Must-Read: Tim Duy: Fed Struggles with the High Water Mark

Posted on by Brad DeLong

Must-Read: I continue to fail to understand the apparent thinking of the center of the Federal Reserve. The following argument seems to me to be obviously correct:

  1. Asymmetric risks and the strong desirability of not returning to the zero lower bound after interest-rate lift-off call for raising interest rates not early and slow but late and fast.
  2. That plus the strong desirability of making it clear by actions that show their consequences in the data 2%/year for the PCE chain index–2.4%/year for the core-CPI–is a target and not a ceiling means that optimal risk management is to wait until rising inflation is present in the data before beginning lift-off
  3. The risks of damaging credibility via error are much less if the policy is to delay lift-off until there are signs of rising inflation as opposed to lifting-off as soon as demand plus the shakily-estimated Phillips curve say rising inflation is coming.
  4. Committee harmony is lost, whether there are formal dissents in December or not.

Even if the center of the Federal Reserve has not internalized Staiger, Stock, and Watson and pretends that their estimated Phillips curve is is the eternal truth of The One Who Is–on the grounds that “you need a forecast to make policy”–interest rate increases in December make no sense, and interest rate increases in March make no sense unless core inflation starts trending up right now:

FRED Graph FRED St Louis Fed

Tim Duy: Fed Struggles with the High Water Mark: “If we get two more reports hovering around 200k a month [in employment growth]…

…between now and December, matched with generally consistent data across other indicators, then December is on the table…. If jobs growth slows to 100k a month… we are looking at deep into 2016 before any hike. Around 150k is the gray area…. I suspect that more numbers like the last two will make the December meeting much like September’s. That I fear is my current baseline–another close call in which the Fed concludes to take a pass.

Gavin Davies: Is the US slowdown for real?: “Several investment banks’ economics teams have ruled out a December rise…

…The expected federal funds rate at the end of 2016 implies only two Fed rate hikes in total over that entire period. Clearly, investors increasingly believe that the US economy is now slowing enough to throw the Fed off course. This big change in market opinion is, frankly, surprising. The rise of 142,000 in non-farm payrolls in September was not all that weak…. The US slowdown [is] for real… but it is not yet very severe…. Unless it grows worse in the next few weeks, it is unlikely to dislodge the Fed from the path it has now firmly chosen.

Must-Read: Marshall I. Steinbaum and Bernard A. Weisberger: Economics was Once Radical: Then It Decided Not to Be

Posted on by Brad DeLong

Must-Read: Marshall I. Steinbaum and Bernard A. Weisberger: Economics was Once Radical: Then It Decided Not to Be: “When it was first formed in 1885, the AEA was a radical challenge to the orthodoxy of classical, free-market economics…

…A generation of young American economists trained at German research universities in the 1870s returned to find their field dominated by an establishment largely confined to Harvard and Yale…. Richard Ely, an avowedly Christian Heidelberg-trained professor at Johns Hopkins with a calling to make economics a friend of the working man…. As originally drafted, the opening platform of the AEA declared ‘We regard the state as an educational and ethical agency whose positive aid is an indispensable condition of human progress. While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals,’ and it went on to excoriate ‘the conflict of labor and capital.’ The mission of the new organization was to promulgate empirical economics research, including the nascent concept of peer review, a powerful weapon in asserting the scientific superiority of the new school over the establishment’s dry, unshakable orthodoxy….

