31 October 2015

Economic Philosophy on the Left and Right

The usual explanation for different approaches to economic policy from the political left and right leaves much to be desired. To suggest that economic policy debates are really, at their deepest, just disagreements about ways to achieve the same goal of maximum prosperity is ignorant of the severe differences between proposals about fiscal policy on the left and right. These debates do not stem from disagreements about how to set up the welfare system or how big the welfare system should be; they arise out of a disconnect on what kinds of behavior and outcomes ought to be prioritized by the government.

The discourse on the right is dominated by an idolization of employment and for Pareto efficiency. Proposals seeking to substantially reduce taxes on labor and investment reflect these priorities. Lower and flatter income taxes are consistent with incentivizing people to work longer hours and with removing some of the alleged Pareto suboptimality that arises when higher incomes are deliberately taxed more than lower incomes. Lower taxes on investment serve this purpose as well; they reduce the problematic progressive taxation that, rather than helping to bring the poor up and the rich down, reduce everyone’s income. Meanwhile, anti-welfare policies are supported because of their effectiveness at bringing conservatives closer to their two-fold economic purpose. Programs like unemployment insurance and food stamps make it easier for people to not work and increase the income of the poor at the expense of everyone and must therefore be annihilated.

In contrast, left-wing discussion is primarily concerned with minimizing involuntary employment and raising the average level of welfare in the population. These two ideals inspire proposals that would provide healthcare for all and make sure that anyone in the country has the ability to survive regardless of circumstances. A completely private health system may very well be maximally efficient, but it is heavily tilted against those on the lower income scale. Nationalization makes sense; some efficiency will be lost because of the monopoly, but the health of the average constituent can allegedly be raised and so must be raised. More broad welfare programs are also consistent with these goals. Unemployment insurance, pensions, and food stamps serve as subsidies for those who find themselves unable or unwilling to work at any point in time and serve the purpose of raising the average income, especially the income for those at the low end of the income and wealth distribution.

The clash between left and right should not be seen simply as a clash over the appropriate size of government or the optimal method of achieving the same goals. It is more fundamental, more substantive than that. Conservatives emphasize the inefficiency of government provision and the distortion of progressive taxation while liberals emphasize the broad welfare gains that can be had in spite of the distortion and inefficiency that government necessitates. The most probable reality is one in which both sides are correct and the costs and benefits of each government program must be carefully weighed before implementation.

30 October 2015

The Fed Should Cut IOR

It's difficult to understand why people and financial institutions would willingly carry an asset that earns less interest than other types of asset. A typical way to get around this problem is by assuming that some or all of the goods in an economy must be paid for in cash. Because agents must pay for goods in cash, they choose to hold only as much as they need to pay for those goods. If they were to hold any extra cash, then they would be missing out on valuable interest that they would earn from other assets. The cost that agents face by holding money as opposed to other assets (e.g. government bonds) is called the opportunity cost of holding money.
But what happens when the opportunity cost of holding money is zero (i.e., the interest rate on government bonds is equal to the interest rate on money)? In this situation, it makes no difference to agents what kind of asset they hold, so the distribution of government bonds and money is indeterminate. This indeterminacy breaks the link between inflation and the money supply. Typically, the money supply is linked directly with the nominal value of spending on cash-goods in this economy, so a higher money supply would necessitate higher nominal spending and, assuming flexible prices and wages, higher prices. Now, because there is no opportunity cost of holding money, agents will freely hold any money that the central bank gives them without needing to spend it.

This is the situation that the Federal Reserve is currently in. There is no incentive for financial institutions to do anything will all the money that the Fed has injected into the system since 2009 because the interest rate that money pays (interest on reserves or IOR) is equal (after adjusting for risk/liquidity) to the interest rate that other assets pay. Financial institutions are happy to sit on interest bearing and highly liquid (easy to buy and sell) cash. This is why the vast majority of the increase in the monetary base since 2009 has taken the form of "excess reserves".

In order to reverse this, it is necessary to make reserves less attractive to financial institutions (or, in the case of cash-in advance models, make cash less attractive to agents). This means that there must be an opportunity cost of holding money; that money needs to pay less interest than other assets. Of course, this can be accomplished one of two ways: the Fed can either reduce the interest it pays on reserves increase the interest rate that other assets pay. Since economists widely agree that raising interest rates would have a negative effect on the rate of inflation, it seems clear that the way to increase inflation in the US is to cut IOR.

05 October 2015

Effect of Austerity on US GDP

I decided I would make a little chart comparing the US output gap [1] to a counterfactual of the output gap without austerity [2]. The graph shows the actual output gap and counterfactual output gaps for government expenditure multipliers of 0.25, 0.5, 0.75, and 1.

[1] The output gap measure I used assumes that potential GDP grows as roughly 2% a year and that the output gap was zero in Q1 2005.

[2] By "without austerity" I mean "if the government spending to potential GDP ratio stayed at 20% from Q1 2005 to Q2 2015."

