Stiglitz, Summers, Secular Stagnation, and the Supply Side

Joe Stiglitz recently published an attack, “The Myth of Secular Stagnation,” on Larry Summers’ hypothesis of secular stagnation, a revival of a term used by Alvin Hansen decades ago. Larry first presented his secular stagnation hypothesis at a conference jointly hosted by the Brookings Institution and the Hoover Institution on October 1, 2013, during the fifth anniversary of the financial crisis. It has gone viral since then.

In his critique, Stiglitz argues that Summers was wrong to say that the slow growth was secular; there was nothing secular about it, Stiglitz argued: if there had been a counterfactual larger demand-side stimulus package, there would have been a faster recovery without stagnation.  In his response, Summers lumps the Stiglitz  critique in with earlier critiques of secular stagnation, including mine “The Economic Hokum of ‘Secular Stagnation’” WSJ Jan 2014, which suggested, in Summers words “that secular stagnation was a fatalistic doctrine invented to provide an excuse for poor economic performance during the Obama years.”

I think that Summers’ critique of what Stiglitz writes is good.The irony is that I and other critics of secular stagnation have a completely different view from Stiglitz, who argues that the problem was insufficient demand and that a larger discretionary stimulus package would have avoided stagnation.  But my empirical research along with John Cogan, Tobias Cwik and Volker Wieland  shows that the demand-side stimulus packages were not successful. A larger package of those types would have done no better. In a 2011 Journal of Economic Literature article I wrote: “Some argue that the economy would have been worse off without these stimulus packages, but the results do not support that view….Others argue that the stimulus was too small, but the results do not lend support to that view either.”

Instead, the alternative view, outlined in my book First Principles, and elsewhere was that tax reform, regulatory reform, monetary reform and budget reform would increase economic growth by raising productivity and labor force participation. These supply side reforms–especially lowering marginal tax rates on investment and reducing costly regulations–were meant to provide incentives to do the things that would raise economic growth. I agree with Stiglitz that there was nothing secular about the stagnation we were seeing when Summers wrote. But the problem with slow growth was the lack of policies on the supply side, not the lack of larger demand-side discretionary stimulus packages.

With the tax reform and regulatory reform of the past two years we are seeing a marked improvement in economic growth. The economy is beginning to roar, as predicted, as these policies are being put in place.

Posted in Regulatory Policy, Slow Recovery, Stimulus Impact

17 Years of Economic and Security Challenges

Today we remember September 11, 2001 and all that has changed in the past 17 years. In his speech today at Shanksville President Trump was right to speak of incredible security challenges and sacrifices: “Since September 11th, nearly 5.5 million young Americans have enlisted in the United States Armed Forces. Nearly 7,000 service members have died” he said, adding “And we think of every citizen who protects our nation at home, including our state, local, and federal law enforcement.  These are great Americans.  These are great heroes.  We honor and thank them all.” There is a plaque at Stanford’s Memorial Auditorium honoring Stanford Alumni killed in Iraq and Afghanistan.

The past 17 years have also brought large changes in the way economics interacts with national security.  This is most clear in the way financial sanctions have worked in tandem with national security in the case of North Korea.  But the challenges began in earnest in the months right after 9/11, and they have grown in importance since then. As I wrote here “Few Americans now remember that the United States launched its first post-9/11 attack on terrorists from a very unusual front—the financial front. As President George W. Bush put it, ‘the first shot in the war was when we started cutting off their money, because an al Qaeda organization can’t function without money.’”  At first, these changes had to be pushed rapidly through the the existing  structure at Treasury and elsewhere, as explained here, but eventually a new Under Secretary of the Treasury for Terrorism and Financial Intelligence was created to handle such matters.  September 11,  2001 and the days immediately following were challenging for economics as well as for national security. As Defense Secretary James Mattis now puts it: we need a strategy for security and solvency.

Posted in Uncategorized

A Boot Camp with a Good Policy Workout

The annual Hoover Institution Summer Policy Boot Camp is now underway with a great group of college students and recent graduates from around the world.  The one-week program consists of lectures, workshops, and informal discussions, but it’s best described as a good “policy workout” on today’s top national and international issues grounded with data and theory.