[But] university presidents seeking stature for their institutions appealed to rich donors among the period’s Robber Barons, and that appeal was unlikely to be successful when rabble-rousers in the economics department were questioning the foundations of American capitalism…. Economists realized there was much to be gained in terms of professional stature and influence from making themselves appealing to the establishment, so they banished those elements that tainted them by association…. Even Ely himself eventually came around after his own notorious trial before the Wisconsin Board of Regents in 1894…. The economic tracts of that era began to enshrine the perfectly competitive market at the center of the intellectual firmament in economics…. It’s hard to escape the conclusion that in choosing to sideline left-wing elements among their own, economists gave up important if inconvenient empirical insights in favor of intellectual self-promotion, and that left them blind to the realities of inequality…

Must-Read: Paul Krugman: Rethinking Japan

Posted on by Brad DeLong

Must-Read: Paul Krugman is musing about and rethinking his 1998 analysis of Japan and its macroeconomic problems:

NewImage

Paul Krugman: Rethinking Japan: “[How] would change what I said in my 1998 paper…

…on the liquidity trap[?]… Japan and the world look different…. First, the immediate economic problem is… weaning the economy off fiscal support. Second… demand weakness looks… permanent…. Back in 1998 Japan… [was] operating far below potential…. This is, however, no longer the case…. Output per working-age adult has grown faster than in the United States since around 2000…. [But] Japan’s relatively healthy output and employment levels depend on continuing fiscal support… ever-rising debt/GDP…. So far this hasn’t caused any problems…. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point…..

With policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion. The big reason to raise inflation… is to… allow… monetary policy to take over from fiscal policy…. But what would it take to raise inflation?… Back in 1998… [I assumed] the Wicksellian natural rate of interest… would return to a normal, positive level at some future date… [thus] the liquidity trap became an expectations problem…. But what is this future… normality[?]… [If] a negative Wicksellian rate is… permanent… [even] a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t….

The only way to be at all sure… is… a changed monetary regime with a burst of fiscal stimulus…. While the goal… is… to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion… really aggressive policy, using fiscal and monetary policy to boost inflation… setting the target high enough… escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

In many ways, things are even worse than Paul says. Paul Krugman’s original argument assuming that the economy would eventually head towards a long-run equilibrium in which flexible wages and prices what make Say’s Law hold true, in which there would be a positive natural nominal rate of interest, and thus in which the price level would be proportional to the money stock. That now looks up for grabs. It is the fact that that is up for grabs that currently disturbs Paul. Without a full-employment Say’s Law equilibrium out there in the transversality condition to which the present day is anchored by intertemporal financial-market and intertemporal consumer-utility arbitrage, all the neat little mathematical tricks that Paul and Olivier Blanchard built up at the end of the 1970s to solve for *the* current equilibrium break in their hands. And we enter Roger Farmer-world–a scary and frightening place.

But there is even more. Paul Krugman’s original argument also assumed back-propagation into the present via financial-market intertemporal arbitrage and consumer-satisfaction intertemporal utility arbitrage of the effects of that future well-behaved full-employment equilibrium. The equilibrium has to be there. And the intertemporal arbitrage mechanisms have to work. Both have to do their thing.

But, as Paul wrote in another context:

Paul Krugman**: Multipliers and Reality: “Rigorous intertemporal thinking…

…even if empirically ungrounded, can be useful to focus one’s thoughts. But as a way to think about the reality of spending decisions, no…. Consider… what the public knows about the biggest new government program of recent years[, ObamaCare]…. If people are that uninformed about something that big, imagining that they do anything like the calculations assumed in DSGE models is ludicrous. Surely they rely on rules of thumb that don’t make use of the kind of information that plays such a large role in our models…

Suppose the full employment equilibrium is really out there. People still have to anticipate that it is out there, and then take account of the fact that it is out there and the way that a rational-expectations utility-maximizing agent would.

Now sometimes we get lucky.

Sometimes the fact that one can transact on financial markets on a large scale means that even if only a few are willing to bet on fundamentals, the fact that they can make huge fortunes betting on fundamentals on a large scale drives current asset prices to fundamental values, and those asset prices then drive the current behavior even those who do not know anything about the future equilibrium that is driving the present via this process of expectational back-propagation inductive-unraveling.

But when we are talking about inducing people to spend more now because they fear their money will be worth less then in the future when the debt will have been monetized–well, if that were an important and active channel, we would not now have our current sub-2%/year inflation in Japan and the United States, would we?

