Wilson was part of the peak period of applying pure theory to this problem and this might have been the most important theory piece in that whole tradition.
From Wikipedia:
Wilson’s paper “The Theory of the Syndicates,”JSTOR 1909607 which was published in Econometrica in 1968 influenced a whole generation of students from economics, finance, and accounting. The paper poses a fundamental question: Under what conditions does the expected utility representation describe the behavior of a group of individuals who choose lotteries and share risk in a Pareto-optimal way?
Link here, this was a contribution to social choice theory and fed into Oliver Hart’s later work on when shareholder unanimity for a corporation would hold. It also connects to the later Milgrom work, some of it with Wilson, on when people will agree about the value of assets.
Here is Wilson’s book on non-linear pricing: “What do phone rates, frequent flyer programs, and railroad tariffs all have in common? They are all examples of nonlinear pricing. Pricing is nonlinear when it is not strictly proportional to the quantity purchased. The Electric Power Research Institute has commissioned Robert Wilson to review the various facets of nonlinear pricing.” Yes, he is a business school guy. Here is his survey article on electric power pricing, a whole separate direction of his research.
Here is his 1989 law review article about Pennzoil vs. Texaco, with Robert H. Mnookin.
Wilson also did a piece with Gul and Sonnenschein, laying out the different implications of various game-theoretic conjectures for the Coase conjecture, namely the claim that a durable goods monopolist will end up having to sell at competitive prices, due to the patience of consumers and their unwillingness to buy at higher prices.
Wilson was the dissertation advisor of Alvin E. Roth, Nobel Laureate, and here the two interview each other, recommended. Excerpt:
Wilson: As an MBA student in 1960, I wrote a class report on how to bid in an auction that got a failing grade because it was not “managerial.”
And here is an Alvin Roth blog post on the prize and the intellectual lineage.
The bottom line? If you are a theorist, Stockholm is telling you to build up some practical applications — at the very least pull something out of your closet and sell it on eBay! A lot of people thought Roberts and maybe Kreps would be in on this Prize, but they are not. The selections themselves are clearly deserving and have been “in play” for many years in the Nobel discussions. But again, we see the committee drawing clear and distinct lines.
Let’s see what they do next year!
The Nanny Tax and the Miracle of Government Loaves
Before it descends into utter madness, Leslie Forde’s Slate article on Nanny pay opens with a good story:
“I’m sorry … but I can’t,” she told me over the phone. My heart sank. I was confident she’d take the job. Quickly, I went into negotiation mode, “But wait, can we talk about the pay? Do you need more to … ” She said no before I could finish. “I just can’t take a job (that pays) over the table. It’ll mess up my housing. I won’t be able to stay in my apartment. I’m sorry. I’ve already taken another job.” I ended the call. …my entire career was at risk because I couldn’t find a nanny—at least, one willing to be paid legally.
It’s estimated that less than 10 percent of 2 million domestic workers and the families who employ them pay employment taxes.
From that opening I was expecting the author to explain that nannies aren’t willing to work on the books because at the bottom of the income scale income is taxed twice–first by Federal and State direct taxes and second indirectly because higher income causes workers to lose benefits. As a result of this double taxation, in some states it’s possible for poor workers to face effective marginal tax rates above 100 percent. If you had to pay to work, would you work?
High marginal taxes rates on the poor are a problem. We ought to be able to agree on that, even if we disagree on proposals to address the problem such as a universal basic income or a negative income tax. But in Forde’s magical world, up is down and down is up and the problem is that taxes on the poor are too low. But not to worry because this presents a hidden opportunity!
There is, however, a hidden opportunity to provide help to our caregivers and the families who employ them. Right now, these under-the-table arrangements are creating a “tax gap”—billions of dollars in additional funding that would be available to support caregivers, if the majority of families and their caregivers paid into the system.
Did you get that? If nannies were taxed the government would have more money to provide nannies with benefits. Wait, it gets worse. According to Forde, we can make both families and nannies better off by giving them back the money the government takes and still have money left over!
The estimated “gap” from the lost tax revenue is a combination of the federal and state employment taxes typically paid by employees (Social Security, Medicare, and income taxes) and employers (in addition to Social Security and Medicare, they must pay federal and state unemployment taxes.) Imagine if just a portion of this revenue were used to reimburse families for more of their child care expenses and to provide caregivers access to better benefits than they get currently with their under-the-table jobs. (italics added, AT)
Indeed, wouldn’t it be nice to live in a world of pure imagination? One without tradeoffs. Where we could rely on the miracle of government loaves to solve all problems?
