Category: Equitablog

Must-Read: Robert Waldmann (2007): The Simple Analytics of Progressive Income Redistribution

Posted on by Brad DeLong

Must-Read: I really object to “money-metric social welfare” as a phrase. I prefer “false Negishi-price plutocratic weights for interpersonal utility comparisons”. When you say the standard goal is to maximize consumer plus producer surplus, you are making interpersonal utility comparisons in a particularly stupid and cruel way. But that is largely orthogonal to Robert’s—very, very good—point here:

Robert Waldmann (2007): The Simple Analytics of Progressive Income Redistribution: “Economists generally agree that redistribution reduces money-metric welfare… http://rjwaldmann.blogspot.com/2007/06/possible-efficiency-gains-due-to-taxes.html

…that is the welfare effects of tax and transfer policies are equivalent to the welfare effects of a set of lump sum taxes and transfers which add up to less than zero. Thus desirable redistribution comes at a price and the standard question is how large is this price worth paying (Brad DeLong explained this to me in 1979). I certainly think that it is and would support massively increased redistribution from the rich to the poor even if I assumed that reality were well described by standard models. Indeed the general view of public economists who developed those models is very egalitarian (see Diamond http://econ-www.mit.edu/faculty/index.htm?prof_id=pdiamond&type=paper, Mirrlees http://nobelprize.org/nobel_prizes/economics/laureates/1996/mirrlees-autobio.html, and Vickrey http://nobelprize.org/nobel_prizes/economics/laureates/1996/vickrey-bio.html).

In this post, I discuss the possibility that redistribution from the rich to the poor might increase money metric welfare. My point, if any, is pessimistic, negative and destructive, as, I think, the discussion suggests that economic theory is not able to answer practical policy questions convincingly, since, even an generally agreed claim depends on assumptions made for convenience.

In each case, I will present an argument in which agents are rational utility maximizers and the world is in Nash equilibrium. I will not argue that it is plausible that the magnitudes of the benefits I describe are great enough to imply that redistribution increases money metric welfare.

(1) First, I have to mention this paper to be fair to Alessandra Pelloni http://ideas.repec.org/p/eui/euiwps/eco97-12.html. In it we show that the standard result, taxing capital income would be a terrible idea if a Romer ’86 endogenous growth model describes reality, depends on the assumption made purely for convenience that labor supply is exogenous. I think the paper shows that once one allows spillovers (or imperfect competition or incomplete markets) anything can happen. it has been published http://www.sciencedirect.com/science?_ob=ArticleListURL&_method=list&_ArticleListID=587522600&_sort=d&view=c&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=e1d717c34a32a86fc73539e2f9249d3c.

(2) Another argument (and one which I personally find convincing) is the Robin Hood and the Welfare State argument due to Hershel Grossman . A standard assumption in general equilibrium models is that agents are free to keep their endowments and only trade if they want to. This assumes that there is no theft. If desperately poor people rob the rich using violence or the threat of violence, the rich can be better off taxing each other to make them less desperately poor http://scholar.google.com/scholar?hl=en&lr=&safe=off&q=grossman+robin+hood&btnG=Search.

3) Dissipative signaling. Theorists love the model of job market signaling http://links.jstor.org/sici?sici=0033-5533(197308)87:3%3C355:JMS%3E2.0.CO;2-3. In this model agents perform a costly effort which produces nothing useful. The only point is that it is less costly to the able. Thus an equilibrium exists in which the able signal their ability by performing the costly effort (the example is obtaining a BA). Employers require the lowest level of signaling such that it is not optimal for the less able to produce the signal of high ability. The able can save on pointless effort by paying the less able to be honest. This is a collective action problem. They can implement this strategy by taxing each other to pay a subsidy to those who admit they have low ability and, therefore have low incomes. Obviously the policy helps the less able (they get something for nothing). Therefore, in a model of job market signalling a progressive tax and transfer program can be Pareto improving.