I led off with the first session on “Monetary Policy: What Works and What Doesn’t.” The session began with a short review of monetary economics including the functions of money, the effect of money on inflation, and the role of central banks such as the Fed. It then examined monetary history—both old and recent—and explained how good monetary policy results in a smooth operating economy with low inflation and low unemployment, while poor monetary policy leads to instability, crises, and deep recessions. Finally, we then used this information to recommend a monetary policy for the future.

Monetary economics and policy are two of the most important topics in economics and government policy, and thus is a good place to start off the Boot Camp. Mistakes in monetary policy – such as those leading to the Great Depression and the Global Financial Crisis—are devastating to people’s lives. Central banks are one of the most powerful agencies of government, and yet they have a great deal of freedom in a democracy. The most important lessons from this session are that monetary reform is needed, that the Fed is getting back on track in the past year and a half, and that it is crucial that it stays on track in the future.

Other policy topics during week include tax policy, budget policy, public pensions, immigration, education, environmental policy, health care, regulatory policy, foreign policy and domestic politics.  The teachers in the program are faculty and fellows from the Hoover Institution, including experts with experience in economics, government, law, history, political science, and foreign policy. The lineup this summer includes Scott Atlas and Josh Rauh (the conference organizers) along with Terry Anderson, Michael Auslin, Michael Boskin, David Brady, John Cogan. Michael McConnell, James Ellis, Morris Fiorina, Stephen Haber, Victor Davis Hanson, Daniel Heil, Caroline Hoxby, Edward Lazear, Amit Seru, George Shultz, Kiron Skinner, Bill Whalen, and John Yoo, with guest dinner speakers Joe Lonsdale, Amy Wax, and Jason Riley.  A series of videos on the various topics is planned for the future.

It’s fun and free of charge, including lodging and meals. So think about applying for next summer!

Posted in Teaching Economics

Turkey Tantrum Contagion Not Automatic, Rather Policy Dependent

Many have been talking about possible international contagion of the financial crisis in Turkey, and Peter Coy touched on the key issues in yesterday’s Bloomberg piece. Recent economic history and theory offer powerful lessons about contagion. Most important is that contagion isn’t automatic, but rather depends crucially on economic policy. And that lesson is fortunately showing up in virtually all the market commentary during the past few days

Consider in contrast the situation exactly twenty years ago on August 17, 1998 when Russia—in the middle of its own financial crisis—defaulted on its debt and the impact spread instantaneously around the world. The three charts on my bookmark, shown here, illustrate that experience. The emerging market bond index (EMBI) spread jumped in Asia, Africa, and Latin America at the time of the Russian dealt which is marked by the red vertical line.

Many argued at the time that this was the way the world markets had become in the globalized economy; policy makers at the IMF and elsewhere, it was argued, had to be ready with bailouts to deal with the inevitability that a financial crisis in one country would automatically lead to crises in many other countries.

This was the still a common view in January 2001 when I joined the U.S. Treasury to run the international division. A crisis was brewing in Argentina then, and many argued that we needed to be ready for bailouts of emerging markets around the world to deal with predicted contagion.

Argentina in 2001, like Russia in 1998, was in a financial crisis and it did default on its debt; however, unlike the Russia case, the international contagion effects were nowhere to be seen, as illustrated on the reverse “no contagion” side of the bookmark shown next.  The EMBI spread in Asia, Africa and Latin America was unaffected by the default.  

There were important policy differences between the two episodes. International policy was becoming more predictable and gradual so that the Argentinian default was widely anticipated, discounted and had little or no impact.  Other countries were better prepared, and, by this time, the notion that there were important policy differences that affected the likelihood of contagion became more widely discussed. One could find a great deal of difference between countries and thus find ways to discriminate between good policy and bad policy.  Kristin Forbes, then at MIT and the Treasury, was doing a lot of the research. There was also the new view that an orderly restructuring rather than a sudden default would lead to less contagion and would be possible if collective action clauses were introduced in sovereign debt.

In my view, it is encouraging that now the policy differences between countries are being examined carefully. Analysts are pointing to poor monetary and fiscal policy in Turkey as the source of the problem. They are creating heat maps, as shown below and drawn from the paper by Peter Coy that tries to show the differences in policy in different countries. Those most susceptible to contagion are countries where policy has been relatively poor in recent years such as Argentina and South Africa.

