Relevant and even prescient commentary on news, politics and the economy.

Institutional Corruption and the Capital Markets

Via Naked Capitalism, Yves writes:

If you are in Boston and not leaving town on Friday, please consider seeing some or all of this full-day program at Harvard Law School: Institutional Corruption and the Capital Markets, sponsored by the Safra Center on Ethics. How often do you hear Serious People talking about systematic corruption, and better yet, giving thought about what to do to combat it?

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Regression Analysis and the Tyranny of Average Effects

by Peter Dorman (re-posted with author’s permission from Econospeak)

Regression Analysis and the Tyranny of Average Effects
What follows is a summary of a mini-lecture I gave to my statistics students this morning.  (I apologize for the unwillingness of Blogger to give me subscripts.)

You may feel a gnawing discomfort with the way economists use statistical techniques.  Ostensibly they focus on the difference between people, countries or whatever the units of observation happen to be, but they nevertheless seem to treat the population of cases as interchangeable—as homogenous on some fundamental level.  As if people were replicants.

You are right, and this brief talk is about why and how you’re right, and what this implies for the questions people bring to statistical analysis and the methods they use.

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Defending higher nominal Fed rates… response to Mr. Thoma

Mark Thoma wrote that the Fed should not have already raised its nominal Fed rate. He wrote that justifications for already raising the Fed rate are misguided. Now I am one who is saying that the Fed should have already raised nominal interest rates for two reasons…

  1. Potential output is lower than people think which raises the Fed rate determined by the Taylor rule.
  2. According to the Fisher Effect, inflation will follow nominal interest rates when the Fed rate is held constant or bound within a tight range for a long time.

Potential Output

When potential output is lower, the output gap to full employment is lower. According to the Taylor rule, a smaller output gap leads to a higher nominal rate. As the output gap closes at full employment, the nominal rate should return to its long run normal rate.

Thus I see that the Fed nominal interest rate would need to return to its “normal” level sooner. (Normal means natural real interest rate + expected inflation target, r + pe.) The normal nominal Fed rate is roughly 4%, based on a real natural rate of 2%, and the inflation target of 2%.

Here is how I see potential output (red line in graph)

update ED recent

Graph #1

Potential output has fallen to a new trend line since the crisis and is holding steady. This video explains how I determine potential output. I show that the government has been wrong about potential output. Likewise, they keep revising potential output downward but I can see how far down they really should be revising it. I have not had to revise my determination of potential output, as real GDP is trending steadily along my potential output.

Fisher Effect

Mark Thoma mentions the Fisher Effect, which uses the Fisher equation. i = r + pe. Nominal rate (i) is equal to real rate (r) + expected inflation (pe). As Mr. Thoma says…

“Some economists have argued that when policymakers hold the nominal interest rate at the zero bound, it is deflationary since r is positive, and pe = -r when i=0.”

Mr. Thoma is responding to an error in logic that assumes that the Fisher effect is currently deflationary. I am not saying that the Fisher effect is deflationary, because I foresee the nominal rate rising above the natural real rate as we move toward full employment. Thus inflation will be low, but not deflationary.

However, the Fed has projected a Fed rate well below the “normal” rate. Mr. Thoma says…

“Although there have been many calls for the Fed to raise its target interest rate, the Fed has made it clear that it intends to keep its target interest rate abnormally low even after the economy is well into recovery. There may be some risk of inflation in this approach, but as noted above this risk appears to be small.”

Keep these words in your mind as you read on… “abnormally low“. According to the Fisher effect, inflation will stay low too, because inflation moves with nominal rates in the long run. I need to untangle a little error in Mr. Thoma’s logic. He says…

“If the increase in the nominal interest rate is not accompanied by an increase in inflationary expectations, then the Fisher equation tells us that the real interest rate will rise. That would be very harmful to an economy struggling to recover from a recession.”

He implies that inflation expectations would not rise with an increase in the nominal rate. He implies that nominal rates and inflation do not move together. However, we are witnessing a situation where inflation is moving with nominal rates; They have fallen together. This is happening in Europe too. Therefore the real rate in the long run is holding steady, as the Fisher effect says. One must open up their mind to the possibility that an increase in the nominal rate will be followed by an increase in expected inflation over time. Yet, he can’t see this…

“…it’s hard to see how an increase in the nominal interest rate would cause people to expect an increase in demand and a subsequent increase in prices.”