(4) A little bit of altruism changes everything. If people care about their own physical well being (pleasure minus pain), plus that of those they love, plus 0.00001 times the well being of strangers, redistribution can be Pareto improving. Non-poor agent A doesn’t need taxes and transfers to give his money to the poor. However, after he has chosen my level of private giving, he doesn’t want to give any more via taxes. However he wants to give rich agent B’s money to the poor. He cares a tiny bit about the small cost (in pleasure minus pain) to B and the same tiny bit about the large benefit to the poor. Increasing taxes and transfers from zero will make everyone happier if the population is large enough so that taxing one me is more than balanced by taxing lots of you (Brad DeLong explained this to me in 1988: progress, albeit slow progress). I find this argument totally convincing. I note that, in this case, the transfer itself causes an externality. A much more demanding standard for efficiency increasing taxes (met by examples 1 and 2) is that the incentive effects of the tax and transfer program are good so it would be good if people believed that there will be a tax and transfer program, yet that program isn’t actually implemented. This can occur if:

(5) people are at least slightly altruistic. This not only implies that transfers to the needy create positive welfare externalities but also implies that responses to the incentive effects of taxes can create positive welfare externalities. Imagine a medical doctor who is deciding whether to care for the rich and/or insured or the medically underserved population (say the homeless). I would much rather this MD take care of the homeless who might otherwise go without basic care.
It increases total pleasure minus pain for the doctor to take care of the homeless as they get little care and there are decreasing returns to medical care (implied by the phrase basic care). Only if people who aren’t directly involved care because of altruism, does this increase in welfare imply an increase in money metric welfare.

The doctor cares about the homeless too, but isn’t willing to accept the much lower income. In this case, the market is sending the wrong signal to the MD, since it doesn’t internalise the externality of third people who wish someone took care of the homeless. A high marginal tax rate weakens the MD’s incentive to take care of the rich (or insured) and can, in theory, allow the MD’s altruistic impulse to overcome the desire for high income. This increases money metric welfare as many people who are neither doctors or patients feel better because they know people are getting basic care. This example is actually quite general as many people and firms face choices about whether to make products for the rich or non rich. A key example is the model T. Henry Ford wanted to make a car for regular guys even though profit margins were higher in the luxury car market. In fact, the perception that people face a choice between doing something socially useful and making money is quite common (search for “selling out”). Economists tend to argue against this perception, but all that is needed to make it possibly valid is that “socially useful” refers to utils and economic incentives imply counting the utils of the rich as much more important than the utils of the poor.

(6) Selling out can be worse than taking care of rich people. Consider, for example, the lobbyist who lobbies for subsidies or protection for a particular industry. Economists will generally tend to suspect that the social value of this person’s work effort is negative, however it may benefit his clients. The libertarian straw man will reply that the solution is to rule out once and for all any such evil interventions in the market. I will reply that I am talking about the real world. In my example, the sources of the problem are the legislators who don’t love the market enough (or the constitution which allows them to sell out). I believe there are many other cases in which rent seeking is well rewarded. A desire to do something useful which is too weak to overcome the desire to earn a huge income as a lobbyist might be strong enough if the tax man took away a lot of that huge income.

(7) also spite. Another externality is spite. To the extent that consumption is desired as a means of showing high relative wealth and obtaining status, an income tax has no effect on the welfare of the rich. If the rich are motivated by a desire to win the money game, an income tax does not tilt the playing field, so they don’t suffer from paying taxes so long as their competitors pay them too.

I’d say that’s a pretty long list.

UPDATE: Over at Brad’s blog, this point (4) has lead to a discussion of interpersonal comparisons of utility:

What is it with this obsession with pareto efficiency in welfare economics? Almost no relevant policy initiatives will ever be pareto effecient, but will, arguably, be very a great net welfare improvement. Why this fear of interpersonal utility comparisance? Is it cause needs (as opposed to wants) might sneak in an muddy the waters or is it an atavistic leftover from a time when the liberalistic market was sacrosankt in economics? Posted by: Tomas | June 12, 2007 at 01:05 PM

Tomas, the reason people hate interpersonal utility comparisons is because they don’t work. For example, if you multiply anyone’s utility function by a constant, and their observable behavior won’t change at all. This means that people don’t have uniquely determined utility functions, which means you can’t compare them. That is, if you try to compare two people’s utilities directly, then you get to make up any result you want, because you can multiply one guy’s utility by whatever constant makes the right person’s utility bigger. Posted by: Neel Krishnaswami | June 12, 2007 at 05:01 PM

Excellent point Tomas. ‘Nother excellent point Neel Krishnaswami. I think the (valid) argument that interpersonal comparisons of utility are impossible has had immense influence on economists. There are two ways to make interpersonal comparisons. One is explained by Jean Francois Mertens (this is a joke as “explained by Jean Francois Mertens” is an oxymoron).

