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Monetary Policy in a Liquidity Trap

Robert Waldmann

Matthew Yglesias is puzzled by something Paul Krugman wrote.

I don’t totally understand this argument, however:

It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you.

Right now we’re very far from full employment. But we still have a little inflation. And so it seems to me that if real rates go down a bit, we’ll get a bit closer to full employment, and thus a bit more inflation. The result would be a much slower than necessary recovery, but still better than the current path.

I’m not sure my attempted explanation is of any use, but in case it is, it is after the jump.

This was two comments at Yglesias’s blog so it is addressed to him.

Krugman’s argument is that increasing the inflation target from 2 to 2.5% won’t cause any increase in inflation for the foreseeable future and, so, won’t cause any increase in expected inflation and so won’t affect expected real interest rates.

Your counter-argument is that inflation is now positive. it is important to remember is that standard macro models tell us something about the change in inflation not the level of inflation. In these models the level of inflation doesn’t tell us anything. The only points that matter are that the federal funds rate is almost exactly zero and inflation is declining.

Here we have Krugman academic economist (he made this exact proposal discussing Japan in the 90s). That means he is assuming rational expectations. Basically, if the Fed makes a promise it can’t keep, then people don’t believe them.

Your view of monetary policy is different, because you are sure that, even if the Fed couldn’t do anything to produce inflation for the foreseeable future, an increase in the declared inflation target will cause higher expected inflation. I’m not sure that Krugman would have come up with the 2.5% no good conclusion if he started fresh in his current avatar Paul Krugman columnist blogger.

In case anyone is still reading, I will explain the logic of the argument.
1) what the Fed does while we are in a liquidity trap has no effect on anything
(here really what’s true is that a huge intervention has a modest effect. Something involving as many dollars as QE1 (Fed interventions in 2008-9) was inconceivable in the 90s).
2) The Fed can cause higher inflation only when we are out of the trap. In this context “out of the trap” means that a zero federal funds rate implies rising inflation, that is unemployment below the NAIRU.
3) a modest increase in expected inflation will cause a modest decline in unemployment to a level such that the Fed will certainly want negative nominal interest rates even if it had a low inflation target. The assumption is that if unemployment is below the nairu inflation will decline (that’s what the acronym implies and Krugman assumes that there is a non inflation accelerating inflation rate of unemployment).

So actual Fed actions are the same whether the target is 2% or 2.5%. In either case the Fed sets the federal funds rate to zero.

So inflation expectations are the same whether the target is 2% or 2.5% (this argument very much relies on the assumption of rational expectations).

So changing the target from 2% to 2,5% has zero effect.

Krugman makes an implicit assumption that we will never ever get out of the liquidity trap with current policy. He discusses the resulting unemployment rate as if it were constant. In the real world, unemployment will decline, although it might take decades (basically firms will have to start investing again when a lot of their current capital will have depreciated). So Krugman is implicitly assuming that this FOMC can’t make promises which are binding decades from now. In fact, he doesn’t believe that promises made now will bind tomorrow (the assumption that outcomes are subgame perfect Nash equilibria).

In the academic economics literature “it is possible if the Fed can make a binding commitment to do something in the future which it won’t want to do when the time comes” is just like “it is possible if pigs can fly.” This isn’t because any of us believe in rational expectations (one guy once claimed to but I think he was joking). It is because … oh it’s just a rule of the game. Krugman has stopped playing the game, but he remains loyal to this specific conclusion.

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I dare to add to Nate Silver’s thoughts

Robert Waldmann

Nate Silver gives five reasons that Republicans might do better than his model predicts and five reasons that Democrats might do better.

I add two more possible reasons that Democrats might do better after the jump. They are numbered 3.1 and 3.2, because they are variants on his third reason

More on likely voter filters.

3.1 Likely voter filters include to many people over 65 compared to people age 30-40.

3.2 Likely voter polls are too far from registered voter polls when they are very far from registered voter polls.

Long arguments for both below. First 2 facts support LV polls. 1 They didn’t have a meaningful pro-Republican bias in the past. RV voter polls therefore had a pro Democratic bias in the past of around 4% (or is that calculated with this elections congressional generics ? I got the number here). 2 They are on average closer to the outcome than RV polls.

So why might it be different this time ? One is Silver’s argument 3.

