Interest Rates and Debt Ratios

Paul Krugman links us to a fascinating new report by the BOE (.pdf) which also presents some really really long time-series data on a hotly discussed issue over the past years, but also very much relevant for some of the discussions we’re having on this forum: the ability of governments to borrow and the limits to this borrowing. Below the relationship between long-term bond yields and debt-to-GDP ratios of the UK ranging all the way back to the 1700s.

The whole issue is of course strongly related to e.g. the 90% threshold level of debt-to-GDP ratio found (or not) after which economies abruptly start dying (again, or not) in the now infamous Reinhart-Rogoff paper (.pdf). Christoph, in his last guest post, also writes that “Empirical articles show that the higher the deficits and debts are, the higher is the probability of a country to experience a “sudden stop” of capital inflows”. As he points out in the comments, causality and correlation are indeed tricky to disentangle, yet the point seems to stand that a high debt-to-gdp ratio makes a country inherently a more risky investment. I, for one, am not sure why this should be the case. There are many things that might make a country a risky investment, and also many reasons that might lead to “sudden stops” in the willingness of investors to finance a country’s deficit. But, and as counter-intuitive as this might sound, the level of debt-to-GDP simply does not seem to be one of them, as the graph above but also the eperience of e.g. Spain in the current crisis and Japan over the past couple of decades, to name just three of the most obvious examples, show. This supposedly existent causal relationship – or indeed any meaningful relation at all – between debt levels and the ability of a country to finance itself seems not only wrong but utterly destructive. Spain (and Europe in general) has many huge problems it needs to tackle, but its debt level is not one of them (Greece, of course, is a different story).

As a final note, the authors in the paper note that “Increases in the public debt ratio resulting from military spending were often associated with increased government bond yields”. The most obvious exception to that is the second world war. The authors hint that the rise of interest rates in many past episodes of war “mainly reflected fluctuations in the fortunes of war”, but could this also be interpreted as representing the difference of fiscal spending that crowds out and that which crowds in? I don’t really know much about the other historical episodes but the spending undertaken that got us out of the Great Depression clearly would be a case of the latter, explaining why interest rates fell.

Current Account Rebalancing in the Euro-Zone: Challenges Ahead?!

A very interesting guest post by Christoph Zwick following up on our discussion on Eurozone rebalancing.

Current account imbalances within the Euro-Zone are frequently regarded as one of the driving factors that contribute to the ongoing economic crisis in the periphery countries. There is, however, some often observed inaccuracy in the debate about the channel through which the imbalances affect economic growth and employment. I first want to give a more detailed view on how the mechanism works before outlining some challenges that current account rebalancing poses on the Euro-Zone.

From basic economic theory, current account imbalances reflect different saving patterns across countries. In an open economy framework, a country with ample savings can lend to foreigners in the present and increase its future spending while a country with tight savings can borrow from abroad to finance higher current consumption or investment. This “intertemporal trade” is commonly regarded as welfare enhancing. Take for example Norway in the 1970s. The country borrowed extensively from abroad to develop its North Sea oil resources after world oil prices shot up. The result was a large current account deficit for four consecutive years that peaked at close to -14% of GDP in 1978, a value which even exceeds the deficits of the Euro-Zone-periphery before 2008. Soon after, the Norwegian current account returned to positive values, all debts were repaid and the development of the North Sea oil resources is still regarded as a success story.

In contrast to these considerations, current account imbalances are thought to have substantially contributed, if not triggered, the crisis in Latin America in the 1980s, the Asian crisis in the late 1990s and nowadays the crisis in the Euro-Zone periphery countries. So what is wrong with imbalances? The answer is that we should not care about the imbalances itself, but about the contraction of current account deficits. More on that below the fold.

