The FOMC and its Target

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Van R. Hoisington and Lacy H. Hunt write,

The Federal Open Market Committee (FOMC) has continuously been overly optimistic regarding its expectations for economic growth in the United States since the last recession ended in 2009. If their annual forecasts had been realized over the past four years, then at the end of 2013 the U.S. economy should have been approximately $1 trillion, or 6%, larger.

They go on to say that the Fed has over-estimated the “wealth effect” by which higher asset prices lead to more consumption.

If the wealth effect was as powerful as the FOMC believes, consumer spending should have turned in a stellar performance last year. In 2013 equities and housing posted strong gains. On a yearly average basis, the real S&P 500 stock market index increase was 17.7%, and the real Case Shiller Home Price Index increase was 9.1%. The combined gain of these wealth proxies was 26.8%, the eighth largest in the 84 years of data. The real per capital PCE gain of just 1.2% ranked 58th of 84. The difference between the two was the fifth largest in the 84 cases. Such a huge discrepancy in relative performance in 2013, occurring as it did in the fourth year of an economic expansion, raises serious doubts about the efficacy of the wealth effect

Let me try to put on a Scott Sumner hat and speak for him. If he reads this, he can correct me.

1. If the Fed under-forecasts nominal GDP (NGDP) in one quarter, than it ought to try raise its target for NGDP in subsequent quarters. That is, it should engage in level targeting, not simply stick to a growth-rate target after a forecast miss.

2. The Fed should use market forecasts rather than rely on a model to forecast. Ideally, we would have NGDP futures contracts. But in their absence, other nominal market variables, such as the spread between non-indexed and indexed bonds, can be helpful.

3. Wealth effect, shmealth effect. Who cares what particular component of the Fed model caused it to underpredict NGDP? Given (1) and (2), there is no good excuse for the Fed missing its targets by such a large cumulative amount.

4. The period 2008-2014 is the mirror image of 1969-1979. In the 1970s’, the Fed consistently under-predicted NGDP, with the result that monetary policy was too loose. In the recent episode, the Fed consistently over-predicted NGDP, with the result that monetary policy was too tight.

Remember that when I take off my Scott Sumner hat, I reject macroeconomics altogether in favor of PSST.

Brad DeLong is Uncharitable to Piketty’s Critics

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This is an example of the sort of writing that I think serves only to isolate the left-wing blogosphere. Brad starts out innocently enough:

Piketty’s argument is detailed and complicated. But five points seem particularly salient:

1. A society’s wealth relative to its annual income will grow (or shrink) to a level equal to its net savings rate divided by its growth rate.

2. Time and chance inevitably lead to the concentration of wealth in the hands of a relatively small group: call them “the rich.”

…

Pointer from Mark Thoma. Read the whole thing. He then proceeds to heap scorn on Piketty’s critics. He does not cite any criticism of the second point, which is really the heart of the criticism that I have made. I think that many others have criticized point (2), also, but let me just speak for myself.

To reiterate my criticisms:

1. The distinction between capital income and labor income that underlies the forecast for wealth concentration is unrealistic. Most of “labor” income is a return to capital: human capital, social capital, institutional capital, and so on. Much of “capital” income is a return to risk. Brad himself has pointed out that the rate of return on private capital includes a huge risk premium.

2. Several critics (although I believe I was the first) have pointed out that if you believe r is greater than g, then social security is a giant rip-off and should be privatized immediately. Instead, in one of the most disingenuous arguments in the book, Piketty dismisses privatizing social security because of the high risk embedded in capital income. What is disingenuous is that this risk in private investment undermines Piketty’s main thesis.

3. I think it is pretty difficult to reconcile the risk component of investment with a model in which inherited wealth comes to dominate. Instead, given the relatively low rate of return on risk-free assets, my line is that the inheritors shall be meek.

The Capital Asset Pricing Model notwithstanding, it is idiosyncratic risk that makes you rich. People like Bill Gates and Mark Zuckerberg take large idiosyncratic risks that pay off. For wealth to become concentrated into an oligarchy, their heirs will have to invest in ways that outperform future idiosyncratic risk-takers. That strikes me as implausible.

Finally, I have to quote this from DeLong:

To be sure, everyone disagrees with 10-20% of Piketty’s argument, and everyone is unsure about perhaps another 10-20%. But, in both cases, everyone has a different 10-20%. In other words, there is majority agreement that each piece of the book is roughly correct, which means that there is near-consensus that the overall argument of the book is, broadly, right.

If I understand this paragraph, what Brad is saying is that unless a majority of Piketty’s reviewers harp on a particular fault, then there are no faults in the book. That is certainly a charitable approach to assessing someone’s work.

I think that taking the most charitable approach to people with whom you agree and taking the least charitable approach to those with whom you disagree is a path that leads to intellectual isolation.

Rothbard and Krugman

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Jason Brennan trolls,

Yes, libertarians, Paul Krugman is a better economist than Murray Rothbard.

My comments.