(The GDP measure I used is the 'GDPC96' series from fred and the government spending measure I used is the 'GCEC96' series)

03 October 2015

Inflation ≠ Expected Inflation

Neo-Fisherian arguments seem to rest on the idea that expected inflation is somehow related to current inflation - almost to a point of equivalence. A typical argument would be: look at the fisher relation $i_t = r + E_t \pi_{t+1}$. Notice that the nominal interest rate, $i_t$, and the expected inflation rate, $E_t \pi_{t+1}$, are related. Increasing the nominal interest rate must therefore cause the rate of inflation to increase. Before you accuse me of debating a straw man, read this from John Cochrane's recent post:

If you parachute down from Mars and all you remember from economics is the Fisher equation, this looks utterly sensible. Expected inflation = nominal interest rate - real interest rate. So, if you peg the nominal interest rate, inflation shocks will slowly melt away. Most inflation shocks are individual prices that go up or down, and then it takes some time for the overall price level to work itself out.

The problem with this argument is that the current rate of inflation is never modeled; the central bank can choose expected inflation, but there is no reason that the actual rate of inflation must change in response to higher expected inflation. There are a couple of ways around this problem. In the interest of keeping the model as simple as possible, you could assume that the central bank sets the nominal interest rate in response to the current inflation (i.e. a Taylor Rule) or, in the interest of coming of with a more structural model, you could try and come up with a variable that actually does cause current inflation (e.g. the money supply).

The Taylor Rule approach is the way that most economists have gone in the last twenty years or so. Positive deviations of the nominal interest rate from the level implied by the Taylor Rule result in lower rates of inflation. This is itself enough to prove that, as long as a central bank follows a Taylor Rule, a Neo-Fisherian analysis is wrong. There are still some valid contentions that a Neo-Fisherian might make though: a.) central banks set interest rates by discretion, not by adherence to a Taylor Rule b.) Taylor Rules don't actually produce a unique equilibrium value for the initial rate of inflation or the initial price level. In order to deal with contention a, it is clear that a more structural model of inflation is necessary since interest rates clearly do not cause inflation. Contention b is a bit more complicated. In order to make sense of it, it is helpful to look at the coefficient on inflation in the Taylor Rule. If that coefficient is less than one, then any initial rate of inflation will converge to the central bank's inflation target; there are multiple equilibria. Alternatively, the coefficient can be greater than one which will cause the rate of inflation in the future to explode unless the initial rate of inflation is equal to the target rate. The only reason that this calibration works is because economists have chosen to rule out explosive solutions which may make sense for real variables, but does not make sense for nominal variables like inflation.

Contentions a and b leave two options for revision to the conventional approach: come up with a more structural model of inflation or come up with a model that determines a unique equilibrium for "passive" Taylor Rules (i.e. Taylor Rules where the coefficient on inflation is less than one). For some reason, the price determination literature failed to go down the first route and instead chose to come up with 'the fiscal theory of the price level'. Basically, the fiscal authority can threaten to disobey its budget constraint unless the initial inflation rate does not jump to the correct level. I don't really understand how this is all that much better than the trick with active Taylor Rules though. After all, both involve threats to either cause a hyperinflation or not pay off debt at some point that force the initial inflation rate to be on target. 

Because of this, it seems obvious to me that the structural path should be taken. There should be a way to determine a unique equilibrium rate of inflation without requiring that fiscal or monetary policy be intentionally unstable. Of course, a cursory analysis using something like the money supply is easy. Current inflation is caused by current money growth and expected inflation is caused by expected money growth, so interest rates and inflation will go up in response to an increase in the growth rate of the money supply that is expected to be persistent. The debate should end there.

P.S. I don't necessarily mean to say that applies to the current situation; the zero lower bound is special both in theory and in practice.

P.P.S. For the more visually oriented, here's a graph that illustrates the explosive behavior of inflation under a Taylor Rule:

01 October 2015

'Liberal' and 'Conservative' Theories

Recently I found myself unfortunately coerced into reading "Jeb Bush Keeps Repeating A Phrase That's Central To A Liberal Economic Theory" (link). The article brought to my attention that the public sees theory in a much different light than I - and hopefully most members of academia - do.

The author asserts the Keynesian economics is a "liberal theory" as if scientific theories (social or otherwise) simply exist to advocate different political positions. This view represents a complete failure to understand the way that science is done. Rather than assuming a conclusion and attempting to prove that conclusion by any means possible, a good scientist will not assume that any position is correct and instead see what the data suggests and come of with a theory that attempts to match that data. Keynesian theory is no more 'liberal' than monetarism is 'conservative'. Yes, both economic ideologies are characterized by differing assumptions, but those assumptions do not come from inherent political bias.

The view of theory presented in the article can be especially dangerous because it allows for politicians to write off any bit of theory on the grounds that it is a 'liberal' theory or a 'conservative' theory. This is how the Cameron government in the UK can ignore the fact that austerity reduces GDP in even the most friction-less models (e.g. here) by arguing that any theory that suggests austerity is contractionary has a liberal bias. 

Behind this whole issue seems to be the idea that every side in any political argument is at least somewhat right regardless of whether their opinions are backed up by academia. Essentially, politicians can redefine the political center whenever they choose and the media won't try and stop them. No matter how insane a policy proposal is, it can not be one hundred percent wrong in the eyes of the public and the media. 

For this reason, the media ought to shift its primary concern from representing each position fairly to determining the facts or the consensus theories and criticizing those who fail to understand or accept them. Policy proposals that are in direct contempt of the scientific consensus should not be tolerated.