Month: July 2014

Who are today’s supermanagers and why are they so wealthy?

Posted on by Ed Paisley

What explains the changes in top-earning occupations over the past four decades? Perhaps the most intriguing argument about the current state of income inequality in the English speaking economies that Thomas Piketty makes in his bestseller “Capital in the 21st Century” is this—“the vast majority (60 to 70 percent, depending on what definitions one chooses) of the top 0.1 percent of the income hierarchy in 2000-2010 consists of top managers.” He goes on to argue on page 302 of his book that the rise in labor income “primarily reflects the advent of ‘supermanagers,’ that is, top executives of large firms who have managed to obtain extremely high, historically unprecedented compensation packages for their labor.”

top-earners-infographic

This really begs the question as to how and why these supermanagers came into existence. Nobel Laureate Robert M. Solow points out in The New Republic that this is primarily an American outcome. And Henry Engler at Thomson Reuters Accelelus’ Compliance Complete recently published an excellent piece on Piketty’s supermanagers in the United States and the United Kingdom. Both writers agreed with Piketty that these supermanagers were being vastly overly compensated given their questionable contributions to productivity.

I hope to shed a little more light on this issue by examining the change in professions comprising the top 0.1 percent of tax filers between 1979 and 2005. The purpose: to examine whether the changing composition of this super elite reflects changes in our economy that may explain the link between rising economic inequality and anemic economic growth over this period.

To do so, I used data from the April 2012 white paper “Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data,” by economists Jon Bakija of Williams College, Adam Cole of the Office of Tax Analysis at the U.S. Department of the Treasury, and Bradley Heim of Indiana University. They used tax data on the top 0.1% of filers to identify the top earning professions. The infographic below tells the tale, charting the change in occupations at the tippy top of the income ladder in 1979 and 2005.

The biggest change in the distribution of top earners is in the types of executives, managers, and supervisors at non-financial firms. In 1979, most of these people worked for large, publicly traded firms but by 2005 more were working in closely held firms. There is not enough information to provide a clearer picture as to who exactly these people are, but chances are they are employed by firms that are owned by private equity firms—the growth in the private equity industry over this period of time was substantial—and because financial professionals saw large gains, too. The share of people in the top 0.1 percent working in finance also increased substantially, to 18 percent in 2005 from 11 percent in 1979.

These findings are consistent with Piketty’s analysis in his new book. But there are alternative explanations. One is presented in George Mason economist Tyler Cowen’s latest book, “Average is Over.” He claims a skill biased-technological change is responsible for the shift in top occupations over roughly the same period. He argues that technology allows top performers to capture more of the market and thus earn substantially more than average performers. He and many other people hypothesize that this is a driver of increased economic inequality.

But if technology were a primary driver of inequality, then one would expect that skilled trades would have larger incomes and would have become a larger share in the top 0.1 percent. While there are slightly more technical types and entertainers among top earners (as can be seen in the data presented in our interactive) the biggest gains in both percentage terms and magnitude were among privately held business professionals.

Thus, the so called “average is over” argument—that that the top performers in each field will capture a bigger share of the pie—may be a driver of inequality, but it does not appear to explain the bulk of the changes in occupations at the top of the income ladder. Instead, the supermanagers appear to be capturing greater share of the wealth as is argued by Piketty and others. More detailed data would be required to assess who these people are and how workplace dynamics changed from 1979 to 2005 that would explain the change in income. The Washington Center for Equitable Growth will be examining this data in more detail in forthcoming publications.

Things to Read on the Morning of July 16, 2014

Posted on by Brad DeLong

Should-Reads:

  1. Paul Krugman: On the Neo-paleo-Keynesian Phillips Curve: “I mentioned…in passing that recent data actually look like an old-fashioned pre-accelerationist Phillips curve–that is, unemployment determines the inflation rate, not the rate of change of the inflation rate…. There seems to be one of these funny situations right now where people who don’t work on such issues consider this a wild and crazy, or maybe just silly assertion, while those actually doing serious empirical work treat it as a matter of course…. Is that just me? No. Consider two recent studies on unemployment and inflation…. Michael Kiley… had the very good idea of adding power by estimating the relationship across a number of metropolitan areas… his Phillips curve is non-accelerationist for the past 15 years…. Klitgaard and Peck at Liberty Street… does a similar exercise for eurozone countries. Their results… [are] a relationship between the change in unemployment and the change in inflation, equivalent to a relationship between the level of unemployment and the level of inflation–i.e., an old-fashioned Phillips curve…. All I’m saying is that people trying to fit recent data keep finding something that looks like the old-fashioned relationship. You can offer various explanations–downward wage rigidity, anchored expectations, or maybe it just isn’t worth adjusting price-setting to match fairly small variations in expected inflation. But anyway, that’s what the data look like.”

  2. Tim Duy: Yellen Testimony: “Her choice of words is important here.  Note that she does not say ‘If the labor market improves more quickly’. Yellen says ‘continues to improve more quickly’ which means that the economy is already converging towards the Fed’s objective more quickly than anticipated by current forecasts…. It brings into question whether or not the Fed should maintain its ‘considerable period’ language: ‘The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends…’. There will be resistance… the Fed will want to ensure that any change is interpreted as the result of a change in the outlook rather than a change in the reaction function.  But the hawks will argue that the communications challenge is best handled by dropping the language sooner than later…. Bottom Line: A generally dovish performance by Yellen today consistent with current expectations…”

Should Be Aware of:

And:

  1. Zack Beauchamp: Why Hamas’ military wing scuttled a ceasefire with Israel: “Just hours after Israel accepted an Egyptian-brokered cease fire agreement on Tuesday morning, the calm collapsed. Hamas continued to fire rockets into Israel, and its militant wing announced ‘We will continue to bombard until out conditions are met’…. After six hours of holding its fire, Israel resumed bombing the Gaza Strip–and it’s not clear, now, when the fighting is going to stop…. No one’s quite sure what Hamas thinks about the cease fire agreement. That may sound bizarre, given that they’ve clearly violated its terms and never accepted it, but the group has not yet issued any official statement on the deal. The New York Times, CNN, and leading Israeli newspaper Ha’aretz all reported that Hamas’ cabinet was still considering the proposal as rockets were falling. What this suggests is that there may be a real division between Hamas’ military wing, the Izz ad-Dim al-Qassam Brigades, and its political leadership. Nominally, the military wing reports to the political wing, but it’s not clear that the political wing has total control over rocket fire. Notably, an al-Qassam statement, not a Hamas political spokesman, claimed responsibility for the rocket attacks that continues after the ceasefire. And just after the proposal was announced, a military wing statement said the ceasefire agreement ‘is not worth the ink that wrote it’…”

