Thursday, December 5, 2013

Message from Berkeley Chancellor

This came in a campus-wide email from Chancellor Nicholas Dirks:
Dear Campus Community: 
Today, the UC Berkeley campus mourns the loss and celebrates the life of Nelson Mandela. We are all part of a global community united in grief and reverence for a man whose clarity of moral purpose and extraordinary perseverance brought freedom to the oppressed, hope to the hopeless and light to all the dark places where human dignity struggled to survive. We pause to not only mourn but also to reflect with gratitude on the good fortune we had to witness all that Nelson Mandela accomplished and exemplified. 
At Berkeley we also remember the special ties that will forever bind our campus to this man and his movement. As we know, the Bay Area was the epicenter of the American anti-apartheid activity due, in no small measure, to the passionate engagement of Berkeley students. In 1990, on a worldwide tour after serving 27 years in prison, Mandela spoke to a crowd of 60,000 at the Oakland Coliseum. During that speech South Africa’s future president specifically cited our university’s “Campaign Against Apartheid” as having been particularly significant in hastening the end of white-minority rule in his country. That recognition highlights what is, in my opinion, one of Berkeley’s proudest moments. 
Today, I am also thinking about something Nelson Mandela said that goes to the heart of who we are and what we stand for as a university: “Education is the most powerful weapon which you can use to change the world.” With that in mind, I have asked our academic leadership to begin working on a Spring event that will celebrate Nelson Mandela’s life and extend his legacy through an exploration of, and discussions about his historic accomplishments. 
Words alone cannot pay adequate homage to an extraordinary life that so deeply altered the course of history. We can truly honor Nelson Mandela only through our ongoing individual and collective efforts to ensure that every man, woman and child reaches the final destination on humanity’s long walk to freedom. 

Nicholas B. Dirks

Wednesday, November 27, 2013

The Economic Exhortation of Pope Francis

I'm glad to see Pope Francis' apostolic exhortation Evangelii Guardium featured so prominently in the media. With a 224-page document and a 2000 year Church history, however, media coverage is bound to include some oversimplifications. One is the title of Emma Green's piece in the Atlantic, "The Vatican's Journey From Anti-Communism to Anti-Capitalism." While the article includes a lot of good information, it does oversimplify historical Church teaching on the economy. Green writes:
Throughout 224 pages on the future of the Church, he condemns income inequality, “the culture of prosperity,” and “a financial system which rules rather than serves.” 
Taken in the context of the last half-century of Roman Catholicism, this is a radical move. Fifty years ago, around the time of the Second Vatican Council, Church leaders quietly declared a very different economic enemy: communism. But Pope Francis’s communitarian, populist message shows just how far the Church has shifted in five decades—and how thoroughly capitalism has displaced communism as a monolithic political philosophy.
The Catechism of the Catholic Church, published in 1992, "presents Catholic doctrine within the context of the Church's history and tradition." According to the Catechism,
2425 The Church has rejected the totalitarian and atheistic ideologies associated in modem times with "communism" or "socialism." She has likewise refused to accept, in the practice of "capitalism," individualism and the absolute primacy of the law of the marketplace over human labor. Regulating the economy solely by centralized planning perverts the basis of social bonds; regulating it solely by the law of the marketplace fails social justice, for "there are many human needs which cannot be satisfied by the market. Reasonable regulation of the marketplace and economic initiatives, in keeping with a just hierarchy of values and a view to the common good, is to be commended.
The Church has a long history of rejecting both communism and capitalism in their pure forms. The Catechism elaborates on private property:
2403 The right to private property, acquired or received in a just way, does not do away with the original gift of the earth to the whole of mankind. The universal destination of goods remains primordial, even if the promotion of the common good requires respect for the right to private property and its exercise. 
2404 "In his use of things man should regard the external goods he legitimately owns not merely as exclusive to himself but common to others also, in the sense that they can benefit others as well as himself." The ownership of any property makes its holder a steward of Providence, with the task of making it fruitful and communicating its benefits to others, first of all his family. 
2405 Goods of production - material or immaterial - such as land, factories, practical or artistic skills, oblige their possessors to employ them in ways that will benefit the greatest number. Those who hold goods for use and consumption should use them with moderation, reserving the better part for guests, for the sick and the poor. 
2406 Political authority has the right and duty to regulate the legitimate exercise of the right to ownership for the sake of the common good.
The following passages concerning economic activity and profit are also quite relevant:
2423 ...Any system in which social relationships are determined entirely by economic factors is contrary to the nature of the human person and his acts. 
2424 A theory that makes profit the exclusive norm and ultimate end of economic activity is morally unacceptable. The disordered desire for money cannot but produce perverse effects. It is one of the causes of the many conflicts which disturb the social order. 
2425 A system that "subordinates the basic rights of individuals and of groups to the collective organization of production" is contrary to human dignity. Every practice that reduces persons to nothing more than a means of profit enslaves man, leads to idolizing money, and contributes to the spread of atheism. "You cannot serve God and mammon." 
These passages from the Catechism are based on a long history of Catholic teaching on economic justice, including Encyclicals from the Popes. Quadragesimo Anno, for example, written by Pope Pius XI in 1931, responded to economic conditions and inequality following the Great Depression. More recently, Pope Benedict in Caritas in Veritate stated that "Profit is useful if it serves as a means towards an end that provides a sense both of how to produce it and how to make good use of it. Once profit becomes the exclusive goal, if it is produced by improper means and without the common good as its ultimate end, it risks destroying wealth and creating poverty."

I am very grateful for Pope Francis' exhortation. I do not think it represents a radical shift in Church teaching, but rather a renewed and louder cry for the teaching to be taken seriously. His cries that "The dignity of each human person and the pursuit of the common good are concerns which ought to shape all economic policies." I hope the world will listen.

Friday, November 8, 2013

Financial Networks and Contagion

"Financial Networks and Contagion," a recent paper by Matthew Elliott, Benjamin Golub, and Matthew Jackson, uses network theory to study how financial interdependencies among governments, central banks, investment banks, and other institutions can lead to cascading defaults and failures.

Source: Elliott et al. 2013

While the model is quite technical, the main theoretical findings are fairly intuitive. They define two key concepts, integration and diversification. Integration refers to the level of exposure of institutions to each other through cross-holdings. Diversification refers to how spread-out the cross-holdings are; in other words, whether a typical organization is held by many others or just a few. The key finding is that at very low or very high levels of integration and diversification there is lower risk of far-reaching cascades of financial failures. The risk of a far-reaching cascade is highest at intermediate levels of integration and diversification. The authors explain:
"If there is no integration then clearly there cannot be any contagion. As integration increases, the exposure of organizations to each other increases and so contagions become possible. Thus, on a basic level increasing integration leads to increased exposure which tends to increase the probability and extent of contagions. The countervailing effect here is that an organization's dependence on its own primitive assets decreases as it becomes integrated. Thus, although integration can increase the likelihood of a cascade once an initial failure occurs, it can also decrease the likelihood of that first failure... 
With low levels of diversification, organizations can be very sensitive to particular others, but the network of interdependencies is disconnected and overall cascades are limited in extent. As diversification increases, a "sweet spot" is hit where organizations have enough of their cross-holdings concentrated in particular other organizations so that a cascade can occur, and yet the network of cross-holdings is connected enough for the contagion to be far-reaching. Finally, as diversification is further increased, organizations' portfolios are sufficiently diversified so that they become insensitive to any particular organization's failure."
Near the end of the paper, they illustrate the model using cross-holdings of debt among six European countries. The figure above is their representation of financial interdependencies in Europe. They conduct something akin to stress tests, simulating cascades of failures under various scenarios that very roughly approximate conditions in 2008. The simulations find that, following a first failure in Greece, Portugal is fails from contagion. After Portugal fails, Spain fails due to its large exposure to Portugal. The high exposure of France and Germany to Spain causes them to fail next in most simulations. Italy is always last to fail due to its low exposure to others' debt. They emphasize that this is intended only as an illustrative exercise at this stage, but could eventually be refined and incorporated into analysis of failure and contagion risk.