1. I agree with Brennan that Krugman’s scholarly work is more important than Rothbard’s.

2. On matters of economic analysis, I have serious disagreements with both. Krugman on the liquidity trap. Rothbard on banking.

3. I think that a point of similarity is that both Rothbard and Krugman attract devoted fanatical followers who are unable to appraise their hero objectively and instead are sentimentally loyal. I am not sure, but I think that may be what Tyler Cowen means when he uses the phrase “mood affiliation.”

4. I think that at his worst (and he is often at his worst), Krugman reaches intellectual lows in terms of straw-man arguments and asymmetric insight (the claim that you understand your adversary’s motives better than the adversary understands himself) that I suspect are lower than Rothbard’s intellectual lows. Perhaps I am being charitable to Rothbard, because I have almost no first-hand acquaintance with his work.

Krugman explains his approach here.

Politics and policy are overwhelmingly dominated by what I call the Very Serious People — people who insist that deficits are our most pressing problem, that high unemployment must be a matter of inadequate skills, that low marginal tax rates on the rich are essential for growth. Behind the conventional wisdom of the VSPs lies a vast mass of power and prejudice.

Pointer from Tyler Cowen. Read the whole thing. I see this as pretty much standard Krugman. He takes the least charitable view of those who disagree with him, and he makes that the core of his argument. I think that this approach mostly inflicts damage, not so much on his enemies as on his friends. I think it brings down both their cognitive ability and their emotional intelligence.

New EconTalk Feature

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I only recently noticed that an experimental Continuing Conversation feature on EconTalk. It is like a comments section, but with the comments guided by questions from Amy Willis.

My reading of the first two continuing conversations is that they went well. When I started my economics blog, it was called Great Questions of Economics, and I ended every post with a discussion question. I stopped doing that, more out of laziness than anything else.

It would be amusing/humbling to have Willis-style questions after I wrote a blog post. “What was Kling saying when he wrote ____?” It would be even more amusing/humbling to read the answers.

Which Errors Would You Prefer?

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Nick Timiraos reports,

some economists, together with policymakers at the White House and Federal Reserve, are warning that mortgage-lending standards have become too restrictive, years after carelessness by lenders inflating the housing bubble.

… the Urban Institute, a think tank in Washington, estimated that around 200,000 fewer mortgages were made in 2012 due to credit standards that were more stringent than they were before the housing bubble.

Don’t say that like it’s a bad thing!

In mortgage lending, a type I error is making a loan that defaults. A type II error is turning down a loan that would have been repaid. Some remarks.

1. When home prices rise, it very hard to make a type I error and very easy to make a type II error. If the house price has gone up, the borrower’s equity is presumably positive, and borrowers who get in trouble will sell their homes and pay off their loans.

2. During the bubble, Congress and HUD officials were convinced that lenders were making type II errors due to racial bias and anachronistic conservative lending standards.

3. After the crash, Congress and government officials were convinced that lenders had been making type I errors due to greed, predatory lending, and lack of regulatory oversight.

My own view is that lenders make type I errors and type II errors all the time. Still, I would rather have errors made by people for whom credit risk assessment is a profession, without the amateur meddling that comes from the political sector.

SNEP: A Spectrum Solution

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In Setting National Economic Priorities, the three problem areas are

1. Impediments to labor supply and demand
2. Anachronistic regulatory environment relative to technological change
3. Unsustainable fiscal path

Under (2), there is the problem of the FCC and spectrum. Many years ago, Coase argued that spectrum could be allocated using property rights, rather than command and control. The path of technology since then has made his ideas both more feasible and increasingly desirable.

I view the FCC as both structurally and culturally unable to move decisively away from command and control. Accordingly, my proposal would be to take spectrum regulation out of the hands of the FCC. Instead, I would transfer responsibility to a new agency, which might be called the Spectrum Property Rights Resolution Authority. All spectrum licenses would immediately convert to property rights. The owners of a particular band in a particular location could determine its use. The Resolution Authority would define these property rights more precisely. It also would provide mechanisms for settling conflicts among spectrum rights owners and resolving disputes between spectrum rights owners and device manufacturers.

Another problem is that some spectrum bands are reserved for government agencies, which proceed to waste spectrum by holding onto more than they need or by using obsolete equipment. I would propose privatizing this spectrum, and then having the government lease back what it needs. A Government Spectrum Leasing Corporation should be chartered for that purpose. This is similar to the Government Services Administration, which leases government buildings. The spectrum leasing corporation would be encouraged to upgrade the equipment used by government agencies, in order to economize on spectrum leasing.

Neither of these proposals is particularly original, by the way.

Spending Our Accumulated Wealth: Who Decides?

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Reihan Salam writes,

in trying to avoid a doom loop of oligarchy we instead wind up with a doom loop of technocracy, in which elite research universities grow ever larger and more powerful and non-profit organizations press for the expansion of a government that operates largely through private administrative proxies. This doom loop might move at an even faster clip than the doom loop of oligarchy, as non-profit organizations are tax-exempt, a fact that has had significant consequences for jurisdictions like New York city, where non-profit medical providers have been growing robustly. Imagine “profitable non-profits” that offer their employees lavish salaries, thus drawing talented workers away from firms engaging in productivity-enhancing business-model innovation, and devoting just as much of their effort to preserving and extending their privileges as they do to their ostensible social missions.

