They Needed Someone to Blame. They Found the Fed.

Scott Sumner on the obtuse claim that the Fed's "inflationary" policy stance is responsible for the continued slump in income:

The WSJ Says the Lowest Inflation in 50 Years is Killing the Middle Class

Lets take a look: (I've included both the PCE and the CPI)

David Beckworth lends an assist, but about the claim that the Fed is responsible for low real interest rates. 

PSA: Brief but Substantial Inflation is Expected in a Recovery

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I've been thinking on the Kocherlakota turn-around and the recent hubbub over the increased TIPS spread, and I'd like to say a piece on inflation in recoveries.

My outlook on inflation in recoveries is informed mostly by John Maynard Keynes in his General Theory of Employment Interest and Money. In one of the final chapters Keynes lays out dynamics of the price level in a slump and in a recovery with regard to the price-output split. Basically, as aggregate demand increases, some of that demand manifests itself as more real output and some as inflation; the amount of each is determined by the slope of the short-run aggregate supply curve. If all workers and capital goods were perfectly fungible, no factors of production would be in a position to demand higher nominal compensation while some resources were still idle. So any increase in nominal demand would be met purely with an increase in real GDP while real GDP was below its potential. Once real GDP was at its potential, however, any increase in demand would merely add more inflation with no increase in output. No inflation while the economy is depressed, soley inflation once the economy is recovered.

In reality, however, workers and capital goods are far from perfectly fungible. This means that as aggregate demand increases, some factors of production find themselves fully employed before others and before real GDP is at its potential, so that they can demand higher rates of remuneration while the economy recovers but before it has fully. So in a normal recovery, we should expect to see a spurt of increased inflation as employment and prodction recovers, and for this inflation to tapper off once recovery has been achieved. There is no long-tradeoff between inflation and unemployment; but the two should reverse correlate during a healthy recovery.

Note how inflation rises and falls with the utilization rate of manufacturing capacity; the price level is determined by aggregate demand AND supply. 

Teams with Plans, not Men with Cred

As with any presidential election, the decision between President Obama and Mitt Romney ultimately comes down not to which man is more suited to the office but to what team they will bring in to conduct policy. And the spoils of the general election go to the candidate who convinces the American electorate that their team will deliver them the goods. Obama's message in 2008 that he would make Americans richer with infastructure spending, education support and more progressive taxation trumped John McCain's attempt to run on his military and service credentials. In 2000, Bush's calls to redistribute the budget surplus in the form of tax cuts overcame Gore's message of... okay, bad example.

Americans in 2012 must evaluate the different promises made by the Obama and Romney team, not just the personal gravitas or experience each man may or may not have. We have a rather clear idea of what Obama's plan will entail; thats the benefit of being the incumbant. We can expect continued investments in public infrastructure, an open but cautious stance toward international trade, and perhaps increased spending on scientific research and subsidies for new engery industries. If Obama moves on taxes at all, we can expect him to allow the Bush tax cuts to expire, which would boost top marginal rates slightly. As far as the Federal Reserve, Bernanke and Co. are likely to stay in place, and that crowd seems to be moving in the direction of NGDP targeting, or at least likely to remain sympathetic to accomodative monetary policy as labor and capital markets stay slack. 

We have to distill Team Romney's plan from what he has claimed on the campaign trail, the history of his running mate's plans, and the opinions of his closest economic advisors. From that, we can predict reduced spending on infrastructure, reduced spending on scientific research and alternative energy subsidies, and a combative stance on international trade. In tandem, Romney would slash taxes by reducing capital taxes and marginal tax rates across the spectrum. As far as monetary policy, its widley expected that Romney would replace Bernanke with advisor John Taylor at the first chance. This would mean a change in the stance of monetary policy away from NGDP targeting and expansion and toward a tightening intended to raise the Fed funds rate to the level determined by Taylor's own Taylor Rule. 

As a caveat applied to both teams, I highly doubt either approach will be successful in closing the long-term budget deficit. I say that because despite the posturing, neither side has given a comprehensive or coherent plan for dealing with the driver of those deficits, Medicare.

Has Obama Made Us Better Off?

Not according to Mitt Romney. But the facts claim other wise. Let's take a look at some charts of key indicators to distill the President's real economic record: In order of appearence, we have unemployment, real GDP, capacity utilization in manufacturing, and the S & P index.

So we have lower unemployment, more national income, less idle manufacturing capacity, and a substantially healither stock market. And that doesn't count as being better off? I suppose the facts really are stubborn things; but who needs the facts when you've already got the answers?

Kocherlakota may be a Dove, But he Needs to Read his Milton Friedman

So Narayana Kocherlakota, one of the perennial hawks on the FOMC, has revealed himself to be a dove. 

"The new “liftoff plan,” Kocherlakota said, was an alternative to the proposal from Charles Evans, president of the Chicago Fed Bank, in which the central bank would commit to keeping rates exceptionally low until unemployment falls below 7%, only stopping if inflation rises to 3%."

I would add one large adjustment. Basically, it comes down to a question of derivatives. Kocherlakota is advocating using the derivative of the price level as an indicator. He needs to monitor the second derivative of the price level. 