*Edited to fix my mistake pointed out by Phil.

Monday, November 4, 2013

Argentine Inflation Saga Approaches Critical Moment

Argentina's time is up. In February, the IMF censured Argentina on account of its notoriously dubious inflation statistics. Under terms of the censure, Argentina was given until September 29, 2013, to improve the flawed data. The deadline has passed, and IMF Chief Christine Lagarde will report to the IMF Executive Board by November 13 on Argentina's progress (or, likely, lack thereof.)

Lagarde's impending report follows a long and nearly unbelievable saga (see timeline at the end of this post.) The gist of the matter is that officially-reported inflation has been in the vicinity of 10% for the past few years, while a variety of private estimates place the true value at 25% or higher. Oh, and the independent economists who publish these private estimates are threatened with criminal prosecution. This September, economist Orlando Ferreres published his estimate that June monthly inflation was 1.9%, compared to the official estimate of 0.8% (with compounding, that's a big difference) and could face a two-year prison sentence. I searched for Ferreres' website on November 3, and it appears to have been hacked (see image below.) I could not find Ferreres' independent inflation estimates on his site; only official estimates appear.

Red flags were raised in earnest in 2007, when then-President Néstor Kirchner dismissed several staff statisticians at INDEC, the statistics institute that publishes the official consumer-price index (CPI) for Argentina. The government takeover of INDEC included the demotion of Graciela Bevacqua, director of the inflation index, who had prepared the inflation data for six years. In 2005, Bevacqua estimated that inflation was over 12% and rising. Bevacqua says that Interior Commerce Secretary Guillermo Moreno began pressuring her to underreport inflation data in May 2006. From then until her demotion, Moreno harassed her unrelentlessly, challenging her data and methodology and demanding more "favorable" estimates. Bevacqua refused to comply, resulting in her demotion and eventual resignation from government.

The 2007 Presidential elections certainly contributed to the pressure for more "favorable" inflation data. With Kirchner's appointees in place at INDEC, end-of-year inflation "fell" from 12.3% in 2005 to 9.8% in 2006 to 8.5% in 2007. Christina Fernandez de Kirchner, wife of Néstor Kirchner, was elected President. After the elections, the data manipulation had to continue, to cover the previous manipulation.

In Argentina, inflation statistics have political significance that extends even deeper than their economic significance, as is common in countries with a history of hyperinflation. In the 1970s, like several other Latin American countries, Argentina borrowed heavily to fund its industrialization efforts. A variety of factors combined to exacerbate a debt crisis in the 1980s, which was accompanied by high inflation in Argentina and neighboring countries. Argentina faced quadruple-digit inflation in 1989 and 1990, with a hyperinflationary peak in March 1990. The disastrous consequences of hyperinflation, including stagnation of growth and capital flight, prompted structural reforms in the 1990s, under direction of the IMF, which restored inflation to low levels. For a time, Argentina was viewed as a model of success.

The situation in Argentina took a turn for the worse around the time of the Brazilian devaluation in 1999. A protracted recession erased most of the decade's gains in poverty reduction. As the federal government deficit widened to 2.5% of GDP in 1999, the IMF advised the De la Rúa administration to implement austerity measures. Distress escalated to full-scale crisis, climaxing with the largest debt default in history in December 2001. Following the default, Argentina faced exclusion from international capital markets and 41% inflation in 2002. Legal battles with a subset of the bondholders continue to this day.

With this history, it is not surprising that both inflation and IMF relations are sensitive issues for Argentina. Bevacqua says that Secretary Moreno "said that if we didn’t aim for zero inflation, we were unpatriotic.” The  irony is that the deceptive data, intended to improve appearances, fooled no one, and made the country look worse rather than better. Consumers in Argentina are well aware that inflation is several times the official rate. A consumer survey run by Torcuato di Tella University has measured inflation expectations near 30% for several years.

Source: Torcuato di Tella University. Yellow bars indicate median expectation and gray line indicates mean expectation.
MIT economist Alberto Cavallo published an investigation into Argentina's official price index in the widely-read Journal of Monetary Economics in 2012. Here is the abstract:
Prices collected from online retailers can be used to construct daily price indexes that complement official statistics. This paper studies their ability to match official inflation estimates in five Latin American countries, with a focus on Argentina, where official statistics have been heavily criticized in recent years. The data were collected between October 2007 and March 2011 from the largest supermarket in each country. In Brazil, Chile, Colombia, and Venezuela, online price indexes approximate both the level and main dynamics of official inflation. By contrast, Argentina’s online inflation rate is nearly three times higher than the official estimate.
Cavallo suggests that "the way the data is being altered is far simpler than commonly assumed. INDEC is a large organization, with many employees involved with the data collection and construction of the price indexes. Instead of changing the prices at the item level, it is probably easier for the government to change the aggregate numbers, which are seen by just a handful of people at the end of the CPI calculation process."

He adds, in conclusion, that "There is no obvious reason for why the government continues to manipulate the official price indexes. Some economists point to lower interest payments for inflation-linked bonds, while others highlight the fact that, by using artificially low inflation estimates in the budget, the government can avoid distributing any excess tax income to the provinces. However, these short-term resources are negligible next to the negative effects and uncertainty the manipulation has introduced in the economy."

Regarding Argentina's inflation-linked bonds, doubts about data accuracy began to wipe away their market in 2007. Argentina originally issued inflation-linked bonds in 1973, and the "linkers" came to play a large role in public debt management. Even as late as 2009, a third of Argentine debt was linked to inflation. But in September 2009, Argentina launched a new bond, the Bonar 2015, as part of a debt swap that replaced much of the inflation-indexed paper.

The collapse of Argentina's inflation-indexed bond market, though destructive, pales in comparison to the harms that have been inflicted on workers and consumers. A government-imposed price freeze implemented in February, and another in June, appear unsurprisingly ineffective. The mismatch between official data and generally perceived cost-of-living increases makes satisfactory wage negotiations between trade unions and the Ministry of Labor impossible. Erosion of purchasing power is likely much worse in the informal sector, which accounts for an estimated 40% of Argentine workers. In addition, strict capital controls fuel a large currency black market.