There is still a danger of poor policy responses in Turkey or elsewhere that could make the problem worse, and even lead to contagion.  Trade policy skirmishes could become a trade war and are already a source of uncertainty.  If Turkey resorted to capital controls to limit outflows, then investors might expect such controls in other countries, and get out while the getting is good, which could result in contagion. The fact that the IMF has developed and publicized the concept of capital flow management in recent years could hastened this contagion.

Some are blaming the normalization of policy in the United States, and suggesting that the policy be slowed or halted. The normalization by the Fed seems to put downward pressure on exchange rates in some emerging market countries. But it would be a mistake for the US and the world economy to change policy at this time.

Posted in Financial Crisis, Monetary Policy, Teaching Economics

Rules and Strategies in the Fed’s New Monetary Policy Report

The Fed’s Monetary Policy Report released last Friday devotes a lot of space to monetary policy rules. This is the third time in a row that the monetary policy report has included such discussions, the first being in July 2017 and the second in February 2018.  Compared with the previous two monetary policy reports, this Report adds new material on policy rules, and is joined with a helpful discussion of policy rules now integrated into the Monetary Policy Principles and Practice section of the Fed’s web page.

All this represents progress in my view. It would be good if the new material generates some questions and answers in the Senate and House hearings with Fed Chair Jay Powell this week. Having such a discussion is one of the purposes of the bills in Congress under which the Fed would report on policy rules and strategies.

As with Fed minutes, there is something to be gained from examining the similarities and differences compared the most recent and previous reports, though the process of reporting is probably still evolving and a purpose of policy rules is that they entail less not more fine-tuning.

The new report presents (p. 37) the same key principles of policy embedded in the Taylor rule and other policy rules as discussed in previous reports: “Policy rules can incorporate key principles of good monetary policy. One key principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second key principle is that monetary policy should be accommodative when inflation is below the desired level and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third key principle is that, to stabilize inflation, the policy rate should be adjusted by more than one-for-one in response to persistent increases or decreases in inflation.” The section “Principles for the Conduct of Monetary Policy” on the Fed’s web site discusses in more detail how these principles relate to policy rules and explains the rationale for the third principle, sometimes called the Taylor principle.

Another similarity is that that the new report focuses on the same five rules as in February: the “well-known Taylor (1993) rule” and “Other rules” which “include the ‘balanced approach’ rule [Taylor rule with a higher coefficient on the output variable], the ‘adjusted Taylor (1993)’ rule, the ‘price level’ rule, and the ‘first difference’rule.”

The paragraph with the title Monetary policy rules (p. 3) is identical to the previous reports.  Among other things, it states that monetary policymakers “routinely consult monetary policy rules.”  But later paragraphs differ (italics added to show this):

Feb 2018: “However, the use and interpretation of such prescriptions require careful judgments about the choice and measurement of the inputs to these rules as well as the implications of the many considerations these rules do not take into account. (pp. 31-32)

July 2018” “However, the use and interpretation of such prescriptions require, among other considerations, careful judgments about the choice and measurement of the inputs to these rules such as estimates of the neutral interest rate, which are highly uncertain (p 36)

That is, the latest report focuses on uncertainty about the “neutral” or “equilibrium real” interest rate while the earlier reports also focused on uncertainty about the neutral  unemployment rate and the measures of inflation. Indeed, the latest report has a new table (p. 41) shown below, and long discussion reporting on recent research on the neutral rate. Note that the point estimates range from 0.1 percent to 1.8 percent.

I think it is significant that the discussion of the neutral rate is placed within the discussion of policy rules in the report. Like many aspects of uncertainty, this particular uncertainty has profound effects on policy making whether policy is rules-based or not. However, the discussion of the policy implications of this uncertainty is much clearer and more informative when it falls, as in this report, within a framework of policy rules.

That there is a wide range of uncertainty is illustrated in this time-series diagram drawn from the report. Note that the the estimated neutral rate was much higher in the years from 2002 to 2007 before the Great Recession indicating that, according to these estimates, the “two-low-for-too long” period cannot be rationalized as due to a decline in the neutral rate.