As far as I can tell after listening to him for 90 minutes, his proposal is as follows. First, consider people whose happiness is definitely bounded above and below, so there is an epsilon so small no outcome so wonderful that they would trade 90% of their lifetime wealth for epsilon chance of that outcome and vice versa—there is none so horrible so that they would trade 90% of their lifetime wealth to avoid an epsilon risk of that outcome. This is reasonable, otherwise one can get to a St Petersburb paradox (warning pdf) http://www.springerlink.com/content/d0k7604j263788ht/.

If so, for each agent say the upper bound of his utility is 1 and the lower bound is zero. The rest can be filled in observing his choices over lotteries. Now we have interpersonally comparable utility. This can also work even if happiness is, in principle, unbounded, so long as, for each person there is an upper and lower bound of technologically feasible happiness (misery). Finally, it can work even if there are no psychological or technological limits, there can be limits based on some non utilitarian principle of fairness (say starving to death is infinitely horrible but we believe as a moral principle that before we begin adding up utils we have to save everyone from starvation if we can(or maybe torture is infinitely awful but also before we think about utils we must respect peoples right to not be tortured as a prior and absolute moral principle)). The 0 is the lower bound of misery which we can morally allow someone to suffer (even if technology makes a much more horrible outcome possible).

This is really a simple method to arrive at comparable numbers which are linear in happiness such that your argument does not apply. I wonder why this idea is not more influential (again a joke, Mertens may be the worlds worst lecturer).

The other is an “assume we have a can opener” approach based on absolutely absurd assumptions about mega rationality. Imagine being someone else (a super mega rational being can do this). Now imagine your soul being removed from you and planted in a random person (a super duper mega rational being can do this). Now, if you can make rational choices under risk, you can decide how to maximize the sum of human happiness e voilà (this approach is advocated by a friend of mine, Peter Hammond, so I am being polite).

Or to be really picky now that no one is reading, Tomas,
technically you are arguing that Pareto improvements are impossible in the real world. Pareto efficiency just occurs when no Pareto improvement is possible, so there are many many Pareto efficient outcomes (slavery was Pareto efficient, or else slaveowners would have freed their slaves). Pareto improvements are always possible in the real world which is complicated (in simple models there can be simple Pareto improvements). Thus Pareto efficiency is just about nothing. It gets attention because of the result that, under very strong assumptions, the market outcome is Pareto efficient. Arrow proved this and has been trying to explain (to no avail) that the proof amounts to just about nothing ever since…

Time for the Fed to look beyond 2 percent target inflation?

Posted on by Meghan Miller
Federal Reserve Chair Janet Yellen answers a question during a news conference after the 2016 Federal Open Market Committee meeting, June 15, 2016, in Washington.

If insanity is repeating the same thing over and over again and expecting new results, then perhaps it’s insane to expect the Federal Reserve to wait for inflation to hit the U.S. central bank’s inflation target of 2 percent before tightening monetary policy. With no serious sign that inflation is accelerating, the Fed seems ready to hike interest rates. Only once in almost five years has inflation cracked that level—set by the Federal Open Market Committee, or FOMC—for a single month. (see Figure 1)

Figure 1

For most of the past half decade, inflation measured by the Personal Consumption Expenditure price index—both the headline figure and the core inflation rate that strips out volatile food and energy prices—has been below target. Chair Janet Yellen and the rest of the FOMC have noted that they consider the target to be “symmetric,” meaning that missing that target both above and below 2 percent is treated the same. Yet given that the central bankers seem ready to announce an increase in interest rates when their meeting concludes tomorrow, they don’t seem that comfortable with inflation even getting close to 2 percent.

Maybe it’s time for the Fed to rethink its inflation target. Maintaining stable inflation is half of the Federal Reserve’s dual mandate—the other being full employment—and one would hope that this sort of track record on inflation would spark a rethink of the inflation target. In fact, it might, at least in part. Last week, a group of economists, including Equitable Growth’s Heather Boushey, sent a letter to the Fed’s Board of Governors asking them to reconsider the current 2 percent target.

