As the previous post suggests, I support targeting an NGDP path. I think an NGDP path target is superior in nearly every respect to an inflation target, and so would represent a clear improvement over current practice. [1]

But, unlike the “market monetarists”, I do not believe that central banks can sustainably track their target, whether NGDP or inflation, given the set of tools currently at their disposal. If those tools are (misguidedly) expanded to permit central banks to lend more freely or purchase a wider range of debt instruments, “success” might prove counterproductive. Although Scott Sumner and Bill Woolsey and Matt Rognlie hate the idea, I think we need to add direct-to-household “helicopter drops” to our menu of instruments. Ultimately, I have a different theory of depressions than the market monetarists do.

Self-fulfilling expectations lie at the heart of the market monetarist theory. A depression occurs when people come to believe that income will be scarce relative to prior expectations and debts. They nervously scale back expenditures and hoard cash, fulfilling their expectations of income scarcity. However, if everybody could suddenly be made to believe that income would be plentiful, everyone would spend freely and fulfill the expectations of plenty. The world is a much more pleasant place under the second set of expectations than the first. And to switch between the two scenarios, all that is required is persuasion. The market-monetarist central bank is nothing more than a great persuader: when “shocks happen”, it persuades us all to maintain our optimism about the path of nominal income. As long as we all keep the faith, our faith will be rewarded. This is not a religion, but a Nash equilibrium.

If the market monetarists’ theory of depressions is correct, then their position is correct. They are famously vague and prickly on the question of what instruments or “concrete steps” central banks will use to achieve their objective. That is because it doesn’t matter one bit, as long as those instruments are persuasive. Whether police wield pistols or tanks or tear gas or nightsticks to keep the peace really doesn’t matter, as long as their choice is sufficiently intimidating that people are deterred from resisting their authority. We only care about the weapon they’ve chosen when deterrence has failed and they are forced to act. Then we are faced with damage from the violence required to sustain their credibility. Even then, if we are certain they will restore order quickly and that incidents of disorder will be rare, we might not worry so much over means. But if conditions are such that lawlessness will not be deterred, there will be no general peace but frequent mêlées on the streets, then it matters very much how the police fight their battles. We start to ask whether the medicine is better than the side effects, whether police tactics are well tailored to improve the underlying conditions and restore a durable peace.

I have a Minsky/Mankiw theory of depressions. The economy is divided into two kinds of people, spenders and savers. Perhaps some people lack impulse control and have bad character, while others are patient and provident. Perhaps structural inequality renders some people hungry but cash-constrained, while others have income in excess of satiable consumption. Let’s put those questions aside and just posit two different and reasonably stable groups of people. Variation in aggregate expenditure is due mostly to changes in the behavior of the spenders. Savers spend at a relatively constant rate and save the rest. Spenders spend whatever they can earn or borrow, which varies with the level of wages, the cost of servicing debt they’ve accrued in the past, and the availability of new credit.

In this world, a central bank that targets something — NGDP, inflation, whatever — doesn’t regulate behavior via expectations. Instead, the central bank regulates access to credit and wages. When the economy is “overheating”, the central bank raises interest rates to increase debt servicing costs, tightens credit standards to diminish new borrowing, and if absolutely necessary squeezes so hard that a recession reduces spenders’ wages via unemployment. When the economy is below potential, the central bank reduces interest rates and relaxes credit standards, encouraging spenders to borrow and leaving them with higher wages net of interest payments.

This is a pretty good gig, it works pretty well, especially when the marginal dollar of expenditure is borrowed and easily regulated by the central bank. But if there are lower bounds on interest rates and credit standards, the scheme is not indefinitely sustainable. Even when spenders hold consistent, reasonably optimistic expectations about the economy, it becomes continually more difficult to persuade them to maintain their level of spending. The cost of debt service grows as their indebtedness grows, reducing their ability to spend. New borrowing becomes more difficult as wages are dwarfed by liabilities. Individuals become more nervous that some blip in their complicated lives will leave them unable to meet their obligations. In order to hold expenditure constant, interest rates must fall, credit standards must loosen, the value of spenders’ one consumption good that survives as pledgeable collateral — their homes — must be made to rise. Stabilizing expenditure requires continual easing. Any sort of lower bound provokes a “Minsky moment”, as expenditures that can no longer be sustained unexpectedly contract, rendering maxed-out spenders unable to service their debts.

All of this is just a theory, but I think it fits the facts better than a theory that takes stable demand and depression as arbitrary “sunspot” equilibria, selected by expectations. If the demand-stable “great moderation” had been an equilibrium, one might expect parameters like interest rates and aggregate indebtedness to be stable or to mean-revert around their long-term values. They were not. Interest rates were in secular decline throughout the period, and the indebtedness of some households to others was consistently rising as a fraction of GDP. Credit standards declined.