  2. Nate Cohn and Derek Willis: More Evidence That Thad Cochran Owes Runoff Win to Black Voters: “The precinct-level results for… Mississippi… all but prove that Senator Thad Cochran defeated Chris McDaniel, a Tea Party-backed state senator, through a surge in black, Democratic turnout…. Cochran won by 7,682 votes in the state’s 286 most Democratic precincts, where President Obama won a combined 93 percent of the vote in 2012. That tally slightly exceeds Mr. Cochran’s… margin of… 7,667…. He won 92 percent of the vote in the state’s most uniformly Democratic precincts, where Mr. Obama won 99 percent of the vote. These precincts voted for Mr. Cochran by 3,889 votes, or more than half of his statewide margin of victory…”

  3. Zeynep Tufekci: Engineering the public: Big data, surveillance and computational politics: “Digital technologies have given rise to a new combination of big data and computational practices which allow for massive, latent data collection and sophisticated computational modeling, increasing the capacity of those with resources and access to use these tools to carry out highly effective, opaque and unaccountable campaigns of persuasion and social engineering in political, civic and commercial spheres. I examine six intertwined dynamics that pertain to the rise of computational politics: the rise of big data, the shift away from demographics to individualized targeting, the opacity and power of computational modeling, the use of persuasive behavioral science, digital media enabling dynamic real-time experimentation, and the growth of new power brokers who own the data or social media environments. I then examine the consequences of these new mechanisms on the public sphere and political campaigns…”

  4. John Holbo: Dreams and Plagiarism: “In other news: Zizek isn’t looking like an especially responsible scholar. I find the explanation that ‘a friend’ sent him a long passage cribbed from a white supremacist book review and told him ‘he could use it freely’, in addition to being insufficient, rather incredible. With ‘friends’ who trick you into plagiarizing white supremacists, who needs enemies?…”

Already-Noted Must-Reads:

  1. Chris Blattman: Links to Reviews of James Scott’s “Seeing Like a State”: “Daron Acemoglu and James Robinson discuss the work of Jim Scott in a (so far) three-part series: here, here and here…. Brad Delong on Seeing Like a State. Also, Paul Seabright’s review in the LRB.

  2. Chang-Tai Hsieh and Enrico Moretti: Growth in Cities and Countries: “We use a Rosen-Roback model of urban growth to show that a summary statistic for the aggregate effect of local growth (decline) is whether it shows up as an increase (decrease) in local employment or as an increase (decrease) in the nominal wage relative to other cities. Differences in the nominal wage across cities reflect differences in the marginal product of labor across cities which, ceteris paribus, lower aggregate output. We show that the dispersion of the average nominal wage across US cities increased from 1964 to 2009 and may be responsible for a 13% decline in aggregate output. Changes in amenities appear to account for only a small fraction of this output loss, with most of the loss likely caused by increased constraints to housing supply in highly productive cities. We conclude that welfare gains from spatial reallocation of the US labor force are likely to be substantial…”

  3. Mark Blyth: Europe’s Goldilocks Dilemma: “The policy of austerity has twin goals: reducing growth in public debt and boosting investor confidence. On both counts, the eurozone’s attempts have been an unmitigated failure…. The confidence-inspiring powers of what was curiously called ‘expansionary fiscal contraction’, the idea that budget cuts today make people spend more since they will have lower taxes in the future, haven’t been any better. European consumer confidence dropped precipitously during the crisis and has yet to return to positive territory. Investment expectations, as measured by business confidence surveys, similarly fell as austerity took its toll and are now barely positive. Growth rates track these declines but with a North-South twist: Germany is pulling ahead, France is flat-lining, Italy is stagnating, and the periphery remains in negative territory. Unemployment rates (outside the export-driven North) are stuck at levels last seen on the eve of World War II. Given all this, you would think a halt to such self-defeating policies would be a good idea. And indeed, it is. But that doesn’t mean that Brussels and Berlin can actually stop austerity…”

  4. NewImageJoe Romm: Hottest March-June On Record Globally, Reports Japan Meteorological Agency: “The JMA reported Monday that last month was the hottest June in more than 120 years of record-keeping…”

The value of search-and-matching models for the labor market

Posted on by Ed Paisley

University of Queensland economics professor John Quiggin of Crooked Timber recently published an excellent blog post questioning the usefulness and empirical success of the dominant macroeconomic model of the labor market: the search-and-matching framework.  Peter Diamond of the Massachusetts Institute of Technology, Dale Mortensen of Northwestern University, and Christopher Pissarides of the London School of Economics won the Nobel Prize in Economics in 2010 for their foundational work on this model. Most recent theoretical and empirical work on macro labor markets, including my own dissertation, is based on it because it was the best thing economists had on hand when the world came calling to ask about unemployment in the Great Recession.

Moreover, several high-quality datasets that track the model’s observables have also become available in recent years and have enabled important empirical work based on investigations of the model’s predictions and the implications of their success and failure. But Quiggin’s critiques are well taken, and have sparked an interesting conversation, with contributions from Stony Brook University economist Noah Smith, the Roosevelt Institute’s Mike Konczal, and others. Why is it worth having this discussion? Is this just an ivory tower academic debate about oversimplified mathematical formalizations with no empirical basis?

On the contrary, a correct understanding of the labor market is of central importance to assessing its ailments and ordering the right prescription. And the labor market is the way that the majority of people earn the majority of their living, although that living has gotten more meager for all but the top few over the past several decades. The middle fifth of the household income distribution earned labor income of $45,315 in 2011 dollars, or 77.1 percent of their total income, in 1979, and only $45,997 (amounting to 65.8 percent of their income) in 2007—a mere 1.5 percent increase despite a 129 percent increase in inflation-adjusted gross domestic product. The overall share of national income going to labor has declined from 79 percent in 1979 to 71 percent in 2010.