Time to drop a link to my New Economic Thinking, Hicks-Hansen-Wicksell Macro, and Blocking the Back Propagation Induction-Unraveling from the Long Run Omega Point: The Honest Broker for the Week of May 31, 2015.

In fact, let me just repeat the whole thing below the fold…

Over at Equitable Growth: In the long run… when the storm is long past, the ocean is flat again.

At that time–or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero–expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base. READ MOAR

That was and is the logic behind so many economists’ beliefs. Their beliefs before 2008 that economies could not get stuck in liquidity traps (because central banks could always create inflation by boosting the monetary base); beliefs in 2008 and 2009 that economies’ stays in liquidity traps would be very short (because central banks were then boosting the monetary base); and beliefs since then that (because central banks had boosted the monetary base) those who believe will not taste death before, but will live to see exit from the liquidity trap and an outburst of inflation as the Federal Reserve tries and fails at the impossible task of shrinking its balance sheet to normal without inflation–all of these beliefs hinged and hinge on a firm and faithful expectation that this long run is at hand, or is near, or will soon draw near (translations from the original koine texts differ). Because the long run will come, increases now in the monetary base of sufficient magnitude that are believed to be permanent will–maybe not now, but soon, and for the rest of our lives, in this long run–produce equal proportional increases in the price level, and thus substantial jumps in the inflation rate as the price level transits from its current to its long-run level.

Moreover, there is more to the argument: The long run is not here. The long run may not be coming soon. But the long run will come. And so there will will a time when the long run is near. At that time, those who are short long-term bonds will be about to make fortunes as interest rates normalize and long bond prices revert to normal valuation ratios. At that time, those who are leveraged and short nominal debt will be about to make fortunes as the real value of their debt is heavily eroded by the forthcoming jump in the price level .

And there is still another step in the argument: When the long run is near but not yet here–call it the late medium run–investors and speculators will smell the coffee. This late medium run will see investors and speculators frantically dumping their long bonds so as not to be caught out as interest rates spike and bond prices collapse. It will see investors and speculators frantically borrowing in nominal terms to buy real assets and currently-produced goods and services so as not to be caught out when the price level jumps. Thus even before the long run is here–even in the late medium run–their will already be very powerful supply-and-demand forces at work. Those forces will be pushing interest-rates up, pushing real spending levels, and pushing price levels and inflation rates up.

The next step in the argument continues the induction unraveling: When it is not yet the late medium run but only the medium run proper, rational investors and speculators must still factor the future coming of the long run into their decisions. The long run may not be near. But it may be that soon markets will conclude the long run is near. Thus in the medium run none will want their portfolios to be so imbalanced that when the late medium run does come and with it the time to end your exposure to long-term bonds and to nominal assets and leverage up, you are on the wrong foot and so last person trying to get through the door in the stampede. There may be some short run logic that keeps real spending low, prices low, inflation quiescent, and interest rates at zero. But that logic’s effects will be severely attenuated when the medium run comes, for then investors and speculators will be planning not yet for the long run or even the at-handness of the long run, but for the approach of the approach of the long run.

And so we get to the final step of the induction-unraveling: Whatever may be going on in the short run must thus be transitory in duration, moderate in their effects, and limited in the distance it can can push the economy away from its proper long run equilibrium. And it certainly cannot keep it there. Not for long.

This is the real critique of Paul Krugman’s “depression economics”. Paul can draw his Hicksian IS-LM diagrams of an economy stuck in a liquidity trap:

The Inflationista Puzzle NYTimes com

He can draw his Wicksellian I=S diagrams of how the zero lower bound forces the market interest rate above the natural interest rate at which planned investment balances savings that would be expected were the economy at full employment:

Lifestream vpdoc 2015 06 02 Tu Krugman Feldstein

Paul can show, graphically, that conventional monetary policy is then completely ineffective–swapping two assets that are perfect substitutes for each other. Paul can show, graphically, that expansionary fiscal policy is then immensely powerful and has no downside: it does not generate higher interest rates; it does not crowd out productive private investment; and, because interest rates are zero, it entails no financing burden and thus no required increase in future tax wedges. But all this is constrained and limited by the inescapable and powerful logic of the induction-unraveling propagating itself back through the game tree from the Omega Point that is the long run equilibrium. In the IS-LM diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the IS curve up and to the right, and thus leading the economy to quickly exist the liquidity trap. In the Wicksellian I=S diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the I=S curve up so that the zero lower bound will soon no longer constrain the economy away from its full-employment equilibrium.

