Debt Explosion Still Looks Like July 4th Fireworks

Six years ago, on July 4, 2010, in a post on this blog, I plotted the CBO’s projection of the ratio of federal debt to GDP because it reminded me so much of the Fourth of July fireworks. What does it look like now?

The most recent CBO long term projection was made in June of last year (CBO is later than normal this year).  For some reason, however, the CBO no longer reports debt levels higher than 250% of GDP, as it did in the past, though it does publish estimates of the primary deficit (the difference between revenues and non-interest spending) under its alternative fiscal scenario through 2089. So I use those estimates and calculate the debt levels assuming that the interest rate remains at the levels forecast by CBO.  test


As you can see from the figure, the fireworks explosion is still there, and it looks just the same! Clearly this future debt picture is not sustainable.  A fiscal consolidation—a reduction in the primary deficit—is needed if the debt explosion is to be avoided. That the debt is projected to grow relatively slowly as a share of GDP for the next 5 or 6 years has led to complacency, but the longer the fiscal consolidation is postponed the harder it will be to carry out without disruptions.

The decrease in the debt to GDP ratio in the late 1990s was largely due to a decline in defense spending as a share of GDP coupled with strong economic growth. The increase in recent years is due to the weak economy—the recession of 2007-2009 and the slow recovery.  The projected increase in future years is mainly due to the rapid growth of entitlement spending compared to GDP

Posted in Budget & Debt

Whither Economic Freedom Post-Brexit?

As events are turning out, the Brexit decision is providing an opening to revive a trend toward economic freedom and thus stronger economic growth. But will the UK leadership and their counterparts in the EU and the US take that opening?  That depends in part on whether they understand the economic benefits.

A good way to see this is to look at the following chart of recent trends in economic freedom. The index combines well-known measures of regulatory burdens and openness to international trade along with the rule of law and the scope of government, gathered together by the Heritage Foundation. econfreeNote that throughout the past two decades the UK has been well above the EU average of economic freedom. So it is not surprising that the UK economy has grown nearly 1 percent points faster than the EU as a whole and with an unemployment rate only ½ as high.

The chart also shows that the EU score rose and started to catch up to the UK during the period from 1995 to 2005, but unfortunately economic freedom has not kept that pace with that improvement in the past ten years, and that the UK has even declined.

This is where the opportunity lies: The hope is that by escaping the difficult political, and at times very bureaucratic, constraints of Brussels—which have made regulatory reform difficult—the UK will be able to get back to and surpass the level of economic freedom it has achieved in the past. Even with the possibility of a costly transition, the long term gains in income and employment would be substantial.

This will, of course, take a good deal of leadership in the UK and an embracing of the principles of–and practical ways to implement–economic freedom. It is promising that the recently declared, and already front-runner, for Prime Minister, Theresa May, has pledged to carry out a successful exit strategy without the strings of the EU, even though she was against Brexit.  It is also promising that UK Independence Party leader, Nigel Farage, suggested to the European Parliament this week that “Why don’t we just be pragmatic, sensible, grown-up, realistic and let’s cut between us a sensible, tariff-free deal.”

The danger, however, is that the EU will not be accommodating to the international trade part economic freedom—which includes free trade in goods and in services and open capital markets.  This attitude runs the risk of going in the wrong direction: pulling down the index of economic freedom—which factors in the degree of market openness—to the detriment of all Europeans.  Already there have been calls by some EU leaders to reject a continuation of open trade in goods, services, and capital between the UK and EU, unless the UK agrees to such concessions on immigration, a clear way to kill a mutually beneficial trade deal. There is also a danger that another UK ally—the United States—will turn protectionist and refuse to enter into a trade deal with the UK, which would also pull down the index of economic freedom. So the direction that economic freedom takes following Brexit now depends on the economic leadership in the UK, the EU and the US.

Posted in International Economics, Regulatory Policy

Solid Economic Support for Sensible Financial Reforms

Economic research, including work in the 1970s on time inconsistency, has long provided a rationale for central bank independence in conducting monetary policy. Indeed, the research encouraged the spread of central bank independence and inflation targeting around the world in the 1990s.

But the rationale for the independence of other activities at central banks, including many financial regulatory activities, is much weaker. At the least one needs to establish a clear connection between monetary policy actions and regulatory actions to justify placing these activities in an independent central bank.