This is where economists cannot understand the Fisher effect. They cannot see a scenario where an increase in the nominal rate leads to higher prices. They only see as far as a higher nominal rate would decrease demand, which as he says would be a “disaster”. They only see as far as the monetary shock as Mr. Krugman did over the weekend. They do not see that the shock wears off, and then the Fisher effect takes over. They do not see that in order to escape from this “low nominal rate – low inflation rate” trap, we need to be like a little chicken breaking through its shell. If we do not break through the shell, we will never leave the Fisher effect holding down inflation. Just look at Japan.

So how does a higher projected nominal rate lead to higher inflation over time?

We have a situation where business is projecting an abnormally low Fed rate even at full employment. The implication is that inflation will have to naturally be lower since the real rate holds steady.

Let’s suppose that in the aggregate, business is projecting a 1% natural increase in output. That is the natural real rate underlying aggregate macroeconomic conditions. Then they see a long run Fed rate of 2%. In the aggregate, inflation will conform to 1% through contracts of pricing and wages.

If people in the aggregate expected an inflation rate of 1%, more people would enter into contracts knowing that inflation would not take away their expected return. Even people who benefit from a higher expected inflation would still enter into contracts. As more people reach for yield, getting a balanced inflation expectation is essential to contracts. Here is a graph for the additional expected returns after figuring in real rates and inflation.

exp ret 1

Graph #2

The market will optimize in the long run at an expected inflation of 1%. It is safe to do so because the Fed guarantees abnormally low nominal rates.

Now, if the projected nominal Fed rate was 3% instead of 2%, what would happen? Then a 2% inflation would give the aggregate equilibrium to optimize people entering into long run contracts. Here is a graph.

exp ret 2

Graph #3

The higher projected nominal Fed rate allows for a higher expected inflation equilibrium.

The key is that people are basing contract decisions upon the more reliable factor of the Fed rate. They know that the Fed rate will stay low, more than they know what inflation will be. Thus they feel safe in the aggregate to negotiate pricing upon the projected Fed rate and expected increases in output. In the aggregate, people feel safe seeing low inflation with long run low nominal rates.

So through time in the aggregate, inflation expectations are optimized to projected nominal Fed rates and the underlying real rate… This is according to the long run Fisher effect.

Noting the Difference between Short run and Long run movements of inflation

The above is looking at the long run equilibrium when the nominal Fed rate is seen as stuck within a tight range of movement. Policy rate shocks are taken out of the equation. So inflation adjusts to that range over time. However, as Mr. Thoma implied, the short run can work against you. Here is a graph of how inflation responds to the nominal Fed rate in the short run and in the long run.

exp ret 3

Graph #4

In the short run (orange line) policy rate shocks create an opposite effect in inflation. If the Fed rate was to unexpectedly rise now, inflation would fall from a negative demand shock. However, in the long run (blue line) and in the absence of further unexpected policy rate shocks, inflation will go to the Fisher effect equilibrium. And the higher the projected nominal Fed rate, the higher the equilibrium expected inflation.

The red dot to the left shows where we are now. (Fed rate = 0.15%, inflation = 1.5%) The red dots to the right correspond to graphs #2 and #3. You will notice that the movement of inflation going to the right is down first, then up. The initial down movement is what scares economists. They think it will create a recession. Yet, they are not looking deep enough at the dynamics. If you raise the Fed rate properly and carefully with balanced expectations, you can minimize the downside impact on inflation.

The slope of the short run change in inflation (orange line) was more horizontal a couple years ago. Price levels had a momentum to hold steady with nominal rate increases. When expectations of the projected Fed rate are balanced, the slope is more horizontal. There is less downward movement in inflation. Yet, now the slope of the orange line would be steeper. Fed rate increases would have a larger short run negative impact on inflation. Thus the best policy for nominal Fed rates is to start early and raise them steadily toward their natural level.