The Shortcomings of the Friedman Rule

My recent background reading on all things monetary economics has often led me to stumble on what is generally dubbed the Friedman rule for optimal monetary policy. As the name already implies, it is the result at which Friedman arrived when trying to derive how a central bank should set its nominal interest rate in order to achieve the best, most socially desirable outcome. The logic behind it is simple. Interestingly enough, even Friedman assumed that money was indeed not neutral, essentially for reasons similar to the mundell-Tobin effect: money always pays 0% nominal interest rates. Yet, people still both want and need to hold money, so the optimal policy in this world is one were the opportunity costs of holding cash is minimized, which means setting the nominal interest rate in the economy also to zero. This implies that the optimal inflation rate is should be negative – negative the real interest rate, to be precise. This finding seems odd, and is obviously very different from what central banks do in practice.

First of all, holding cash does indeed bring higher opportunity costs if the nominal interest rate set by the central bank is positive. Yet, of course, holding money also has benefits, the most important of which is liquidity. As such, it would seem that these benefits, that no other financial asset offers in the same degree, should seem to alter the optimality rule. Setting nominal interest rates to zero in this setting would seem to “unfairly” make money more attractive than comparable assets, and present a distortion in and of itself. The only way to argue that these benefits should not be taken into consideration would be if these private benefits were of the same magnitude as the social benefits they bring, which might but also might not be the case. Also, some have argued that inflation should be positive since it can be the only way to tax things that we would want to tax but often find hard to do (like tax evasion, for instance), but also for a whole slew of other reasons.

But, and more importantly, this “friction” from the demand of fiat money is the only friction entailed in the model. Yet probably one of the most vital things that Keynesianism taught us is that prices are sticky, particularly when it comes to the downside. This assymetry also means that the optimal inflation rate is not zero, but positive to take into consideration the natural “variance” of inflation. There is, of course, no way that a policy that calls for considerable negative inflation rates can be optimal in the real world, and even though the inflationary 70s did represent a major defeat of the type of Keynesianism found both in practice and in theory at the time, throwing all of it overboard, as evidently done by Friedman and others in coming up with this not-so-optimal monetary policy rule was a horrible idea that thankfully was never implemented. To be fair, even new Keynesian models find that the optimal inflation rate is considerably lower than the one used in practice, which is puzzling, but at least they include many of the real world issues we face to come to the conclusion.

Can Redistribution Get Us Out of The Recession?

Another Guest Post by Max Gödl, enjoy!

One argument I frequently hear in discussions on macro policy is that income inequality is a big drag on our economy right now. The reason is that rich folks save a larger fraction of their income than poor folks. Hence redistributing income from the top to the bottom increases aggregate spending which “grows the economy”. Let’s do it!

My response to that is: woah, woah, woah!

First of all, when presented in this way the argument is a non sequitur. It’s pretty clear that the rich have a higher average propensity to save than the poor. But that does not imply that their marginal propensity to save is higher, too. And it’s the latter that counts: Redistribution from rich to poor increases aggregate consumption only if the poor spend a larger fraction out of additional income than the rich. (Nerds, think Keynesian consumption function: C = a + bY. C/Y decreases with income, but dC/dY doesn’t!)

Now it turns out that the evidence on the marginal propensities to save of different income groups is surprisingly inconclusive. It has been known for ages that the positive correlation between current income and saving rates typically found in cross-sectional data doesn’t tell us anything about the relationship between saving rates and permanent income. There is a pretty large (but pretty old) literature, beginning with Milton Friedman’s classic 1957 work, showing that the MPS does not vary systematically with permanent income. So if income is measured over longer periods, the rich seem to save the same fraction out of additional income as the poor.

A more recent study by Dynan, Skinner and Zeldes (pdf) produces evidence that the rich actually do have a somewhat higher MPS than the poor. According to one of their estimates, the MPS of the bottom quintile of the income distribution is 16 percentage points lower than the MPS of the top quintile. And that’s their most generous estimate! Dynan et al. use U.S. data and I couldn’t find a similar study for Europe. Nevertheless, let’s take this number and think this through. The share of the top quintile in aggregate income is roughly 40 percent in the European Union, while the share of the bottom quintile is below 10 percent. If we would take 10 percentage points away from the top and give it to the bottom, aggregate consumption would increase by only 1.6 percent of aggregate income. So even a massive redistribution would only have a modest expansionary effect.