3.1 Another reason is that much of the success of LV filters might be due to their indirectly conditioning on age. Age has a huge effect on the probability of voting. Many LV questions clearly relate to age. For example \”I always vote\” does not mean \”I have voted in every election since I turned 18\” but \”I have voted in almost all general elections since so long ago it doesn’t matter.\” It must be a slowly changing function of past voting. This means that, since actual voting increases sharply up till age 35 then more slowly thereafter, answers to the question will tend to remove too many 35-50 year olds. Taking the word \”always\” literally, the answer can only move from \”I always vote\” to \”I don’t always vote\” the probability of answering yes would never increase. I’d guess that it increases but much too slowly.

I’d guess that following elections closely will have even more to do with being retired than actual voting.

Some Gallup questions very clearly select on age. One is have you voted at your current polling place (another is do you know where it is?). This is partly about past voting and partly about \”have you moved since the last election\”

Now I guess that LV filters would not be fixed if it turned out that \”likely voters\” were significantly more likely to be over 65 than actual voters. I guess that LV filters are mainly chosen and changed based on the performance of past polls with the LV filter in predicting the result (that is the bottom line).

This means a major change in the probability of voting as a function of age and change in the probability of supporting the Democrats as a funciton of age will both make the past data on the reliability of LV polls invalid.

We know that support for Republicans currently increases steeply with age all the way up. It wasn’t always this way. It used to be about level age 40 and up with an actual hump of self identified Republicans in generation X. The huge shift in the association of age and partisan support is part of the explaination of the huge increase in the LV-RV gap and also a reason that it might be a failure of LV filters.

3.2 A third reason it might be different this time, is just that current gaps are unusual, and maybe when the gap is unusual likely voter polls do badly. This can happen if say paying attention to the election is moderately associated with voters but huge swings in partisan differences in paying attention are not correlated with the predicted very large swings in voting. I’d guess there is more of a bandwagon effect in paying attention. I sure wouldn’t blame Democrats who don’t want to hear about the elections this year provided they vote.

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In Other News, 90% of VeloNews Readers Consider Themselves Above-Average Cyclist

Floyd Norris discovers a mathematical impossibility:

Asked to rank, on a scale of one (excellent) to five (poor), the ability of their board’s compensation committee to “effectively manage C.E.O. compensation, 83 percent of the directors chose one or two, and only 4 percent picked four or five.

But asked, “In general, do you believe U.S. company board are having trouble controlling the size of C.E.O. compensation?” 58 percent thought the boards were having trouble, while 34 percent disagreed and the rest were unsure.

Since CompComs generally benchmark against the packages of CEOs in “similar” companies, you have to be really stupid or ignorant as a Director to believe you do it right while your competitors don’t.

But don’t think the Directors know they are incompetent:

Even if directors are not doing a good job, it is not a good idea to give others a say, at least to most directors. More than three-quarters are against giving shareholders a vote on C.E.O. compensation….

As for their own pay, the directors split almost down the middle: 45 percent thought pay should rise, and 53 percent thought it should not. The other 2 percent thought director pay should be reduced. If their identities leak, they are unlikely to be renominated.

Michael Jensen is rolling over in his grave, despite not being dead yet.

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Comparing the Fed, the ECB, and the BoE before policies diverge

The coming week is G4 central bank week. The Federal Reserve Bank (Fed) announces its policy decision on November 3; the European Central Bank (ECB) and the Bank of England (BoE) will make policy announcements on November 4; and the Bank of Japan pushed forward its November 15-16 meeting to be held now on November 4-5.

At this juncture, G4 ex Japan monetary policy is likely to diverge sharply: the Fed is expected to announce an extension of its asset purchase program, while the ECB and BoE are not expected to increase theirs. In fact, the policy wedge between the three central banks is already wide. Despite the ECB’s enacting its covered bond purchase program, the amount is small, roughly 1.4% of Eurozone GDP (see chart below), and the central bank is sterilizing the flow – sterilizing the operation means that the ECB performs equal and opposite monetary operations to reduce bank reserves by the amount of the bond purchase program.

The chart above illustrates the size of the bond purchase programs (assets sitting on the central bank balance sheet) as a share of 2010 GDP (IMF forecast). Ostensibly, and from a bank-lending point of view, Eurozone financial conditions appear to be “healthier” than those in the UK or US.