The “depression economics” equilibrium Paul plots on his graph is a matter for today–a month or two, or a quarter or two, or at most a year or two.

But it will soon be seven years since the U.S. Treasury Bill rate was more than whispering distance away from zero. And it is now more than two decades since Japan’s short-term bonds sold at less than par.

Paul has a critique of the extremely sharp Marty Feldstein’s latest over at Project Syndicate (parenthetically, I must say it is rather cruel for Project Syndicate to highlight Feldstein’s August 2012 “Is Inflation Returning” in site-searches for “Feldstein”):

Paul Krugman: The Inflationista Puzzle: “Martin Feldstein has a new column on what he calls the ‘inflation puzzle’…

…the failure of inflation to soar despite the Fed’s large asset purchases, which led to a very large rise in the monetary base. As Tony Yates points out, however, there’s nothing puzzling at all about what happened; it’s exactly what you should expect when interest rates are near zero…. This isn’t an ex-post rationale, it’s what many of us were saying from the beginning. Traditional IS-LM analysis said [it]… so did the translation of that analysis into a stripped-down New Keynesian framework that I did back in 1998, starting the modern liquidity-trap literature. We even had solid recent empirical evidence: Japan’s attempt at quantitative easing in the naughties, which looked like this:

NewImage

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen.

Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right…. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves[?] ([But] Japan never paid such interest[.]).

Anyway, inflation is just around the corner, the same way it has been all these years.

Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon–that that was the duration of the short run–while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.

And it was not just me. Consider Ben Bernanke. I have no memory any more of who was writing [Free Exchange] back in 2009. But whoever it was was very sharp, and wrote:

????: Person of the next five to ten years: “There are those who blame [Bernanke] for missing all the warning signs…

…those who blame him for managing the crisis in the most Wall Street-friendly way… those who blame him for laying the groundwork for a future asset bubble or inflation crisis…. I think his defining decision… has been to conclude that 10% unemployment is acceptable–that having averted a Depression-style 25% unemployment scenario, his countercyclical work is complete… that the risk of sustained high unemployment is outweighed by the risk of… efforts to boost the economy… by asking for more fiscal stimulus… targeting nominal GDP or… committing… to some [higher] level of inflation….

Bernanke believes most of the increase in unemployment… to be cyclical… does not think that pushing… unemployment… down to… 7% would overextend the economy…. He simply seems to think that leaving his primary job half done is acceptable. That’s a pretty momentous choice, affecting millions of people directly and billions indirectly. It will shape American politics and economics for the next decade, at least…. He deserves… person of the year…. But reappointment? That’s another story entirely.

What this leaves out is that Bernanke was willing to take his foot off the gas in late 2009 with an unemployment rate of 10% because, like Marty, he could smell the back-propagation of the induction-unraveling of the short run equilibrium. He us expected that, with his foot off the gas, unemployment would be 8.5% by the end of 2010, 7% by the end of 2011, 6% by the end of 2013–and thus that further expansionary policies in 2010-2011 would run some risk of overheating the economy in 2013-2014 that was not worth the potential game. He didn’t see the liquidity trap short run as as brief as Marty did. But he also didn’t see the short run as as long as I did–and I have greatly underestimated its duration.