The search-and-matching model works like this: one class of agents, “workers,” is either searching for a job or employed while another class of agents, “firms,” is either vacant, meaning it has a vacancy posted, or filled, in which case it employs a worker and together they hum along productively. In the earliest formulation of the model, the only economic decision made by either agent was whether a firm would post a vacancy in an attempt to match with a worker or would choose not to, thus remaining inactive. Otherwise, both searching workers and vacant firms mindlessly wait until they match up, then commence a productive relationship that lasts until their match spontaneously dissolves. Then the worker goes back to searching and the firm makes its decision about whether to post a vacancy or not once again.

The reason why search-and-matching labor market models have something to say about the recent history of the labor market is because they are a good deal richer than the simple search-based story, which is the reason why Federal Reserve Bank of Richmond economist Karthik Athreya, whose book sparked this discussion, said that “search is not really about searching.” Specifically, they allow for alternative theories of wage-setting, a factual timeline for unemployment spells and what determines their duration, a rich set of labor market outcomes beyond employment and unemployment, and an implementable notion of power that is often a critical missing piece of economic modeling.

Like all economic models, the search-and-matching model is a simplification, even a ludicrous one. Quiggin argues that it fails even as a simplification of reality because the main reason why unemployment exists is not because workers and firms are groping in the dark for one another, a process which just by its nature takes time. And he’s right about that. So do we search theorists have a big problem?

Notice that my summary of the model left out one big thing: how the fruits of the productive employment relationship are split between the worker and the firm. This is by far the biggest controversy in the field of search theory. The assumption made by the earliest search-and-matching models is that the “surplus” the two agents generate is split between the parties in the optimal way, where the optimality concept is defined within the model but with some relationship to a more general intuition about what each party would want. (That optimal way is known as the “Nash Bargain” after the Nobel-Prize-winning mathematical theorist John Nash, the protagonist of the film A Beautiful Mind.)

The problem is that this theory of wage setting is an empirical disaster. Not only is it inconsistent with investigations into how actual wages are actually set, but it generates false predictions about unemployment spells that crucially fail to line up with what happens to unemployment during recessions (it goes up, and it stays high for a long time, when the optimal theory of wages says that wages should do the adjusting). Refinements that make the theory with Nash Bargaining consistent with the data on unemployment in recessions yield their own big empirical problem: those refinements imply that being unemployed isn’t really that bad for workers, which everyone who is sentient knows to be untrue.

So the search-and-matching model has a crazy theory about how wages are set, and that makes it a crazy model of how labor markets work, right? No. What the search-and-matching theory has, and what its alternatives lack for the most part, is indeterminacy about how wages are set. The “Nash Bargain” theory is optimal, but it’s not necessary—other wage-setting assumptions can be used to resolve the indeterminacy. And if economists can get their minds around the idea that the “market solution” is not always optimal then they can make real headway with the search-and-matching approach precisely because it’s consistent with those alternatives.

That’s where the most promising research into the macro labor market is happening. If wage-setting in the search-and-matching model is made more factual by including what seems to be the well-established norm of not actually cutting pay in nominal terms, then it generates long unemployment spells and high unemployment rates—not because something about the matching process has become more inefficient, which Quiggin is correct to call absurd, or because workers don’t care whether they’re employed or unemployed— but because the labor market is a great deal stickier than the canonical competitive equilibrium model assumes.

The search-and-matching model boasts several other strengths. In the popular imagination (mostly of those who have never been unemployed), unemployment follows a large-scale layoff. Basically, it’s the destruction of employment that leads to high unemployment. But in reality, high unemployment occurs mostly when the hiring rate declines. The overall job separation rate is, in general, not related to the business cycle, and it has been in long-run decline, which is itself evidence of ill health in the labor market. There was a very transient uptick in mass layoffs during the 2008 recession, but the market reverted to its long-run level of around 1.2 percent laid-off per month as the official recession ended in late 2009.

Hiring, on the other hand, went down at the beginning of the recession and has remained lousy for a long time. The factual way to interpret this is that there’s inherently churn, or movement in the labor market as workers quit jobs or get laid off and are hired for a new job. The labor market is unhealthy when the workers who leave their jobs can’t find new ones. That is a story that can’t be told without a search-and-matching model.

Furthermore, modifications to the search-and-matching model allow it to explain numerous other phenomena. Instead of workers being only either employed or unemployed, non-employed workers can be allowed to exit the labor force entirely, to go on disability, or to remain in traditional unemployment (that is, receiving unemployment insurance while searching for a job), or enter some other unattached state. Employed workers can be allowed to remain happily with their existing firm or look for a new job while staying employed at the old one. These elaborations obviously allow for a richer set of predictions, and they also let trends such as a prolonged slack labor market to manifest themselves in more ways than high unemployment and/or low wages, including the reduced size of the labor force and more job-lock as those lucky enough to have a job cling to it tenaciously.

Another strength of the search-and-matching approach, and one that is essentially an implication of the indeterminacy of wages, is that it has room for the concept of power, which alternative approaches, especially the competitive equilibrium, do not. In the Nash Bargain, there’s an explicit mathematical parameter that captures the relative power that workers and firms have in the wage-negotiation process. That alone is not terribly meaningful because if anything is an endogenous concept requiring an explanation rather than simply a mathematical assumption, it’s power.

But power also works its way into the model through what are known as the parties’ threat points, meaning the alternatives each agent has available when they are negotiating. When the labor market is weak and unemployment is high, the threat point for workers deteriorates, which means they can be squeezed by firms, a phenomenon that captures a great deal of truth about the functioning of the labor market and needs to be in any model of it. That phenomenon is right there in search-and-matching.

Quiggin makes much of the observation that the rise of Internet-based job searches has not led to a decline in the unemployment rate by making the search process more fluid, as the search-and-matching model supposedly predicts. But the issue is this: has the Internet actually changed how the labor market works? In some ways, it has. My organization, the Washington Center for Equitable Growth, currently has a job vacancy posted (one that would not be captured by the standard data on job vacancies) for which we’ve received a great many applications, whereas in the past a classified advertisement might have yielded a dozen phone calls and half that many mailed resumes.

But we will still take many weeks to interview candidates and fill the position. Thus, a decline in what might be considered search costs just leads to more searching, but not necessarily more matching. A similar dynamic is at play in the rise of the average number of colleges most applicants apply to: instead of streamlining the search process, more information just intensifies it.

