Results for “interest rates risk fed”
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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.

Overdraft-chart

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

From Bill Gross:

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.

Jeremy Stein, a new FOMC nominee

Stein is one of the most creative contemporary economists, with some truly interesting and first-rate papers in the early to mid 1990s.  He has kept up his quality and creativity since then.  Most of the early papers are in mid-brow theory, industrial organization, and signaling.  Here is one of his very recent papers on macroprudential regulation; it stresses the importance of dynamic bank recapitalization. He is a very smart and still underrated economist; he’s one of the few where I will more or less automatically start reading his papers when I run across them.  I have no idea how he would do in the all-important political side of the job.  From the paper, an excerpt:

If significant increases in capital ratios have only small consequences for the rates that banks charge their customers, why do banks generally feel compelled to operate in such a highly-leveraged fashion, in spite of the obvious risks this poses? And why do they deploy armies of lobbyists to fight against increases in their capital requirements? By way of contrast, it should be noted that non-financial firms tend to operate with much less leverage than financial firms, and indeed often appear willing to forego the tax (or other) benefits of debt finance altogether. In Kashyap, Stein and Hanson (2010) we argue that the resolution of this puzzle has to do with the unique nature of competition in financial services. Unlike in many other industries, the most important (and in some cases, essentially the only) competitive advantage that banks bring to bear for many types of transactions is the ability to fund themselves cheaply. Thus if Bank A is forced to adopt a capital structure that raises its cost of funding relative to other intermediaries by only 20 basis points, it may lose most of its business. Contrast this with, say the auto industry, where cheap financing is only one of many possible sources of advantage: a strong brand, quality engineering and customer service, and control over labor and other input costs may all be vastly more important than a 20 basis-point difference in the cost of capital.

Here he argues for a very gradual phase-in of tough capital requirements.  In this paper he argues for a credit-based channel of monetary transmission, and here.  This puts him in an alliance with early Bernanke.  Here is his paper on the cyclical effects of Basel capital standards; he has done a lot of work with Anil Kashyap in that area.  Here is his overly optimistic paper on the eurozone.  In this paper he lays out his generally positive view of the efficacy of monetary policy, with a nod to Hyman Minsky on the debt issue.

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.

Earthquakes and spending and deficits

Brad titles his post: “I Genuinely Do Not Understand Why There Is A Question Here…” and after quoting my post from yesterday writes:

If people thought that government debt was risky, its price would be falling as well. The fact that people are willing to pay more for government debt indicates that it is increasingly valuable–and so we should make more of it.

Ryan Avent comments as well.  A few points:

1. My post and question is about spending, but Brad has shifted the discussion to borrowing.  It’s easy enough to borrow more without increasing spending, if that is needed.  It’s still an open question whether spending should go up.

2. The countervailing forces which might favor lower government spending simply aren’t mentioned.  Those include lower wealth and higher tail risk.  If those can’t, at least possibly, imply lower government spending, what could?  The Japanese will need to spend on recovery, but must the U.S., normatively speaking, now feel compelled to spend more on its domestic programs?  A priori?  No way.

3. The earthquake and related events are a negative supply shock, so on Keynesian grounds they need not increase the case for activist fiscal policy.

4. Don’t forget that Mike Jensen answered Kenneth Arrow on risk in 1972.  Even if government spreads its pecuniary losses over many taxpayers, the relevant real risk is the covariance of the value of government output with private consumption.  Given that, an increase in risk still implies at least one force operating in favor of less government spending.

5.  It is an oddly non-Keynesian or perhaps even anti-Keynesian point.  In 1936 Keynes argued that the rate of interest did not allocate investment properly, or correctly signal the proper amount of investment, because interest rates also channeled liquidity preferences.  Today this is a claim which DeLong and Krugman are arguing against.

In other words, it’s an open question, as my original post implied.

Megan McArdle had some to-the-point words:

It’s hard to argue that we should become more willing to borrow because Japan had an earthquake that will cut into global GDP.

And:

And the bad signals aren’t just to the federal debt market–the flight to quality is ultimately going to push things like mortgage rates down too.  Would the people urging the government to take on as much debt as possible also urge our homeowners to once again leverage themselves as far as the banks will allow?

Update (12:25 pm) Reader abUWS has perhaps the best, most succinct metaphor I’ve ever seen for this argument:

“When the Titanic was sinking everyone eventually rushed to the stern of the ship. That didn’t mean that that part of the ship was actually safe.”

Addendum: Arnold Kling offers relevant comments.

Sumner and Krugman on zero MP workers

Scott's post is here, Krugman's is here.  (My first post on the topic is here, my last post here).  Let's start with Scott, excerpt:

This post by Stephen Gordon shows US employment in 2010:3 falling about 5% below its 2008:1 peak, while output seems to have declined only about 0.7%.  This is what Cowen finds puzzling. 

