A desirable property of a monetary instrument is that it holds its value over short periods of time. Most assets do not have this property: their purchasing power fluctuates greatly at very high frequency. Imagine having gone to work for gold a few weeks ago, only to see the purchasing power of your wages drop by 10% in one day. Imagine having purchased something using Bitcoin, only to watch the purchasing power of your spent Bitcoin rise by 100% the next day. It would be frustrating. 

I'd like to offer a few thoughts on this piece by Brad DeLong.

He seems to think that some people in the profession are confused about things like the natural rate of interest and its relation to the market rate. What's ailing the economy is so painfully obvious. Why are these dopes trying to make things harder than they are? This is not rocket science after all.

Well, I freely admit to being a bit confused. Let me explain why.

First, the "natural rate of interest" is a term that seems to mean different things to different people. According to DeLong, the natural rate of interest is the (real) interest rate consistent with "full employment." Well, that's all fine and good, except that he does not define what he means by "full employment." (I certainly hope he does not define it as the level of employment consistent with the natural rate of interest!)

In my view, the natural rate of interest and the full employment level of employment are theoretical objects. They may or may not exist in reality. Economists use these terms to help them interpret the world. Nobody knows for sure just by looking at the data where the economy sits in relation to the natural rate of interest or full employment (however these terms are defined theoretically).

One might of course try to estimate their values by sample averages in the data. But this approach is not without problems. The employment-population ratio in the U.S. shows secular variation. Moreover, it varies across different demographic groups. Take a look at this, for example. While there are more sophisticated ways of estimating these things, the whole exercise is predicated on the assumption that these objects actually exist. (They most certainly do, if only in the minds of some economists).

In any case, with that little bit out of the way, I'd like to see whether I can make sense of the various claims that DeLong makes in his column.

1. The current natural interest rate is much lower than it is normally--the natural rate is too low--and that is a problem.

One way to understand this statement is with the classic "loanable funds" market diagram. There is a supply for loanable funds S(r,Y), increasing in the real interest rate r, and increasing in the level of real income Y. The the demand for loanable funds, or investment demand, I(r) is a decreasing function of r. Let Y* denote the full-employment level of GDP. Then, in a closed economy, the natural rate of interest r* satisfies S(r*,Y*) = I(r*).

Now, imagine that investment demand collapses for some reason. Moreover, assume that the zero lower bound (ZLB) is not binding. What happens to the full-employment level of Y? I am not sure what DeLong is assuming here. I think he assumes that it remains unchanged at Y*, but that actual Y may move along some "short run" (sticky price) AS curve. So, are we currently in the short-run or long-run? He does not say. I say that after four years, the sticky price frictions are probably no longer relevant, especially since U.S. CPI is close to its long-run trend. If this is the case, then he must be assuming that Y* is currently at its pre-crisis level (or would be, if the ZLB was not a problem).

But what is the problem here? If the interest rate is free to move, then the economy achieves full employment and GDP remains at "potential" Y*. (This, despite the collapse in investment, which lowers the future capital stock, future real GDP, etc.? How can Y* remain unchanged years after lower-than-normal investment?) I am led to infer from this discussion that he views the real problem as stemming from the ZLB, which he tackles in his next statement.

2. The current market interest rate is higher than the natural rate--the market rate is too high--and that is a problem.

Alright, suppose that r0 cannot be attained because of the ZLB on nominal interest rates (despite the fact that yields on longer maturities are not at the ZLB, but anyway, ignore this too.) Then the market interest rate r1 is too high; i.e. r1  > r0. If this situation  persists, then according to this simple model, the level of output must decline to some Q satisfying S(r1,Q) = I(r1); where Q < Y*. This is also a problem; see also Krugman.

If this latter problem is indeed the problem, then there are simple fixes. First, the Fed could raise its inflation target. Inflation serves as a tax on saving because it lowers the real rate of interest (given the ZLB). At the same time, it stimulates spending. The fiscal authority could achieve the same result by just taxing saving directly. I wonder, however, how many people really believe this to be *the* problem.

*The* problem seems more related to whatever caused the collapse in investment demand in the first place. I'm sure that most economists, including DeLong, would agree with this. But the key question, in my view, is precisely what factors (institutional arrangements and exogenous shocks) caused the collapse and whether the desired policy response should be made contingent on specific causes. My experience in working with economic models is that the optimal policy response generally depends a great deal what one assumes about the underlying shock. I believe that this lesson likely holds for real economies too and I wish that economists would spend more time talking about this.

3. Increasing G--printing more Treasury bonds, selling them, and buying goods and services--(a) increases the supply of safe assets, (b) lowers the proper value of safe assets via supply and demand, thus (c ) raises the "natural" rate of interest, and (d) could fix our problems if the policy raises the natural rate of interest so much that it is no longer lower than the market rate of interest.

Listen folks, I am not against increasing government spending (see for example, here). But we have to be clear about what economists mean by "increasing G." What they mean is an increase in spending in any form. This is the proverbial "digging up holes and filling them up again" prescription. Or Krugman's famous "let's build a bunch of stuff and export it to Mars" prescription. Of course, they do not mean that this is the way resources should be used. The statement is simply that even if the resources were to be used in a wasteful manner, it would work. Well, forgive me for not being so comfortable with that proposition.

