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Necessary and Sufficient Conditions for Effective Monetary Policy at the Zero Lower Bound

As long since noted by Krugman, for the monetary authority to be able to stimulate demand when the safe short term interest rate is almost exactly zero,  it has to be able to credibly pre-commit to causing high inflation, by keeping that interest rate extremely low in the future when  the economy has recovered  and is overheating.   This is enough of a problem that the leading theorists and practitioners of monetary policy at the ZLB (obviously Krugman, Michael Woodford, Ben Bernanke Sinzo Abe and Haruhiko Kuroda *)  insist that efforts to stimulate with unorthodox monetary policy be complemented by expansionary fiscal policy.

I think, however, that there is another problem.  I do not find arguments including “credibility” to be credible.  At the very least the word should be “credited” that is believed, not “credible” that is believable.  The assumption of rational expectations has snuck into the language, which is a problem since it has nothing to do with reality.  Once we understand that the issue is what people do believe and not what they should believe, we must ask which people ?  My efforts to check on the effectiveness of non-conventional monetary policy have been total Fred.  I look (often) at interest rates on TIPS and normal nominal Treasuries.  I am finding out what bond traders seem to believe.  But my interest is in the effect on aggregate demand most of which is not purchases by bond traders (a large fraction of them are rich, but there aren’t all that many of them).

 

I will hint at a model with three sectors non-durable goods, houses, and financial assets.   Note the goods and houses are made from pure labor without any productive capital and the assets are traded on street corners or something without any bank buildings.  I think this corresponds to one of the two real puzzles and problems with the US economy, which is why housing construction has not recovered (the other is why does the Republican party still exist but I have no clue on that one).  Financial assets include overnight loans and 30 year fixed interest rate mortgages.

There are two ways in which expected inflation can affect demand, in both cases demand for housing.  First higher expected inflation implies higher nominal wage growth so the fixed nominal mortgage payments correspond to fewer hours of work.  Second house prices generally rise proportional to other prices (except for a relative decline during the depression, increase during WWII and the recent bubble).  Expected house prices should move roughly one for one with the expected CPI (price of the non-durable).  So if potential home buyers and home builders understand these basic stylized facts expected inflation will cause higher expected demand and a pony.

Look economists don’t know much, but we do know for sure that people do not believe that inflation causes high wages and house prices.  If people are asked what’s wrong with inflation (which they totally hate) they tend to say it means you can’t buy as much. That is, they assume that inflation means higher prices but not higher wages so real wages are lower.   This means that if people believe there will be high inflation, they will tighten their belts reducing demand.   Similarly people other than Robert Shiller didn’t notice the almost perfect correlation of housing prices and the CPI.

 

I don’t really know this.  I am assuming the result of a poll which I haven’t conducted.  But I am willing to bet that if people are asked whether high inflation makes it rational to buy a larger and more expensive house or a smaller cheaper house more will say that inflation should cause reduced demand for housing.  I am willing to make this bet mostly because I am confident the poll won’t be conducted so I won’t risk losing it.  I do not think it is wise to bet the economy on the confident assumption that I have it backwards.

OK so let’s assume I’m wrong and that people will buy more and or larger houses if they expect higher inflation.  Let’s assume that home builders know this, so they hire more construction workers and build more houses if they expect higher inflation.  Does this mean that we can tell if policy is effective by observing asset prices ?  Well we can if we assume a representative agent so there is only one subjective expected inflation rate.  Not so much if we imagine that maybe the average bond trader pays more attention to hints of possible tweaks to monetary policy than the average home buyer does.

I will present a model in which H. Kuroda can influence asset prices but not aggregate demand.  Above I mentioned financial assets which include overnight loans and 30 year mortgages.  As that suggests, I assume that there are other financial assets whose value depends in part on what H Kuroda does. Can we determine the effect of monetary policy on aggregate demand by observing H Kuroda and those asset prices ?  Obviously not.

To be more clear H. Kuroda is Hiroki Kuroda, the baseball player, not Haruhiko  Kuroda, the central banker, and the financial assets are bets on the outcomes of baseball games.  Yes if H Kuroda gives up, asset prices will change,  But the point spread on Yankees games is not the key to recovery.  Of course this is silly.  Point spreads have very little to do with the real economy while every twist and turn of asset prices on Wall street is worthy of obsessive attention.  Suuuure.