Interview with John Cochrane
There are many interesting bits from the interview, sometimes polemic bits too, here is one excerpt:
EF: What do you think are the biggest barriers to our own economic recovery?
Cochrane: I think we’ve left the point that we can blame generic “demand” deficiencies, after all these years of stagnation. The idea that everything is fundamentally fine with the U.S. economy, except that negative 2 percent real interest rates on short-term Treasuries are choking the supply of credit, seems pretty farfetched to me. This is starting to look like “supply”: a permanent reduction in output and, more troubling, in our long-run growth rate.
This part reminds me of some ideas in my own Risk and Business Cycles:
There is a good macroeconomic story. In a business cycle peak, when your job and business are doing well, you’re willing to take on more risk. You know the returns aren’t going to be great, but where else are you going to invest? And in the bottom of a recession, people recognize that it’s a great buying opportunity, but they can’t afford to take risk.
Another view is that time-varying risk premiums come instead from frictions in the financial system. Many assets are held indirectly. You might like your pension fund to buy more stocks, but they’re worried about their own internal things, or leverage, so they don’t invest more.
A third story is the behavioral idea that people misperceive risk and become over- and under-optimistic. So those are the broad range of stories used to explain the huge time-varying risk premium, but they’re not worked out as solid and well-tested theories yet.
The implications are big. For macroeconomics, the fact of time-varying risk premiums has to change how we think about the fundamental nature of recessions. Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. Yet all of macroeconomics still talks about the level of interest rates, not credit spreads, and about the willingness to substitute consumption over time as opposed to the willingness to bear risk. I don’t mean to criticize macro models. Time-varying risk premiums are just technically hard to model. People didn’t really see the need until the financial crisis slapped them in the face.
I’ve long believed the risk premium is the underexplored variable in macroeconomics and finally this is being rectified.
The new “carry trade”?
Loosely regulated non-bank lenders have emerged as among the biggest beneficiaries of the Federal Reserve’s ultra-low interest rates with three specialist categories increasing their assets by almost 60 per cent since the height of the financial crisis.
Such lenders, widely considered part of the “shadow banking” system, have expanded rapidly on the back of investors who are clamouring for the higher returns on offer from financing riskier types of lending.
From the FT, there is more here.
For how long can the carry trade go on?
Here is a rather scary article by @exantefactor, consider it speculative and please use with care, nonetheless I thought it was worth a ponder. Here is one bit:
This QE carry trade nightmare became reality last week, and the Eurodollar pit was ground zero. As carry trade asset prices come under pressure due to rising US real interest rates, investors are forced to sell Eurodollars to hedge higher financing costs and negative gamma exposure. The magnitude of the selling implies that there is a lot of money exposed, but it’s not clear what still needs to unwind.
Last week, there were rumors of bond dealers who were both liquidating MBS inventory and ceasing to bid on these securities until quarter end. There were also accounts of liquidity drying up in the Treasury market. When dealers cease to bid on the assets that collateralize the loans for carry trades, the system is frozen. This is serious.
If you believe the accounts in the media, you would think the Fed believes the move in the front end of the yield curve, including the Eurodollar strip, is a misinterpretation of Fed tightening. The Eurodollar market not only has an interest rate component but also a credit component, and one interpretation of the blow out in the strip is a spike in banking system credit risk.
…Make no mistake about it: Bernanke is blowing up the QE trade he engineered. The question for markets at this juncture is not what assets are exposed to this trade but rather how much capital is exposed and who will take the other side of the unwind. The move in the most liquid part of the rates curve suggests that the position is very deep; the reluctance of dealers to bid on financing collateral suggests the bid is very shallow. Finding a level where that bid/ask comes together is likely to be a very disruptive process, and if history is any guide, the “collateral” damage will be felt around the world.
The full article is here, hat tip goes to Izabella Kaminska. Is “we haven’t been understanding the carry trade” the key to unpacking some otherwise puzzling recent asset price movements?
Are we living in a time of asset bubbles?
Here is one typical complaint about bubbles, from Jesse Eisinger, excerpt:
We are four years into the One Percent’s recovery. Now, we are in Round 3 of quantitative easing, the formal term for the Fed injecting hundreds of billions of dollars into the economy by purchasing longer-term assets like Treasury bonds and Fannie Mae and Freddie Mac paper. What’s that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields at record lows. Ratings shopping on structured financial products.
These are dangerous signs of prebubble activity.
Here is a Krugman rebuttal. I will offer a few points on a series of debates which in general I have stayed away from.