(Someday I want Christina Romer to write up her memoir of late 2009-late 2010, as she wandered the halls of the White House, the Federal Reserve, the IMF, and the OECD, trying to convince a bunch of economists certain that the short run was a year or two that all the historical evidence we had–the Great Depression and Japan’s Lost Decades, plus what we dimly think we know about 1873-9, and so forth–suggested, rather, that it the short run would, this time, be a five to ten-year phenomenon. Yet even with backing by Rinehart and Rogoff on the short run equilibrium duration (albeit not the proper fiscal policy) front, she made little impression and had next to no influence.)

Ahem. I have gotten off track…

My point:

Back in late 2009 I thought that the liquidity-trap short run was likely to be a three-to-five-year phenomenon. It has now been six. And the Federal Reserve’s proposed interest-rate liftoff now scheduled for the end of 2015 appears to me profoundly unwise as a matter of technocratic optimal control, prudent policy, and recognition of the situation. The duration of the short run thus looks to me to be, this time, not three to five years but more like ten. Or more. The backward-propagation of the induction-unraveling of the short run under pressure of the healing rays of the long run Omega Point is not just not as strong as Marty Feldstein thought, is not just not as strong as I thought, it is nearly non-existent.

Thus I find myself getting somewhat annoyed at Paul Krugman when he writes that:

Paul Krugman: Choose Your Heterodoxy: “A lot of what I use is 1930s economic theory…

…via Hicks. And I should be deeply ashamed…. [But] plenty of physicists who still use Newtonian dynamics, which means that they’re seeing the world through the lens of 17th-century theory. Fools!… Farmer is trying to explain an empirical regularity he thinks he sees, but nobody else does–a complete absence of any tendency of the unemployment rate to come down when it’s historically high. I’m with John Cochrane here: you must be kidding…

Or that:

Paul Krugman: Nonlinearity, Multiple Equilibria, and the Problem of Too Much Fun: “Was the crisis something that requires novel multiple-equilibrium models to understand?…

…That’s far from obvious. The run-up to crisis looks to me more like Shiller-type irrational exuberance. The events of 2008 do have a multiple-equilibrium feel to them, but not in a novel way… pull Diamond-Dybvig…. And since the crisis struck, as I’ve argued many times, simple Hicksian macro–little equilibrium models with some real-world adjustments–has been stunningly successful…

Or:

Paul Krugman: Learned Helplessness: “We knew all about liquidity traps, and had at least thought about balance-sheet crises…

…a decade ago…. The Return of Depression Economics in 1999. The world we’re now in isn’t that different from the world I suspected, back then, we’d find ourselves in. Oh, and about Roger Farmer and Santa Fe and complexity and all that: I was one of the people who got all excited about the possibility of getting somewhere with very detailed agent-based models–but that was 20 years ago. And after all this time, it’s all still manifestos and promises of great things one of these days…

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980. That is the framework that Marty is using know, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well. You need to explain why the back-propagation induction-unraveling worked at its proper time scale in the 1970s and the 1980s, but is nowhere to be found now.

And so I am much less confident that I have solid theoretical ground under my feet than Paul Krugman does.

Noted for the Morning of October 20, 2015

Posted on by Brad DeLong

Must- and Should-Reads:

Might Like to Be Aware of:

Must-Read: MathBabe’s Guest: Dirty Rant About The Human Brain Project

Posted on by Brad DeLong

Must-Read: MathBabe’s Guest: Dirty Rant About The Human Brain Project: “Some simple observations must be made, which are true now…

…and will still be true in ten years’ time…. (1) We have no f—ing clue how to simulate a brain: We can’t simulate the brain of C. Elegans, a very well studied roundworm (first animal to have its genome sequenced) in which every animal has exactly the same 302-neuron brain…. Pretty much whatever data you want, we can generate it. And yet we don’t know how this brain works. Simply put, data does not equal understanding…. (2) We have no f—ing clue how to wire up a brain: Ok, we do have a macroscopic clue… with a resolution of one cubic millimeter per voxel… [but] any map with cubic-millimeter voxels is a very coarse map indeed. And microscopically, we have no clue…. Imagine taking statistics on the connectivity of transistors in a Pentium chip and then trying to make your own chip based on those statistics. There’s just no way it’s gonna work.