But I don’t see any puzzle at all.  If employment didn’t change, I’d expect US output to grow at about 2% a year, which is the trend rate of productivity growth.  Because we are looking at a two and a half year period, you’d expect output to grow roughly 5% with stable employment.  Now assume that employment actually fell 5%.  If the workers who lost jobs were similar to those who remained employed, I’d expect output to be flat over that 2.5 year period.  Because output fell slightly, it seems like the workers who lost jobs were slightly more productive than those who remain employed.

Do I believe this?  No, for several reasons I think they were less skilled than those who remained employed.  Labor productivity growth (assuming we were at full employment) probably slowed in the most recent 2.5 years, as investment in new capital declined.  Measured productivity continued to rise briskly, partly because technological progress continues in good times and bad, and partly because those workers still employed are somewhat higher skilled, or perhaps are trying harder in fear of losing their own jobs.  So Tyler is probably right that those workers who lost their jobs have a lower than average marginal product.  I just don’t see why zero is the natural starting point for consideration of the issue, as you only get that number by making some fairly extreme assumptions about technological progress coming to a screeching halt after 2008:

A few points:

1. The claim is that some workers have zero marginal product (net of employment costs), not all workers (as Krugman inexplicably ponders for two full paragraphs), and not even all unemployed workers.  Just as a hypothetical example, if unemployment is 9.5 percent and the natural rate is 5.5 and zero MP helps account for half of that difference, that's two percent of the labor force at zero MP.  Try hiring labor for a while and see how crazy that sounds.

2. Zero MP is a property which may hold in an AS-AD equilibrium, it is not a substitute for an AS-AD view.  Krugman mischaracterizes the hypothesis here, by identifying it with "AD denialism."  In my post which Krugman links to (and indeed for years), I've made it clear that demand matters in any coherent account of the equilibrium.  

Oddly, Krugman himself stated one of the coherent versions of the Zero MP view in July 2010, and then he considered it possible and appropriately, he expressed uncertainty about what might be going on.

3. The Zero MP hypothesis is simply another way of talking about "labor hoarding," a well-known and time-honored idea, except that the labor is not in fact hoarded.  It doesn't encounter strange paradoxes and it is more intuitive than when the labor is hoarded (which appears to violate first-order conditions).  There is plenty of very specific and indeed striking evidence that the "previously hoarded labor" isn't being hoarded any more.  That same link implies that Krugman's invocation of 1983 is a red herring and probably not a good instance for finding many zero MP workers.  The "oughties" job market differs in a number of other "real" ways from the 1980s, including the fact that we've had no net job growth over the last decade, not even pre-crisis.  Here is further evidence on how productivity patterns were different during the early 1980s.

4. For another take on #3, during the job-destroying periods of 2009, per hour labor productivity growth is rising at astonishing rates, try 3.4, 8.4, 7, and 6 percent, each quarter, annualized.  That's not just the regular accretion of technological progress (though some of it may be), it is an artifact from dumping lower quality and zero MP workers.  If I look in the second quarter and see labor hours go down 7.9 percent and see per hour productivity rise 8.4 percent, well, that's no proof but I sure go hmm….

5. I would not take it for granted that "normal" productivity growth continues in times of shock and crisis.  Maybe yes, maybe no. Scott's talk of the "trend rate" is assuming that the growth and cyclical components are separable and that is begging part of the question.

6. The zero MP hypothesis helps explain why unemployment is so much more severe among the less educated and the lower earners.  In contrast, Krugman writes: "As Mike Konczal points out, basically everyone’s unemployment rate has doubled, no matter their education level or location."  In reality, that kind of multiplicative relationship is very much consistent with joint AS-AD determination, including a zero MP for many workers in the equilibrium.  I'll write an entire blog post on that question soon, and then we'll see that this result actually discriminates against pure AD theories or is at best a neutral pointer.

7. What does the zero MP hypothesis add?  First, the zero MP hypothesis explains why wage adjustments can't do the trick for a lot of the unemployed, as wages won't fall below zero.  Second, the zero MP hypothesis explains why you need steady real growth, boosting the entire chain of demand, to reemploy lots of workers and reflation alone won't do the trick.  (I still, by the way, favor reflation because I think it will do some good.)  Those predictions are not looking terrible these days.

8. The AD-only theories, taken alone, encounter major and indeed worsening problems with the data.  Year-to-year, industrial output is up almost six percent, sales up more than six percent, but the labor market has barely improved.  How does that square with the AD-only hypothesis?  Has it been seriously addressed?  Arnold Kling also has relevant comments and in passing I'll note that the "increases in the risk premium" factor is being neglected in this discussion of Kling's points. 