Now, suppose we instead take Steve Williamson's view (more correctly, my interpretation of his view) that the collapse in investment spending is related to the evaporation of private label liquidity products (like the MBS products that used to circulate in the repo market). In fact, Steve has an interesting paper where he lays out the details of a specific model here: Liquidity, Monetary Policy, and the Financial Crisis. Brad may want to read this himself, once he works his way through Wicksell.

Unfortunately, there is no simple way to summarize Williamson's model in a short blog post. As in reality, what happens depends on a specific set of circumstances. In one case he considers, the shock that afflicts the banking sector drives up the demand for relatively safe securities, which drives the real interest rate down. Hence, the statement that "the interest rate is too low" (relative to the rate that would prevail if the economy worked perfectly). There is no talk of "natural" rate of interest or "full employment" in Willamson's paper. In Descartes-like fashion, we could say that Willamson had no use for that language.

In his model (as in reality), U.S. Treasuries are substitutes for the now missing private collateral objects. In his "scarce interest-bearing asset" case, a one time open market operation by the Fed (purchase of UST) has a perverse effect: it diminishes the supply of good collateral and therefore raises its price; i.e., it lowers the real interest rate--but in a way that is bad for the economy because it further depresses investment (that is, the lower interest rate is a reflection of a downward shift in the investment demand schedule.) Williamson calls this the "illiquidity effect."

[Note: I am not arguing that this is in fact what is happening. It may or may not constitute one of many forces that are currently in operation. It is a property that emerges from a standard economic model with realistic frictions. It is standard practice to use theory to help guide us what to look for in the data. For example, it was theory that motivated modern day NIPA design, not the other way around!]

The policy prescription in Williamson's model is for the Treasury to expand its supply of debt, both to meet the hightened demand and to cover for the shortfall in (private) supply. What is the Treasury to do with its proceeds? In principle, the Treasury could buy up private securities (this is like a banking operation--an open market operation, but with Treasuries instead of money). Or taxes could be cut. Or, yes, an increase in G too (but whether and how much to do this should be based on standard cost-benefit calculations.)

Unlike the "this is not rocket science model" that DeLong likes to work with, there are many interesting cases that emerge in the Williamson model. Macroeconomists should go read it. His paper is by no means the last word on the subject. Indeed, it may turn out one day to be all wrong. But that is the nature of research. There are still a lot of things we do not understand about the way the macroeconomy works.  Well, for those of us who remain confused, in any case.

Krugman has an interesting article today, Monetary Policy in a Liquidity Trap. I (sort of) agree with much of it. But I believe that a few comments are in order.

Consider this statement:

So, at this point America and Japan (and core Europe) are all in liquidity traps: private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment. And interest rates can’t go below zero (except trivially for very short periods), because investors always have the option of simply holding cash.

This statement is, in varying degrees: [1] interpretative, [2] assertive, [3] misleading, and [4] wrong.

First, the quoted passage above suggests that a liquidity trap is the byproduct of "insufficient private demand," with the implication, of course, that more "public demand" is needed to rectify the situation. This may or may not be true. Regardless, the statement is [1], [2], and [3] above. Beware of economists making bald assertions.

Second, the statement is wrong in suggesting that our current liquidity trap is associated with zero nominal interest rates. Liquidity trap phenomena are much more general than this. And if you really want to further your understanding on this matter, please go read this piece by Steve Williamson: Liquidity Traps, Money, Inflation, and Bond Yields. As Steve says: this is not your grandma's liquidity trap.

In grandma's liquidity trap, the real interest rate is too high because of the zero lower bound. Steve argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries.

If this latter view is correct, then "corrective" measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors.

Given these "real" problems, Steve's view is that the Fed is largely irrelevant. But he does assign hope to the Treasury: increase the supply of its securities to meet the world demand for them. I've been making similar arguments for some time now; for example, here.

Apart from all this, it will be interesting to see how the experiment in Japan plays out. Most of the massive purchases announced by the BOJ are for JGBs -- I'm really skeptical what sort of effect this should have (since the operation constitutes swaps of two assets that are close to perfect substitutes--although some purchases will take the form of higher risk assets--see Noah Smith on this). But what I think really does not matter--it is what market participants think--and the program does appear to be having some effect in financial markets.

Thank you, Japan, for this interesting experiment. Domo arigato, gozaimasu!

Well, here's an eyebrow raiser: Germans Among Poorest in Europe: ECB Study. 

The paper is available here: The Eurosystem Household Finance and Consumption Survey. The cross country comparison of net wealth can be found in Table 4.1 on page 76.

Median net wealth in Germany for 2010 was 51K eur. Compare this to median wealth in Greece (101K), Italy (173K) and Spain (182K).

This just doesn't sound right to me, but I haven't gone through the report in detail. Evidently, the differences are driven primarily by real estate wealth. Thankfully (?), Germany escaped the housing price "bubble" that afflicted many European countries; see figure below.


Moreover, as I noted here, the German growth experience over the past 20 years has been nothing to write home about.

Germany: low growth, no asset price bubbles, low wealth, but...stable. Das ist gut?



April 16, 2013: Update here from VOX, who emphasize that the wealth distribution in Germany distorts the picture presented here.