So I refute Mr. Thoma’s premise that nominal rates should not have risen earlier

Mr. Thoma’s primary premise was that nominal interest rates should not have risen before, and should still stay low. Yet, earlier was the best time to raise rates. The economy had momentum to keep on growing. Now we are simply too close to the end of the business cycle. Profit rates are already peaking. The economy would most likely suffer a larger hit from an unexpected rise in the Fed rate.

I think he has a fear of raising the nominal Fed rate to where it needs to be. And his fear is justified because the dangers of raising the Fed rate have continually increased. Mr. Krugman shares his fear.

Yet, in order to break this cycle of low inflation with low nominal rates that the Fisher effect describes, at some point we will have to raise the Fed rate back to its normal and natural level. We should have started that process earlier but there was little hope of that since calculations of the output gap were so wrong. However, we will have to do it at some point. The only option Mr. Thoma gives us would be after the next recession, but the fear of raising the Fed rate to a normal level would probably still exist… We are Japan, aren’t we?

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China’s Trilemma Maneuvers

by Joseph Joyce

China’s Trilemma Maneuvers

China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mudell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

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Longevity and Long-Term Care: The Medical Crisis of the 21st Century : Part 2 Update: Maggie Mahar will be doing a radio interview at 12:30 PM The Attitude with Arnie Arnesen 94.7 FM WNHN Concord NH

Maggie Mahar at The Health Beat Blog discusses Alzheimer’s care and the alternatives.

Throughout the 20th century, most Americans saw “longevity” as a goal. If we took care of our bodies, we reasoned, we could “live longer and better.”

But in the 21st century, I suspect that some of us will learn to fear “longevity” the way we now fear cancer.

This is the second in a series of posts that will explore the anguish that some experience when they live into their late eighties and nineties–and how we, as a society, can address the hardships of “old, old age.”

Senile Dementia

Thanks to better diets, exercise, and advances in medical knowledge, more and more of us are living to four score and seven. But the downside is that in too many cases, our bodies are out-living our minds. As I note in the post below, since 2011, 40% of the increase in Medicare’s outlays can be attributed to spending on Alzheimer’s patients.

Why is the incidence of Alzheimer’s (AHD) spiraling? Because we are less likely to die of heart disease or strokes, millions of Americans are living long enough to be diagnosed with senile dementia. One could say that longevity is the proximate cause of Alzheimer’s.

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The Etymology of the Cooptation of ‘Freedom’ by the Tea Party

Readers of my AB posts know that a recurring theme of mine is the right’s cooptation of the word “freedom” to disembody the word from actual physical freedom–e.g., from imprisonment–or from personal choice, and to instead define it as a Reagan-era Conservative Legal Movement checklist.  And that these folks achieve this by declaring it mandated by the Constitution’s “structure,” an oddly phantom foundation visible only to them. It’s a pernicious gimmick that five current Supreme Court justices are using to effectively rewrite the Constitution.

In a lengthy article published yesterday in the New Republic, Cass Sunstein, a former longtime University of Chicago law professor, then an Obama-administration official, and now a law professor at Harvard, deconstructs the provenance of this stunningly successful gimmick. The article is called “The Man Who Made Libertarians Wrong About the Constitution: How Richard Epstein’s highly influential, highly politicized scholarship cemented Tea Party dogma.” The occasion for it is a review of a newly published book by the man in question: Sunstein’s former University of Chicago law school colleague Richard Epstein titled “The Classical Liberal Constitution: The Uncertain Quest for Limited Government.”

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The Two Inequalities

by Peter Dormand

The Two Inequalities

In the wake of Piketty, “inequality” is in.  But it comes marinated in confusion.

The problem is that there are two inequalities with relatively little in common.  The one we had been arguing about for several decades is wage inequality.  Most pay has stagnated in the US, while a few occupations, like finance, have seen stupendous rewards.  Within the professions, a few superstars are making oodles while the rest are left to envy.  There has been a big debate: is it about “human capital”?  Winner-take-all?  Deunionization, deregulation and political derepresentation?

But a second inequality has appeared on the scene: the growing share of income going to capital rather than labor.  This is Piketty’s issue, the topic of his book.

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Neo-Fisherite looks beyond the Shocks… response to Mr. Krugman

Paul Krugman wrote today the obvious criticism against the Fisher Effect. He completely based his criticism on monetary shocks, which is a short-sighted view.  He is not thinking beyond the shocks.