What this means is that instead of an increase in prices, the Fed should watch for an acceleration in prices. This harkens back to the original work on the Philips Curve by Milton Friedman in his 1967 speech to the AEA. Friedman dissproved that there is a long-run tradeoff between inflation and unemployment, despite the statistical appearance of a short-run trade-off.

His reasoning went as follows: as inflation rises, final product prices rise faster than nominal wages which take longer to adjust due to labor contracts. This rise in P relative to W (the nominal wage) leads to a lower real wage or (W/P). The structure of real wages is now lower than the equilbirum value that clears the labor market, creating an excess demand for labor. This leads to faster job growth as employers try to soak up "cheap" labor, and this creates the short-run Philips Curve illusion.

The buck does not stop there, however; workers find that their nominal wages do not command the purchasing power they did now that inflation has caused the price level to rise. So nominal wage contracts are renegotiated upward, so as to return real wages to their equilibrium value. 

Central banks, therefore, can only lower unemployment below the "full employment" level of unemployment if they continually increase the rate of money growth, not merely create a high rate of growth. Final product prices need to rise faster than workers can anticipate, so as to keep real wages below equilibrium and create the excess demand for labor. 

What this means for Kocherlakota is that a high rate of inflation, if it stabilizes, does not indicate that labor markets are in equilibrium. Accelerating inflation, however, is the inicator that labor markets have cleared, and further additions to aggregate employment will only persist as long as the Fed can fool workers.

In short, here's my prediction: Kocherlakota's 5.5% unemployment target will only be met if inflation is permitted to rise above 3%. 

Video Time: A Very European Break Up

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

Who Owns the Income Now?

Something I've been curious about for awhile; you here a lot about income inequality, but rarely about where the income is located geographically; here's the answer.

On the subject of economic geography, check out this old paper by Paul Krugman on the subject.

and the same map, for 2008

Also, here's unemployment by county.

The Fed Joins the Expansionist Choir

Good news come from both sides of the Atlantic! Last week it was Draghi announcing his open-ended debt-swaping operation to lower yields in Periphery debt, and today we have this from Bernanke:

"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

It's still not a committment to target Nominal GDP, but at least we're seeing expansion where it counts, from the ECB and the Fed. Its a step in the right direction. 

Who's Afraid of Inflationary Finance?

The Germans, of course. I'm a tad late to this party, but now's as good a time as any to jump in. It seems the German central bank (ReichsBundesbank ) has challenged the ECB's newest bond-buying scheme (which to my understanding consists of the ECB selling German bonds and using the proceeds to buy up Italian and Spanish debt to suppress yields) in the German Constitutional Court. Check it out:

http://www.independent.co.uk/voices/comment/the-bundesbank-is-calling-the-shots-now-8125952.html

Apparently, the head of the Bundesbank, Jen Weidsmann, has threatended to resign over what he calls "state financing via the money press." Of course, inflationary finance is a touchy subject for Germans, given its history with hyperinflation from 1921-1924 under the Weimar Republic. And of course, as everyone knows, it's that hyperinflation that lead to the collapse of democracy in Germany and the rise of Hitler!

Except that's not true. Hyperinflation in Germany ended in 1924, when Germany revalued and issued a new currency called the Rentenmark, at an exchange rate of 1,000,000,000,000 reichsmarks = 1 rentenmark.

Hitler was not elected as Chancellor of Germany until the 1932 elections, taking office on Jan. 30, 1933. That's a full nine years after the end of hyperinflation, in the middle of the deflationary Great Depression. Whats the connection between the election of 1933 and an inflation that occurred a decade earlier?

Lets get the history straight, shall we? Inflationary finance did not bring about the Nazis; mass unemployment did. Crushing debt burdens owed to foreigners did. Foreign mandates imposed in a beleagured population did. THAT'S the kind of environment that leads to radical leaders who's messages of spite and hatred can take root.

American "Competitiveness" In a Eurozone Context

For fun, I threw the unit labor costs for the United States onto the graph I made for the previous post, to see how American labor costs fare in comparison to the European situation. The results are pleasantly suprising: American labor costs are well below European labor costs.

Further evidence that the United States does not have a "competitiveness" problem, and that our labor and capital markets price inputs appropriatley to compete with the best exporters in the world.

In insolation, here's the US vs. Germany directly.

Labor Costs and the Eurozone Adjustment...

Here's Barry Eichengreen on the necessary adjustment process in the Eurozone: 

"Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period’s investment took the form of residential construction), the result is a loss of cost competitiveness.  The country then faces slow growth, chronic high unemployment and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area.  The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a “healthy” dose of inflation."                                                                   

Now here's a chart I made showing unit labor costs in Italy and Spain, relative to Germany. It gives an idea of what adjustment the periphery countries need to make to bring themselves into line with Germany and regain competitiveness. It's for the manufacturing sector only because thats what most tradeable output consists of (not a lot of Italian haircuts sold in Germany). 

Unit Labor Costs = Labor Compensation /  Total Output 

Either real labor compensation in Italy and Spain needs to fall or output needs to expand, because labor costs obviously became seriously out of line during the "boom" following the creation of the euro in 2002.