(3) We have no f—ing clue what makes human brains work so well:… There’s a guy whose brain is mostly not there, and he was probably one of the dumber kids in class, but still he functions fine in human society (has a job, family, etc.). Is this surprising? Not surprising? How would we know…. So, the next time you see a pretty 3D picture of many neurons being simulated, think ‘cargo cult brain’. That simulation isn’t gonna think any more than the cargo cult planes are gonna fly. The reason is the same in both cases: We have no clue about what principles allow the real machine to operate. We can only create pretty things that are superficially similar…

A look at U.S. tax rates at the top

Posted on by Bridget Ansel

As the 2016 U.S. presidential election campaign inches forward, there’s more and more conversation about tax rates on the highest incomes. Tax rates, of course, have long been at the center of public debates, and the discussion about tax rates touches on a number of issues important to economic policy. Not only do higher tax rates affect the level of inequality, but they also determine the amount of revenue available to the government. In other words, it’s a matter of how much the government gets and who it gets it from. So as the debate continues, taking a quick look at taxation at the top might be helpful.

In a recent piece for The New York Times, Patricia Cohen tries to estimate how much the government could actually raise by increasing tax rates at the top. Cohen, in contrast to many other pieces about tax rates, focuses on the effective tax rate instead of the marginal rate. (The marginal rate is the rate paid on the next additional dollar; the effective rate is simply the percent of your income that gets paid in taxes.) By focusing on the effective rate, the analysis doesn’t have to consider the interplay between marginal rates on ordinary income and capital gains, and the potential shifting between the two. Nor does the analysis consider the specific loopholes and tax expenditures to cut. Instead it’s a simple account of how much money would be raised by increasing effective rates.

In short, increasing effective rates would raise large amounts of money. Cohen focuses on the top 1 percent of earners, which makes sense as the share of taxable income going to that top rung on the ladder has increased dramatically since the late 1970s. Pushing the effective rate on just the top 1 percent to 40 percent, about 6.5 percentage points higher than its current level, would generate an additional $157 billion a year in tax revenue.

To put that number in context, that’d be a 5 percent increase in the tax revenues the federal government got in 2014, according to the Office of Management and Budget. Focusing even higher up on the income ladder, a 45 percent tax rate for those in the top 0.01 percent—their current rate is about 35 percent—would raise $109 billion a year. That’d be a 3.6 percent increase in total federal revenues.

A 5 percent bump in tax revenues may not sound that large, but as Cohen points out, those additional revenues could fund major proposals such as eliminating undergraduate tuition at all public universities and college. Three times over.

One issue with Cohen’s analysis, however, is that there would be some behavioral responses from taxpayers at the very top. How they would react and by how much would have a big impact on the level of inequality and perhaps the pace of economic growth. Research by economists Thomas Piketty at the Paris School of Economics, Emmanuel Saez at the University of California-Berkeley, and Stephanie Stantcheva at Harvard University argues that taxpayers wouldn’t work less or less hard. But perhaps those at the top would put less effort into trying to bargain for ever-higher salaries. That decline in bargaining would reduce their income—and therefore pre-tax income inequality—without really affecting economic growth. Now, taxes alone seem unlikely to take on the lion’s share of reducing income inequality, but it’ll certainly take an important share.

Of course, knowing which effective rates we might want to target leaves us with the question of how we’d get to those rates. Increases in marginal tax rates, cutting exemptions, or some combination of those two are needed. The mix of those options is certainly up for debate.

Monday Smackdown Watch: Paul Krugman Admonishes Me on My Making Out of Milton Friedman Not a Golden, But a Paper-Money Calf

Posted on by Brad DeLong
NewImage

Paul Krugman: Milton, Money, and Interest Rates: “I have a moderate disagreement with Brad DeLong…

…[who] has been arguing that demands for tight money are, in fact, contrary to the bankers’ own interests:

It was Milton Friedman who insisted, over and over again, that in any but the shortest of runs high nominal interest rates were not a sign that money was tight–that the central bank had pushed the market interest rate above the Wicksellian natural rate–but rather that money had been and probably was still loose, and that market expectations had adjusted to that.

