eP*/P

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Those are the symbols for the “real exchange rate,” or the terms of trade, both measured inversely, or “competitiveness,” measured directly. That is, when this expression goes up, the real exchange rate depreciates, the terms of trade worsen, and competitiveness improves. e is the nominal exchange rate. Say that we are Japan, and e is yen/dollar. As e goes up, it means that our exchange rate is depreciating. (I am forever confused by that way of writing e, but that’s how it’s done.) P* is the domestic price index of our trading partners, and P is our domestic price index. Suppose that we (Japan) are relatively deflationary, which means that P*/P is going up. That has the same effect as a currency depreciation.

It appears to me that Japan is experiencing both a nominal currency depreciation (a rise in e) and an increase P*/P. That means that Japan is certainly experiencing a real exchange rate depreciation, or a real deterioration in its terms of trade. It has to give up more Toyotas to import the same amount of beef. In terms of purchasing power in world markets, the Japanese are becoming worse off.

At the same time, Japan has become more competitive. Japanese consumers will be inclined to import less beef. Toyota will find itself able to export more cars.

The question I have is this: when does Japan succeed in inflating away some of its debt? In terms of world purchasing power, it is already doing so. Japanese holders of government bonds are earning negative returns relative to the cost of a consumption basket. But that does not help the government. The government needs an increase in yen-denominated tax revenue.

Possibly related: Brad DeLong writes,

That process–the rise in domestic nominal prices and wages, and the larger fall in the nominal value of the currency–may derange the price system and so disrupt aggregate supply. The new equilibrium may be one in which the real depreciation of the currency is expansionary in the sense that it tends to push real aggregate demand above potential output. But the economy may nevertheless be in depression, if the process of getting to the new equilibrium has entailed nominal price swings large enough to have been sufficiently disruptive to the market-mediated division of labor. Weimar 1923.

Pointer from Mark Thoma.

I see that as the crux of the issue. If investors lose confidence in Japan’s bonds, the Japanese government loses its ability to borrow. When you lose the ability to borrow and you are running large deficits, watch out.

UPDATE: Read Tyler Cowen’s post on this topic.

John Cochrane Walks Back, and Now I am Grumpy

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He writes,

Now, if you read FOMC minutes, Fed speeches, or talk to people at the Fed about policy, you will see that this intertemporal, expectation-focused approach resulting from the revolutions of the 1970s permiates [sic] the policy-making process. For example, “forward guidance” is the rage. It only takes one beer for the conversation to quickly acknowledge that QE likely worked as much by signaling low interest rates for a long time than it did by exploiting some sort of permanent price-pressure in Treasury markets.

Consider two questions:

1. Why does employment fluctuate?

2. How does the Fed affect financial markets?

If you want to use the term “intertemporal, expectation-focused approach” to talk about (1), I am not convinced. I think that this dubious idea took hold because economists were writing down models of a GDP factory, abstracting from the question of which goods to produce. The only meaningful choice left was intertemporal–do you run the GDP factory faster now or next year? This is a case in which an overarching theory was dictated by a simplistic modeling strategy.

If you want to use the term “intertemporal, expectation-focused approach” to talk about (2), you have a strong case. I believe in at least the weak form of the efficient markets hypothesis. When you incorporate that into your thinking, then you have to think of the Fed either as affecting markets with surprises or with rules. As Cochrane points out, this leads to a discussion of rules.

However, there is another consideration, which is that perhaps in financial markets the Fed is throwing small pebbles into a big pond. Maybe in the grand scheme of things, monetary policy does not do much to change long-term interest rates, stock prices, and other important market rates. Yes, I know that many investors believe that Fed policy matters, and there is this whole industry of trying to “read” the Fed, and it is possible that the Fed can influence the readers in some way–but again, markets are overall weakly efficient.

What I keep coming back to is my view that the Fed’s regulatory policies have big effects on credit allocation. Tell banks that they can multiply the interest rate on regulator-designated low-risk assets by three to get their regulation-adjusted rate of return, and by golly banks will load up on regulator-designated low-risk assets. But I am doubtful that its monetary policies do anything.

Sympathy for the Gruber

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Dana Milbank writes,

Gruber wasn’t about to get a defense from Democrats. “Stupid — I mean absolutely stupid comments,” the panel’s top Democrat, Elijah Cummings (Md.) told the witness. “They were irresponsible, incredibly disrespectful and did not reflect reality.”

I disagree with some of what Gruber has said about both the substance and the politics of health care policy, and I think that his “micro-simulation model” of health insurance take-up was over-valued. However, I deplore the personal attacks on him. And I hate that he was made to grovel before Congress.

If the sin is arrogance, then it is an understatement to say that Congressmen should not cast the first stone. They should be the first to be stoned.

I am not a fan of Congressional committees that pillory ordinary citizens. In my personal files, I have the clippings from a front-page story about another Congressional hearing, held 57 years ago. It was the House Un-American Activities Committee, and the witness that they were using to try to advance their careers was my mother. Because she refused to name names, she was going to be prosecuted. She was saved by the Watkins case.

James Otteson on Socialism

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In a Russ Roberts podcast, Otteson says,

So, who is making the relevant economic decisions? Is it a third party, a person, group, agency who is making it on behalf of others? That’s what I’m calling the impulse toward centralism. Or, is it principally individuals or communities, localized communities, themselves? That’s what I’m calling decentralized decision making. And that is a spectrum.

This ties in to what I call the FOOL theor, meaning Fear of Others’ Liberty. Chances are, few people want to cede their own decision-making to a third party. But many of us think that others’ decisions are bad for them or for society as a whole, and we want a third party to make those decisions instead.