Finally, the expansionary redistribution hypothesis has an awkward implication. If shifting income from top to bottom increases aggregate spending, doing the opposite must decrease it. Do those who want to tax the rich and feed the poor to stimulate the economy in recessions also want to tax the poor and feed the rich during the boom years when the economy is overheating? I very much doubt it. But it would seem to be the logical implication of their theory.

There may be a good case for higher taxes on the rich and higher transfers to the poor. But we shouldn’t expect redistribution to get out of the recession.

Alan Greenspan on The Daily Show

First of all, Jon Stewart is awesome. I have no idea how I could have gone so long without ever stating this here. If you are even remotely interested in American politics and enjoy good comedy, The Daily Show is as good as it gets.

If you’re here just for the economics, you can always just skip the first part and scroll right to the interview, which starts at around 14:00. Clearly, The Daily Show is not the platform for overly wonkish, in-depth policy discussion, but still very worthwhile. From what I’ve read on his new book, the degree to which Greenspan has changed his views since the financial crisis seems to be fairly limited, but no real comment on that for now.

PS: It seems I cannot embed the second part of the interview. Here’s the link to the Daily Show directly.

Some More on Targets and Inequality

Caution: wandering mind and thoughts in process of clarification.

After reading through Max’s useful feedback in the comment section to my post on the possible effects on inequality of raising the inflation target I was forced to rethink the whole issue somewhat. First of all let me start by saying that, in the bigger scheme of things, the effects of raising the target inflation rate by 2% on inequality are indeed likely to be small, so how much this even matters is a question of debate in and of itself, but I hate to leave loose ends untied. To recap a bit, clearly there is a big difference between expected inflation and unexpected inflation. A central bank increasing its target inflation rate would have the effect of moving the value at which inflation expectations are anchored.

Yet even if fully expected this would have real effects due to what is generally known as the Mundell-Tobin effect – essentially the fact that, due to cash always paying 0% nominal interests, portfolio choices would change. More precisely, people would want to move away from cash and into bonds (or whatever you want to call the financial product used in your model). This move into bonds would raise the prices of bonds while lowering their yields, and it is this switch in portfolio compositions that would also cause the real interest rate in the economy to fall compared to where it was before. It would also change the distribution of income and wealth through various channels. As an example, it might be possible that there are constant entry costs when it comes to entering the bond market. Clearly this would mean that poorer households would be less able to protect themselves from the higher inflation rate as participating in the bond market would involve decreasing average costs, thus increasing inequality. At the same time the literature on the topic generally assumes that poorer households are net-debtors in the economy, and lower real interest rates would mean lower real interest payments, reducing inequality. In short, it seems to be anyone’s guess which effects dominate. Inflation is also generally referred to as a regressive tax on cash holdings, which would again drive up inequality somewhat.

But enough of that: to the main point of the post: from a perspective regarding the most direct effects on inequality, is a higher inflation target or a higher NGDP target preferable? Clearly my first post implied that I consider the answer to be the latter. I am not so sure anymore. As Max correctly pointed out, the change in inflation rate (a one-off effect) affects inequality, but within the moderate levels of inflation we’re talking about, there seems to be no reason to assume that inequality would be meaningfully affected beyond this initial movement. The big difference now between a higher inflation target and an NGDP growth or growing level target would be the degree to which inflation changes over time. Ideally, in the first case it would not change at all, while in the second case inflation would fluctuate as RGDP fluctuates.