Lagarde describes the IMF censure of Argentina as a "yellow card." When Lagarde makes her report to the IMF Executive Committee later this month, if the data is not suitable, she will give a "red card." It is not clear how harmful any potential IMF sanctions could be. Argentina is already the only Group of 20 country that refuses to allow the IMF to conduct an annual review of the economy known as the Article IV consultation, and may not be overly concerned with further deterioration of relations with the IMF. A likely, if unsatisfactory, outcome is some knuckle-rapping and maintenance of the status quo for all practical purposes. The IMF could suspend Argentina's voting and related rights and begin the process of compulsory withdrawal from the fund. A top international priority should be the minimization of contagion to other emerging markets-- which should be possible, since the situation is sufficiently Argentina-specific. The way out of the mess in Argentina is difficult to foresee. The way into the mess is outlined in the timeline below.


1970s: Argentina borrows heavily to fund industrialization efforts.

1973: Argentina issues inflation-indexed bonds.

1980s: Argentine inflation heats up in the midst of Latin American debt crisis.

March 1990: Argentina's hyperinflation reaches peak.

1990s: Argentina implements IMF-directed structural reforms.

1998-2002: Argentina suffers severe recession.

June 31, 2001: Argentina swaps $29.5 billion of debt and defers $7.8 billion in interest payments. 

December 5, 2001: IMF announces it will not release $1.3 billion in aid to Argentina because austerity measures are insufficient.

December 23, 2001: Argentina defaults on $100 billion in debt.

May 25, 2003: Néstor Kirchner becomes President, succeeding Carlos Menem.

2007: Kirchner replaces several statisticians at INDEC with political appointees.

December 10, 2007: Christina Fernandez de Kirchner becomes President.

September 2, 2009: Argentina swaps 16.7 billion pesos ($4.34 billion) of inflation-linked bonds for newly-issued 2014 and 2015 bonds to extend maturities and reduce financing costs.

January 2010: Standoff between Central Bank President Martín Redrado and President Kirchner over use of central bank reserves to pay debt. Redrado is fired, then reinstated by courts.

January 30, 2010: Central Bank President Redrado resigns. Redrado accuses government of data manipulation.

February 3, 2010: Mercedes Marcó del Pont appointed President of Central Bank.

February 1, 2012: IMF Executive Board gives Argentina 180 days to implement specific measures to address quality of inflation data.

September 17, 2012: IMF Executive Board determines Argentina has made insufficient progress in implementing remedial measures.

February 1, 2013: IMF Executive Board censures Argentina.

February 4, 2013: Argentina announces two-month price freeze.

September 29, 2013: Deadline for Argentina to address concerns with inflation and GDP data.

November 13, 2013: Deadline for Christine Lagarde's report to IMF Executive Board on Argentina's progress.

Monday, October 28, 2013

Abenomics and Japanese Inflation Expectations

Paul Krugman has an "extremely wonky" new post about how to measure inflation expectations in Japan under Abenomics. The measure uses Treasury Inflation Protected Securities (TIPS), the topic of a series I am writing on this blog and the Noahpinion blog. Inflation-protected securities may be used to infer breakeven inflation expectations from the market. Japan's market in inflation-protected securities is considered too thin to provide useful information about expectations, so Krugman, building on the approach of Benjamin Mandel and Geoffrey Barnes, combines US TIPS data and real exchange rate data to measure Japanese inflation expectations:
I took the implied 10-year breakeven inflation rate from US TIPS, minus the 10-year interest rate differential, plus the real appreciation Japan would experience if the real exchange rate against the dollar 10 years from now were to return to its level in January 2010. You can adjust this as you like with whatever your estimate of the difference between the 1-2010 rate and the equilibrium rate is; it will just shift the line up or down.
The result is inflation expectations just below 0 until the start of 2012. Expectations rise to almost 3% by May 2013, then fall to around 1.5% by July 2013. Krugman writes:
I have my doubts about the apparent decline in recent months. It’s being driven not by events in Japan but by the taper scare, which drove up US rates. There is a question about why that rise in US rates didn’t produce a lot more yen depreciation, but something seems off here. 
The main point, however, is that this measure does suggest a substantial rise in expected inflation since Abenomics began, which is good news.
Another indicator of inflation expectations is the Bank of Japan's Opinion Survey on the General Public's Views and Behavior. According to this survey, there is no evidence of a decline in inflation expectations in recent months. The most recent survey, from June 2013, shows a continued rise in one-year-ahead expectations from December to March to June. The June average expectation was 5.1% and the median expectation was 3%. In 2010, the median expectation was 0% and the mean around 2%. Longer-term inflation expectations (which should correspond more closely to Krugman's measure) are also rising, though more gradually.

Source: Bank of Japan Opinion Survey
Also at a new high is the survey's measure of land price expectations. This is a newer development; the sharp rise began in late 2012:
Even if the expectations reported by surveyed households are not an accurate indicator of what will actually happen with inflation, they are still relevant. In the United States, households in the Michigan Survey of Consumers report higher inflation expectations than professional forecasts or TIPS-based measures. A new paper by Yuriy Gorodnichenko and Olivier Coibion, summarized by Jim Hamilton, suggests that the household expectations are important in explaining the "missing deflation" of the past few years.

Neither Krugman's US TIPS-based measure nor the household survey-based measure are perfect indicators of Japanese inflation expectations. But the fact that both indicate a rise in expectations since Abenomics began, combined with the dramatic increase in the index of land price expectations, convinces me at least qualitatively that expectations are rising, though I'd put huge error bars on any quantitative estimate. 

Krugman calls the rise in inflation expectations "good news." I agree, with a qualification. In an earlier post, "What Does Abenomics Feel Like?", I noted that Japanese consumers viewed rising prices extremely unfavorably. This, unsurprisingly, has not changed. There are, after all, no significant changes in perceptions of employment and working conditions.  In the mind of a typical consumer, more concerned with her own purchasing power than with liquidity trap economics, rising prices are not such a signifier of salvation. 

But there is a glimmer of hope. Consumers' perceptions of current economic conditions and of the economy's growth potential are both looking-- well, not bright, but brighter than before.

Thursday, October 24, 2013

People are Different: A Partial Bibliography

"Turns Out People Are Different, Say Economists" is the title of Brendan Greeley's new article at BloombergBusinessweek. He writes that "the idea that different families respond differently to the same event—that households are heterogeneous—is a relatively new way of looking at the economy." This claim prompted an interesting Twitter discussion about the origins and acceptance of heterogeneous agent economics and the relevance of this literature to policymakers.

The discussion prompted me to create a (very incomplete) bibliography of heterogeneous agent literature. I've separated it into Recent Papers, Classics, and Remarks by Policymakers. I will add to it as I come across or remember other papers. I will also add papers that people suggest via the comment section or Twitter.

Recent Papers

Heterogeneous Consumers and Fiscal Policy Shocks, by Emily Anderson, Atsushi Inoue, and Barbara Rossi (2013)
"unexpected fiscal shocks have substantially different effects on consumers depending on their age, income levels, and education. In particular, the wealthiest individuals tend to behave according to the predictions of standard RBC models, whereas the poorest individuals tend to behave according to standard IS-LM (non-Ricardian) models, due to credit constraints."

Household Balance Sheets, Consumption, and the Economic Slump by Atif R. Mian, Kamalesh Rao and Amir Sufi (2013)
"the 2007-09 housing collapse in the United States resulted in a very unequal distribution of wealth shocks due to the geographical concentration of ex-ante leverage and house price decline. We investigate the consumption consequences of these wealth shocks and show that the consumption risk-sharing hypothesis is easily rejected."