1. I don’t find most predictive discussions of bubbles interesting, while admitting that such claims often will prove in a manner correct ex post. “OK, the price fell, but was it a bubble? I mean was there froth, like on your Frappucino?” Or to quote Eisinger, it might also have been “dangerous signs of prebubble activity” (what happens between the “prebubble” and the “bubble”? The “nascent bubble”? The “midbubble”? The “midnonbubble”?)
2. Good news and improving conditions may well bring more bubbles or greater likelihood of bubbles, but that is hardly reason to dislike good news and improving conditions.
3. Relative to measured real interest rates, stocks look cheap right now. That doesn’t mean they are, but reread #1.
4. No one understands the term structure of interest rates, no matter what they tell you. Reread #1.
5. I don’t see why anything particular about the current state of affairs, at least in the United States, needs to be “unwound.” I sometimes draw a distinction between those of us who have been thinking about interest on reserves since S. Tsiang, Fischer Black, and the Reserve Bank of New Zealand, and those of us who have not.
6. One coherent definition of bubble is that of a hot potato, traded in a world of heterogeneous expectations, but which must ultimately pop, because eventually the price of that asset will consume all of gdp, a bit like those old Tokyo parking spots. Fair enough, but I don’t see that in many asset markets today if any (Bitcoin for a while?).
7. Another coherent definition of a bubble has less to do with a dynamic price path and ongoing resale for gain, but rather there may be a (temporary) segmentation across classes of asset market buyers. The obvious candidate here is that many people and institutions have been frightened into Treasuries and away from almost everything else. That could mean we have a real interest rate bubble, but it also could mean that lots of other assets are undervalued, at least if the liquidity effect defeats the higher real interest rate effect of moving out of Treasuries. (It would be odd to think that a shift of funds out of Treasuries and into stocks would cause stock prices to fall, but perhaps some people fear this.)
I don’t agree with this view, but I do feel I understand it. The most likely “bubble” is then in real interest rates, due to a (temporary?) skewing of the risk premium. That all said, I do not think this should be called a bubble. Changes in the risk premium and “bubbles” have traditionally been considered alternative explanations for asset prices. Reread #1, and reread #4 while you’re at it.
8. Ruchir Sharma made some interesting points yesterday:
Far from fighting off a deluge of foreign capital, leaders from India to South Africa are struggling to attract a greater share of global capital flows in order to fund widening current account deficits. Over the past decade, the foreign exchange reserves of the developing world grew at an average annual rate of 25 per cent, swelling from $570bn in 2000 to $7tn in 2011. But over the past year, the average rate slowed to a crawl of barely 5 per cent.
The idea that money is still flooding emerging markets misses the big picture, which is that global cross-border capital flows are down 60 per cent from their 2008 peak. The largest shares of cross-border capital flows are in bank loans, trade and foreign direct investment, which are slowing worldwide.
9. I expect the real economy over the next twenty years to be more volatile than it was say in the 1990s. In that sense, many current asset market prices may be revised and quite dramatically. Still, I don’t find the bubble category to be so useful in this regard. We really don’t know what is going to happen and that is why the current prices are wrong, not because of a “bubble.”
10. I am probably done blogging about bubbles for a while. Satisfying you was not the goal of this post, but that is in the nature of the subject area, not out of any desire for spite.
Thoughts on how to avoid another Great Depression
This is another excellent Martin Wolf column, read the whole thing. Here is one excerpt:
Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.
I believe people should take more seriously the notion that the ECB will remain hopeless, and that the crisis can only be addressed by some kind of joint US-German-UK-toss-in-the-other-sound-countries radical multilateral move. Which is not to say I am predicting that. But at least in principle, those three countries can get something done and they also have stronger common interests than those across the eurozone, sorry to say.
Just to make the comparison biting, what if we postponed the costly benefits part of ACA for a year (it may be struck down anyway) and send $200 billion directly to Spain and its banks? Is more money needed? Use this as an excuse to get rid of farm subsidies and cut defense spending. Surely the Germans would then chip in too, and perhaps even the Chinese, if we made the donors club sound exclusive and toney enough. Drop hints about various silly islands (not Taiwan).
Have the new QEwhatever driven by purchases of Spanish mortgages. If they keep the money abroad, we lose only the cost of the paper or the electronic bookkeeping entries. If they buy American goods and services with it, consider it QEwhatever as applied to American exports rather than mortgage paper. No liquidity trap there, and the Fed doesn’t itself have to choose which exports to buy. Combine with the Fed’s FX swap facility in some kind of nefarious way, and we can invent four or five new acronyms. And so on. We would still have a long, grinding worldwide recession but perhaps much less of an AD collapse with it.