There is more on policy rules in the report and also, as mentioned above, on the the web page. I would note in particular the section Policy Rules and How Policymakers Use Them which discusses alternative policy rules, the section on Challenges Associated with Using Rules to Make Monetary Policy which delves  into issues that the Fed faces when it implements rules, and the section Monetary Policy Strategies of Major Central Banks which contains a good discussion of what is happening abroad with the conclusion that “other major central banks use policy rules in a similar fashion.”  This section is very important when one considers monetary policy normalization and monetary reform on a global scale, which is entirely appropriate in today’s integrated world economy

Posted in Monetary Policy

Still Exploding After All These Years

For the past nine years on Independence Day (see here and here for example), I’ve plotted the most recent long-term projection of the federal debt by the Congressional Budget Office as a reminder that it’s as explosive as the Fourth of July fireworks seen all over America. The CBO just released its latest long-term forecast, and while their shortening of the horizon and eliminating the alternative fiscal scenario may blur the underlying problems, the message, like the fireworks display, is still loud and clear: The debt is still exploding after all these years.

The figure shows three explosions: Net interest payments on the debt as a share of GDP and the debt as a share of GDP before and after the “Tax Cuts and Jobs Act of 2017.” The chart is constructed from CBO forecasts for 2018 to 2048 in 2018 Long-Term Budget Outlook released on June 26, 2018.

Note first that net interest payments quadruple as a share of GDP over the period, rising from 1-1/2 percent to 6 percent, due to a combination of rising interest rates and rising debt. This will bring net interest payments to 21 percent of the federal budget. If interest rates on the debt rise to level higher than the 4.4 percent assumed in the forecast, then the debt situation will be even worse.

Second, note that the debt was on an explosive path before the 2017 Tax Act and it is still on an explosive path even though, and this is important to note, the debt is a couple of percentage points lower as a share of GDP in 2048 with forecast after the 2017 Tax Act.

While the CBO no longer goes out more than 30 years, the scary trajectory for the rest of the century is unmistakable.  In my view, as in most of the past decade, there is not enough attention paid to this problem in Washington. The problem is increased entitlement growth, not the recent tax reform, as was pointed out in a recent oped by Michael Boskin, John Cochrane, John Cogan, George Shultz and me in the Washington Post.

Posted in Budget & Debt

What We Wanted We Got: A Debate on the Fed’s Balance Sheet

A big question addressed at this year’s annual Hoover monetary conference was “The Future of the Central Bank Balance Sheet,” including the amount of reserve balances that banks hold at the Fed. The issue is one that “the [Federal Reserve] Board and the FOMC are in the process of observing and evaluating” as Vice-Chair Randy Quarles put it at the conference.

There are two basic approaches to the question. One is for the Fed to aim for a supply of reserve balances in which the interest rate is determined by the demand and supply of reserves—in other words, by market forces.  Sometimes called the corridor approach, it’s what Fed used for decades before financial crisis. The second approach is for the Fed to aim at a supply of reserves well above quantity demanded, and then set the interest rate through interest on excess reserves.  This method is sometimes called a floor system.

I’ve written in favor of the first approach which implies a much lower level of reserves. But it’s a crucial decision, and the Fed needs a good open debate of different views. That is what we got at the conference with a panel of Fed officials, market participants, and academics:

This is a topic where any short summary will miss the mark, and there’s no substitute for reading the the fascinating evidence-based papers, some with really catchy titles.

Lorie Logan, from the NY Fed trading desk, argued for the second view, emphasizing that markets would be less volatile if the Fed sticks to a floor system. Fisher, who used to run the NY Fed trading desk, disagreed, saying that operational considerations for the staying Big are not convincing, and that the rationale is completely orthogonal to the case made of going Big in the first place. Bill Nelson, who is familiar with operational considerations from his time at the Board, argued in favor of the first approach, and Mickey Levy noted the economic and political risks of maintaining an “out-sized balance sheet,” and concluded that “The Fed’s exposure to Congress’s dysfunctional budget and fiscal policy making in the face of mounting government debt and debt service costs is particularly concerning.”

I understand that a Fed decision is likely in the next year. So let the debate go on.

Posted in Monetary Policy