Friedman did in fact make that claim. But… he was wrong.

Consider the Volcker disinflation. The Fed… did everything one might imagine to make it clear that there was a regime shift that would lead to disinflation…. This policy change nonetheless led to a severe recession… conclusive evidence against both the Lucas notion that only unanticipated monetary policy has real effects, and the Prescott view that business cycles reflect real shocks. But the episode also undermines the Friedman claim on interest rates…. Short rates… were sharply elevated for three years…. Long rates… rose along with short rates and stayed high for several years. So put yourself in the (very expensive) shoes of a bank CEO today…. Even if you understand the macroeconomics and know the history (which you probably don’t), this is a story about a better bottom line four or five years down the pike, by which time you will have foregone a lot of bonuses and may well be retired. As I see it, interest-rate hawkery on the part of bankers isn’t irrational, just evil.

Touché…

I confess I have been thinking that we have a choice between:

  • The Federal Reserve starts its liftoff this fall, and then has to reverse course within two yours back to the ZLB, thus cementing market expectations that we will be at the ZLB for a loooong time…

  • the Federal Reserve waits two years to start liftoff, and then successfully accomplishes normalization…

Paul says: It won’t be that quick. And the historical evidence is certainly on his side.

Plus: Dean Baker piles on:

Dean Baker: The Argument for Higher Interest Rates: Are the Bankers Evil or Stupid?: “I would mostly agree with Krugman, but for a slightly different reason…

…An unexpected rise in the inflation rate is clearly harmful to banks’ bottom line. This will lead to a rise in long-term interest rates and loss in the value of their outstanding debt…. While we (the three of us) can agree that such a jump in inflation is highly unlikely in the current economic situation, it is not zero. Furthermore, a stronger economy increases this risk….[Banks] are faced with a trade-off between a greater risk of something they really fear, and something to which they are largely indifferent. It shouldn’t be surprising that they want to the Fed to act to ensure the event they really fear (higher inflation) does not happen. Hence the push to raise interest rates.

I suspect also there is a strong desire to head off any idea that the government can shape the economy in important ways. There is enormous value for the rich to believe that they got where they are through their talent and hard work and that those facing difficult economic times lack these qualities. It makes for a much more troubling world view to suggest that tens of millions of people might be struggling because of bad fiscal policy from the government and inept monetary policy by the Fed.

Macro Situation: Things Are Profoundly Different Today from What 10 Years Ago We Thought Would Be

Posted on by Brad DeLong
NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage

Must-Read: Paul Krugman: Nutcases and Knutcases

Posted on by Brad DeLong

Must-Read: If you work really, really hard, you might be able to make something not completely unintelligible out of Andrew Sentance. You might agree with Paul Krugman that interest rates need to be even lower to provide people with an incentive to consume and invest at the economy’s sustainable non-inflationary potential. But you might go on to say that interest rates need to be higher to curb people’s desires to engage in overleverage, bubbles, and Ponzi schemes–that debts of extraordinarily long duration with extraordinarily low rates of amortization is asking for trouble.

But if you did that, you would be advocating not tight money but, rather, a higher inflation target. Amortization rates and durations of debt, you see, depend primarily on nominal interest rates. While the Wicksellian real rate to balance aggregate supply and aggregate demand and make Say’s Law true in practice is a real interest rate. And a higher inflation target is the way to make a bigger wedge between the two.

So even if you try really, really hard to make something not completely unintelligible out of Andrew Sentance, you conclude that he has no idea what he is talking about:

Paul Krugman: Nutcases and Knut Cases: “Monetary permahawkery takes two forms…

…One is obviously ridiculous… with a lot of influence on right-wing politicians… the likes of Ron Paul, Zero Hedge, and Paul Ryan. Hyperinflation is always just around the corner. And no matter how wrong the scare stories have been in the past, there’s always a willing audience.