Essentially it would seem RGDP, for different reasons including exogenous shocks, would fluctuate under both targets. The main advantage of an NDGP target would be to reduce this fluctuations since, much like the Taylor rule, it includes both output and inflation, while a strict inflation target (like the one of the ECB) does not. Clearly, however, the variance of inflation would, if the central bank does its job, be bigger under an NGDP target. That’s pretty much the feature of it. But, and in line with the thoughts outlined above, this would also mean that constant (essentially central bank-induced changes) in the inflation rate would, even if fully expected, also lead to constant (therefore also essentially central bank-induced) changes in real interest rates. Again, of course this is part of the idea – if RGDP falls, inflation would rise to meet the NGDP target, and real interest rates would fall (not only all other things equal but despite all other things adjusting), which would boost the economy causing RGDP to rise again – the whole point of the exercise.

Now, the general assumption is that variance in RGDP is bad for welfare – we would much rather have a constant real growth rate of, say, 2% per year than growth that is all over the place yet, over a certain period of time, averages 2% as well. Yet what does variance in RGDP do to inequality? I honestly would not know. In general, people with lower qualifications (i.e. on the lower end of the income spectrum) would get fired first in a downturn, but then again they also get hired first in an upturn. Is this process symmetric? That would seem to depend on the costs of hiring and firing people. If they are similar, the process would probably be symmetric, and the impact on inequality unimportant on average. But it would not seem farfetched to argue that, due to e.g. transaction costs and other market imperfections, variance in Inflation hurts the poor more than the rich. Again, if the technology for “inflation protection” (i.e. switching from cash to bonds) has decreasing average costs, as is likely, every switch would be more costly for poorer households than for richer ones. In short, the costs of protecting against inflation, which arise particularly when inflation changes, seem to be higher the poorer you are. So on these isolated grounds, a higher inflation target may be more desirable from a strict inequality standpoint.

Again, probably fairly trivial and not even I’m sure this really matters, but just sayin’.

On Growth Rates and Growing Levels

Monetary economics, as any other academic field, requires basic agreement on a limited but vital set of definitions in order to be able to debate in a meaningful way. For central banks, two important terms are the distinction between monetary policy targets and monetary policy instruments. At the risk of stating the obvious, the targets of a central bank is generally a fairly easily verifiable variable that is supposed to be influenced by the central bank in the hope of achieving good economic outcomes. In most cases this target currently is the inflation rate, but other might also be nominal GDP, a monetary aggregate or even an exchange rate. The influencing of this target involves adjustments to the instruments of monetary policy, which include things like open market operations, the discount rate and reserve requirements.

In the choice of the target it is also of vital importance to specify whether we are talking about a growth rate target or a (growing) level target. Our current system works using growth rates: no matter what happened in the past, the central bank tries to get inflation rate back to its target of generally 2%. This is a sort of let-bygones-be-bygones policy. A growing level target, such as the one championed by Scott Sumners with NGDP level targeting, on the other hand, tries to get the target variable back on track to reach its pre-crisis trend level, meaning in the case of a depression would require considerably stronger monetary easing than a mere growth rate target. A mix of sloppyness and lack of clarity on my side has sometimes led me to muddle the two together in the past. “Basically, it is a central bank’s role to stabilize NGDP growth, and it should do whatever it takes to do so” is clearly a bit ambiguous, so let me try and set some of that straight by shortly going into why this difference is important

McCallum (.pdf) for one, in a survey of the literature on the topic, seems to favor a growth rate target. He stresses that, again by essentially ignoring the past, such a target essentially introduces a kind of random walk into the time series, and theoretically allows for the target variable to wander arbitrarily far away from any predetermined path. But then again, it wasn’t the point to begin with to follow any predetermined path. A growing levels target, on the other hand, by often requiring a more activist monetary policy in response to shocks, would tend to increase cyclical swings in demand, potentially increasing the variability (note: not the variance! I am not quite sure how accurate the term “variability” is, but I’m sticking to McCallum’s definition here) of variables such as real GDP in the process. In his words, “variability in output or other real aggregative variables is probably more costly in terms of human welfare than is an equal amount of variability in the price level about a constant or slowly-growing path”. Also, if what the economy just experienced turned out to be a permanent shock, stubbornly clinging to a predetermined growing level path would clearly be counterproductive.