Consider three groups that might decide how to allocate large concentrations of wealth:

1. Private individuals and money managers, seeking the highest return.

2. Government officials.

3. Non-profits.

Progressives fear (1). Conservatives fear (2). Salam is saying that at some point we should start to worry about (3). He has a point.

Reihan Salam on Low-Wage Employers

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He writes,

McDonald’s and other low-wage employers…are taking on a task that many American families and schools are failing to perform. To put it bluntly, McDonald’s is a company that hires large numbers of people with limited skills, many of whom are teenagers and young adults, and it introduces them to the ways of the workplace.

…Perhaps the employers who makes a risky bet on a raw employee, and who take the time and effort to train her, should be entitled to a small portion of her lifetime earnings as she moves on to more lucrative employment. That would create a powerful incentive for employers to devote real resources to building the skills of their workers.

At this point, the working title for my economic priorities project is “Setting National Economic Priorities.” “Setting National Priorities” makes a grandiose idea seem even grandioser. “Setting economic priorities,” which is another alternative, might not refer to economic policy at all.

I am currently most comfortable with the following three priority areas:

1. Improving labor supply and demand incentives for low-wage workers. Improving labor supply means making sure that the structure of means-tested benefits does not create high implicit marginal tax rates for low-wage workers. Improving labor demand means lowering the cost to employers of hiring low-wage workers, particularly health insurance mandates and payroll taxes. I think it also means removing barriers to entry in the education and health care industries. I think it also means reducing the economic friction caused by occupational licensing.

2. Reconfiguring for the 21st century the regulatory missions and mechanisms for dealing with industries that have undergone significant technological change. This includes telecommunications, medicine, the electric grid, and eventually probably should include air traffic and motor vehicles (because of drones and self-driving cars).

3. Reducing the risk of a fiscal train wreck. I suspect that bringing this risk down to what I would consider a reasonable level requires taking steps on Social Security and Medicare that are more radical than what is politically feasible. I would aim for more modest goals, such as indexing the eligibility age for both programs to longevity (hardly a modest goal from a political standpoint!) and developing budget reporting mechanisms (accrual accounting? stress testing?) that provide important information not currently used in the budget process.

Anyway, Reihan’s column fits in with (1).

Ryan Decker on Piketty

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He concludes,

ultimately this is a chart book, with plenty of economic data but very little economics.

Pointer from Tyler Cowen. And lest you think that the quoted sentence is a compliment, earlier in the post Decker writes,

By referencing only charts (if even that) for many of his claims, he is feeding the sloppy and destructive “this one chart proves…!” fad that has spread in the blogosphere; a chart is never sufficient to make causal claims or demonstrate optimal policy. In this sense, Piketty does his readers a disservice. He should have asked them to think harder instead of just gazing at graphs.

Many economists, including Jamie Galbraith, Robert Solow, Brad DeLong, Matt Rognlie, and myself, automatically credit Piketty with having a neoclassical production function in the background, with some strong and and unconventional assumptions built in. Decker questions whether Piketty is using a model at all.

After reading Decker’s post, I searched Piketty’s book using Google booksearch for the phrase “production function.” It appears only 9 times, without much in the way of accompanying equations. So maybe Decker is right, although it is still possible that Piketty has some math in his back pocket that he can pull out for us.

I am a critic of the use of math in economics, and that includes a lot of macroeconomics as well as the production function. But at a deeper level, what I am against is making sweeping statements about phenomena that are too complex to be amenable to sweeping statements. Making sweeping statements that are backed up by mathematical equations is bad. Making sweeping statements that are not backed up by math is worse.

Repo and the Financial Crisis, a Follow-Up

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My former student writes,

I just read the post–thanks. But I now have more questions. Am I slow, or is the repo market really hard to understand?
When you talk about the original intent of repo, I have a few questions:

1) I understood from Metrick in class that the repo market functions as a type of banking system. Dealers take “deposits” and provide securities as collateral; these deposits are returned at some point with interest. Is that different than what you say the repo system used to be, or is that the same?

2) You say that Gorton/Metrick make no distinction with what the repo market used to do, and what it now does. That investment banks used to keep inventory and sell it, but now they have trading and investment portfolios. What does this mean with regard to the repo market? I.e. how does this change what’s happening?

3) Metrick did say that the securitization of real estate was what created new “safe” securities that people with assets they didn’t want to put at risk demanded. Is this the thing you find inherently dangerous? The idea of manufacturing new, relatively “safe”, liquid assets?

Sorry if these questions are stupid–or even embed inaccuracies/misunderstandings. I think I understand the type of transactions that takes place in the repo market, but I’m not at all sure who are the counterparties on opposite sides of the deal, why they want these deals in the first place for such brief periods, and why this market is as large as it is.

Here are my answers: Continue reading →