Is deregulating firm entry good for the workers? Which workers? by Ana P Fernandes, Priscila Ferreira, and L Alan Winters (2013):
"deregulating firm entry appears to boost competition and employment (and possibly aggregate income) but its gains seem largely to be reaped by better-off, better-educated workers."

Fiscal Policy and Consumption, by Tullio Jappelli and Luigi Pistaferri (2013)
"A different type of experiment is a balanced-budget redistributive policy whereby the government finances a transfer to the poor by taxing the top 10% of the income distribution. With a homogeneous marginal propensity to consume, a pure redistributive policy has no effect on aggregate consumption. However, with a heterogeneous marginal propensity to consume, the effect is positive and highest if the programme targets the very poor."

Inflation and the Price of Real Assets, by Monika Piazzesi and Martin Schneider (2012)
"This paper develops an asset pricing model with heterogeneous agents and incomplete markets to study the 1970s. The key elements of the model are that households differ by age and wealth and that all credit is nominal, so that inflation matters for bond returns and the cost of borrowing. Our empirical strategy is based on the idea that micro data on household characteristics can be used to directly parametrize household sector asset demand."

Monetary Policy with Heterogeneous Agents, by Nils Gornemann, Keith Kuester, and Makoto Nakajima (2012)
"monetary policy shocks have strikingly different implications for the welfare of different segments of the population. While households in the top 5 percent of the wealth distribution benefit slightly from a contractionary monetary policy shock, the bottom 5 percent would lose from this measure"

"Agent-Based Models...can make an important contribution to our understanding of potential vulnerabilities and paths through which risks can propagate across the financial system." (HT David Ballard)

Center for Economic Studies, U.S. Census Bureau Working Papers, Various Authors and Years
A collection of papers addressing macro questions with microdata (HT Ryan Decker)


Income and Wealth Heterogeneity in the Macroeconomy, by Per Krusell and Anthony A. Smith, Jr (1998)
"Among the models we study, those that come the closest to matching real-world wealth distributions are precisely models with heterogeneous preferences and incomplete markets."

Asset Pricing with Heterogeneous Consumers, by George M. Constantinides and Darrell Duffie (1996)
"a potential source of the equity premium is the covariance of the securities' returns with the cross-sectional variance of individual consumers' consumption growth."

Remarks by Policymakers

Inflation Expectations and Inflation Forecasting, speech by Ben Bernanke (2007)
"median measures of inflation expectations often obscure substantial cross-sectional dispersion of expectations. On which measure or combination of measures should central bankers focus to assess inflation developments and the degree to which expectations are anchored?"

Sunday, October 13, 2013

Credit, Crises, and Consequences

"What the crisis made abundantly clear is that private and public debts cannot be looked at only in isolation," say the authors of "Sovereigns Versus Banks: Credit, Crises, and Consequences." In this working paper, Òscar Jordà, Moritz Schularick, and Alan M. Taylor study the co-evolution of public and private sector debt in advanced countries since 1870. To do so, they use a new dataset covering 17 countries and 140 years.

Source: Jordà, Schularick, and Taylor

First, they find that total economy debt levels have risen a lot over time, but most of the increase has come from the private sector. The key public sector debt event was World War II (see the peak in Figure 1). Averaging across 17 advanced countries,  the ratio of public debt to bank assets went from 3/4 in 1928, to 1/2 in 1967, to 1/3 in 2008. Private borrowing is strongly pro-cyclical whereas public debt is usually mildly counter-cyclical.

Next, they classify recessions as either "normal" recessions or recessions associated with a financial crisis, and examine the cyclical public and private debt patterns associated with each. They find that private credit booms, not public debt booms, are the main precursors of financial instability.  While public sector debt has little influence on whether a financial crisis will occur, it does seem to matter for the speed of the recovery after a financial crisis. High levels of public debt are correlated with slower recoveries, which the authors contribute to fiscal space constraints, or less room to maneuver with fiscal policy.

They are careful to emphasize that high public debt is associated with slower growth only in the aftermath of financial crises. Private credit booms, on the other hand, are associated with slower growth after any type of recession.

Many countries and international bodies are considering or implementing macroprudential rules that incorporate private credit indicators. The authors support this idea in light of their findings. It is also worth considering the causes of the fiscal space constraints and whether, by making them less binding, the slow recoveries from financial crises can be sped up.

Monday, September 16, 2013

Academic Scribblers and the History of Inflation-Protected Securities

In most financial and economic analysis, U.S. Treasuries play the role of the "risk-free" asset. They are risk-free to an approximation only. In particular, since Treasury bonds are nominal, and future inflation is not known with certainty, they carry some inflation risk. Treasury inflation-protected securities (TIPS), like Treasuries, are backed by the full faith and credit of the US government, but are also linked to the Consumer Price Index, reducing inflation risk.

TIPS have a surprisingly interesting history, one that is both longer and shorter than you might expect. Though inflation-indexed bonds made a brief-lived appearance in Massachusetts in 1780, they then disappeared for more than two centuries. TIPS were not issued until 1997, at the urging of then Treasury Secretary Robert Rubin. This is the first of a series of posts I will write about inflation-indexed securities. In this post, I describe their history. In future posts I will review the evidence on whether TIPS have lived up to Rubin's claims that they would benefit savers and reduce the government's borrowing costs, as well as exploring other implications of this teenage asset.

The Commonwealth of Massachusetts created the earliest known inflation-indexed bonds in 1780 in the Revolutionary War. Robert Shiller writes, "These bonds were invented to deal with severe wartime inflation and with angry discontent among soldiers in the U.S. Army with the decline in purchasing power of their pay. Although the bonds were successful, the concept of indexed bonds was abandoned after the immediate extreme inflationary environment passed, and largely forgotten until the twentieth century."
Commonwealth of Massachusetts inflation-indexed bond, 1780, from Shiller (2003).
The 1780 bond reads,
"Both Principal and Interest to be paid in the then current Money of said STATE, in a greater or less SUM, according as Five Bushels of CORN, Sixty-eight Pounds and four-seventh Parts of a Pound of BEEF, Ten Pounds of SHEEPS WOOL, and Sixteen Pounds of SOLE LEATHER shall then cost, more or less than One Hundred and Thirty Pounds current money, at the then current Prices of said ARTICLES—This SUM being THIRTY-TWO TIMES AND AN HALF what the same Quantities of the same Articles would cost at the Prices affixed to them in the Law of this STATE made in the Year of our Lord One Thousand Seven Hundred and Seventy-seven, intitled, 'An Act to prevent Monopoly and Oppression.'"
Thus, the bond functioned similarly to today's TIPS, which are also linked to the price of a market basket of goods (the CPI). Shiller notes that the price index described on the 1780 bond increased 32-fold in three years. The inflation-linked bonds allowed soldiers' pay to keep pace with rising prices. (Curiously, the President of Harvard College, Samuel Langdon, also had his pay linked to this index.) With no explanation, an act in 1786 ended the experiment with indexed bonds.