9. Krugman (not Scott), in particular, is proposing an alternative view with a) upward-sloping AD, b) downward-sloping AS, c) the implication that huge boosts in the minimum wage would restore the economy and employment, and d) requires a tight liquidity trap when the theoretical literature distinguishes between "interest rates literally at zero" and "interest rates near zero."  His comparison of ZIRP and ZMP does not raise those issues on the other side of the ledger.

I think Scott is underplaying some of the more detailed facts about labor markets, such as mentioned in #3, #4, #6, and #8.  Krugman simply isn't considering the stronger versions of the zero MP hypothesis and thus he is dismissive rather than confronting the very real problems in the AD-only point of view.

Addendum: Arnold Kling has more.

Don’t flip out over QEII (repeating myself)

I'm not sure it will work, because it won't fix the housing market, may not restore the demands for wealth-elastic goods in a sustainable manner, may not restore the normal flow of credit to small businesses, may not lower subjective estimated risk premia, and may not fix the general disconnect between expectations and reality.  The effects on long-term interest rates are murky.  No one — and I mean no one — has a coherent story about how nominal stickiness of wages lies at the heart of our current dilemma.

Still, QEII may do some good.  Money matters, even if we don't always understand how or why, and excessively tight money has never done market-oriented economics any favors.  Think of QEII as a make-up for some earlier monetary policy mistakes.  Some of the relevant alternatives include a trade war with China or direct government employment of the unemployed and with what endgame?  QEII is not some terrifying burst of potential hyperinflation.  The TIPS market is forecasting in the range of two percent inflation and it's gone up — what — sixty basis points since August?  That's hardly the end of the Republic.  During the Reagan recovery, inflation never fell below four percent.  I've thought through "trigger models" of rapidly escalating inflation, but they don't scare me much.  The Fed simply needs to be ready to unload its heavy balance sheet without delay.

I do take seriously some of the more speculative criticisms, namely that QEII may set off bubbles in some emerging markets, or that it may break the euro (and that the euro would not otherwise break of its own accord).  Still, those hypotheses are far from established and it is difficult to believe that say three percent U.S. price inflation should bring international doom.  These factors also need to be weighed against the international and political economy costs of continued American economic stagnation.

I'm unhappy with claims that "we're not doing enough" and that therefore this is no test of the idea of monetary stimulus.  This is what QEII looks like, filtered through the American system of political checks and balances.  And if it looks small, compared to the size of our problems, well, monetary policy almost always looks small compared to its potential effects.  I'm willing to consider this a dispositive test and I am very curious to see the results.

Will QE work?

Basile, Landon-Lane, and Rockoff have a new paper on the Great Depression.  They conclude:

The main finding is that as we move away from short-term government bonds on the "liquidity spectrum" we encounter rates that appear to have been sensitive to changes in monetary policy, although the mortgage rates were an exception.

They note that Keynes himself did not believe America was in a liquidity trap, though some of the American Keynesians did.

Here is a new paper from the Kansas City Fed, by Taeyoung Doh, summarized by the Fed bulletin as such:

Doh uses a preferred-habitat model that explicitly considers the zero bound for nominal interest rates.  His analysis suggests that purchasing assets on a large scale can effectively lower long-term interest rates.  Furthermore, when heightened risk aversion disrupts the activities of arbitrageurs, policymakers may lower long-term rates more effectively through asset purchases than through communicating their intentions to lower expected path of future short-term rates.

I hold the default belief that such policies could prove effective today.  There's also the broader point that QE can work by stimulating AD, without having to push around long rates very much.

Response from Brad DeLong on fiscal policy

Read the whole thing; my original post was here.  

On my point 1, that the central bank moves last, Brad writes:

Yes, the central bank can neutralize any additional fiscal stimulus by raising interest rates. (It is not clear that it can undo any fiscal contraction by some combination of lowering interest rates and quantitative easing: it may be able to.) What is clear is that the U.S. Federal Reserve and the Bank of England are right now definitely not in a place where they would neutralize any additional fiscal stimulus by raising interest rates. And my bet is that the ECB is also not in such a place–although it is much harder to figure out what they think and what they will do. That the central bank moves last is important and relevant, but not determinative when you are in the neighborhood of the zero lower bound on interest rates.

Maybe the central bank cannot undo a fiscal tightening, but surely it can undo a fiscal expansion, by making money tighter, limiting QE, and/or changing the pace at which it undoes previous QE.  My assumption is that the central bank has a preferred inflation vs. unemployment position for the economy, so why be so sure they won't undo the expansion of the fiscal authority, if only probabilistically?  Portfolio considerations, or public relations, may matter, so I am not postulating strict neutrality, rather changes in fiscal debt do less good than we might think.   