The idea that a stable and credible inflation target must be 2 percent is an accident of history, a figure “plucked out of the air” in New Zealand more than a quarter century ago and which has since been adopted by other high-income countries, including the United States. Inflation this low may have been a positive development in the past, but it presents problems now. With nominal interest rates so low, a 2 percent inflation target limits how low inflation-adjusted, short-term interest rates can go.

Josh Bivens of the Economic Policy Institute argues persuasively that a higher inflation target would make monetary policy more effective the next time interest rates need to be slashed to cope with the next U.S. economic downturn. A higher inflation rate could also boost growth by redistributing money toward net debtor households, many of which would be more likely to spend that money. Given that one of the most cited costs of higher inflation—price distortion—might not be that large, the case for higher inflation seems quite strong.

But perhaps the rethink should go beyond just a higher level of inflation. A higher inflation target would be beneficial, but monetary policy in the United States might still have a “ceiling” problem, not a “target” problem. The Fed might go from undershooting 2 percent to undershooting 4 percent should it lift its inflation target. To avoid this possibility, the FOMC could target not the pace of price increases—inflation—but the price level.

Under such a regimen, if inflation undershot 2 percent for a period of time, then monetary policymakers would need to balance it out with a temporary overshoot of inflation. Targeting inflation more flexibly may also help central bankers deal with the problems of the “zero-lower bound.” And if central bankers want to go even further, they could consider targeting something entirely new: the level of nominal gross domestic product.

Frustration with the current monetary policy response to sub-2 percent inflation could lead to complaints that the current rules aren’t being followed or to requests for new ones. The 2 percent inflation target might have been the right target at a certain point in time, but it looks like its time has passed. The conversation to have is how much policymakers want to shake things up.

Up from slavery? African American intergenerational economic mobility since 1880

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06132017-WP-African-American-intergenerational-mobility

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Authors:

William J. Collins, Terence E. Adderley Jr. Professor of Economics, Vanderbilt University & Research Associate, National Bureau of Economic Research
Marianne H. Wanamaker, Associate Professor of Economics, University of Tennessee Knoxville; Research Fellow, Institute for the Study of Labor (IZA); Faculty Research Fellow, National Bureau of Economic Research

Abstract:

We document the intergenerational mobility of black and white American men from 1880 through 2000 by building new datasets to study the late 19th and early 20th century and combining them with modern data to cover the mid- to late 20th century. We find large disparities in intergenerational mobility, with white children having far better chances of escaping the bottom of the distribution than black children in every generation. This mobility gap was more important than the gap in parents’ status in proximately determining each new generation’s racial income gap. Evidence suggests that human capital disparities underpinned the mobility gap.

Who loses disability insurance when it’s harder to apply?

Posted on by Meghan Miller
A woman walks past a sign for the Social Security Administration in Los Angeles, July 2011.

The rise in the number of Americans on disability insurance is sparking increased concern about the program. Some critics complain that the Social Security Disability Insurance (SSDI) program has become too generous, drawing workers into the program who could otherwise find work. These critics believe that the federal program is now too easy to join and that restricting access to the program would result in healthy individuals not joining the program. Recent research, however, finds that merely making it more difficult to apply for disability insurance pushes away applicants who are more likely to be accepted into the program—lower-income individuals and those with lower levels of education.

The paper, by economists Manasi Deshpande of the University of Chicago and Yue Li of the University at Albany, State University of New York, looks at how the closure of Social Security field offices affects how many people apply for disability programs and the changes in the kinds of people who apply for the program. Using administrative data from the Social Security Administration, the authors can see what happened to SSDI and Supplemental Security Income applications and the number of recipients in ZIP codes closest to the closed offices.

Part of what this paper is investigating is how increasing the cost of applying for disability insurance can improve the “targeting” of a program. It could well be, for example, that increasing the hassle associated with applying to the program pushes away the people who need the program the least. Increasing the hassle would reduce efficiency in processing applications, but it might boost “targeting efficiency” if applicants who really don’t need the program are deterred. This assumes that the people most sensitive to increased application costs are more likely to be ultimately rejected and to be healthier.