Shiller explains that this historic episode is a good example of the role of economic theory in financial innovation. "John Maynard Keynes is widely quoted as asserting that most economic innovations derive ultimately from some 'academic scribblers.' But, in fact, in the case of indexed bonds, there was no academic precursor." He adds,
"It seems here that necessity was the mother of this invention. The example of the creation of indexed bonds in Massachusetts in 1780 appears to deny the importance of the “academic scribblers” that Keynes extolled, for the invention appeared long before the scholars wrote about it. And yet, in another sense, it only reinforces their importance, for the practice of indexation of bonds did not take hold at that time. It is a reasonable supposition that the indexed bonds did not continue because there was no well-conceived model that would justify and explain them."
Certain developments in index number theory, for example, did not take place until the twentieth century. A simple price index like the one used on the 1780 bond has what is now a well-known problem. If the price of one of the goods rises, consumers can shift some of their consumption to other goods. Because of the ability to substitute, the increase in the price index is more than the increase in the true cost of living. Irving Fischer proposed a solution in 1922.

It wasn't until later in the twentieth century that inflation-indexed government bonds reappeared. This time around, academic scribblers abounded. The UK was a much earlier adopter than the US. On the recommendation of the Wilson Committee Report of 1980, then Chancellor of the Exchequer Geoffrey Howe announced the Government's intention to issue index-linked gilts.

Other countries, including Canada, Sweden, and New Zealand, followed in subsequent years. Whereas the high inflation in the Revolutionary War prompted inflation-indexed government debt, the high inflation in the US in the late 1970s did not have the same effect, at least not immediately. Shiller became one of the academic scribblers, coauthoring "A Scorecard for Indexed Government Debt" with John Campbell in 1996. Their scorecard came out in favor of creating inflation-indexed government debt. TIPS were introduced in 1997, and have since grown as a share of debt and of GDP (see figure below).
Source: Campbell, Shiller, and Viceira 2009
Campbell and Shiller enumerated multiple potential upsides and downsides to TIPS in their 1996 report. I plan to delve into these in future posts (perhaps at Noahpinion, where I've been guest blogging lately).

(Since I'm writing about finance, I should add the disclaimer that this is not intended to be investment advice.)

Monday, September 9, 2013

Capital is Back: Wealth Ratios over Several Centuries

This afternoon I attended a seminar called "Capital is Back: Wealth-Income Ratios in Rich Countries 1700-2010" by Thomas Piketty and Gabriel Zucman. From the abstract:
"How do aggregate wealth-to-income ratios evolve in the long run and why? We address this question using 1970-2010 national balance sheets recently compiled in the top eight developed economies. For the U.S., U.K., Germany, and France, we are able to extend our analysis as far back as 1700. We find in every country a gradual rise of wealth-income ratios in recent decades, from about 200-300% in 1970 to 400-600% in 2010. In effect, today’s ratios appear to be returning to the high values observed in Europe in the eighteenth and nineteenth centuries (600-700%). This can be explained by a long run asset price recovery (itself driven by changes in capital policies since the world wars) and by the slowdown of productivity and population growth...Our results have important implications for capital taxation and regulation and shed new light on the changing nature of wealth, the shape of the production function, and the rise of capital shares."
The authors put together a new macro-historical data set on wealth and income, available online, which is "the first international database to include long-run, homogeneous information on national wealth...It can be used to study core macroeconomic questions – such as private capital accumulation, the dynamics of the public debt, and patterns in net foreign asset positions – altogether and over unusually long periods of time."

They suggest that from the interwar period until the 1870s, asset prices were depressed. Then an asset price recovery was driven by changes in capital policies. A U-shaped history of wealth-income ratios is more pronounced for Europe than for the US (Figure 4).

The following two figures show the changing nature of national wealth in the UK (Figure 3) and the US (Figure 10). (The picture for France is quite similar to the UK.) Agricultural land accounted for a staggering 400% of national income in 1870 in the UK, and is basically negligible now. The picture for the US changes if you include slaves as wealth in the antebellum period (Figure 11).

The author also decompose the accumulation of national wealth from 1970-2010 into a saving-induced wealth growth rate and a capital-gains-induced wealth growth rate for eight rich countries (Table 4). Germany is the only country to have experienced a negative capital-gains-induced wealth growth rate.
In Figure 16, below, Piketty and Zucman make a variety of assumptions to compute and simulate the worldwide private wealth to national income ratio from 1870-2100. The ratio bottomed-out in 1950, and they predict that it will continue to rise. This means, they suggest, that wealth inequality is likely to matter more now than in the postwar period, and will continue to matter even more in the future, raising a new set of issues about capital regulation and taxation.

Wednesday, September 4, 2013

Japanese Wage Data Not All That Spectacular (Exception: Finance Industry)

The results of Japan's Provisional Report of Monthly Labour Survey for July 2013 are now available. The Wall Street Journal calls the wage data "not all that gloomy," citing the fact that nominal earnings are up 0.4%. According to the article,
"That’s good news for Prime Minister Shinzo Abe as he has made wage growth a key measure of success for Abenomics, which seeks to lift Japan out of 15 years of deflation. While the aggressive monetary easing and government spending measures have pushed up production as well as prices, Mr. Abe has acknowledged that without substantial wage growth, there can be no sustainable economic expansion."
I think it's too early to claim good news or to call this substantial wage growth. Here are just a few quick points from my skim-through of the survey results. The 0.4% increase that the article refers to is for nominal total cash earnings (compared to the same month a year ago), for all industries. This can be broken down into a 0.3% fall in contractual cash earnings and a 2.1% increase in special cash earnings. Companies are giving summer bonuses but not committing to presumably more permanent base-pay increases.

Both the contractual and special cash earning changes vary a lot across industries. In the finance and insurance industry, total cash earnings were up 1.5% and special cash earnings were up 17.8%. On the other extreme is the education and learning support industry, for which total cash earnings were down 6.1% and special cash earnings were down 20.1%.

The total real wage is down 0.4% from the same month a year ago. On a seasonally-adjusted basis, the number of regular employees has neither increased nor decreased. If any readers are adept at interpreting this survey data, please chime in with any insights I have missed.

I believe my earlier post--"What Does Abenomics Feel Like?"-- is still quite relevant.