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The Stock Market and Interest Rates

The quick and dirty rule of thumb is that the relationship between bond yields and the S&P 500 PE is one-to-one.

That is, 100 basis point change in bond yields should cause about a 100 basis point change in the PE.

Clipboard01 pe bond

Since WWII, the long term trend for earnings growth has been some 7%, or about the same as nominal GDP growth. I’ve long thought that the PE is an expression of the present value of a perpetual stream of 7% earnings growth

In the 1990s bubble , investors came to believe that long term earnings growth had moved to a permanently higher level and that justified the higher valuation.

Now, I wonder if the market, in its wisdom is already discounting a lower level of earnings growth, maybe about 4%.  That could explain why the market looks cheap.  Interestingly, in this recovery nominal GDP growth has been very stable around 4%.

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“Profits Without Production”

For me, Profits Without Production equates to Profits sans Direct Labor Input. In most manufacture in the US today, Direct Labor Input is an extremely small ~10% of the Cost of Manufacturing which will vary up and down dependent upon the industry. (For the accountants and the purists, this does not include customary or legislative benefits which I categorize as Overhead. Drucker and many other consultants [including myself] have repeatedly pointed out that whacking labor to reduce the costs of manufacturing is akin to beating a dead horse and this cost has been dropping because of efficiencies since the sixties. It no longer represents the mountain of cost even though it has been fictionalized and demonized by Delphi’s Miller while Delphi was angling for bankruptcy in the last decade.) Maybe I have not searched in the right areas or blogs to read up on this topic; but, Paul Krugman in his latest article dicusses what I believe has become more wide spread in the US over the last decade, Profits Sans Labor or as he points to Production. Yet this is a growing trend and I have not seen much on the topic of Profits sans Labor or Production.

“You can argue that Apple earned its special position — although I’m not sure how many would make a similar claim for … the financial industry… But here’s the puzzle: Since profits are high while borrowing costs are low, why aren’t we seeing a boom in business investment? …

Well, there’s no puzzle here if rising profits reflect rents, not returns on investment. A monopolist can, after all, be highly profitable yet see no good reason to expand its productive capacity. . . .”

While it is possible to produce a part without direct labor input to it with automated machines, my point in particular is about the rise of profits in certain industries (if one could call them such) with no direct labor input or material product in the end. Paul points to the financial industry as having spectacular profits as a percentage of the whole and most recently at 30% of Corporate Profits in the US. Pre-2008 Wal Sreet/TBTF recession, the percentage of corporate profits coming from the financial industry was even higher at 40%. Given not much has changed in the financial industry with new regulations and transparency of transactions, I suspect the financial industry will recoup this high with the government’s backing after almost committing self destruction in 2008.

“From 1990 to 2006, the GDP share of the financial sector in the broad sense increased in the United States from 23% to 31%, or by 8 percentage points. The figures on profits are even more striking. For example, the financial services industry’s share of corporate profits in the United States was around 10% in the early 1980s but peaked at 40% last year.How might the current financial crisis shape financial sector regulation and structure?

While I agree with Paul Krugman on the problem of growing monopoly rents or the profits without investment, I think he misses the larger picture. The growth of profit without production is coming at the expense of labor input and has been going on for a longer time than just recently. The financial industry has become gambling professionals with its CDS, naked CDS, etc. involving little or no investment in production or labor. That excessive profit-taking has expanded into nonfinancial industry such as Apple is no surprise. The tax rate supports such action by companies. Why should they invest?

Perhaps, I take it a bridge too far with Mr. Krugman’s comments; but until companies begin to expand utilizing Labor input, the problem with unemployment and a shrinking Particiaption Rate are not going to go away. In the end, we may yet reach the the Fed’s 7% unemployment goal as Participation Rate shrinks and U3 is determined from its smaller base.