What actually happened when the closest Social Security field offices closed and the cost of applying increased? The number of applications dropped quite a bit, 11 percent after a few quarters, and stayed at that lower level. At the same time, the number of recipients of disability insurance in ZIP codes near the closed field offices dropped 13 percent and also remained low. The fact that the number of recipients dropped more than the number of applicants—the difference is statistically significant—means that the people not applying were more likely to have been accepted if they had applied. Deshpande and Li also find that the field office closings discouraged people with lower education levels and low earnings levels from applying.

The results of this research show that instead of increasing targeting efficiency, the increase in application costs actually decreases that form of efficiency. The program is less likely to reach the people who would be more likely to need to tap disability insurance and those most likely to need it. The people affected the most at this margin are seemingly exactly the people for whom the disability insurance program is designed. These results are hard to mesh with critics’ view that disability insurance should be more restrictive. Doing so could be harmful for the people who need help the most.

I Am Heartened by the Improvement in the Prime-Age Employment Rate. Now Let Us Let It Continue Rather than Stopping It…

Posted on by Brad DeLong

Here in the United States, there were always three arrows to “hysteresis”—to the argument that the failure to adopt policies that properly fought the downturn of 2008-2009 in an aggressive manner to restore full employment rapidly did not just temporary but permanent damage to the economy’s productive potential. A long period of very slack demand:

  1. slowed experimentation with business models, organizations, and technologies and so reduced total factor productivity growth by a poorly known but perhaps very substantial amount.

  2. diminished investment and reduced our productive capital stock relative to a rapid-recovery counterfactual baseline by a well understood and large amount.

  3. caused workers to exit from the labor force with little hope of getting them back—too much time out of the workforce had destroyed their social networks they needed in order to effectively search for jobs.

(1) and (2) dealt mighty and powerful permanent blows to American economic growth. Barring some currently-unanticipated large positive shock, we are never getting back to our pre-2007 growth trend:

Real Gross Domestic Product FRED St Louis Fed

But there has, over the past couple of years, been good news about (3).

The prime-age employment-to-population ratio is no longer lower than it has been since the 1980s, before the full coming of the feminist economic revolution to the workplace.

Fears that we would never get any significant fraction of the 5%-points of the prime-age population that lost their jobs in 2008-2009 back into work—fears that were very live and very scary over 2010-2013—appear to have been wrong. The prime-age employment-to-population ratio has been climbing at a rate of 0.6%-points per year since the end of 2013. Labor-side hysteresis has thus turned out to be a much smaller deal than worst-case analyses feared back even as little as three and a half years ago.

Do note, moreover, that this increase in the prime-age employment-to-population ratio has been accomplished with no signs of any inflationary pressure whatsoever. The fact that it has been accomplished leads to harsh judgments on the Federal Reserve and the administration of 2010-2014, which were unwilling to pursue the much more stimulative policies within their control—more and faster quantitative easing,

Simon Wren-Lewis: Could austerity’s impact be persistent?

: “How Conservative macroeconomic policy may be making us persistently poorer… https://mainlymacro.blogspot.com/2017/06/could-austeritys-impact-be-persistent.html

…I was happy to sign a letter from mainly academic economists published in the Observer yesterday, supporting the overall direction of Labour’s macroeconomic policy. I would also have been happy to sign something from the Liberal Democrats, who… have the added advantage of being against Brexit, but no such letter exists…. We desperately need more public investment and more current spending to boost demand, which in turn will allow interest rates to come away from their lower bound…. Nominal interest at their lower bound represent a policy failure…. In the textbook macroeconomic models, this policy mistake can have a large but temporary cost in terms of lost output and lower living standards…. In these basic models a short term lack of demand does not have an impact on supply…. Gustav Horn and colleagues… find that the impact of recent fiscal shocks have been persistent rather than temporary, at least so far…. I do not have to argue that such permanent effects are certain to have occurred. The numbers are so large that all I need is to attach a non-negligible probability to this possibility. Once you do that it means we should avoid austerity at all costs. In 2010 austerity was justified by imagined bond market panics, but no one is suggesting that today. The only way to describe current Conservative policy is pre-Keynesian nonsense, and incredibly harmful nonsense at that. That was why I signed the letter…

Should-Read: B.G.: Because I said so: Why the Fed is likely to raise rates, despite low inflation

Posted on by Brad DeLong

Should-Read: The surprising thing about B.G.’s long and convoluted Fed-hiking-interest-rates-to-punish-market-like-taking-away-LEGOS-to-punish-misbehaving-toddler metaphor is this: the markets have not misbehaved.