The argument concerning the permanence of shocks is well-taken and important. As he notes, “although it is not entirely clear that fully permanent shocks are predominant, most time-series analysis seems to suggest the effects of shocks are typically quite long lasting – indeed, are virtually indistinguishable from permanent”. As far as I can tell this depends not so much on the nature of the shocks analyzed but rather on the policy response to that shock. If a central bank has a growth rate target, and thus does not try to force the economy back to its pre-crisis growth path, the obvious result would be to make a shock permanent even if it actually was not. How permanent a shock is would therefore seem to depend in practice, more often than not, on the adequacy of policy response to that shock rather than on the shock itself. Also, just because an economy experienced a “permanent” shock in one area doesn’t mean that with adequate policy another area of the economy can take up the slack. The bursting of a housing bubble might well be a permanent shock to the housing market, yet there is no reason it has to be a permanent shock to the economy as a whole.

And what the variability argument is concerned, I would also not agree that a lower but more stable level of economic activity, as we are currently experiencing, would be more preferable to a few years of increased variability after which we can then return to operating at full capacity. Sure, variability is a issue, but so is demand shortfall. When increased variability comes from an upswing it would seem like the lesser of the two evils. Further, the mere announcement that the level and not just the growth rate would be targeted implicitly states, as already mentioned, that a central bank is aiming to be more activist, which in an of itself might reduce the magnitude of downswings and thus variability through its effect on expectations. In any case it would seem sensible to, as generally with monetary policy, err on the side of doing too much rather than doing too little, and as such a growing levels target seems to be the superior choice.

Eurozone Inflation Arithmetic

It would seem that my initial post on raising the inflation target has sparked a pretty fruitful debate. Here’s a quick follow-up by Max on the topic.

I think the case for raising the inflation target is very strong. But it’s especially strong in the context of the European Monetary Union.

You see, the key problem in the Eurozone crisis is “rebalancing”: The periphery countries (the GIIPS) need to reverse their current accounts. And that requires a real devaluation of the periphery vis-à-vis the core (Germany, mainly). My colleague Christoph Zwick reckons in his new working paper that the periphery-core real exchange rate needs to fall by at least 13-17 percent over the next three years. There is, of course, a lot of uncertainty about this estimate. Nevertheless let’s assume a value of 15 percent, which sounds reasonable. This implies an annual real devaluation of (approximately) 5 percent for the next three years. Within the Eurozone, real devaluation can only come through an inflation differential: inflation in the periphery (p) needs to be 5 percentage points below the inflation rate in the core (p*).

Now the ECB targets the Eurozone inflation rate, i.e. the weighted average of core and periphery inflation rates. The share of the core in total Eurozone GDP is about 2/3. Let the ECB’s inflation target be t. So we have t = (1/3)p + (2/3)p*. If you combine this with the requires inflation differential, p* – p = 5, we get p =  t – (10/3) and p* = t + (5/3). Hence the periphery inflation rate has to be 3.3 percentage points below the Eurozone target and the core inflation rate has to be 1.7 percentage points above.

An inflation target of 2 percent implies 1.3 percent deflation in the Eurozone’s periphery each year for the next three years. This would be incredibly painful. If the ECB would target 4 percent average inflation, it would allow 0.7 percent inflation in the GIIPS. That also hurts, but probably much less than hardcore deflation. Meanwhile, the new target would imply 5.7 percent inflation in the core countries, which is higher than what we had during the last decade but not at all high by historical standards.

Obviously the concrete numbers are debatable, but the general result is not: Under the ECB’s current inflation target, the necessary current account adjustment in the Eurozone seems pretty impossible. Raising that target would make it a whole lot easier.

Senior Stupidity or Bad Punditry?

It would seem the US budget/debt ceiling crisis is on its way to getting resolved, yet an article on it that I read last week did strike me as weird.