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The importance of redistribution

by Linda Beale

The importance of redistribution

I have dedicated ataxingmatter to a concept I call “democratic egalitarianism”–the idea that individuals flourish best in a free society that allows them to choose democratically the rules that govern their lives, with the understanding that the institutions must be sustainable and must allow all individuals to flourish, not just a select few. It is that latter idea that supports a view of egalitarianism–not that everyone is always “exactly” an equal of others, but that the society’s resource allocation provisions have to counter the tendency for resources to concentrate in the hands of a powerful few. Since there can be no absolute equality, society’s institutions must counter the tendency for wealth and power to aggregate in the hands of those with more wealth and power by mandating downward redistribution of wealth and power.

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The Tax Code Ain’t Nearly So Big as Often Claimed

by Linda Beale

The Tax Code Ain’t Nearly So Big as Often Claimed

I can’t resist pointing readers to tax professor Jim Maule’s excellent post chastising everybody–from those obviously slanted propaganda-tank tax gurus Chris Edwards (you all know him as the purported tax expert from the right-wing pseudo-libertarian Cato Institute, whose other associate, Dan Mitchell, makes similar ridiculous claims in touting the purported “Laffer Theory” about how tax cuts restore tax revenues–I should note that I debated Chris in the run-up to the 2012 elections on Herman Cain‘s ridiculous tax “plan”) and Steve Malanga (you all know him as the purported tax expert from the right-wing Manhattan Institute) to generally reasonable Taxpayer Advocate Nina Olson–about their ridiculous claims of a tax code that runs to the tens of thousands of pages. See James Maule, Code-Size Ignorance Knows No Bounds, MauledAgain (June 5, 2013).

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“Technology Causes Inequality” Refuted

I’m getting to this a little late due to extensive travel (in South Africa now), but David Cay Johnston has a nice writeup of a recent paper on inequality based on the World Top Incomes Database. The paper, by Facundo Alvaredo et al., is important because it largely refutes the idea that technological change is the big reason for diverging incomes between skilled and unskilled workers. As Johnston writes:

That [sharply different levels of increased inequality] is significant because it means that new technologies and the ability of top talent to work on a global scale cannot explain the diverging fortunes of the top 1 percent and those below, since the Japanese have access to the same technologies and global markets as Americans. The answer must lie elsewhere. The authors point to government policy.

As the paper shows, the income share of the top 1% in the U.S. declined from a high of around 24% just before the Great Depression to a low of about 9% in the late 1970s. Since then, it has soared all the way back to about 23% just before the Great Recession, but falling back to 20% in 2010. Other English-speaking countries have had similar “U shaped” patterns, as the authors describe them (i.e., reaching Great Depression levels again), but the share of the 1% is much less in other countries. For example, in Australia, even though the 1% share is close to what it was in the 1920s, it is still only 10% of total income, compared to 20% in the U.S. This difference is part of the reason that median wealth is so much higher in Australia.

The paper gives examples of other countries where the 1% share is permanently below its 1920s level, such as Germany, Japan, France, and Sweden. In all four cases, that share is only about 10%. As Johnston emphasizes, these countries are all essentially equal to the U.S. technologically (remember back in the 1980s when so many people thought Japan was poised to eclipse the U.S. in technology?), so their substantially lower levels of inequality stand in direct contradiction to frequent economists’ claims that technology is the problem (Richard Freeman has a balanced analysis).

It is also important to point out, as Johnston does, that lower tax rates on the 1% have an impact on this. One suggestion the paper makes is that lower tax rates give CEOs and other top managers more incentive to bargain for higher income, so the effect even shows up in pre-tax income. Obviously, lower tax rates make post-tax income even more unequally distributed.

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Going Dark–not just an SEC issue, when companies keep their tax classification secret

by Linda Beale

Going Dark–not just an SEC issue, when companies keep their tax classification secret

Today’s Times includes an interesting piece by Floyd Norris about the problem of companies that are neither private nor public but have (or claim to have) few enough public investors that the SEC allows them to “go dark”–quit reporting their financial statements, or anything else for that matter, to the public at large or even their few public investors–even though at least some of their shares continue to be publicly traded. See Floyd Norris, Going Dark, and Putting Blindfolds on Investors, New York Times (July 13, 2013), at B1.

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