It is as if the parent (Federal Reserve) said: “you, toddler, are going to misbehave” (inflationary pressures will emerge), so I will take your LEGOS away (raise interest rates).” Yet the toddler does not misbehave (inflationary pressures do not emerge). But even so the parent (Federal Reserve) then says: “I have to take your Legos away because I said I would (I have to raise interest rates because I said I would), even though you did not misbehave (even though inflationary pressures did not emerge).”

This certainly gains you a credible reputation.

But is it really the kind of credible reputation you actually want to have?

And yet B.G. thinks that this is a normal and acceptable way to behave…

And at this point I suggest that the entire FOMC—and B.G.—enroll in Daniel Davies’s One-Minute-MBA course, and that the Federal Reserve print up the $30,000 fee for each of the 19 notional FOMC meeting principal participants, and pay it to him…

B.G.: Because I said so: Why the Fed is likely to raise rates, despite low inflation: “Like a parent teaching a child it means business, the Fed may feel it must hike to preserve its credibility with financial markets… http://www.economist.com/blogs/freeexchange/2017/06/because-i-said-so

…CREDIBILITY is a thing you have to worry about with toddlers. You cannot reason with them. The best you can hope to do is respond consistently to undesirable behaviour. Get this wrong and your work becomes harder. If your correspondent doesn’t actually go and hide the box of Legos every time he has to count to three, for example, his child will not find his threats to be credible, and will fail to respond to them. This is the problem the Federal Reserve has now with financial markets…. Having told the market what it’s going to do with the Legos, does it now have to do just that, even if it’s a bad idea?… If the committee doesn’t care what markets think, there’s not much of a case for hiking….

When it meets next week, the FOMC will be concerned about two things. First, it must follow its mandate, keeping unemployment low and inflation within reason. Here, there is not much of an argument to do anything. Second, however, the committee wants markets to continue to believe that it will do what it has said. Even though the Legos are not causing a problem just now, it feels pressure to take them anyway to show it means business. Yet while it may hope that in doing so it will preserve the ability to threaten Lego removal in the future, its actions are not without risks. Markets, like toddlers, could fuss, throw tantrums and break things…

Should-Read: Cardiff Garcia: US capex, investment, and growth—re-re-upped

Posted on by Brad DeLong

Should-Read: Cardiff Garcia: US capex, investment, and growth—re-re-upped: “Srinivas Thiruvadanthai… has passed along his interesting new note about capex… https://ftalphaville.ft.com/2017/06/06/2189480/us-capex-investment-and-growth/

…About the long-term factors that affect capital spending, Thiruvadanthai writes:

Many observers have been puzzled by the capital spending weakness in this cycle in the face of an aging capital stock, relatively high profitability, and strong cashflow. Cashflow and aging capital stock are important influences on capital spending but are overshadowed by capacity and growth expectations. One major influence on weak net private nonresidential fixed investment over the past 15 years has been the growing and pervasive overcapacity…. Industry capacity utilization actually tracks remarkably well with nonresidential net fixed investment throughout history. The current level of capacity utilization suggests that the level of investment is not inexplicably low…

Must-Read: Josh Bivens: Is 2 percent too low?: Rethinking the Fed’s arbitrary inflation target to avoid another Great Recession

Posted on by Brad DeLong

Must-Read: The answer to the question is Josh Bivens’s title is: YES!!