But the clear and present danger comes from people like Andrew Sentance, who was until recently a member of the Bank of England’s Monetary Policy Committee… a remarkable piece… castigating the Fed for not hiking rates…. Sentanc[has] made up his own version of macroeconomics… unaware that he has done so. As I… [and] others, notably Ben Bernanke… point out… monetary wisdom… starts with Knut Wicksell’s concept of the natural interest rate. Try to keep rates too low, and inflation accelerates; try to keep them too high, and inflation decelerates and heads toward deflation. Now comes Sentance, claiming that monetary policy has been consistently too easy, not just in recent months, but for the past generation….

This should imply that policy has had an inflationary bias, right? Except that inflation has trended downward…. You might have expected at least some effort to explain why this isn’t a problem…. Sentance mocks the decision not to raise rates, suggesting that it has no real justification…. How about the fact that inflation is still below the Fed’s target, and shows no sign of rising? And that doesn’t even get into the argument, which Larry Summers, yours truly, and many others have made, that the risks of getting it wrong are highly asymmetric…. Maybe Sentance is right to toss almost everything economists have said about interest rate policy for the past 117 years out the window. But… it’s hard to escape the suspicion that he has no idea that this is what he’s doing. And he sat on the committee making British monetary policy!

Putting rents at the center of U.S. income inequality

Posted on by Bridget Ansel

The rise of income inequality in the United States since the late 1970s is a well-documented fact, but the reasons for the rise still aren’t well understood. The possible culprits include skill-biased technological change, globalization, the rise of the robots, and an increasingly popular reason: increased “rents” in the U.S. economy.

Rents, in economics parlance, are extra returns above and beyond what we’d expect in a competitive market. A new paper by Jason Furman, chair of the President’s Council of Economic Advisers, and Peter Orszag, former director of the Office of Management and Budget and a current Vice Chairman at Citigroup Inc., presents some evidence that not only have rents increased, but they provide a fundamentally important explanation for rising inequality.

Furman and Orszag’s analysis centers on the idea that the firm, where workers are employed, plays a major role in the level of income inequality. A number of research papers over the past couple of years find that a large share of rising income inequality is due to larger inter-firm inequality. While some of the rising inequality is because of forces related to characteristics of individual workers—such as education level or union status—a large chunk also is due to the characteristics of the firms at which workers are employed.

One possible explanation for why some firms are pulling away from others is because of increased rents that these firms are capturing. Using data from the McKinsey Corporate Analysis, Furman and Orszag look at the distribution of returns on invested capital across firms, and find a high and rising dispersion of returns among firms. The ratio of returns at the 90th percentile to returns at the 50th percentile was once about 3-to-1; now it’s close to 10-to-1. But the level of return is quite high for firms well below the top—about 30 percent for firms at the 75th percentile. These kinds of returns and their distribution is a sign of increasing rents, and the capture of those rents by leading firms.

But these rents don’t necessarily go all to the owners of the firm. In fact, for rising rents to be a major contributor to rising income inequality, the rents have to be shared with workers at those firms. Furman and Orszag point out that for this to be true then there has to be a significant amount of friction in the labor market. And there is quite a bit of evidence for this idea—the two economists point to the large amount of research in recent years showing a decline in job-to-job transitions. The exact source of this declining dynamism isn’t certain yet, though there is evidence that declining demand for labor is responsible.

While the evidence is far from definitive, increased market power could help explain raising rents as well as decreased labor demand. In conjunction with product, frictions in the labor market generate rents. If a firm has monopsonic power, for example, results in firms hiring fewer workers than is optimal for the entire economy. Increased market power and rents are also potential reasons for the decline in the share of income going to labor.

As Furman and Orszag make clear several times in the paper, the story presented here is far from a slam dunk. The evidence for each individual link in the chain isn’t rock solid yet, and digging into the different research areas is vital. Putting more emphasis on rents in the investigation of income inequality prompts a lot of interesting questions.