When central banks drift away from monetary policy and go into other areas, their actions bypass the checks and balances so important in a democracy, and this can lead directly or indirectly to poor economic performance.  For example, the Consumer Financial Protection Bureau—with oversight of such activities as payday loans that have little or no connection to monetary policy—is located in the Fed with no appropriation role for Congress.

A sensible reform to deal with this problem would be to require congressional appropriation of funds for regulatory and supervisory activity within the Fed leaving the monetary policy function to be independent and funded by Fed earnings. The Fed already distinguishes between regulatory/supervisory activities and monetary activities in its internal accounting so this would be a reform that could readily be carried out in practice.

The Financial CHOICE Act outlined two weeks ago by House Financial Services Committee Chair Jeb Hensarling includes such a reform. The act has other reforms with good economic rationale: It would encourage banks to have more capital by offering them in return relief from complex regulations which slowdown the economy. It would restore the regular constitutional role of the Congress by requiring congressional approval of major financial regulations based on cost-benefit analysis. It would reform the bankruptcy code with a new chapter to prevent bailouts and financial spillovers of failed financial firms. And it would require the Fed to report on its strategy for monetary policy.

In general, the act emphasizes the use of incentives and market mechanisms operating through the rule of law to raise economic growth. A number of economic experts with a great deal of research and policy experience over many years have signed on to a statement supporting the proposed legislation, including Michael Bordo, Michael Boskin, Charles Calomiris, John Cochrane, John Cogan, Steven Davis, Marvin Goodfriend, Lars Peter Hansen, Robert Heller, Peter Ireland, Jerry Jordan, Robert Lucas, Allan Meltzer, Bennett McCallum, Lee Ohanian, Athanasios Orphanides, William Poole, Edward Prescott, Thomas Saving, George Shultz, John Snow, John Taylor, Daniel Thornton, and Peter Wallison.

Posted in Monetary Policy, Regulatory Policy

Rules Are Green and Discretion Is Red in the Monetary Game

Raghuram Rajan, Governor of the Reserve Bank of India, is calling for a reform of the international monetary system.  He has been calling attention to problems in the system for a while, and now he is looking for a solution.  In his March 21 Project Syndicate article “New Rules for the Monetary Game,” he argues that “what we need are monetary rules that prevent a central bank’s domestic mandate from trumping a country’s international responsibility.”  The details are laid out in a paper with his colleague, Prachi Mishra.

Raghu has a particular idea in mind.  He suggests that the international community assign colors (green, red, and orange, like traffic lights) in this way: “policies with few adverse spillovers should be rated ‘green’…and policies that should be avoided at all times would be ‘red,’” and in-between policies would be ‘orange’.  He then suggests that economists at central banks, at international financial institutions, and in academia get started with the classification based on economic models and data.

I have been writing about the merits of a proposal for “A Rules-Based Cooperatively Managed International Monetary System for the Future” for some time and with some recognition by Central Banking Publications; it’s already based on economic models and data. In fact, a lot of research and experience over the past several decades shows that rules-based monetary policies lead to better performance nationally and globally. So the proposal is pretty straightforward:  An international agreement on a rules-based system would be built on clear descriptions and commitments to monetary policy rules in each country.  So let’s color rules- based policies green, and discretionary policies red (with Raghu’s orange for monetary policies that are in the transition or normalization phase), and get on with implementing the proposal.


Posted in International Economics, Monetary Policy

New Test Finds No Impact of QE on Long-Term Interest Rate

The Fed’s stated purpose of quantitative easing (QE) was to lower long-term interest rates, and many papers have endeavored to test empirically whether it achieved that purpose. Some, such as the paper by Gagnon, Raskin, Remache, and Sack, have looked at the impact of QE announcements, finding the intended impact. Others have questioned estimates based on announcement effects because they may miss reversals that come after the initial effect; a paper by Stroebel and Taylor has instead looked at the direct cumulative effects of bond purchases during QE1, controlling for various risks, and they do not find a significant impact.

A recent study by Ansgar Belke, Daniel Gros and Thomas Osowski takes a whole new approach by controlling for global effects on long-term interest rates. They focus on QE1 and they find no significant impact. The paper was presented yesterday by Ansgar Belke at the Conference on Macroeconomic Analysis and International Finance in Crete, where I was the discussant

The basic idea is explained simply at the start of the paper using the following chart of the 10-year US Treasury rate along with comparable rates in Europe.