Sunday, September 1, 2013

Limited Time Offer! Temporary Sales and Price Rigidities

Even though prices change frequently, this does not necessarily mean that prices are very flexible, according to a new paper by Eric Anderson, Emi Nakamura, Duncan Simester, and Jón Steinsson. In "Informational Rigidities and the Stickiness of Temporary Sales," these authors note that it is important to distinguish temporary sales from regular price changes when analyzing the frequency of price adjustment and the response of prices to macroeconomic shocks.
"The literature on price rigidity can be divided into a literature on "sticky prices" and a literature on "sticky information" (which gives rise to sticky plans). A key question in interpreting the extremely high frequencies of price change observed in retail price data is whether these frequent price changes facilitate rapid responses to changing economic conditions, or whether some of these price changes are part of “sticky plans” that are determined substantially in advance and therefore not responsive to changing conditions.  
We use an exceptionally detailed dataset on retail and wholesale prices to investigate these questions. Our dataset has the advantage of providing accurate administrative measures both of the Regular Retail price and of the retailer’s marginal cost—i.e., the Base Wholesale Price. We find that temporary sales are unresponsive both to movements in the Base Wholesale Price and to movements in underlying production costs..." 
They provide some interesting institutional features of temporary sales and promotions:
"Due to the logistical complexity of holding successful temporary sales and associated promotional activity, manufacturers and retailers jointly set a schedule for temporary sales – a promotion calendar – through an annual planning process. This means that temporary sales follow sticky plans...Wholesale price drops associated with trade deals typically do not represent commensurate drops in the retailer’s marginal cost, since the retailers is “spending down” a finite trade deal budget.  
We believe that there are two other notable institutional features of trade deal budgets. First, the most common way that manufacturer trade deal budgets are determined is via accrual accounts, which are analogous to frequent flyer accounts. Just as consumers accumulate “miles” when they fly on, say, United Airlines, retailers accrue funds in a manufacturer trade deal budget for the total volume purchased from a manufacturer. Second, payment from the manufacturer budget to the retailer is typically contingent on execution of a trade deal. Retailers typically receive money after there is verification of a price discount, in-store signage or advertising of the manufacturer’s project."
They conclude that regular (non-sale) prices exhibit stickiness, while temporary sale prices follow "sticky plans" that are relatively unresponsive in the short run to macroeconomic shocks:
"Our analysis suggests that regular prices are sticky prices that change infrequently but are responsive to macroeconomic shocks, such as the rapid run-up and decline of oil prices. In contrast, temporary sales follow sticky plans. These plans include price discounts of varying depth and frequency across products. But, the plans themselves are relatively unresponsive in the near term to macroeconomic shocks. We believe that this characterization of regular and sale prices as sticky prices versus sticky plans substantially advances an ongoing debate about the extent of retail price fluctuations and offers deeper insight into how retail prices adjust in response to macroeconomic shocks."

Wednesday, August 28, 2013

"Forecasting Profitability": A New Study of Uncertainty and Investment

I hope macroeconomists don't overlook this new paper from the development literature: Forecasting Profitability, an NBER working paper by Mark Rosenzweig and Christopher R. Udry, provides an extremely concrete and clean example of how uncertainty can matter for an economy.  (They don't actually use the word uncertainty, because it's apparently not as much of a buzzword in other fields of economics right now as it is in macro.)

The uncertainty studied in this paper concerns the weather. The authors note that "in India the India Meteorological Department (IMD) has been issuing annual forecasts of the monsoon across the subcontinent since 1895, and it is widely reported in the Indian media that farmers’ livelihoods depend upon the accuracy of the forecast." From the introduction [emphasis added]:
"It is well‐established that agricultural profits in developing countries depend strongly on
weather realizations. It is similarly well‐known from the development economics literature that farmers without access to good insurance markets act conservatively, investing less on their farms and choosing crop mixes and cultivation techniques that reduce the volatility of farm profits at the expense of lower expected profits. Economists have focused valuable attention on policies and programs that can provide improved ex post mechanisms for dealing with the consequences of this variability. For example, innovations in insurance can spread risk across broader populations, or improved credit or savings institutions can permit more effective consumption‐smoothing over time...
Economists, however, have paid little attention to directly improving farmers’ capacity to deal
with weather fluctuations by improving the accuracy of forecasts of inter‐annual variations in weather. Like actuarially fair insurance, a perfectly accurate forecast of this year’s weather pattern, provided before a farmer makes his or her production decisions for the season, eliminates weather risk. However, a perfect forecast permits the farmer to make optimal production choices conditional on the realized weather and thus achieve higher profits on average compared with a risk‐neutral or perfectly‐insured farmer. The profit and welfare gains associated with improvements in the accuracy of long‐range forecasts (forecasts that cover, for example, an entire growing season) are potentially enormous, given the tremendous variability in profits and optimal investment choices across weather realizations."
Here's a bit about the methodology and results:
"In this paper we used newly‐available panel data on farmers in India to estimate how the
returns to planting‐stage investments vary by rainfall realizations using an IV strategy in which the Indian forecast of monsoon rainfall serves as the main instrument. We show that the Indian forecasts significantly affect farmer investment decisions and that these responses account for a substantial fraction of the inter‐annual variability in planting‐stage investments, that the skill of the forecasts vary across areas of India, and that farmers respond more strongly to the forecast where there is more forecast skill and not at all when there is no skill. Our profit‐function estimates indicate that Indian farmers on average under‐invest, by a factor of three, when we compare actual levels of investments with the optimal investment level that maximizes expected profits over the full distribution of rainfall realizations.
We also used our estimates to quantify how farmers’ responses to the forecast affect both the
level and variability in profits... These indicated that farmer’s use of the forecasts increased average profit levels but also increased profit variability compared with farmers without access to forecasts. Indeed, based on the actual behavior of the farmers, our estimates indicated that they do better than farmers who would undertake optimal, unconstrained investments but have no forecasts when rainfall realizations are high, but worse under adverse rainfall conditions. Finally, we also assessed how profit levels would increase in the future as forecast skill increases under current climate conditions and under conditions predicted by climate models. These exercises indicate that even modest skill improvements would substantially increase average profits, and slightly more so in a warmed climate."
Obviously, weather realizations affect farmers' livelihood. But the precision with which farmers can predict the weather ahead of time also affects their livelihood: less precision (more uncertainty) reduces investment and reduces expected profits. The above allusion to "a warmed climate" is an example of what an "uncertainty shock" could be in this context. If climate change increases weather volatility, then without an improvement in forecast skill, there would be more uncertainty. The model in the paper can get at quantifying the impact of that uncertainty shock. The paper also mentions a new government policy aimed at improving the economy through reducing uncertainty. Monsoon Mission, launched in India in 2012, has a five-year budget of $48 million to support research on improving weather forecasting ability.

Wednesday, August 21, 2013

Diversity in Economics

Bank of England Governor Mark Carney, in an interview earlier this month, pointed out that there are no women on the Monetary Policy Committee (MPC). There also happen to be no female ministers in the Treasury. Carney suggested,
“What we have to do at the Bank of England is grow top female economists all the way through the ranks. That adds to the diversity in macroeconomic thinking, it adds to qualified candidates for the MPC including qualified candidates to be a future governor.” 
This seems like a reasonable message, but Philip Booth at the Institute of Economic Affairs wonders "why Osborne and Cameron are not hauling Carney in for a dressing down." He makes a deeply confusing comparison between Carney and Larry Summers, and then adds:
"It is worth noting that I am quite comfortable with the idea that the sexes are complementary and that, in any business, social or family situation, they may (on average) bring different characteristics to the table. However, if Carney holds this position, there are some interesting conclusions because, if it is accepted that women (on average) might exhibit certain skills in greater preponderance than men, then the opposite may have to be accepted too. But, let’s move on…"
Before moving on, though, what are these "interesting" conclusions? If men do exhibit certain skills (like passive-aggressive ellipses usage) in greater preponderance than women, do we really know that each of these man-skills are beneficial for monetary policymaking? 

Booth writes, "Surely, there can only be two reasons [for Carney's remarks] – that Carney believes that there are intrinsic differences between the ways in which men and women reason and assess evidence or that their social experiences are different from those of men who have similar career patterns."

Really, can these be the only two reasons? Isn't it also plausible that Carney thinks the lack of women on the MPC is a sign that some qualified candidates are, for various and perhaps subtle reasons, not making it into or up the ranks, and that excluding part of a talent pool is a generally bad idea? It is not just that the social experiences are different for men and women who have similar career patterns-- different social experiences also lead men and women to having different career patterns. Does Booth himself think that it is just a big coincidence that there are zero women out of nine on the committee? Surely his manly math skills are good enough that he doesn't chalk that up to random chance. So even though Booth is chiding Carney for implying that men and women are intrinsically different, he seems to be working off of some "interesting" assumptions himself.