I understand that Obama may not be the binding constraint here, but is he even thinking about pulling this off? Is he sitting around wishing for it? Is anyone talking to him about these options?
Excess Reserves and Intraday Credit
In my 2008 post, Interpreting the Monetary Base Under the New Monetary Regime, I argued that the massive increase in bank reserves was neither a necessary harbinger of inflation (as people on the right feared) nor a sure sign of a liquidity trap (as people on the left claimed) but rather represented, at least in part, a sensible aspect of the new regime of paying interest on reserves. I wrote:
When no interest was paid on reserves banks tried to hold as few as possible. But during the day the banks needed reserves – of which there were only $40 billion or so – to fund trillions of dollars worth of intraday payments. As a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit. Thus, in essence, the banks used to inhale credit during the day – puffing up like a bullfrog – only to exhale at night. (But note that our stats on the monetary base only measured the bullfrog at night.)
Today, the banks are no longer in bullfrog mode. The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night. Thus, all that has really happened – as far as the monetary base statistic is concerned – is that we have replaced daylight credit with excess reserves held around the clock.
A post today at Liberty Street Economics, the blog of the New York Federal Reserve illustrates and explains how the excess reserves have reduced transaction costs in the payment system and risk to the Federal Reserve.
The last chart shows the level of intraday credit extended by the Federal Reserve to Fedwire participants, measured as the daily maximum amount extended by the Federal Reserve. There has been a dramatic decline in the amount of credit extended since the expansion of reserve balances in October 2008. The reduced level of daylight credit has the benefit of reducing the risk exposure of Federal Reserve Banks, as well as the Federal Deposit Insurance Corporation’s (FDIC) fund. Indeed, the expected losses to that fund would be greater if some of the assets of a failed bank had been pledged to a Federal Reserve Bank to collateralize a daylight overdraft, as the collateral would not be available to pay other creditors of the bank. With a greater amount of reserves in the system, banks largely “prepay” for their liquidity needs by maintaining large reserve balances with which to fund their outgoing payments.
Bubbles and economic potential and potential gdp
Here is a Krugman post on the question, here are earlier posts from Sumner and Yglesias. I will put my remarks under the fold…This topic is easiest to understand if you sub out the United States and sub in Greece. There is no AD boost that can (anytime soon, without a lot of extra growth kicking in), restore Greece to its previous output peak and its previously expected performance-to-come. Circa 2006, Greece was in an unsustainable position, if for no other reason the market didn’t understand the correct risk premium for Greece. Once the correct risk premium is applied, Greek output falls and furthermore numerous (related) bad events kick in and also a whole set of previous plans are shown to be unsustainable (and no this doesn’t have to be an Austrian argument!). The gap between Greece’s current path, and the path previously envisioned for Greece is thus:
a. part AD gap which can be fixed by AD policy
b. part a difference in risk premia, and for Greece the old risk premium, when the country borrowed at very low rates, was wrong and is gone more or less forever. The concomitant financial and fiscal stability is gone too.
c. part a difference in enthusiasm in supply, based on the differences between earlier expectations that “get rich quick” really does apply to Greece, and the current more pessimistic expectation that “get rich quick” is now unlikely, and thus “smaller-scale, scrabble-around projects just to make ends meet” are the order of the day. DeLong gets at some of this here.
Greece does have to rebuild a) — don’t get sucked into aggregate demand denialism! — but it also has to rebuild b) and c) and perhaps other factors too. This follows rather directly from — dare I breathe the words? — the synthetic real business cycle/neo Keynesian models which form the backbone of contemporary macroeconomics and which Krugman apparently still doesn’t wish to recognize. (To various commentators and other bloggers: when I write macro on this blog I usually take knowledge of these models for granted; if you don’t know those models that is fine, call me arcane, but it doesn’t mean I am the one who is wrong.) Krugman runs through a bunch of weak arguments and responses, and counters them well enough, but he doesn’t see or consider the baseline response that would follow from standard contemporary macro, with the possible exception of his brief parenthetical phrase about credit conditions.
Turning for a moment to broader points, the astute reader will note that in this framework the current sluggishness of recovery need not be evidence for Old Keynesianism. An ineffective response to fiscal policy does not per se have to mean we just didn’t do enough fiscal policy. And so on. Maybe yes, maybe no, but all of a sudden there is a lot more room for agnosticism about macroeconomics and more broadly there is more room for epistemic modesty.