QE test graph

“Eyeball econometrics” reveals a lot of co-movement in these rates, which raises basic questions about the finding that changes in the US rate were due to QE. In fact, while the authors show that the US 10-year Treasury rate fell by 1.1 percentage points around the time of QE1—leading to the view that QE had the intended effects—it turns out that the long-term rate in the Euro area (measured by long-term German bonds) came down by about the same amount.  Using rigorous statistical techniques, the authors find that QE1 has no significant effect on the long-term relationship between the interest rate differential and the exchange rate.  Here they use co-integrated time series models with residual tests for structural breaks—modern versions of Chow tests.

This finding also raises doubts about some of the rationales for the effect of QE, including portfolio balance arguments, which would not be expected to have such large global effects.   To be sure, it could be that QE1 had the signaling effect that short-term policy rates in the US would be lower for longer, and thereby signaled the same for the ECB policy rate assuming some kind of policy contagion.  If so, term structure models might suggest co-movements in long-term rates in Europe.

Their model also includes the exchange rate, which will enable them or others to use the approach to examine exchange rate effects in other periods and countries, and perhaps estimate the effect of QE by the Bank of Japan and the ECB in 2012-2015, which eyeball econometrics suggest led to depreciation of the yen and then the euro.

Posted in International Economics, Monetary Policy

The Fed’s Normalization: How Long and How Far?

The Monetary Policy Subcommittee of the House held a hearing yesterday on “Interest on Reserves and the Fed’s Balance Sheet,” a difficult, but important and timely subject as the Fed begins what it calls its normalization process, or its transition to normal monetary policy, in its Policy Normalization Principles and Plans. I was a witness (here is written testimony) and because reserves are a very large part of Fed’s balance sheet, I started with a “before and after” look at Fed’s balance sheet focusing on the major items in 2006 and 2016:

Fed balance sheet

A quick glance shows that:

  • The size (total assets) grew enormously from $842 B to $4,478 B.
  • Currency increased from $758 B to $1,407 B (6% growth, pretty typical)
  • Securities jumped from $760 B to $4,234 B due to “quantitative easing”.
  • Reserves exploded from $14 B to $2,410 B as the Fed payed for securities by crediting banks with deposits on itself.

The chart shows the details of the jump in reserves at the times of QE1, QE2, and QE3. Clearly the large amount of reserves is a legacy of quantitative easing.


This big jump in the supply of reserves with no rise in demand would be expected to cause the interest rate to fall to zero. So to raise the interest rate above zero the Fed has to pay interest rate on reserves (IOR) near its interest rate target. Thus when the Fed raised the interest rate target in December by .25 percentage points, it raised IOR by .25 percentage points.

Thus with the current bloated balance sheet, the interest rate is not market determined by supply & demand. Rather it is administered by the Fed. This disconnect between the interest rate and reserves is unavoidable with balance sheet so large, but as a normal policy, the disconnect is a mistake. It enables the Fed to be a multi-purpose discretionary institution—allowing its balance sheet to remain large and available for many purposes, including credit allocation—rather than a limited-purpose rules-based institution. This detracts from good monetary policy.  If Congress wants these other things, such as credit allocation, it should assign another agency.

Given these problems, it is promising that the Fed says in its “Policy Normalization Principles and Plans” that it “will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities….”  But more specificity about the meaning of “efficiently”, “effectively” and “primarily” is clearly warranted. In my view, a statement that in the longer run the Fed will pay interest only on required reserves and that the federal funds rate will be determined by the supply and demand for reserves would help clarify the nature of monetary policy in the normal state following the normalization period.

In sum, my testimony showed that the high level of reserves is a legacy of QE, that with the supply of reserves now much greater than demand, the Fed has no alternative to paying interest on reserves as it normalizes policy, and that in the years ahead the balance sheet should be bought down in size to be consistent with a market determined interest rate rather than administratively determined by the Fed. The normalization period, during which monetary policy returns to a normal state, should be as short as possible. In my view, normalization should be shorter than currently implied by the Fed’s “Policy Normalization Principles and Plans.”

Posted in Monetary Policy

A Reawakening of International Monetary Policy Research

International Monetary Stability: Past Present and Future was the topic of this year’s monetary policy conference held last week at Stanford’s Hoover Institution. With highly volatile exchange rates, the spread of unusual monetary policies, and disappointing growth and stability, it was a hot topic for the researchers, the market participants, the media, and the four FOMC members who attended. In contrast to the frequent focus on exchange rate interventions and capital flow management at many other international meetings recently, this conference focused more on the need for a classic rules-based reform of the international monetary system.  In this respect, especially when combined with two previous monetary conferences (with books here and here), it constituted a reawakening of monetary research.  A book on the conference proceedings is planned, but in the meantime here is a quick summary.