On point two, that monetary expansion is easy, even at the zero bound, Brad writes:

That's why having the government hire unemployed people to do useful things and paying for it by printing up money at basically zero budgetary cost (right now) is an even better policy. Even if consumers do save all that money, fiscal stimulus on the spending side still has an impact: useful stuff gets done.

That's fine, with the side note that I am more skeptical about public sector spending.  I'll push this line of reasoning to the next step, however, and stress we don't need to increase debt at all to have a big and effective stimulus.  (By the way, accepting this argument means that a central bank can undo a decrease in the federal debt, as mentioned in point one.)   

On point three, on federalizing Medicaid, we agree.  Point four is about the value of worst-case thinking and that means a fiscal crisis can come even when it appears unlikely.  I wish to heed that risk by doing something other than pledging our next President and Congress will solve the problem.

Elsewhere, Brad has written:

The obvious policy is the long-term debt neutral stimulus: spending increases and tax cuts for the next three years, standby tax increases with triggers and spending caps with triggers thereafter, all calculated to guarantee that the debt is no larger ten years from now than in the baseline.

An alternative version of this would be:

We can and should do major stimulus without increasing the debt burden, short-term or long-term.  Increasing M, through monetary policy, is usually more effective than making periodic attempts to keep V up and running, through fiscal policy.  Plus it is often easier to turn monetary rather than fiscal policy on a dime, especially in a democracy and for Brad I can cite the risk of a Republican administration.  Talk of the zero bound doesn't matter much for the policies we should choose, namely money-financed, non-exotic direct stimulus.

Why is it necessary to take on or intellectually defend higher debt levels?  Short-term debt can too easily become a long-term commitment.  Why is it necessary to discuss the zero bound so much?  In my view of this exchange, Brad and I largely agree, but he does not (yet?) agree that we largely agree.  I want to see him criticize debt finance more than he seems willing to do.

I believe the "zero bound" is perhaps the single largest "red herring" in the economics profession today.

Addendum: Arnold Kling comments.  And Brad DeLong responds in the comments section.

Writing down the principal on mortgages

It's obvious that the economy still isn't doing well.  Furthermore the rate of foreclosures won't peak until the end of 2010.  On top of that, most observers agree that the Obama mortgage modification plan has been a failure.

That all said, I'm surprised that so few commentators have leapt on the "we should write off some of the principal" bandwagon.  It's not currently a bandwagon at all.

I know that a) this idea is WRONG, b) it is terrible for the long run rule of law, and c) it is EVIL and UNFAIR.  It's also one of the few suggested economic remedies that might have worked or maybe could still work. 

How so?  It limits value-destroying foreclosures.  It gives homeowners the right marginal incentive to keep on making payments and maintain the value of the home and to maintain their credit capabilities.  It gives the housing market a fresh start rather than this waiting/coordination game where we wait for everyone to move on down a notch in house quality, thereby freezing parts of the housing market and choking off required recalculations.  (How can you have a well-functioning housing market when so many people have negative equity?  I've read estimates of twenty percent of the U.S. population.)  It also limits the problem of future ARM resets, once interest rates rise in the future.

It's all about long-run vs. short-run and I usually side with the long run.  But the short run modification of property rights has so many defenders in other contexts, so why not here?  Call it "clearing up financial logjams" if you wish.

Is it a better marginal incentive than suddenly increasing the taxes on banks?

Bernanke himself once suggested the idea.

I might add that by fostering an actual recovery, writing off the principal on mortgage loans might limit some of the other bad interventions that we will try or have ended up trying.  There's more than one way to toss away the rule of law.

Are stock and bond markets contradicting each other?

Stocks are doing well yet interest rates remain low and flat.  What's up?  John De Palma sends along this very interesting analysis by Paul McCulley.  Excerpt:

Thus, as long as economic recovery appears underway, even if stoked primarily by (1) policy stimulus and (2) a turn in the inventory cycle, there is no urgent reason for investors to run from risk assets. Put differently, investors can be agnostic about (3) the strength of private demand growth until the one-off forces supporting growth exhaust themselves, as long as they don’t have fear of Fed tightening.

In turn, a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside. Accordingly, Treasury players, like their equity brethren, need not fear the Fed, as there is no economic rationale for an early turn to a tightening process.

Thus, both rich risk markets and the lofty Treasury market can be viewed as rational in their own spheres, even if they are seemingly irrational when compared to each other. The tie that binds them, that allows them to co-exist, need not be a common view regarding the prospective strength of the recovery, but rather a common view as to the Fed’s friendly intent and reaction function.

Is it a good thing when asset markets are so much about the Fed?  There is more to the short essayt, read the whole thing.  Here is his conclusion:

Simply put, big-V’ers should be wary of what they wish for. U’ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that’s no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.

Addendum: Arnold Kling comments.