There are other examples where one might have expected advances in information technology to have had a significant macroeconomic impact but which in fact have not. Financial integration is one: in the 1990s and early 2000s, then Federal Reserve Board chair Alan Greenspan assured us that in a world of instantaneous financial transactions and global credit markets, systemic risk could not rise because everyone is connected to everyone. We all saw how that turned out. Similarly, ATMs were supposed to have decreased the economy’s structural demand for money, which means that unless the money supply also shrank dramatically there would be high inflation. Nope. Exactly why supposedly world-changing technologies don’t actually change the world is a difficult question, but that critique is not one that pertains to search-and-matching labor market models specifically.

Quiggin also argues that the big question in labor market macroeconomics—essentially, why is labor demand low and why does it stay low—can only be answered by macroeconomic models. He asserts that search-and-matching models don’t add any insight. Let me offer an alternative schematization. There are two big questions in business cycle macroeconomics. Why do recessions happen? And why do they look the way they look, with high, persistent unemployment and a cascade of other symptoms of illness in the labor market?

Search-and-matching models don’t do anything on the first question; one has to assume the recession into the story. But the model goes a long way toward answering the second one if you allow for factual wage-bargaining and other modifications. In short, the model is a great tool to have in the economist’s toolbox, provided it’s used skillfully and with attention to the data, first and foremost.

 

The importance of CBO’s new interest rate projections

Posted on by Ed Paisley

The Congressional Budget Office released its long-term budget projections today. The document shows CBO’s estimates of long-term trends in federal government spending and revenues. But the report also contains the nonpartisan organization’s estimates of a variety of economic variables, among them population growth, productivity, and long-term economic growth. One variable, long-term interest rates, is particularly interesting given the recent conversation about the global savings glut, the “everything bubble,” and secular stagnation. CBO is projecting lower annual interest rates than in the past. Given the importance of trends in interest rates to our financial system, our long-term fiscal outlook and economic growth, this trend shouldn’t go unnoticed.

In its 2013 long-term budget projections, CBO forecasted that the long-run average annual interest rate would be 3 percent. This year’s forecast has lowered that projection to 2.5 percent. This new projection is not only lower than previous forecasts but also lower than the average range of 3.1 over the period of 1990 to 2007. Thankfully, CBO goes through the different factors that influenced their lower projected interest rates. And these factors are interesting in their own right.

The organization considered several factors that might increase long-run interest rates.First is a higher level of public debt, which will crowd out some private investment, reducing the amount of capital per worker and increasing interest rates. Second is a lower savings rate among developing countries as these economies become richer and their consumption will increase, which means less capital flowing into the United States and therefore less capital per worker. Third is the higher share of income going to capital that would boost the return on capital and therefore interest rates. (This last factor sounds familiar to the one presented in Thomas Piketty in “Capital in the 21st Century.”)

Weighing these three factors against others, CBO on the whole finds that interest rates will decline. They point out that in the wake of the financial crisis there is more demand for low-risk assets, which would result in lower interest rates for U.S. treasury bonds. The budget office also notes that lower growth in total factor productivity growth, or how efficiently capital and labor are used to create output, will reduce interest rates for a given rate of investment.

Interestingly, CBO also notes that rising income inequality will increase savings, which helps push down interest rates. Higher-income people save more, so shifting more income toward them would increase overall savings. In fact, they note that the magnitude of this effect is large enough that declining savings from aging demographics wouldn’t offset this inequality induced increase in the savings rate.

The valuation of financial assets and the amount of money the federal government pays back to debt holders are just some of the few important economic factors influenced by interest rates. Understanding how and why this important variable will change over time is vital for understanding how the long-run future of our economic growth and stability.

Lunchtime Must-Read: Mark Blyth: Europe’s Goldilocks Dilemma

Posted on by Brad DeLong

Mark Blyth: Europe’s Goldilocks Dilemma: “The policy of austerity has twin goals…

…reducing growth in public debt and boosting investor confidence. On both counts, the eurozone’s attempts have been an unmitigated failure…. The confidence-inspiring powers of what was curiously called ‘expansionary fiscal contraction’, the idea that budget cuts today make people spend more since they will have lower taxes in the future, haven’t been any better. European consumer confidence dropped precipitously during the crisis and has yet to return to positive territory. Investment expectations, as measured by business confidence surveys, similarly fell as austerity took its toll and are now barely positive. Growth rates track these declines but with a North-South twist: Germany is pulling ahead, France is flat-lining, Italy is stagnating, and the periphery remains in negative territory. Unemployment rates (outside the export-driven North) are stuck at levels last seen on the eve of World War II. Given all this, you would think a halt to such self-defeating policies would be a good idea. And indeed, it is. But that doesn’t mean that Brussels and Berlin can actually stop austerity…

Lunchtime Must-Read: Chang-Tai Hsieh and Enrico Moretti: Growth in Cities and Countries

Posted on by Brad DeLong

Chang-Tai Hsieh and Enrico Moretti: Growth in Cities and Countries: “We use a Rosen-Roback model of urban growth…

…to show that a summary statistic for the aggregate effect of local growth (decline) is whether it shows up as an increase (decrease) in local employment or as an increase (decrease) in the nominal wage relative to other cities. Differences in the nominal wage across cities reflect differences in the marginal product of labor across cities which, ceteris paribus, lower aggregate output. We show that the dispersion of the average nominal wage across US cities increased from 1964 to 2009 and may be responsible for a 13% decline in aggregate output. Changes in amenities appear to account for only a small fraction of this output loss, with most of the loss likely caused by increased constraints to housing supply in highly productive cities. We conclude that welfare gains from spatial reallocation of the US labor force are likely to be substantial…

Things to Read on the Morning of July 15, 2014

Posted on by Brad DeLong

Should-Reads:

  1. David F. Hendry and Grayham E. Mizon: Why standard macro models fail in crises: “Many central banks rely on dynamic stochastic general equilibrium models. The models’ mathematical basis fails when crises shift the underlying distributions of shocks. Specifically, the linchpin ‘law of iterated expectations’ fails, so economic analyses involving conditional expectations and inter-temporal derivations also fail. Like a fire station that automatically burns down whenever a big fire starts, DSGEs become unreliable when they are most needed…”