Josh Bivens: Is 2 percent too low?: Rethinking the Fed’s arbitrary inflation target to avoid another Great Recession: “The end of 2017 will mark 10 years since the beginning of the Great Recession… http://www.epi.org/publication/is-2-percent-too-low/

…The terrible damage it inflicted… should inspire deep thinking…. All major tenets of macroeconomic stabilization policy… should be subject to this rigorous evaluation…. The very low inflation rate currently targeted by the Federal Reserve as a long-term macroeconomic policy goal (2 percent annual inflation) should be reassessed…. A higher inflation target… will make conventional monetary policy more effective in fighting recessions and spurring recoveries during periods when nominal interest rates are near-zero… greatly increas[ing] the probability that the next recession will be shorter and the recovery faster, not just because it will allow inflation-adjusted interest rates to be lowered further, but because it will be easier for households to climb out from under overhanging debt…

Must- and Should-Reads: June 10, 2017

Posted on by Brad DeLong

Interesting Reads:

My Sections: As Delivered: Fed Up Rethink 2% Inflation Target Blue-Ribbon Commission Conference Call

Posted on by Brad DeLong

Opening Statement (as Delivered): I digress from my job here to say that I agree with everything that Jason and Josh have said. They do not speak just for themselves. They speak for me as well.

And let me also digress by trumping both Jason and Josh.

They both said “if you thought a 2% inflation target was appropriate a decade ago”. A decade ago I did not think a 2% inflation target was appropriate.

It was twenty-five years ago this summer that Larry Summers and I went to the Federal Reserve’s conference at Jackson Hole to say, among other things, that we thought it would be extremely risky and inappropriate to drop the Fed’s informal inflation target from its then-five percent to two percent. The 1990 savings and loan crisis was a small macroeconomic shock. Yet the Federal Reserve cut short-term interest rates by 600 basis points to respond to it. If there were ever a big shock, we said, the Fed would want all that much room to maneuver and more. It would not have that room to maneuver with a two percent inflation target.

So I’ve been beating this drum for twenty-five years off and on, and feeling very Cassandra-like for the past decade.

Now on to my job here. It is to get all medieval, in the sense of Thomas Aquinas, on you. It is to deal with the objections to our position, and then to provide what we believe are sufficient answers to those objections.

I hear four arguments for not changing the 2%/year inflation target, even though pursuing that target found us in a situation where monetary policy was greatly hobbled in its ability to manage the economy for a solid decade. And, as best as I can evaluate them, all four of these arguments seem to me to be wrong. They are:

The Federal Reserve, even at the zero lower bound, has powerful tools sufficient to carry out its stabilization policy tasks (Cf.: Mankiw and Weinzierl (2011) https://scholar.harvard.edu/files/mankiw/files/exploration_of_optimal.pdf), so moving away from 2%/year as a target is not necessary. This leaves begging the questions of why, then, employment has been so low over the past decade and why production is still so low relative to our circa-2007 expectations.

The problem is not the 2%/year target but rather pressure on the Federal Reserve: pressure from substantial numbers of economists and politicians practicing bad economics and motivated partisan reasoning. (As an example, somebody sent me a video clip this week of the very smart Marvin Goodfriend half a decade ago, arguing that faster recovery required the Fed to hit the economy on the head with a brick to make people more confident in its willingness to fight inflation http://www.bradford-delong.com/2017/06/on-the-negative-information-revealed-by-marvin-goodfriends-i-dont-teach-is-lm.html.) This ignores the Fed’s long institutional history of being willing to ignore outside pressure as it performs its standard monetary policy task of judging what appropriate interest rates are. Pressure only mattered when we got into “non-standard” monetary policies, which we needed to do only because the low inflation target had caused us to hit the zero lower bound.

At 2%/year, inflation is non-salient: nobody worries about it. A higher inflation rate would bring shifting expectations of inflation back into the mix, distract people and firms from their proper task of calculating real costs and benefits to worry about monetary policy, and make monetary policy management more complicated. But right now people and firms are “distracted” by the high likelihood of depressions that last longer than five years. That is a much bigger distraction than worrying about whether inflation will be 4%/year of 5%/year. And right now the zero lower bound makes monetary policy management much more complicated than it was back in the 1990s when the impact of Fed policy on inflation expectations was in the mix.

The Federal Reserve needs to maintain its credibility, and if it were to even once change the target inflation rate, its commitment to any target inflation rate would have no credibility. But the credibility you want to have is credibility that you will follow appropriate policies to successfully stabilize the economy—not credibility that you will mindlessly pursue a destructive policy because you think it somehow wrong to acknowledge that the considerations that led you to adopt it in the first place were wrong or have changed. As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credibility really worth having?” http://crookedtimber.org/2006/11/29/reputations-are-made-of/

Over to you, Joe…

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Answers to Questions: There is no unemployment rate target right now.