A major puzzle for me has always been how irrational, incompetent and often plain and simply stupid many economic commentators make out large swaths of the population to be. As a self-declared liberal I find this strange at best and deeply troubling at worst. Obviously, the whole concept of fully rational economic actors is bogus, but to start from the premise that most of the population of a country is simply yet obviously dumb brings up huge problems when you believe that, in most cases and on average, individuals know fairly well what is in their interest and what is not and are therefore generally in a fairly good position to act accordingly. There are plenty of market failures, but for the most part they involve skewed incentives, not sheer stupidity. This latest episode involves a note to clients written by Greg Valiere, a researcher at the Potomac Research Group, in which he apparently states that:

“[I]t’s just a matter of time before President Obama throws a game-changer — warning senior citizens that their Social Security checks won’t be mailed because of John Boehner.”

That sentence makes no sense at all unless you assume most senior American citizens have absolutely no clue whatsoever why and from whom they get money each month. Does it really take the president to tell seniors that them receiving social security checks (as federal a program as they get) depends on the federal government actually being able to pay for stuff? Markets don’t seem all too worried about the debt ceiling either – are they also just stupid (and by that I mean far beyond the obvious failings of the strict forms of the EMH)? Or is this guy simply getting paid by quantity rather than by quality of memos he puts out?

Does your mother pay for my studies?

For something completely different, here’s a guest post by Maximilian Gödl from the Economics Department at the University of Graz. Really looking forward to more.

Does your mother pay for my studies?

Of course she does. And she would have to pay one way or the other.

“Your mother pays for my studies” was the campaign slogan of the JuLis (never mind) in this year’s student council elections in Austria. It was meant to make Austrian students aware of a simple truth – namely that university education actually costs money which comes mainly from taxes on the working population, i.e. your mother. In a country like Austria, where the government is widely known to create resources from thin air, stating simple thruths can be a sacrilege.

What the JuLis don’t seem to understand, however, is this: Since the income of the currently young is generally too small to cover the costs of their education, they have to get the money from the currently middle-aged one way or the other. The only difference between the existing tax-based system and the alternative tuition-fee system favored by the JuLis lies in the way the money is channeled from your mother to me.

The tax-based system now in place in Austria relies on a government-enforced “generational contract” whereby generation 1 is taxed to pay for the education of generation 2, who in turn will be taxed to pay for the education of generation 3, and so on. Under the alternative system practiced in most English-speaking countries, education is mostly paid for by student loans. Where do the funds for these loans come from? Well, they come from the savings of the middle-aged. So under that system, generation 1 saves to pay for the education of education of generation 2, who will save to pay for the education of generation 3, and so forth.*

In short, the distinctive feature of the tax-financed education system is not that your mother pays, but how your mother pays.

So whether you are in favor for that system or not depends on whether you think that the government does a better job at channeling funds between generations than the market. Given the current predicament of our tax-financed pension system, we should be generally skeptical about generational contracts. The problem with such contracts is that they tend to be exploited by one side at the expense of the other, depending on whoever has the upper hand in the democratic process. On the other hand, my trust in the capital market to allocate funds efficiently is also not limitless, to say the least. Above all, one has to make sure that students from poor households can get loans to pay for tuition fees. You could do that through subsidies, for instance. One should also be concerned that the student loan market doesn’t become too volatile. So these markets have to be pretty heavily regulated.

In my opinion universities should be free to charge tuition fees, mainly because that it’s the only way they can really be independent from political influence. That doesn’t mean that you have to rely entirely on capital markets for financing education. You could give students a tax-financed voucher, for instance. Or you can have the government lend directly to students. (That’s what they do in Australia, sort of.)

But no matter which system is used, it remains true that your mother pays for my studies.

*) Note for nerds: There is a purely theoretical argument in favor of a tax-financed education system from “overlapping generation” models. It is well known that in those models the steady-state real interest rate does not coincide with the socially optimal rate which implies a sub-optimal allocation of resources among generations. A tax-and-transfer system could achieve the optimum at least in principle. I am currently working on such a model.