The chart above illustrates total bank lending in the Eurozone, UK, and the US; but this may change as austerity measures in some European countries infect the stronger economies via a tightly integrated trade relationship.

Policy is already much tighter in the ECB compared to its US and UK counterparts. This discrepancy is expected to diverge, as the Fed moves into QE2 mode this week.

Rebecca Wilder

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Economic stimulus–the right and the wrong of it

by Linda Beale

Economic stimulus–the right and the wrong of it
crossposted with Ataxingmatter

Clearly, for ordinary Americans, the US economy is still in a funk from the financial crisis caused by the housing boom funded by the easy credit of turnover securitization of mortgage loans, coupled with the casino banking mentality spurred by proprietary trading and naked credit default swap bets. (The wealthy, on the other hand, seem to be recuperating nicely, thank you, or at least still spending on luxury goods. See Even in Moribund Economy, Wealthy Spending More on Travel, Luxury Goods, Kiplinger, Sept. 24, 2010.)

The political parties have two very different answers to resolving this ongoing economic crisis for ordinary Americans.

  • The GOP thinks that we need more of the same “medicine” that got us into this mess to start with–deregulation, privatization, tax cuts, and militarization. On deregulation, see, e.g., The Electricity De-Regulation Con Game, (discussing the coalition of conservative groups supporting deregulation, including Heritage Foundation and Tom DeLay), Republican Candidate Seeks Return of De-Regulation , Newark Democrat Examiner, Sept. 30, 2010 (discussing NJ candidate Little’s support for Tea Party “free market” with the “absence” of government regulation). On tax cuts, see, e.g., Senate Republicans Firm on Tax Cuts for Rich, Reuters, Sept. 13, 2010; Republicans Pledge to Fight to Preserve Bush-Era Tax Cuts, Washington Post, Sept. 13, 2010 (noting that the GOP, unlike the Dems, wants to pass a new law providing a tax cut to the wealthiest Americans when the Bush cuts expire as scheduled at the end of 2010). On privatization, see, e.g., 104 Republicans in Congress Want to Privatize Social Security, ThinkProgress, Oct. 27, 2010; GOP Budget proposes to Ration Medicare, Privatize Social Security, CrooksandLiars, Feb. 5, 2010 (discussing the GOP alternative to Obama’s budget proposals); GOP’s Pledge to America would end up privatizing Social Security, The Nation, Sept. 24, 2010 . On militarization, see, e.g., Hard Line: The Republican Party and US Foreign Policy since World War II, The Nixon Center, Oct. 31, 2010 (suggesting that there is some division within the party based on its mantra of fiscal conservativism, but that most Republicans, and neo conservatives especially, support military spending even while demanding cuts elsewhere); David Broder, The War Recovery?, Washington Post, Oct. 31, 2010 (apparently suggesting war, and its huge military expenditures, as a way out of recession, in spite of the already huge costs of Bush’s two wars of choice) ; Conservatives Profess Support for Defense Budget Cuts But Still Want Weapons the Pentagon Calls Unnecessary, ThinkProgress, July 2010; Benjamin Fordham, Evolution of Republican and Democratic Positions on Cold War Military Spending (noting that the Republicans originally opposed increased military spending after WWII, but in the 1960s, the party began supporting militarization). It’s hard to believe that the American voters can be gullible enough to fall for the argument that we need “more” deregulation and tax cuts to cure the problem caused by deregulation and tax cuts, but apparently a good many may be. Party acolytes mouthe the mantra of tax cuts and spending cuts, but what few spending cuts are ever discussed are ones targeted at the so-called “entitlements”–meaning, programs that aid the down and out, the elderly, and the unemployed, like Social Security (and pensions generally, especially public pension plans for public employees), health care, and other such programs. Meanwhile, privatization includes privatizing Social Security (at least in part) and eliminating the progress (not complete) that we’ve made under the Democrats towards a more sustainable health care system (preventing insurance companies from refusing to cover someone, alowing children to stay on parents’ plans longer, making sure that insurance companies don’t refuse to pay covered items, creating a universal system so that the people who pay for their health insurance are not also forced to pay for those who gamble on having no health insurance but end up with expensive hospital stays, etc.). Presumably, if the GOP candidates win a majority, they will fight to ensure that tax cuts extend to the wealthy who have garnered an increasingly huge share of the income stream from GDP growth as they cut out the safety net from those whose wages have stagnated and declined because of their policies.
  • The Dems (the ones that aren’t too afraid to talk about what their polilcy views really are) generally are on the other side of those issues–re-regulation (to prevent the kinds of casino banking problems that occured under Bush), maintaining public safety nets (rather than leaving the vulnerable at the mercy of the “markets”), decreasing military spending (especially for unneeded weapons systems and ideally by ramping down Bush’s wars), and tax cuts for the middle class but not for the rich who’ve gotten all of the growth while the middle class declined). They are also aware that when the private economy is slack, government spending needs to pick up the slack. Ideally, that government spending will be aimed at real needs–unemployment compensation, more money in the pockets of consumers in the bottom half of the income distribution who will spend it on things that they need, and/or public infrastructure that will help our economy expand (like public transit projects, research projects, support for research universities, etc.).