The Federal Reserve thinks about what the non-accelerating inflation rate of unemployment might be. But they claim not to have any strong view. They claim to be guided by the data, in terms of assessing how much pressure the economy can take. By contrast, the Federal Reserve had an informal inflation target of four to five percent per year in the late 1980s and early 1990s. And it then shifted down first, in the mid-1990s, to an informal target of two percent per year for the core PCE index under Alan Greenspan. It then formalized that under Bernanke in the late 2000. If they did have an unemployment rate target to talk about, we would be talking about that as well. But they don’t.

The question is a very good one. When I come write the economic history of the 2010s, I think that both Ben Bernanke and Janet Yellen are likely to be judged quite harshly. Once the recession of 2008-2009 had reached its end, the Federal Reserve had one overwhelming first priority: to create a strong enough economy that it could sustain short-term safe nominal interest rates of 400 to 500 basis points, and still grow at potential, in order that the Federal Reserve would have room to deal with the next recessionary shock when it came by conventional interest rate policy. The Federal Reserve did not prioritize that objective. Now here we are, late in a recovery, with short-term safe interest rates at 80 basis points or so, and with substantial fear that the economy is not robust enough to support any substantial rise over the time before the next severe recessionary shock hits. Indeed, an attempt to push short-term rates higher in the near future might well be such a recessionary shock.

The Federal Reserve has wedged itself into a position where it has almost no conventional monetary policy ammunition to deploy.

Let me say that the housing bubble did not blow up the economy. Let me say that the deflation of the housing bubble did not blow up the economy. As of the start of 2008, the housing bubble had collapsed, and all of the excess workers who had
been employed in construction had moved out and overwhelmingly found jobs in other sectors without even a small recession or more than a trivial rise in the unemployment rate.

But there was left in the bowels of the financial system the fact that the big money center banks had been playing regulatory arbitrage—claiming that the mortgage-backed securities they were holding were true AAA assets when they were nothing of the sort. It was this concentration of overvalued and mischaracterized assets in the highly leveraged money center banks that got us into big trouble, not the collapse of the housing bubble.

You can see this if you recall that the collapse of the dot-com bubble in 2000-1 took down about five times as much in the way of investors’ wealth as the collapse of the housing bubble took down the wealth of subprime lenders. And yet the 2000-1 bubble collapse did not cause a big recession. Why not? Because the people who took the hit were the rich equity investors in Silicon Valley, rather than the highly overleveraged money center banks that had decided to get a little bit too clever with how they characterized the assets they were holding.

Note that there are people like Larry Summers and Olivier Blanchard who are right now much more on now on Team Expansionary Fiscal Policy than on Team Raise the Inflation Target, in substantial part because of a desire to keep inflation non-salient and because our understanding of how bubbles are generated and what role ultra-low interest rates and quantitative easing play in generating them is very poor.

Let me underscore Jason’s point: Marvin Goodfriend is a potential future nominee to the Federal Reserve Board. Marvin Goodfriend has a remarkable aversion to and suspicion of quantitative easing. But has been very comfortable with the Federal Reserve’s interest rate management role.

When I have pitched this idea of a blue-ribbon examination of the proper inflation target in the past, what I have believed was my cleverest thought was to make Ben Bernanke and Larry Summers co-chairs, and make them in charge of figuring out where the rough consensus of—once again getting Thomas Aquinas on you—the greater and wiser part of the informed community of thinkers about this is.

I have to run to two pointless bureaucratic meetings. If you have any more questions, please email me at delong@econ.berkeley.edu, and if I can hide my phone keyboard and use my thumbs I will answer during the meetings, and if not I will answer as soon as I can afterwards.

And one thing I did not say: We have had four pieces of bad news in the past decade, all of which strongly argue against preserving the two percent per year core PCE inflation target. They are:

  1. bad news about the value of the Wicksellian neutral interest rate.
  2. bad news about the public sphere’s understanding of what the non-interest rate macroeconomic policy tools are and how to deploy them.
  3. bad news about partisanship—the solid opposition of the Republican Party to the policies of South Carolina Republican Ben Bernanke because it was thought they might redound to the benefit of Obama.
  4. bad news about the strength of non-standard stimulative monetary policies.

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