  2. John Aziz: Rube Goldbergnomics, or how I learned to stop worrying and love fiscal stimulus: “It is strange, to say the least, to witness the logical machinations of those who believe that austerity is the answer to a depressed economy…. It is an inherently reactionary position.  That is it originates not so much as in being an idea designed to solve a problem, but an idea designed to justify a political position. More specifically, the political position that greater government is never the solution, and that government spending just sucks money out of the productive economy. And that, I think, is why so few austerians have updated their priors against austerity as a remedy to a depression, and continue to clutch at straws to justify their position…. Here’s the key thing: cutting government spending is contractionary by definition. Cutting spending is cutting spending. The net effect will not always be contractionary, of course, because sometimes it will lead to a confidence boost (particularly, I think, if the cut spending was particuarly wasteful). But that confidence boost… depends on a pretty nebulous mechanism: that businesses will see a government policy, interpret the policy in a certain way and choose to respond in a certain manner. It is a Rube Goldberg mechanism: action A needs to lead to action B, needs to lead to action C…. There is no guarantee that this stream of events will occur…. What isn’t Goldbergian? Boosting government spending is expansionary by definition…”

  3. Emma Sandoe: Medicaid is the Best: Part 1: “Medicaid is my personal favorite federal (more accurately federal-state partnership, but you get what I mean) program.  If you read this blog regularly I will attempt to convince you of that fact and you too will love Medicaid.  Soon, we all will be on Team Medicaid and I will finally have a purpose for these hundreds of t-shirts I ordered. Today: Medicaid as an innovator…”

Should Be Aware of:

And:

  1. Robert Waldmann: Comment on Del Negro, Giannoni & Schorfheide (2014): “1) I have just skimmed the paper. I didn’t work through the equations. 2) I am very hostile to the whole discorso (roughly literature or research program). 3) I am more favorably impressed than I would like to be…. Del Negro et al contest the claim that some special nominal rigidity at zero change is needed to fit the data…. In effect the story of the 70s and 80s is one of the bold Volcker regime shift which caused a dramatic change in inflation by causing a dramatic change in expected future inflation. Here there are implications for variables other than inflation–in the 70s and 80s explicit forecasts of inflation from surveys, and in this millennium TIPS spreads as well. These implications are not tested…. Risk premia are central to Del Negro et als (and DeLong’s) explanation…. The paper does not confront the risk premia forecast by the model for 2008-2014 with the time series of actual risk premia…. I have an even crankier complaint about the financial frictions. They are modelled as the effect on risk premia of exogenous and otherwise unobserved variation in the variance in skill across entrepreneurs…. Since this variable appears only as a shifter in the risk premium… the microfoundations add nothing and subtract nothing…. The only implication of the microfounded model is that risk premia can vary for unexplained reasons and risk premia affect investment. My objection is that, since in practice all deviations between microfounded models and an ad hoc aggregate models are bugs not features, what possible use could there ever be in micro founding models?”

  2. Hussein Ibish: What Israel and Hamas are really trying to accomplish in Gaza: “Hamas has been desperately trying to get out of this morass that it’s found itself in…. They tried to foment trouble in the West Bank, and it didn’t succeed. They didn’t get anything out of the unity agreement, so it’s falling back on what it knows sometimes gets results–which is rocket attacks. What they are hoping for, this time, is concessions not from Ramallah or from Tel Aviv, but from Cairo…. What Hamas can get can only come from Egypt. From Israel, they’re demanding the release of prisoners that were part of the shahid squad [a Hamas military group] that was arrested when Israel was pretending they didn’t know the teenagers were dead. Israel tracked them down and dealt Hamas a serious blow. Which is why Netanyahu isn’t so interested in getting into an artillery/aerial exchange with Hamas–the Israelis frontloaded their retribution. It was all done in the West Bank, before the bodies were found…”

  3. Gregg Carlstrom: Is This Hamas’ Last War?: “Sisi’s military-backed [Egyptian] regime… has declared Hamas a terrorist organization, and destroyed most of the smuggling tunnels into Gaza on which the group relied for weapons and tax revenue. The tunnel closures have brought Hamas to a point of diplomatic and financial isolation, which compelled it to announce a reconciliation deal with Fatah in April…. Hamas agreed to a ‘national consensus’ government that contained no members of the group. The deal had already begun to flounder before the Israeli military campaign, with both sides arguing over who should control Gaza, and the kidnapping pushed the Hamas-Fatah relationship again to the point of collapse.”

Already-Noted Must-Reads:

  1. Noah Smith: Should the Fed crash the economy now to prevent a crash later?: “To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash. That isn’t a good idea…. Higher asset prices due to lower safe interest rates aren’t some kind of nefarious plot–this is just Finance 101…. That’s rational price appreciation, not a bubble…. When practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools out there. If you look at past bubbles, such as the late-’90s tech bubble or the mid-2000s housing bubble, you see that there was always a large contingent of society that thought it wasn’t a bubble at all…. Who nowadays thinks that there’s some special Big New Thing that’s going to push stocks and bonds and commodities all to stratospheric heights forever?…. I say we hold off on our calls for anti-bubble rate hikes.

  2. Nick Rowe: Some simple arithmetic for mistakes with Taylor Rules: “If you see your neighbour thinking of doing something daft apparently unaware of one of the problems, you ought to speak up. Especially if it will affect you too, because you do a lot of trade with your neighbour. A fixed Taylor Rule… makes the danger of hitting the ZLB bigger than you think it is. And Taylor Rules don’t work at the ZLB…. What happens if you are wrong about the natural rate of interest, or wrong about potential output?… If actual potential output is one percentage higher than you think it is, that makes you set the nominal rate 0.5 percentage points too high, and so inflation would need to be 0.33 percentage points too low on average to have a big enough offsetting effect to cancel out your mistake…. For a normal central bank, that is a problem, but it is not a big problem…. They fix mistakes in their Taylor Rule as they go along…. That’s probably the main reason why we always observe a lagged interest rate in the equation when we estimate a central bank’s reaction function…. But if the parameter values of the Taylor Rule are fixed by law, central banks are not allowed to learn from their mistakes…. If you really really want to legislate a Taylor Rule, OK. But there’s a price you must pay, if you want to maintain the same margin of safety against hitting the ZLB. That price is a higher average rate of inflation built right into that legislated Taylor Rule. Your choice: legislated Taylor Rules; hitting the ZLB more frequently; a higher rate of inflation. Pick any two…”

  3. Simon Wren-Lewis: Why macroeconomists, not bankers, should set interest rates: “[The] interest rate… which closes the output gap [maintains] the level of output and unemployment that will keep underlying inflation constant… [is] the Wicksellian natural rate…. But, respond[s]… the BIS… monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles…. The implication is that a financial crisis only happens because interest rates are set at the wrong level…. The… deregulation of the financial sector in the decades before?–not an issue. The widespread misselling of subprime mortgages?–these things happen. All the other examples of misselling and fraud?–boys will be boys. An industry that profits from a massive implicit public subsidy?–we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s?–all the result of keeping interest rates too low. When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low….
     
