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

Economics 1 Online. Summer 2018. Free.

This summer we will again offer Stanford’s Principles of Economics course online for free.  You can register now for the course on Stanford’s open on-line platform Lagunita. We will start on Monday June 25 and go through August 24. I will be teaching the course with the help of Ryan Triolo, an experienced and excellent teaching assistant who I am happy to say is back for summer 2018

The course is based on the on-campus course at Stanford. Each day after giving a 50-minute lecture, I recorded the same lecture divided into smaller segments for online viewing. We added graphs, photos, and other illustrations–just as in the on-campus course; we captioned and indexed the videos–an attraction not in the on-campus course; and we added study material, reviews, quizzes, and a discussion forum.

The first week of the course covers “The Basic Core of Economics” focusing on such ideas as opportunity cost and the supply and demand model with practical applications. Just learning this Basic Core is a significant and worthwhile accomplishment. The course then considers topics in microeconomics and macroeconomics including key economic policy issues. I draw on experience in government and the private sector.

People who participate in the open online course and take the short quizzes following each video will be awarded a Statement of Accomplishment, or a Statement of Accomplishment with Distinction.

My textbook with Akila Weerapana, Principles of Economics, and its shorter versions, Principles of Microeconomics and Principles of Macroeconomics, can be downloaded and used online to go along with the course thanks to FlatWorld.

Here is a sampling of views about the course that have gone out on Twitter:

  • Russell Roberts‏ @EconTalker: Great class. Great teacher. No charge. Get your basics right here.
  • Ike Brannon‏ @coachbuckethead: The most entertaining economist I know.
  • Brian Wesbury‏ @wesbury:  If you want to learn Economics from one of the best, click on this link!  What great news!
  • Juan Carlos Martinez‏ @juank700410: Educación gratuita y de calidad
  • Tom Church @TomVChurch Interested in economics? Take Econ-1 online. Pass the quizzes and get a statement of accomplishment! Plus, you’ll learn a thing or two.
  • Chris Pippin @ChrisPippin This is the class and the professor that made me an Econ major. Thanks to the generosity of @EconomicsOne and the miracle of the internet, now anyone can take it.
  • Nicolas Petit  @CompetitionProf Great course by terrific teacher, comprehensive & more than all eye opening on real world problems like trade wars and monetary policy.

Thank you!

Posted in Uncategorized

Still Crazy After All These Years—And What About the Next 50

Yesterday I was talking to a friend in my office about the great benefit to students from writing undergraduate honors theses in their senior year.  I have long advised students to do so, perhaps because of the rewarding experience I had years ago.  It got me thinking, so I pulled my undergraduate thesis off the shelf, and I noted that it was dated April 5, 1968–submitted exactly 50 years ago to the day. The thesis was all about policy rules, and, yes, I am still working on that topic, “still crazy after all these years.”

I got the idea from Phil Howrey who was then on the Princeton faculty. Phil was doing research with Michio Hatanaka, who had just published Spectral Analysis of Economic Time Series with Clive Granger who had visited Princeton.  They were all interested in dynamic stochastic models of the economy, and so I got interested. How lucky for me. I had taken a macro course from Phil, without ISLM but with many dynamic stochastic equations—quite unusual for the time, and I was forced to view the economy as a moving dynamic structure. The idea of policy as a rule made so much sense. There was no other way to do policy with those models.

I recall that I really loved working on this project. I spent long hours in a carrel in the basement of the library reading and deriving equations in the winter and spring of 1968.

I did the simulations of the differential equations at the Princeton University Computer Center on a digital computer (an IBM 7094)

and on an electro-analog computer (an Electronic Associates TR-20 located at the Engineering School)—a circuit with capacitors, resistors, and amplifiers hooked up to an oscilloscope.

I simulated monetary policy rules of the kind that engineers had used to stabilize mechanical processes: proportional, derivative and integral. The monetary policy rules had the money supply on the left-hand side, rather than the interest rate.

Milton Friedman gave his famous AEA presidential address that academic year (on December 29, 1967) in which he criticized the Phillips curve and discussed the role of monetary policy. My thesis combined two strands of A.W. Phillips research: evaluation of policy rules and a model cyclical growth. But, fortunately, the thesis did not exploit any long-run trade-off implicit in the Phillips curve by trying to raise money growth and inflation permanently to get a permanently lower unemployment.

We have made progress in the development and application of monetary policy rules in the past 50 years, but I am optimistic that we will make much more progress in the next 50 years. Laptops are thousands of times faster than that old IBM 7094, and we now have artificial intelligence, machine learning, big data, bitcoin, now-casting, and instantaneous and global communications. And we are accumulating vast amounts of practical experience over time and in different countries. So, students, get started on that thesis.