“And we know what happens after a positive shock to policy interest rates: output and inflation both fall.”

Yes, that is obvious, but what I have been showing here with the System Dynamics model is that once the shock wears off, the Fisher Effect can passively appear.

Nick Rowe (via David Beckworth) used the same logic against the Fisher Effect. He uses 20 years of Canadian monetary policy to show that the Fisher Effect was not seen. Well, of course, when policy rates are able to create shocks to overcome the passive Fisher Effect, you will not openly see the Fisher Effect.

Look… if policy rates are able to create continual shocks, Yes, output and inflation both fall as a short run reaction. Thus, monetary policy could keep inflation constantly reacting within the short run period of policy shocks. But if you then de-activate policy rates taking away their power to create shocks (maybe because of a zero lower bound with large output gap scenario), then the shocks disappear and how does inflation respond then? Inflation responds to the passive Fisher Effect.

An analogy is like a feather falling. You can blow under the feather to keep it in the air. and you can even blow in such a way that it looks as though the feather is not falling at all. Yet, if you stop blowing, the feather will naturally fall.

I showed evidence of the passive Fisher Effect for Japan and Sweden.

Mr. Krugman solely bases his criticism of the Fisher Effect on policy rate shocks, yet now he needs to address the various situations where shocks from policy rates disappear.  What would he expect to happen then? As I see it, in those situations, inflation will move according to the long run Fisher Effect.

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Eighty percent of current jobs may be replaced by automation in the next several decades.

That’s the conclusion of Stuart W. Elliott in his recent paper, “Anticipating a Luddite Revival.” (Hat tip: RobotEconomics.)

We’ve seen that scale of transformation before. But this one promises to be roughly four times as fast, dwarfing Luddite-era concerns:

…the portion of the workforce employed in agriculture shifted from roughly 80% to just a few percent. However, in the shift out of agriculture, the transformation took place over a century and a half, not several decades.

But there’s a much bigger difference this time — a hard limit that time can’t ameliorate:

The level 6 anchoring tasks in Table 2 are not only difficult for IT and robotics systems to carry out, but they are also difficult for many people to carry out. We do not know how successful the nation can be in trying to prepare everyone in the labor force for jobs that require these higher skill levels. It is hard to imagine, for example, that most of the labor force will move into jobs in health care, education, science, engineering, and law.

I’ve said it before: the median IQ is 100, by definition. Fifty percent of people are below that level. We (and they) are facing a hard cognitive limit that the Luddites never approached. I don’t think anybody reading (or writing) this post can appreciate how hard it would be to make a go of it in today’s technological society — even get through high school, much less provide a healthy, happy, financially secure life for one’s family — with an IQ of 80 or 90.

Are people who aren’t born smart lacking in “merit”? That’s what meritocrats are claiming. (Though they will vociferously defend themselves, deploying endless arguments both specious and obfuscatory.) If you’re in the low-IQ group (and don’t inherit), your miserable position in life is fixed at birth. Get over it.

Currently, work is the only way for the majority of people to legitimately claim any significant share of our remarkable prosperity. (Social-support programs provide a pretty insignificant and tenuous, insecure claim that’s not generally viewed as legitimate, only unfortunately necessary.)

If those folks 1. can’t find jobs that they can do, and 2. receive negligible claims on our prosperity if they are lucky enough to find one of the few remaining, we’re facing a world of haves and have-nots. Sound familiar?

Here’s the depressing chart of fastest-growing job categories and their wage levels that Elliott provides, based on BLS data:


One fundamental belief has to change: that finding and doing a job is the only thing that gives you any claim on a decent life. Because for many, jobs that provide decent claims simply aren’t there, or won’t be soon. (Likewise the belief that rebalancing your financial portfolio annually — doing the arduous, taxing work of “allocating resources” — is extremely meritorious and gives you a just claim on an outsized share of our collective prosperity.)

Horses faced exactly this situation in the first industrial revolution. They could never learn to drive tractors and trains.

I’ll be the first to say that people aren’t horses. Which gives rise to the ugly next thought:

They shoot horses, don’t they?

Cross-posted at Asymptosis.


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