    “I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates.”

How to Understand the BIS View as an Analytical Position Rather than a Rhetorical Attitude?: Tuesday Focus for July 15, 2014

Posted on by Brad DeLong

Paul Krugman admonishes me for thinking I should try to work out what model underlies the Bank for International Settlements’ 84th Annual Report. It is, he says, not so much a macroeconomic model or an analytical framework. Rather, he says, it is a mood: the rhetorical stance of austerity a outrance:

Paul Krugman: Liquidationism in the 21st Century: “The BIS position… [is] that of 1930s liquidationists like Schumpeter…

…who warned against any ‘artificial stimulus’ that might leave the ‘work of depressions undone’. And in 2010-2011 it had an intellectually coherent–actually wrong, but coherent–story… that mass unemployment was the result of structural mismatch… [and] easy money would lead to a rapid rise in inflation…. it didn’t happen. So… it… look[ed] for new justifications for the same [policy] prescriptions… playing up the supposed damage low rates do to financial stability…. That over-indebtedness on the part of part of the private sector is exerting a persistent drag on the economy… is a reasonable story…. But the BIS… doesn’t understand that model… as if they were equivalent to… real structural problems… [which] makes a compelling case for… fiscal deficits to support demand while the private sector gets its balance sheets in order, for monetary policy to support the fiscal policy, for a rise in inflation targets both to encourage whoever isn’t debt-constrained to spend more and to erode the real value of the debt. The BIS, however, wants governments as well as households to retrench… and–in a clear sign that it isn’t being coherent–it includes a box declaring that deflation isn’t so bad, after all. Irving Fisher wept….

Are the BIS’s methods unsound? I don’t see any method at all. Instead, I see an attitude, looking for justification…

And Simon Wren-Lewis has an equally difficult time finding an analytical method here:

Simon Wren-Lewis: Why macroeconomists, not bankers, should set interest rates: “Notice what is going on here…

…The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before?–not an issue. The widespread misselling of subprime mortgages?–these things happen. All the other examples of misselling and fraud?–boys will be boys. An industry that profits from a massive implicit public subsidy?–we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s?–all the result of keeping interest rates too low.

When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise…. But of course most working in the financial sector hate regulation. They have an interest in perpetuating different stories about the Great Recession. If you spend too much time around bankers, there is a danger that you come to believe these self-serving stories…

As does Noah Smith:

Noah Smith: Should the Fed crash the economy now to prevent a crash later?: “Asset prices, by historical measures, are high across the board…. Low risk-free rates, courtesy of the Federal Reserve, are driving investors… into risk assets. To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash. That isn’t a good idea…. First of all, higher asset prices due to lower safe interest rates… [are] rational price appreciation, not a bubble.

OK, but what if a bubble does occur?… Bubbles form when people think they can find some greater fool to sell to. But when practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools…. [In] past bubbles… there was always a large contingent of society that thought it wasn’t a bubble at all–that ‘this time, it’s different’. Who nowadays thinks that there’s some special Big New Thing?… No one I know of. Paradoxically, the one time it’s hardest to have a bubble is when everyone and their dog is unhappy about asset prices and scared that there’s a bubble….

There’s laboratory evidence for bubbles…. It’s true that when you give traders in the lab more cash, you get more and bigger bubbles. Unfortunately, it’s also the case that raising interest rates doesn’t pop the bubbles, which tend to form whenever some people don’t understand fundamentals…. Basically, the people calling for Fed Chief Janet Yellen and the Fed to raise rates are demanding that the Fed crash asset prices in order to avoid an asset price crash….

There is also the idea that the rise in asset prices is simply unnatural or artificial. But the Fed has been regulating the monetary base for many decades, and for a lot of that time there were no big bubbles. Like it or not, the Fed is a natural part of the financial ecosystem…. It seems to me that ‘naturalness’ is a pretty weak justification for deliberate government action to crash the value of Americans’ retirement accounts…. The Fed isn’t yet worried enough… to use the blunt hammer of rate hikes. Its cautious, middle-of-the-road policy seems very at-odds with the extremism that a lot of people in the finance industry seem to attribute to it. I say we hold off on our calls for anti-bubble rate hikes.

I am not so sure. I do think that there is a chance that the BIPS view will turn out to be a live analytical position–if only I could figure out what it was. And let me say that the way the BIS phrases its case is not the way that I find helpful at all. But I–tentatively–conclude that it is a live position, albeit a weak one.

The three clearly live analytical positions–on the (1) fear-not, (2) drum-of-creation, and (3) remove-obstacles hands, respectively–are the monetarist, balance-sheet-fiscalist, and balance-sheet-austerian. The question is whether the BIS’s position qualifies as a live analytical position on the (4) flame-of-destruction hand…

On the (1) fear-not hand, the monetarist position holds that central banks can successfully rebalance economies at full employment with low inflation by central banks’ setting the short-term safe interest rates they control low enough and promising to credibly keep them low enough long enough to match Wicksellian planned investment to desired saving at full employment. The major critiques of the monetarist position are three: First, the question of how to manufacture sufficient credibility out of thin air–why should trying to summon the Inflation-Expectations Imp be any easier or more effective than trying to summon the Business-Confidence Fairy? Second, the zero lower bound means that the short-term safe real interest rate now is above its optimum value, and so getting the long-term safe interest rate now to its optimum value requires expected future state real interest rates below their optimum values: a reliance on monetary policy alone requires future expansionary monetary irresponsibility. Third, if (as I believe) the root problem is not a global savings month or investment shortfall but an absence of risk tolerance and a broken credit channel, expansionary policy that reduces all rather than just risky interest rates distorts the economy by incentivizing the creation of too-many long-duration assets. Fourth, very low long-term real interest rates amplify principal-agent problems because debtors no longer have to show their creditors the money via substantial positive cash flows.