Next, Booth manages to list eight female economists, but doesn't personally think that any of them would add diversity to the MPC. He thinks Gillian Tett might add diversity to the group, "but it is the fact that she is an anthropologist that ensures that her views add diversity, not the fact that she is a woman." (In fact, a survey of 400 economists documents notable differences of opinion between the genders.) Then he gets to the most telling paragraph:
"It does not follow that adding those women who choose to become economists to a group of male economists adds to the diversity of thinking of the group of economists. It may be the case...that those women who ‘add diversity’ in intellectual life do not choose to become economists. This would mean that women contribute to diversity in society but not necessarily to diversity amongst economists."
He is inadvertently proving Carney's point, just as he is trying to tear it down. If he thinks that intellectually diverse women do not choose to become economists, he needs to ask himself why that is. It might help to read Neil Irwin's article about what happens when a certain female economist does "contribute to diversity":
Yellen has a perfectly solid relationship with Bernanke, as best as I can tell, but she’s more of her own thinker within the institution. She has spent her time as vice chairwoman urging Bernanke and her other fellow policymakers to shift policy to try to do more to combat unemployment, and thinking through ways to do just that...And people dealing with her within the Fed have viewed her not so much as Bernanke’s emissary but as her own intellectual force within the organization.
Felix Salmon summarizes Irwin's reasons why the White House is uneasy about Yellen:
"The first is the 'team player' attack: Yellen is an independent thinker more than she is a loyal deputy to Bernanke... She never became part of the boys’ club which was making enormous decisions on a daily basis in the fall of 2008... The 'team player' argument, then, is basically the 'one of us' argument, thinly disguised. Which is the first place that the sexism comes in...
This second reason essentially takes the 'team player' argument past its breaking point, to the point at which the Obama team is basically saying 'Yellen needs to share our biggest weaknesses.'"
I hope this post was not too much of a rant. I just wanted to make the point that Governor Carney's remarks are perfectly acceptable and in fact welcome.

Monday, August 19, 2013

What Does Abenomics Feel Like?

Depending on whom you ask and when, Abenomics is or is not working, and Japan is or is not entering a recovery. What if you ask the people of Japan?

The closest thing to asking them is looking at the Bank of Japan's Opinion Survey on the General Public's Views and Behavior, a quarterly survey with a nationwide sample of 4,000 individuals who are at least 20 years old. The results from the June 2013 survey were recently released, giving us a glimpse of how the general public of Japan is experiencing economic life under Abe.

When asked, in the abstract, about the "growth potential" of the Japanese economy, responses are less pessimistic than in previous quarters.  But when asked about their own household's experience, the situation still looks pretty bleak. In one question, respondents are asked, "What do you think of your household circumstances compared with one year ago?" Only 4.9% say they are better off, while 39.2% say they are worse off, and the rest say it is difficult to tell. While not great, these numbers are a minor improvement over a year prior, when only 3.6% said they were better off and 47% said they were worse off. Of the households who reported worse circumstances, 73% said a reason was that their income decreased and 42% said a reason was that their income was not likely to increase in the future (they could choose multiple options).

The 4.9% of households who thought their circumstances improved were also asked why. About 22% responded that their interest income and dividend payments increased and 26% said it was because the value of their assets increased. Insofar as Abenomics has led to a rising Nikkei, this has only been enough to lead about one or two percent of households to notice improvements in their circumstances. (More households might have benefited from the rise, but not enough to offset other challenges.) The stock market rise greatly increased the net profits of regional banks, but the benefits don't seem to have been widely spread.

Positive inflation and higher inflation expectations are cornerstone goals of Abenomics. Deflation has plagued the Japanese economy since the latter half of the 1990s. Japan's CPI less food and energy rose 0.2% from a year earlier in June, the largest rise since 2008. At Bloomberg, Toru Fujioka and Andy Sharp report that "the world’s third-biggest economy may be starting to shake off 15 years of deflation." Fujioka and Sharp declare this a "Boost for Abe," and write that "the increase in consumer prices could stoke inflation expectations and encourage companies and consumers to spend more, bolstering the economic recovery."

The June 2013 survey shows that consumers are noticing rising prices and expect prices to continue to rise. In particular, 50.5% of survey respondents felt that prices had gone up in the previous year, and over 80% expect prices to go up over the next year. However, of the respondents who noticed rising prices, 81.6% described the price rise as "rather unfavorable." This makes it seem unlikely that stoked inflation expectations will encourage consumers to spend more. In fact, 44.8% of respondents plan to decrease their spending over the next year, and only 6.1% plan to increase spending.

I previously wrote a post about how Europeans really dislike inflation, even when it is low, but I think the reason Japanese consumers dread rising prices is different. If price inflation is not accompanied by wage inflation--and is not expected to be-- then the pass-through from inflation expectations to consumer spending is broken. Fujioka and Sharp quote Akiyoshi Takumori, chief economist at Sumitomo Mitsui Asset Management, saying “business executives must have forgotten how to increase pay after decades of deflation." Japanese companies are reluctant to raise base pay. In June, while average total monthly cash earnings, including overtime and bonuses, rose 0.1%, regular pay fell 0.2%. The rise in total earnings was attributable to higher summer bonuses. Over 80% of survey respondents are slightly or quite worried about working conditions such as pay, job position, and benefits.

Monday, August 12, 2013

Heisenberg's Uncertainty Index

The title of Matt O'Brien's recent post--"Uncertainty Isn't Killing the Recovery"-- summarizes a slurry of recent articles. O'Brien writes, "as Jim Tankersley of the Washington Post points out, uncertainty has actually fallen a lot the past few months, but hiring hasn't picked up." Tankersley's title proclaims a similar message: "'Uncertainty' Isn't a Problem Anymore."

The boldest title of all (no surprise) comes from Paul Krugman: "Another Bad Story Bites The Dust."

I thought about following the Very Descriptive Titles trend and calling my post "Whoa, Whoa, Wait a Minute Guys," or "Let's Not Throw Out the Baby with the Bathwater Just Yet" or "Uncertainty Might Matter So Maybe We Should Let Smart People Keep Studying It If They Want." (But I was too much of a nerd to resist the title I actually chose, which I will eventually explain.) Legitimate criticism of political discourse is one thing. But we shouldn't, in the meanwhile, dismiss a large, promising, and growing area of research.

The recent articles find fault with the Economic Policy Uncertainty index of Scott Baker and Nick Bloom of Stanford and Stephen Davis of the University of Chicago. The index is based in part on how often major newspapers talk about phrases related to economic policy uncertainty. The basic idea of the criticism has to do with uncertainty a la Heisenberg. The non-technical version of the Heisenberg Uncertainty Principle is that, in observing something, we change it. The usual context is quantum mechanics, but it applies in other contexts too. In this context, the idea is that once the Economic Policy Uncertainty index was publicized, conservative politicians and pundits found it a useful talking point, and by talking and writing about it so much, they actually drove the index higher. So what the economists were observing--the frequency of mentions of uncertainty-related phrases-- was actually altered by the attempt to observe it.