Now, in that context, what to make of David Broder’s Washington Post op-ed talking about war–it took a war, he says, to get us out of the Great Depression, and he seems to be suggesting that a war with Iran wouldn’t be such a bad idea to get us out of this Great Recession.

“What else might affect the economy? The answer is obvious, but its implications are frightening. War and peace influence the economy.

Look back at FDR and the Great Depression. What finally resolved that economic crisis? World War II.

Here is where Obama is likely to prevail. With strong Republican support in Congress for challenging Iran’s ambition to become a nuclear power, he can spend much of 2011 and 2012 orchestrating a showdown with the mullahs. This will help him politically because the opposition party will be urging him on. And as tensions rise and we accelerate preparations for war, the economy will improve.

I am not suggesting, of course, that the president incite a war to get reelected. But the nation will rally around Obama because Iran is the greatest threat to the world in the young century. If he can confront this threat and contain Iran’s nuclear ambitions, he will have made the world safer and may be regarded as one of the most successful presidents in history.” Id. (Broder in WaPo)

This from a person who has consistently opposed government spending and other Keynesian ideas for stimulus as inappropriate. War, he appears to think, is ok, but government spending on major public infrastructure is not? Now that is crazy. I refer you to Mark Thoma’s Economist’s View for a full dress-down of Broder’s essay, David Broder Calls for War with Iran to Boost the Economy, Oct. 31, 2010.

That Broder column fits with the rest of the GOP policies, which generally suggest that spending on military might is just dandy, but spending on the public infrastructure and safety net for the vulnerable is wasteful, or that tax cuts for the super-rich are fine, but earned income tax credits for the poorest amongst us are not, or that deregulation of banks will lead us to growth while regulation to include a consumer protection agency will hamper banks’ ability to make profits. What a warped view of society. I just hope that Americans aren’t naive enough to fall for it.

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What Exactly is the Comparative Advantage of Banks?

by Mike Kimel

What Exactly is the Comparative Advantage of Banks?
Cross posted at the Presimetrics blog.

What exactly is the comparative advantage of banks? When the bank bail-outs began, I noted that bailing out banks makes no sense whatsoever. The focus should be on a well-functioning financial system, and not on the survival of existing banks. Given the periodic “need” the industry collectively seems to experience for bail-outs, it is clear that something is wrong; a well-functioning financial system should not require regular, large-scale bail-outs.

Here is the first of two back-to-back posts I wrote in 2008:

The Cactus Bail-Out Plan: Cheaper, Better, Faster

One of the goals of Paulson’s Bad Joke seems to be to deal with “counterparty risk.” That is, if Bank A can’t find a greater fool to buy its garbage, it will have trouble paying back Bank B. It would be cheaper to simply tell Bank B to collect what it can from Bank A’s bankruptcy proceedings, and cut them a check for what’s left to eliminate the counterparty risk. Whether helping Bank B makes any sense or not, at least this plan would cost the taxpayer much less, as it wouldn’t include the expense of keeping Bank A afloat. So if we’re going to have a costly bail-out, let’s at least focus only on bailing out the “good banks” and let the “bad banks” die.