On the (2) drum-of-creation hand, the balance-sheet-fiscalist position holds that the key problem is a broken credit channel and a lack of private-sector risk tolerance: savers no longer trust financial intermediaries to do the risk transformation and so to properly back financial assets of the degree of safety savers want to hold with appropriately-managed claims on the income from risky capital, and savers do not have the risk-tolerance to hold the financial assets that they do trust financial intermediaries to create. The solution is therefore to use the government to mobilize the risk-bearing capacity of the taxpayers, and to either guarantee loans in order to create the safe assets that savers want to hold or simply to create the safe assets savers want to hold directly: borrow money and buy stuff. The first critique is that we do not have great confidence that the government will get good-enough value either from its direct expenditures or from its loan guarantees. The second critique is the balance-sheet-austerian position.

On the (3) remove-obstacles hand, the balance-sheet-austerian position is that the problem is indeed a shortage of risk-tolerance and a credit channel that cannot fund enough risky investment projects to attain full employment, but that that is not the root problem: the root problem is excessive leverage. The solution is thus a painful-slog: we must wait for time, bankruptcy, rescheduling, and amortization to deleverage the economy until full employment is once again sustainable given saver tolerance for and intermediary ability to transform risk. The right policy is that government should do what little it can to hurry along the process of deleveraging, to the extent that it can. And this process can certainly be assisted by monetary expansion a outrance and (somewhat) higher inflation.

What this process cannot be assisted by, on the balance-sheet-austerian view, is fiscal expansion. Why not? Because expansionary fiscal and credit policies are very likely to crack the government’s status as safe borrower. If expanded government debt means that the government also loses its status as a creator of safe assets, then we have not reduced but widened the gap between the (diminished) supply of safe assets from financial intermediaries (including the government) and the (enhanced) demand for safe assets from savers. We have thus worsened the problem by greatly amplifying the amount of deleveraging necessary, and so deepened and lengthened the depression.

I believe that all three of these positions–monetarist central-banks-can-do-it, balance-sheet-austerian painful-slog, and balance-sheet-fiscalist borrow-and-spend–are intellectually-coherent arguments that might be true here and now and are definitely true in some possible worlds (and, I would argue, in some past historical episodes). If we want to put them in a table depending on whether they judge monetary and fiscal expansion now to be helpful, neutral, or harmful, it looks like this:

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

The question is whether there is a fourth live analytical position–a coherent argument that both monetary and fiscal expansion are, here and now, bad, and whether as the BIS argues budget deficits need to be further slashed and interest rates raised RIGHT NOW!!:

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

I think the balance-sheet-fiscalist position is more correct. Not that more monetary expansion is unhelpful, mind you, just that it is not first-best and is likely to be insufficient. But it could work. And we should try it. And not that deleveraging is unhelpful, mind you, just that it is not first-best. Put me down as saying: (5) try everything. (And, parenthetically, note that there are four boxes left unfilled: I know of absolutely nobody even trying to take position (6)–both fiscal policy and monetary policy right now are practically perfect in every way–or position (7)–expansionary fiscal policy is good and expansionary monetary policy bad. And positions (8) and (9) that either monetary or fiscal expansion bad but the other neutral seem to slide rapidly into the BIS view…)

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

Why am I not in either the monetarist or the balance-sheet-austerian boxes? Because I buy the four critiques of the monetarist position, and I think that here and now the chances that additional fiscal expansion will crack the reserve-currency issuing governments’ status as safe borrowers are very low, and that we will have plenty of advance warning should that process of the cracking of safe-asset-issuer status even begin.

So let us now try to dig into the mind of the BIS. The place to start is with Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt?, for the BIS report is an implementation of that paper’s theoretical framework. The paper summarizes its section on monetary policy during the post-balance-sheet-recession recovery thus:

What about monetary policy?… Extraordinarily aggressive and prolonged monetary policy easing can buy time but may actually delay, rather than promote, adjustment…. Monetary policy is likely to be less effective in stimulating aggregate demand…. There are at least four possible side-effects of extraordinarily accommodative and prolonged monetary easing. First, it can mask underlying balance sheet weakness…. Second, it can numb incentives to reduce excess capacity in the financial sector and even encourage betting-for-resurrection behaviour…. Third, over time, it can undermine the earnings capacity of financial intermediaries. Extraordinarily low short-term interest rates and a flat term structure, associated with commitments to keep policy rates low and with bond purchases, compress banks’ interest margins. And low long-term rates sap the strength of insurance companies and pension funds, in turn possibly weakening the balance sheets of non-financial corporations, households and the sovereign…. Finally, it can atrophy markets and mask market signals, as central banks take over larger portions of financial intermediation…. Over time, political economy considerations may add to the side-effects… [the] central bank’s autonomy and, eventually, credibility may come under threat….

The first point made is the standard critique of the monetary-policy-is-enough view: In a balance-sheet recession and especially at the zero lower bound, expansionary monetary policy has only limited traction. It must reduce expected future short-term safe interest rates by credibly promising future monetary policies that seem incredible. And beyond that it can only have traction on long-term real interest rates by summoning the Inflation-Expectations Imp. This is, of course, a very standard argument these days. It says that the benefits of expansionary monetary policy in a balance-sheet recession at or near the zero lower bound are low.

More problematic are the next five points: costs of expansionary monetary policy as it:

  1. masks underlying balance sheet weakness.
  2. numbs incentives to reduce excess financial-sector capacity and encourages betting-for-resurrection.
  3. undermines the earnings capacity of financial intermediaries by compressing banks’ interest margins and sapping the strength of insurance companies and pension funds.
  4. atrophying markets and masking market signals, as central banks take over larger portions of financial intermediation.
  5. political economy considerations as the central bank’s autonomy and credibility come under threat.

It does not seem to me that (5) should be a consideration: it is the business of central banks to choose the right technocratic policy and to fight for the technocratic autonomy to do so. Economists do such central banks no good service when they curb their advice as to what is the technocratic first-best and so rob central banks of the ammunition that they need in their contest with political masters.