Contra Tim Duy, you can hold this mixed view without wanting to see the Fed raise interest rates. Just avoid the AD denialism.
Krugman defines “potential GDP is a measure of how much the economy can produce” but keep in mind that this quite possibly won’t be a unique number. With what risk premium? With what enthusiasm of supply? See my Risk and Business Cycles for an extended discussion and also numerous citations.
It’s also worth noting that while gdp is a useful “we can all agree upon what to measure” kind of concept, its real meaning is conceptually fairly slippery and “potential gdp” is not likely to be better pinned down at its foundations. Let’s not reify that concept above and beyond what it is worth.
In any case, we can be agnostic about the size of the potential gdp gap with regard to the United States today and indeed my original post very carefully used a question mark in its title. But there is no incoherence to assert that part of the apparent gap is due to the real side. The new learning about America is not about the correct risk premium for our debt (not yet at least), but about our financial fragility, how well our politics responds to crises, some worrying long-term trends in the labor market, possible misreadings of the productivity numbers, and a few other real factors. It really is possible that previous investment plans were based on expectations of the real economy that were wrong and unsustainable and now have been (partially?) corrected, with negative growth penalties looking forward.
Stephen Williamson offers very detailed comment, noting also that the recession started well over four years ago, which gives plenty of time for nominal resets, and we’ve seen no downward cascading spiral, so maybe there is a non-AD problem with getting back on track at the preferred rate. He also eschews AD denialism. Today Krugman has a brief note along the lines that the views of his opponents on these questions are “even worse than your first impression” but that is best thought of as a) his occasional churlishness, and that b) his writings on this topic do not, at least not to date, reflect a very thorough knowledge of the relevant literature(s).
Claims about monetary policy: the substitution of public credit for private credit
By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming operation twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.
I am surprised we don’t hear this claim more often. When it comes to expansionary fiscal policy, this kind of critique is common, namely that substitution of public debt for private debt makes subsequent “withdrawal” quite difficult. To get to Gross’s point, add on another step or two to the argument. Monetary policy and fiscal policy these days have melded. We pay interest on reserves. We have created a lot more safe securities through bank reserves, but ultimately as a substitute for private intermediation through M3. Through monetary policy, we are trying to expand but at the same time pushing out M3 and getting more bank reserves at the Fed, etc.
The problem with this argument, if interpreted as a critique, is that a superior alternative is hard to outline. It also places too much stress on the term structure rather than the absence of creditworthy borrowers. And besides, who wants extreme deflation? Still, this argument scares me. It illustrates how vulnerable our current position is and it illustrates that we have not solved the fundamental problems which became apparent in 2008-2009.
There is a lot of snorting at people who favor higher interest rates from the Fed. I do not agree with that recommendation, but Gross’s comment gives us some ability to understand it as a recommendation. Think of it as a combined exercise of plug-pulling and collapse of deflationary risk into the present, in the hope that private credit will emerge from the rubble as a source of future economic growth.
Default in a liquidity trap
Here is a very interesting Krugman analysis of this problem. It ends up with the Fed owning all T-bills, and, in Anil Kashyap’s opinion (and mine; there’s not enough cash to cover all the required collateral) the Repo market collapsing. I do see an alternative path. Krugman writes:
What we normally say in a liquidity trap is that the Fed is keeping short-term interest rates at zero, which is as low as they can go because below that cash dominates bonds. And the Fed achieves that zero rate by being willing to buy short-term government debt whenever the rate threatens to rise above zero.
That’s a fair description, but perhaps it is a description rather than a binding equilibrium response; the Fed doesn’t have to do that and why should they if it ends in ruin? (There’s the further tricky question of whether Krugman’s assumption is holding expected fiscal policy constant.)
T-Bills are almost like money today, especially with low short rates. Think of higher default risk as like a Gesellian stamp tax on T-Bills. One equilibrium is that people spend more on durables as they shift out of liquidity, which has now been partially taxed. Another equilibrium is that everyone rushes into the truly safe asset, namely cash, and the T-Bills do truly disappear. Or heterogeneous agents may do a bit of both.
It would seem to boil down to the third derivative on the utility function. Still, empirically cash does not soak up all the periodic shifts out of other risky assets (e.g., commercial paper), so why should it soak up all the shifts out of T-Bills?
More concretely, in a liquidity trap model (which I reject, by the way, but that’s another story) an increase in default risk could have some expansionary properties.
Addendum: Brad DeLong offers comment.