Posted in Monetary Policy, Teaching Economics

Favorite Economics April Fools Day Jokes on Twitter

Thanks for a little humor about two of the most important economic topics of the day: monetary policy at the Fed and bankruptcy policy at Tesla. I am sure there are others, but these two are my favorites:

Monetary Policy

F 🌐 🌮 ☪ @fmn13  April 1, 2018

Marvel: ‘Infinity War is the most ambitious crossover event in history’ Me:



Bankruptcy Policy

Posted in Uncategorized

Monetary Policy Getting Back on Track

In many ways, the Fed has begun to bring monetary policy back on track as it emphasizes a strategy and the use of monetary policy rules:

On January 18 of last year, former Chair Janet Yellen described the Fed’s strategy for the policy instruments, saying that “When the economy is weak…we encourage spending and investing by pushing short-term interest rates lower….when the economy is threatening to push inflation too high down the road, we increase interest rates…”  In a speech the following day, she compared this strategy with the Taylor rule and other rules, and she explained the differences.

On February 11 of last year, former Vice-Chair Stanley Fischer gave a talk with a similar message, comparing actual policy with monetary rules and explaining how rules-based analyses feed into FOMC discussions to arrive at policy decisions.

On July 7 of last year, the Fed added, for the first time ever, a whole new section on “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process” in its Monetary Policy Report . It noted that “key principles of good monetary policy” are incorporated into policy rules. It listed specific policy rules, including the Taylor rule and variations on that rule. It showed that the interest rate was too low for too long in the 2003-2005 period according to the Taylor rule. It showed that, according to three of the rules, the current fed funds rate should be moving up.

On February 23 of this year, the Fed, now with new Chair Jerome Powell, again included a whole section on policy rules in its latest Monetary Policy Report, elaborating on last July’s Report and thus indicating that the new approach will continue.

On February 27 and March 1 of this year, in his first testimony in the House and Senate as Fed Chair, Jerome Powell referred explicitly to making monetary policy with policy rules. He said that “In evaluating the stance of monetary policy, the FOMC routinely consults monetary policy rules that connect prescriptions for the policy rate with variables associated with our mandated objectives. Personally, I find these rule prescriptions helpful. Careful judgments are required about the measurement of the variables used, as well as about the implications of the many issues these rules do not take into account. I would like to note that this Monetary Policy Report provides further discussion of monetary policy rules and their role in the Federal Reserve’s policy process, extending the analysis we introduced in July.”  This emphasis on rules and strategy did not go unnoticed by those who follow policy: As Larry Kudlow put it: “I’ve never seen that in any testimony before….and I think that’s progress.”

On March 8 of this year, the Fed posted a new web site on the principles of sound monetary policy, Monetary Policy Principles and Practice, with a very helpful note on Policy Rules and How Policymakers Use Them.

While the Fed has not yet endorsed the “Monetary Policy Transparency and Accountability Act,” these reforms represent substantial progress in that direction and should be acknowledged.

Posted in Monetary Policy

A Better Way to End Big Bank Bailouts

David Skeel and I wrote the following on an important report on bankruptcy reform just released by the U.S. Treasury:

Yesterday the U.S. Treasury released its official response to President Trump’s memorandum of last April asking for a review of whether an improved bankruptcy law “would be a superior method for the resolution of financial companies” compared to the regulator-run resolution process embodied in the Dodd-Frank Act.  After a year of hearings, consultations, and study, Report to the President on Orderly Liquidation Authority and Bankruptcy Reform states “unequivocally” that bankruptcy should be the preferred method of resolution. The Report calls for a “more robust, effective, bankruptcy process for financial companies” along the lines of the “Chapter 14” proposal of the Hoover Institution Resolution Project, of which we are members, now written into legislation making its way through the House and Senate.

Through careful analysis and judgment of which reform is likely to work politically, financially, and internationally, the Report provides a practical road map to get the legislation passed.  Chapter 14, so called because there is now no Chapter 14 in the bankruptcy code, would rely on the rule of law and strict priority rules of bankruptcy, but would operate faster than current law—over a weekend—leaving operating subsidiaries outside of bankruptcy entirely.  After filing for Chapter 14, the parent company would transfer its operations and short-term debt to a newly created bridge company that is not in bankruptcy.  The bridge company would be recapitalized and ready to continue operations, while the long-term unsecured debt and stock would be left behind in the old company.  The old company would go through bankruptcy in a predictable, rules-based manner without harming the financial system or the economy.