The problem with the approach I laid out is that the process can drag on. But fortunately, if we’ve learned anything from the Bush administration, its that rushing along at breakneck speed isn’t a problem if you claim there’s some sort of national emergency. So… pass the “Banking Patriot Act.” Any bank that is in trouble must liquidate its assets immediately and pay back its creditors to the best of its ability. The government would use its $700 billion to compensate the good banks for their counterparty losses. Voila – no counterparty risk, no uncertainty in the banking system, no rewarding the bad banks, and the system operates as it should.

But… what makes the bad banks go along with this plan? Well, its simple, really. A provision of the “Banking Patriot Act” allows the government to view any communications by anyone at the bank to see if they’re in trouble. And if any bank turns out to be in trouble but did not go along with the “liquidate immediately” order – well, its executives would all be declared enemy bankers, and would be interned at Gitmo. And there would be waterboarding to find out if those enemy bankers know of other enemy bankers.

Yes, yes, I know, many of the banks have paid back the TARP money. That’s the TARP money. Nobody is compensating the government for taking toxic assets off their balance sheets, nor for the ongoing subsidies coming from being allowed to borrow at ludicrously low rates from the Fed and loaning out at higher rates to the Feds.

The second post I wrote at that point was a bit stronger:

An Immodest Proposal – End the Privileges of the Banks

Yesterday I laid out what I think is a better, cheaper, faster approach to the bank bail-out. But that assumes a bail-out is necessary. However, I think a bail-out, any bail-out, is a bad idea.

Consider the role of banks. Banks essentially store money and act as payment agents for depositors, and they loan out money to borrowers.

Now, consider the role of the Fed. The Fed essentially stores money and acts as a payment agent for the banks, and it loans out money to the banks. Put another way – the banks are just an intermediary between the Fed and public. Put even more simply – the banks are a middle-man. Now, back in the day, it was necessary to have a middle-man, someone who knew the local market, who knew the depositors and knew the borrowers, and understood whether making a given load was a good idea. There’s no way the Fed, say, could do that from Washington.

But today, things are different. First, its clear that the banks have no idea who their depositors are, and much less whether the folks borrowing have any chance at all of paying back what they borrowed. That’s self-evident from the fact we’re even debating whether to bail out much of the industry. Second, in this day and age, what information they do have and use generally comes from third parties. They aren’t any better at buying FICO scores than anyone else would be.

So the question is – how exactly do we benefit from having the banks operating as a middle-man between the rest of us and the Fed? Why not let people deposit their money with the Fed, just like banks do, and let people borrow from the discount window, just like banks (and apparently some non-banks) do? I don’t see the benefits to giving banks rights that people don’t have, but I do see plenty of cost. I see a lot of duplication of services between various banks, and I see huge salaries going to the bank executives for that duplication and for acting as middle-men… and that doesn’t even count the cost of the current bail-out. Note also – salaries at the Fed are much lower. I believe Big Bad Ben Bernanke makes about $200K, a pittance compared to the salaries received by the CEOs of a number of banks recently driven into the ground. And there ain’t no stock options at the Fed either!

So I propose letting the public bank at the Fed, just the same way banks bank at the Fed. I’m not proposing banks be made illegal – if they can find a way to operate without having a getting privileged access to the Fed, wonderful. That’s free enterprise and it should be applauded. But the current system, where banks get privileged access to the Federal Reserve is rather unfair, and its been that way since long before this mess began.

Perhaps the most salient objection some readers raised at the time to the plan put forth in the latter post was that while banks might have an account with the Fed, banks borrowing in the overnight market were borrowing from other banks, not directly from the Fed. Of course, that ignored a few details (e.g., the discount window). It also completely missed the point of what would happen over the two years that have followed the writing of that post: while the Fed took billions of dollars of “toxic assets” off the banks hands and gave them prime rib in its place, the business model for much of the banking sector can be described as “get money at a very cheap rate from one branch of government and loan it out at a higher rate to another branch of government” mentioned a few paragraphs up.

Its long past time to stop subsidizing an industry that is not sustainable. If banks do not have any demonstrable comparative advantage (other than sucking down subsidies), keeping them alive should not be a priority.

As an aside, regular readers know I tend to like posts that involve some amount of numerical analysis. For the foreseeable future, I simply don’t have the time to do that on a regular basis. Expect more verbage and very few graphs for the foreseeable future.

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