Incidentally, I have started reading Otteson’s book.

My Review of Peter Wallison’s Forthcoming Book

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is here.

Wallison’s thesis is that policymakers in Washington underestimated the significance of the surge in nontraditional mortgages. What is perhaps even more deplorable is the way that these mortgages continue to be downplayed in the mainstream narratives of the crisis and in the policy responses that followed.

Meanwhile, CNN Money reports on programs that offer 3 percent down payments.

The new loans will only be doled out to those who buy private mortgage insurance, have a credit score of at least 620 and offer complete documentation of their income, assets and job status. And, to further mitigate risk, the agencies will require borrowers to receive home ownership counseling.

Once again, the government is pushing home borrowership, setting households up to fail and making the housing market more speculative. Of course, when the stuff hits the fan, the government officials involved will blame lenders, not themselves.

Government’s Cost of Capital

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Deborah Lucas writes,

Collectively, government investment and insurance operations dwarf those of the largest commercial banks. The size and scope of activities have grown over the last several decades to include the explicit and implicit guarantees of too-big-to-fail private and international financial institutions and non-financial firms, direct and guaranteed loans, and more traditional insurance and guarantee programmes such as for bank deposits.

She adds,

a universal mistake is that governments take their cost of capital to be their borrowing rate, irrespective of the risk of the investment under consideration.

Pointer from Mark Thoma.

Ever since the Basel Capital accords were adopted, the government in effect dictated that private bank loans must carry a risk premium over government bonds. Along with that, you have the mistake that Lucas identifies, which is the government evaluating its own loan guarantees and investment projects at a risk premium of zero.

Here is where this leads: if a private firm has to earn 8 percent interest to undertake a risky construction project, but the government can borrow at 2 percent to undertake that same project, then if that project is undertaken at all, it will be undertaken by the government rather than by the private sector. Thus, the system is rigged to put government in charge of where investment takes place.

We end up with something close to the worst of all worlds. Owners and managers of nominally private financial institutions earn outstanding returns. But we have capital allocation that closely approximates what would result from a socialist system.

Macro Theory and Macro Practice

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John Cochrane writes,

Perhaps academic research ran off the rails for 40 years producing nothing of value. Social sciences can do that. Perhaps our policy makers are stuck with simple stories they learned as undergraduates; and, as has happened countless times before, new ideas will percolate up when the generation trained in the 1980s makes their way to [the] top of policy circles.

I was with him up to the semicolon. But Fischer and his students made it to the top of policy circles some time ago. My sense is that their policy decisions are not driven by the models that they taught graduate students. They are going on the basis of intuition, and the intuition is in turn shaped more by the undergraduate IS/LM story than by anything else.

My own view is that the tools that they are playing with have very little impact on financial markets or the economy. Meanwhile, the bank regulations, both formal rules and informal slaps on the wrist, play a huge rule in directing bank capital toward government bonds and away from commercial loans. And that capital allocation has real consequences.

The European Debt Crisis–Not Quite Over

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Theodore Pelagidis writes,

The latest polls put Syriza ahead by 5-7 points, as angry voters from across the political spectrum get behind the party. It’s not surprising. This “supermarket” party promises almost everything to anyone, masking its policies with romantic pledges to stop humanitarian crises, to make the black market and bureaucracy disappear, to increase the minimum wage and minimum pension by around 40 percent (despite the fact that the social security system is in bad shape) and, last but not least, to negotiate a huge amount of debt forgiveness, mainly by having–sorry, ordering—the European Central Bank to buy most of it.

Have a nice day.

What I’m Reading

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Vintage Bill James.

Given an option to do so, all men prefer to reject information. We start out in life bombarded by a confusing, unfathomable deluge of signals, and we continue until our deaths to huddle under that deluge, never learning to make sense of more than a tiny fraction of it. We get in an elevator and we punch a button and the elevator starts making a noise, and we have no idea in the world of why it makes that noise or how it lifts us up into the air, and so we learn in time to pay no attention to it.

As we prefer to reject any information that complicates our understanding of the world, we especially prefer to reject information about things that happen outside of our own view. If you simply decide that [data that you lack the energy to process] are meaningless, then you don’t have to worry about trying to figure out what they mean. The world is that much simpler.

Bill James is, of course, a famous baseball quant. He was not really the first–I would give that honor to Earnshaw Cook. But James was a dogged empiricist, always questioning and refining his own methods. Instead of manipulating data to support his opinion, he manipulated data in order to arrive at reliable answers. In that respect, I think he sets a great example for economists, which too few emulate.

But the reason I am reading vintage James is because the man could write. There are now many baseball quants, and some of them may have even more baseball-statistics knowledge than James, but they are not worth reading for pleasure.

The quoted passage is from the Bill James Baseball Abstract for 1985.

Attitudes Toward Risk and Growth

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Michael Hanlon writes,

Could it be that the missing part of the jigsaw is our attitude towards risk? Nothing ventured, nothing gained, as the saying goes. Many of the achievements of the Golden Quarter just wouldn’t be attempted now. The assault on smallpox, spearheaded by a worldwide vaccination campaign, probably killed several thousand people, though it saved tens of millions more. In the 1960s, new medicines were rushed to market. Not all of them worked and a few (thalidomide) had disastrous consequences. But the overall result was a medical boom that brought huge benefits to millions. Today, this is impossible.

Pointer from Tyler Cowen.

I think that the problem goes beyond rational risk aversion. One of the findings in behavioral economics is that people exhibit loss aversion. That is, they will avoid rational risks because they regret losses much more than they enjoy gains. It seems probably to me that government agencies exhibit at least as much loss aversion as do individuals.