This is a valid, but not devastating point. First, we don't know how large this "Heisenberg effect" is. Conservative punditry could have had only a small effect on the index. Second, it is not that hard to think of ways to improve the index to minimize this problem. Simplest idea: exclude articles that include the exact phrase "economic policy uncertainty index" or the words Baker, Bloom, Davis, Stanford, or Chicago. Slightly less simple idea: Aren't there really sophisticated quantitative text analysis tools available these days that could measure the amount of uncertainty in the tone of economics/business articles? Third, and most important, is that there is much more to Baker, Bloom, and Davis' research than the index itself. Bloom's 2007 paper, "The Impact of Uncertainty Shocks"--written before the construction of the index-- helped kick off a surge of macroeconomic uncertainty research. Many of Baker, Bloom, and Davis' contributions, and those of authors they have motivated, have been theoretical. A slightly flawed measure beats no measure at all if it encourages researchers to pay attention to an important subject. And I would venture to guess that the vast majority of these researchers are not motivated by a political agenda. They are motivated by the desire to understand something they think might really matter.

For what it's worth, I think the Economic Policy Uncertainty index does have decent construct validity. The creators of the index make an analogous index for Europe. In an unpublished working paper, I make a totally different uncertainty index for Europe, based on the how uncertain professional forecasters are in their probabilistic forecasts for GDP growth 2-years ahead. (I chose Europe instead of the US because of data availability.) My uncertainty measure is plotted along with the Economic Policy Uncertainty index below; the correlation coefficient is 0.8. The fact that they are created by totally different methodologies, from totally different data sources, and yet are this highly correlated, makes me think that there is at least some measurement validity.

I appreciate John Aziz's more moderately-titled post, "On Policy Uncertainty," in which he writes:
Krugman is right to... trash those who view the sluggishness of the recovery as solely Obama’s fault. But he’s wrong, I think, to throw policy uncertainty out of the window entirely as a proximate cause of some of the problem’s we’re now facing.

Wednesday, August 7, 2013

Raghuram Rajan is Not Paul Volcker

Raghuram Rajan will take over leadership of the Reserve Bank of India (RBI) on September 4. The BBC lists some of the challenges facing the Indian economy, including a large current account deficit, weak rupee, the slowest growth in a decade (around 5%), and inequality, adding, "Many believe that the single biggest failure of the government's economic policies in recent years has been the inability to control inflation in general and food prices in particular."

It's clear that Rajan will have his work cut out for him, but what kind of work will that be? 

"The monetary situation is such that he may be forced to act as India’s Paul Volcker, hiking up rates and perhaps even orchestrating a recession to get the currency and inflation under control," writes Dylan Matthews. Matthews notes that "By law, India’s central bank doesn’t have much political independence, as Rajan serves at the pleasure of the government and can be sacked at any time. That could deter him from making tough moves against inflation that could have unpopular implications for growth. But Subramanian thinks he’ll have a great deal of flexibility in practice, even if the opposition Bharatiya Janata Party comes to power again."

There is a tendency to want to frame the challenges of the Indian economy in terms of a power struggle between monetary and fiscal authorities-- an "unseemly battle of wits over interest rates," according to Rajrishi Singhal at Bloomberg.  Singhal describes how the Finance Ministry has piled pressure on Rajan's predecessor, RBI Governor Duvvuri Subbarao, to keep rates low. The idea is that, if only the new Governor can stand up to "bullying" and raise rates, then inflation and the rupee can be stabilized. But India in 2013 is not the U.S. in 1979, and Raghuram Rajan need not imitate Paul Volcker.

A central banker's role in India is much different than a central banker's role in the United States or Europe. Monetary policy, remember, is ultimately based on frictions. Prices and inflation are nominal variables. In a frictionless economy, there is no role for monetary policy. It is because of certain frictions that monetary policy can have short-run effects, and these frictions provide the justification for using monetary policy to stabilize economic fluctuations over the business cycle. The optimal monetary policy depends on the nature and magnitude of these frictions. Sticky prices and sticky information are the two categories of frictions most used in the analysis of monetary policy. Both have similar implications for how monetary policy should generally work.

The theory behind the Taylor rule is based on the sticky price friction. The rule recommends a relatively high interest rate or “tight” policy when inflation or employment is relatively high, and a relatively low interest rate in the opposite scenario. According to the Taylor rule, India's policy rates are currently too low. As Ashok Rao writes (in a very excellent post), "A healthy Taylor rule requires an accurate estimate of the output gap which is founded on long-run trend growth. “Trend” growth is a useless concept in countries like India and China, whose growth rates have both a high mean and variance."

But there may be a more fundamental reason why the Taylor rule is not suitable for India. The Taylor rule is based on the sticky price friction, which may not be the dominant friction. Amartya Lahiri suggests that the dominant friction is asset market segmentation (emphasis added).
A well-known feature of the Indian economy is that access to asset markets and instruments is extremely limited. About 140 million households in India do not have access to any formal banking at all. Consequently, less than half of all individuals have access to any formal financial services...It is thus abundantly clear that there is endemic and widespread segmentation in asset markets in India with only a small subset of India having access to formal asset markets. But curiously, discussions about monetary policy in India are completely divorced from this asset market segmentation."
How does asset market segmentation impact the monetary policy calculus? In this case the central bank needs to use monetary policy to provide insurance to those that are absent from these markets. This policy imperative can naturally imply very different monetary policy responses relative to when prices are sticky.
Rajesh Singh, Amartya Lahiri, and Carlos Vegh study optimal monetary policy in environments with segmented asset markets. As Lahiri summarizes,
Intuitively, the role of policy under this friction is to protect households that are excluded from asset markets from excessive fluctuations in their consumption levels. When output is high, consumption of these households tends to rise due to (a) higher income; and (b) higher real money balances as the exchange rate tends to appreciate. By expanding money supply, the central bank can inflate away some of the increase in real balances and thereby moderate the rise in consumption. This procyclicality of the optimal monetary policy is clearly at odds with the Taylor rule prescription that monetary policy should be countercyclical.
The authors also find that asset market segmentation has surprising effects on optimal exchange rate regimes (effectively the opposite of the Mudellian model). They come down in favor of targeting monetary aggregates instead of targeting the exchange rate. The model of Singh et al. is admittedly very stylized and I have found no existing tests of its empirical implications. So I am certainly not actually recommending that Rajan rush to lower interest rates. Nor am I suggesting that Rao's proposal of a rule-based exchange rate policy should be off the table.

Rather, I just intend to highlight the topsy-turvy theoretical results that can arise when we alter the foundations of our models; in particular, when we acknowledge lack of financial inclusion as a significant friction. I also believe that an important role for Rajan, perhaps more important than any decision about interest rates, will be in reforming the financial system and promoting financial inclusion. I am very optimistic on this front. The Financial Times reports that "economists who know Mr Rajan well say helping hundreds of millions of Indians get access to efficient financial services is close to his heart." In 2008, he wrote "A Hundred Small Steps," a report on financial sector reforms. I am most impressed by his inclusion in Chapter 3, "Broadening Access to Finance," of this chart, which shows the interest rates actually paid by people in each income quartile.

It appears that he is quite sensitive to the severity of asset market segmentation in India and to the fact that interest rate movements are not evenly transmitted across all segments of the population.