It also does not seem to me that (4) should be a consideration. We are in this mess in large part because the–deregulated–financial market could not produce the right price signals and had opened up markets in types of debt that really should not have existed, no? That the process of repairing the damage requires a somewhat larger public-sector role until the damage is fixed is regrettable, but not a reason not to do the job.

And it does not seem to me that (3) should be a consideration either. Organizations like pension funds and insurance companies have assets with a short and liabilities with a long duration. When circumstances have made the Wicksellian natural long-run safe real rate of interest very low, they are weak. Their strength has been sapped. The question is whether they should be given a special government subsidy by having the government keep the interest rate above its full-employment “natural” Wicksellian level. The answer, save for those who are stakeholders, lobbyists, or agents of influence of financial intermediaries, is no.

Thus we are left with (1) and (2): that the necessary process of deleveraging to fix the root problem underlying the balance-sheet recession would be slowed by monetary ease. And this, too, seems to me to be wrong. In an environment with substantial nominal liabilities, (moderate) inflation is an important tool for speeding deleveraging. And so here I side with Rogoff against Borio–monetary ease is a useful crutch, not a handicap, until normal is reattained.

But Borio is looking beyond the normal to the post-mid-cycle phase of the expansion:

Financial liberalisation weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions. A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold…. Major positive supply side developments… provide plenty of fuel for financial booms…. Credit and asset price booms reinforce each other, as collateral values and leverage increase…. The financial boom…[does] not just precede the bust but cause it… sows the seeds of the subsequent bust, as a result of the vulnerabilities that build up…. The presence of debt and capital stock overhangs…. The weakening of financing constraints… leads to misallocation of resources, notably capital but also labour, typically masked by the veneer of a seemingly robust economy…. Too much capital in overgrown sectors holds back the recovery. And a heterogeneous labour pool adds to the adjustment costs. Financial crises are largely a symptom of the underlying stock problems and, in turn, tend to exacerbate them….

[Thus there is a] distinction between potential output as non-inflationary output and as sustainable output…. Current thinking… identifies potential output with what can be produced without leading to inflationary pressures…. Inflation is generally seen as the variable that conveys information about the difference between actual and potential output…. And yet, as the previous analysis indicates, it is quite possible for inflation to remain stable while output is on an unsustainable path, owing to the build-up of financial imbalances and the distortions they mask in the real economy…. Sustainable output and non-inflationary output need not coincide…

These are interesting claims: that output can be too high and “too much” labor can be employed without generating accelerating inflation because the only thing that creates the demand for the excess labor is the unrealistic expectations of savers and investors, and when savers’ and investors’ expectations return to normal they are unwilling to pay the excess workers the real wages that are required to get them to work. I do not think these are likely to be true because I do not believe that our current low levels of employment for 25-54 year olds in either the United States or the Eurozone qualify as in any sense equilibrium levels. Prime-age employment in the United States is now 4%-points below its mid-2000s peak. Prime-age employment in the Eurozone is also 4%-points below its mid-2000s peak–and is 2%-points below its level as of three years ago:

Graph Employment Rate Aged 25 54 All Persons for the Euro Area© FRED St Louis Fed

To the extent that this argument has bite, it seems to me to be a claim not that employment is “too high” during the–non-inflationary–boom, but rather that bad macroprudential regulation has meant that the full-employment level of aggregate demand is attained in an improper way that creates vulnerabilities. The policy response called for is thus not an easier monetary policy–not higher interest rates–but rather better and stricter macroprudential regulation. There seems to me at least to be an analytical error here. To reiterate:

Paul Krugman: Liquidationism in the 21st Century: “Throughout the annual report…

…balance-sheet problems are treated as if they were… real structural problems… a good reason to accept a protracted period of high unemployment as somehow natural, and to reject artificial stimulus that might alleviate the pain. That, however–as Irving Fisher could have told them!–is not at all the correct implication to draw from a balance-sheet view. On the contrary, what balance-sheet models tell us is that left to itself, the process of deleveraging produces huge, unnecessary costs: debtors are forced to cut back, but creditors have no comparable incentive to spend more, so there is a persistent shortfall of demand that leads to great pain and waste. Moreover, the depressed state of the economy can cripple the process of deleveraging itself…

The curious thing, however, is that, once we recognize that right now fiscal space is definitely not scarce for credit-worthy sovereigns who print reserve currencies, Borio (2012) appears to call for more aggressive policy both on the deleveraging and on the fiscal fronts:

Fiscal policy…. The challenge here is to use the typically scarce fiscal space effectively, so as to avoid the risk of a sovereign crisis…. If agents are overindebted, they may naturally give priority to the repayment of debt and not spend the additional income: in the extreme, the marginal propensity to consume would be zero. Moreover, if the banking system is not working smoothly in the background, it can actually dampen the second-round effects of the fiscal multiplier…. Importantly, the available empirical evidence that finds higher fiscal multipliers when the economy is weak does not condition on the type of recession (eg, IMF (2010)). And some preliminary new research that controls for such differences actually finds that fiscal policy is less effective than in normal recessions…. The objective would be to use the public sector balance sheet to support repair and strengthen the private sector’s balance sheet… [both] financial institutions… [and] households, including possibly through various forms of debt relief…. Importantly, this is not a passive strategy, but a very active one. It inevitably substitutes public sector debt for private sector debt. And it requires a forceful approach, in order to address the conflicts of interests between borrowers and lenders, between managers, shareholders and debt holders, and so on….

Whence then comes the BIS’s calls for further fiscal austerity? It remains a mystery to me. But on financial deleveraging it seems to me that Borio has hit the nail on the head.

So how to sum up?

It seems to me that one way to make sense of this is to conclude that the BIS has not made the argument it really wants to make. What it really wants to argue for is (a) aggressive government promotion of deleveraging and recapitalization to solve the balance-sheet recession and (b) fiscal expansion by credit-worthy sovereigns that print reserve currencies. And, I think, it also wants to argue that effective macroprudential policies are impossible because of banking-sector capture of the regulators. And thus its arguments for monetary tightness are, I think, a counsel of despair: since the macroprudential tools cannot be used to manage and limit risk, higher interest rates once we pass the mid-cycle point are the only game in town.

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