The Report concludes that the Orderly Liquidation Authority (OLA), as the current resolution process under the Dodd-Frank Act is known, “confers far too much unchecked administrative discretion, could be misused to bail out creditors, and runs the risk of weakening market discipline.” A particularly glaring flaw is the absence of clear priority rules: as receiver for the distressed financial company, the Federal Deposit Insurance Corporation is permitted to pick and choose which creditors are paid first.  The Report urges the FDIC to commit to honoring the ordinary priority rules in OLA, to make it more rule-like and predictable.

OLA also gives the FDIC access to vast amounts of funding from the U.S. Treasury, which critics worry could function like a bailout.  The Report calls for much tighter constraints on the use of the funding.  The loans should be secured by good collateral, and should require substantial interest payments, in keeping with the classic approach for providing liquidity to a distressed financial institution.  For similar reasons, the Report takes aim at a provision that gives tax exempt status to any bridge institution that is formed for the purposes of an OLA resolution.  There is no justification for this special treatment, and the Report rightly calls for its removal.

This “reform rather than repeal” approach to OLA leaves in place international arrangements through which resolution authorities in different countries can coordinate the resolution of large international financial firms.  If OLA were repealed, there would be no parallel authority in the United States.  Moreover, with Chapter 14 in place, the resolution planning process required by other provisions of the Dodd-Frank Act would work better, because large institutions could credibly outline how their distress would be handled in bankruptcy. Some of the resolution plans submitted by the large financial firms have been rejected by Fed and FDIC.

The Report adopts a middle ground with respect to regulators’ role in the Chapter 14 process.  Unlike OLA, which gives regulators’ complete control, the managers of the troubled company would be the ones to file the Chapter 14 case.  Although our Hoover group recommended that either the company or regulators be permitted to file, the Report worries that regulators and a troubled financial company might engage in a game of chicken if both had the power to file.  The Report would not exclude regulators from the filing decision, however.  It would encourage judicial deference to a Federal Reserve determination that the Chapter 14 transaction should be approved.

The Report, like the versions of Chapter 14 currently pending in Congress, would not provide any government funding of the resolution process.  Although we have advocated access to limited governmental financing, the Report rightly recognizes that Chapter 14 would require much less new funding than a more complex and time consuming resolution framework.  Because the new bridge company would be fully solvent, having left most of its debt behind, private lenders are likely to be willing to provide any necessary new funding.

If Chapter 14 were added to the bankruptcy code, it would become the strategy of choice for resolving the financial distress of large financial institutions.  OLA would still be available as an alternative, but it would rarely if ever be needed.

Bankruptcy reform is an essential element of an economic growth program.  The reform makes failure feasible under clear rules without disruptive spillovers. It would help prevent bailouts, diminish excessive risk-taking, remove uncertainty associated with an ad hoc bailout process, and reduce the likelihood and severity of financial crises.  Research by our colleague Emily Kapur shows the new law might have prevented the contagion associated with the failure of Lehman Brothers in 2008.

The Administration has laid out a clear path to ending too big to fail and making the financial system more resilient. Now is the time to move forward and get the job done.

Posted in Uncategorized

Application Deadline Approaching for Free Public Policy Program

After a very successful launch last summer, Stanford’s Hoover Institution is again offering a one-week public policy boot camp this coming August 19-25. This “residential immersion program” is aimed at college students and recent graduates. It consists of lectures, workshops, informal discussions, and active collaboration with study groups outside of class.  It covers the essentials of today’s national and international policy issues. It requires a 100% time commitment for the whole one-week program, but if last year is any indicator both faculty and students will find it to be rewarding and fun.

As with last year the teachers in the program are faculty and fellows from the Hoover Institution, which includes scholars in economics, government, political science, and related fields. This summer the lineup includes economists Terry Anderson, Michael Boskin, John Cogan, Caroline Hoxby, Edward Lazear, Joshua Rauh, George Shultz, Amit Seru, and me, along with political science and national security experts Scott Atlas, David Brady, James Ellis, Stephen Haber, Daniel Heil, Michael McConnell, Kori Schake, Kiron Skinner, and Bill Whalen. Last year I talked about monetary policy and the Fed, and I will do the same this year, updated of course.

Believe it or not, the program is free of charge to accepted participants, including lodging and meals.  Attendees will be responsible for travel costs and incidentals. There is still time to apply but the application deadlines are fast approaching: February 1, 2018 for early bird applicants and March 1, 2018 for all applicants.   So apply now and I hope we’ll see you next summer!

Posted in Teaching Economics