John Cochrane for Treasury Secretary

I remember seeing this a while back and wondering who would best replace Geithner at Treasury, should Obama win and Geithner decide to leave. Recently I came across an old blog post by John Cochrane in which he laid out a series of proposals to finance the Federal debt that I find absolutely compelling.

Lets take a listen:

"I don't know who in their right mind is lending the US government money for 10 years at 1.59% and for thirty years at 2.67%. You have to believe inflation will be lower than these values just to get your money back, let alone make any real return.  (The best I can do is to opine that these are not long-term investors, and they think they can get out before rates rise. I will admit that understanding such low rates is stretching my rational-investor efficient-market prejudices.)

Well, no matter. When offered a screaming good deal, you should take it!

Restructuring US debt to longer maturities has all sorts of advantages. (Restructuring. I am not advocating stimulus!) It buys lots of insurance, very cheaply.

Think about what happens with very long term debt vs. rolling over one or two year debt, which is what the US does now.  Sooner or later, interest rates will surely rise to normal, 5-6%. If we are rolling over debt, that means the US Treasury has to come up with an extra 4-5% times the outstanding stock of debt, each year, to pay interest. 5% of $15 trillion is $750 billion, more than half our current (and already unsustainable) deficit. Oh, and by then the debt will be a lot more than $15 trillion by then. 

And that's just the "return to normal" scenario. What if the exploding euro leads bond investors to wake up that all debt of highly-indebted, sclerotic-growth, perpetual-deficit, can't-cure-runaway-entitlement governments is dubious?  Greece didn't get in trouble trying to borrow for one year -- it got in trouble trying to roll over debt. If that moment comes and the US has lots of long-term debt outstanding, it just means a mark-to-market loss for bondholders. If we are rolling over short term debt, then the debt crisis comes to the US. And there is no Germany to bail us out.

Notice how the 30 year rate plummets in 2011 and remains low. And this is on indexed debt, not just reflecting low inflation expectations! Cochrane's refinancing ideas would allow taxpayers to pay these low coupon rates for 30 years into the future, potentially saving trillions in interest costs. 

Todd goes beyond the usual 30 year Treasuries, and advocates 50 or 100 year Treasuries. Good idea! I have wilder ideas. We should think about bonds with no principal repayment at all. 30 years of coupons, or even perpetuities. These bonds never have to be rolled over -- you never have to issue new debt to pay off the principal of the old debt. Or, if we want to maximize the duration of the bonds, issue the opposite: zero-coupon 50 year bonds.  At least that puts off any problems for 50 years!  If restructuring physical debt is hard, do what the private sector does: Massive fixed-for-floating swaps could lengthen the US maturity structure very quickly without unsettling somewhat illiquid markets for seasoned bonds. 

Lots of smart money is locking in absurdly low rates. Why not the US?"

Nick Rowe on NGDP and Interest Rates, Theory Edition

Enlightening new post over at Worthwhile Canadian Initiative that clarifies how to think about monetary policy in a non-interest rate paradigm. Check it out here:  http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/09/goldpunk-strategy-space-and-michael-woodford.html#more

This is my favorite excerpt:

"If in that alternate history we had thought nominal interest rates were too near zero, and we wanted to loosen monetary policy, and we wanted to cause nominal interest rates to increase above zero, the central bank would just start raising the price of gold. It would be obvious to everyone. Raising the price of gold is how central banks loosen monetary policy. There's nothing special about the price of gold, of course. Except history. But the price of gold does have the right units, because it's got $ in the units. There's no $ sign in the units for an interest rate. And what central banks really really ultimately do is determine the value of that $ unit."

Observations on Tampa...

A few things I noticed from the RNC, before we get into the DNC this week.

1. There seems to be a definite trend toward protectionsim in the Republican party; both Sen. Rob Portman and Romney made strong allusions toward starting a trade war with China. Its important to remember that the Federal government can't tax or penalize Chinese producers, only American consumers.

2. It remains unclear what exactly the Obama Administration has done to supposedly hurt the economy in the eyes of Republicans. The Feds bailed out the auto-industry, which plays well in swing states like Michigan and Ohio. All the money given out to banks in TARP and successive give aways has been paid back with interest. The Bush taxcuts have been extended. Obama lifted the ban on offshore oil drilling put in place by Bush 41. So where is the impetus for this rhetoric about killing business initiative or driving gas prices higher?

Meanwhile, Obamacare doesn't go into effect until 2014, and the deficits we've run haven't driving up the cost of borrowing for investment; real interest rates, both short-term and long, remain at historic lows.

So at the end of the day, with regard to most Republican complaints, there's no "there" there.

Where does Federal Spending Go?

An illuminating chart I've had packed away that I've been meaning to share. It shows real per-capita Federal spending by sector over time, with interesting implications.

Basically, Federal spending has been steady in all discretiony sectors, while the cost of entitlements has gone through the proverbial roof. And on a positive note, I am at least glad that the national political discourse seems to be centered on this fact and the debate of the Presidential election framed around its  implications.