Sebastian Edwards led off with his work on international monetary policy independence showing that despite flexible exchange rates (and despite arguments to the contrary by central bankers) there is significant policy spillover or contagion from the Fed to central bank decisions in Latin American countries. David Papell, in discussing the paper, considered whether this was due to recent departures from optimal policy rules in the US, concentrating on the concluding lines of Edwards paper that “to the extent that the advanced country central bank (i.e. the Fed) pursues a destabilizing policy, this will be imported by the smaller nations, creating a more volatile macroeconomic environment at home.”

David Beckworth and Chris Crowe came next with a novel paper that demonstrated some of the destabilizing impacts of such policy spillovers especially when the United States is “banker to the world” with a large portfolio of longer term assets financed by short term liabilities.  They considered ways in which more rules-based policy could alleviate these international instabilities. In his comments, Chris Erceg raised some empirical issues and noted that the results implied a positive effect of U.S. policy deviations (shocks to policy rules) on real GDP abroad.

V.V. Chari and Pat Kehoe then examined rules-based policy in the context of a fixed exchange rate system or a currency union. They showed that currency unions bring about more rules-based and less discretionary monetary policy, but noted that such unions have disadvantages in dealing with incentives to bailout the debt of member countries. In his discussion, Harald Uhlig explained in detail the nature of the assumptions and noted that some of the price-stability effects of monetary union observed in the countries of Europe are also observed in the United States.

Pierre-Olivier Gourinchas then presented a model which he has developed along with Ricardo Caballero and Emmanuel Farhi. He showed that the existence of the zero lower bound on the central bank interest rate combined with a shortage of safe assets in the global economy gave rise to the current account imbalances and currency wars that we see in the data.  In his comments on the paper, John Cochrane questioned the relevance of the zero lower bound, and he argued real factors such as the marginal product of capital provide a better explanation of what is going on in the world today. While praising the paper for laying out a model that could be discussed substantively, he also questioned the existence of aggregate demand deficiency so many years after the financial crisis.

The fifth research paper of the conference was an historical analysis by Michael Bordo and Catherine Schenk which focused on the importance of rules. They covered a range of different international monetary systems from the gold standard, to the early Bretton Woods, to the 1980s and 1990s, looking at particular episodes of formal policy coordination. Their over-riding finding is that systems that are more rules-based and do not require active coordination of policy actions work better than more discretionary systems.  Their discussant, Allan Meltzer, delved into some of the reasons underlying their findings based on his studies of the history of the Federal Reserve.

Following these research papers, a panel of three economists with experience with international economic policy coordination at the US Treasury—Richard Clarida, George Shultz and I—discussed Rules-Based International Monetary Reform. Clarida explained how his own research led to the conclusion that a nearly optimal rules-based international system could be generated by optimal rules in each country. He also emphasized, however, that certain inherently global developments—such as a change in the equilibrium real interest rate—required an analysis of trends in other countries. George Shultz described how international reforms that first brought about flexible exchange rates were implemented in practice during his own experience as Treasury Secretary.  I reviewed my proposal for a rules-based international monetary system in which each country announces and commits to its own policy rule.

In many ways the highlight of the conference was the final panel on international monetary policy and reform in practice with four current members of the Federal Open Market Committee: Jim Bullard of St. Louis, Rob Kaplan of Dallas, Dennis Lockhart of Atlanta, and John Williams of San Francisco. Though there was some disagreement, there seemed to be a lot of consensus that the equilibrium real interest rate (r* was the term most commonly used) had declined.  This did not have much bearing on their current interest rate decisions, but it meant that gradual normalization would be to a lower rate than earlier anticipated.  In addition, Jim Bullard presented an analysis in which deviations from optimal rules-based policy could cause instabilities in other countries, a possibility raised by Sebastian Edwards at the start of the conference.

Following each of these presentations there was a lively and robust exchange with the other conference participants—too much to summarize here—which will be brought out in due course in the forthcoming conference volume. While there is no way to summarize a main finding of the conference, George Shultz commented that he heard a wide consensus for a rules-based monetary policy and international system, about which no one disagreed, though differences of opinion about which rule is best were heard throughout the day.

Posted in International Economics, Monetary Policy