If my theory is right, absent significant structural change, attempting to restore demand merely by shocking expectations would be like trying to defibrillate a corpse. Yes, NGDP expectations absolutely did collapse over the course of 2008, but that was not due to a transient shock but a secular change which made the prior stabilization regime untenable. The housing collapse and credit crisis made it impossible to sustain expenditure by loosening credit standards. That left interest rates as the only tool by which to encourage spenders, but the zero nominal bound and rising credit spreads rendered that lever insufficient. Since 2008, whenever expectations have begun to perk up — and they have, several times — yet another “shock” has come along and returned us to pessimism (“OMG, Europe!”). Eventually you have to wonder whether there isn’t something more than arbitrary about these negative expectations.

The market monetarists might retort that a sufficiently determined central bank, if given license to lend and purchase assets as it sees fit, can always meet a nominal spending target, and therefore can always set expectations of nominal demand. That may be true. But in the context of an economy structurally resistant to increasing expenditure, expectations of stable nominal income become equivalent to expectations of continual central bank expansion. NGDP expectations can be maintained, if and only if the central bank demonstrates its willingness to continually intervene.

If intervention will be frequent and chronic, precisely what instruments the central bank intends to use becomes a matter of great public concern, rather than a technocratic detail best left to professionals. Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief Paul Volcker Chuck Norris moment but for the indefinite future.

So, I am all for targeting an NGDP path. I think it’s a great idea, and have more nice things to say about it. I hope the market monetarists are right, that merely by announcing an NGDP target and showing resolve in a one-time wrestling match with skeptics, central banks can restore a high-demand equilibrium. But if we adopt an NGDP target and are serious about it, there is significant risk that we will be committing to chronic intervention. The market monetarists owe us a more serious conversation than they’ve offered so far about how monetary policy would be conducted if resetting expectations turns out not to be enough. Would the interventions they propose be fair, if pursued cumulatively over many years? Would they be wise? Would they help resolve the structural problems that have rendered it so difficult to sustain demand, or would they exacerbate those problems?

[1] Yes, the US Federal Reserve has its murky triple mandate. But in practice tracking a tacit inflation target seems to dominate. Other central banks are at least explicit in their poor choice of a target.

The last few weeks have seen high-profile endorsements of having the Federal Reserve target a nominal GDP path. (See Paul Krugman, Brad DeLong, Jan Hatzius and colleagues at Goldman Sachs.) This is a huge victory for the “market monetarists”, a group that includes Scott Sumner, Nick Rowe, David Beckworth, Josh Hendrickson, Bill Woolsey, Marcus Nunes, Niklas Blanchard, David Glasner, Kantoos, and Lars Christensen. Sumner in particular deserves congratulations. He has been on a mission from God for several years now, and has worked tirelessly to persuade us all that central banks should target NGDP, and that they have to ability to do so even after interest rates fall to zero.

I have reservations about the market monetarists’ project. I’m not certain that the Fed has the tools to meet an NGDP target, or if it does have the tools, that the costs of deploying them to establish its credibility are supportable. Moreover, I don’t think that the market monetarists have sufficiently thought through the consequences of success, in accounting terms, if they restrict themselves to lending to the private sector (or, equivalently, purchasing debt instruments from the private sector). The market monetarists have grown in parallel with another fringe monetary theory, MMT. The two groups don’t consider themselves aligned, but I think they are two sides of the same coin. It would be great if they would combine their insights — the market monetarists with their NGDP-targeting central bank, the MMT-ers with their concern for balance sheet health and their understanding that transfers-to-be-taxed deleverage private sector balance sheets while advances-to-be-repaid do not.

But such quibbles are for another time. Here I want to join the market monetarists’ happy dance, and point out several moral benefits of NGDP targeting.

• The most plain moral benefit of NGDP targeting is that it is activist. Relative to the status quo, it demands a serious effort to combat the miseries of depression. This is a big improvement over our current strategy, which is to shrug off and rationalize mass deprivation and idleness.

• A second moral benefit is that under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. Ideally, we’ll find that once we stabilize the path of NGDP, the business cycle is conquered and there will be no more depressions ever again. But that probably won’t happen. If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation.

  I do not relish inflation for its own sake, or advocate punishing creditors because they are rich and the tall poppies must be cut. But if, despite NGDP stabilization, real GDP cannot be sustained, someone has to bear real losses. There are only two choices: current producers can be taxed in order to make creditors whole in real terms, or past claims can be devalued so that losses are borne at least in part by creditors. In my view, the latter is the only moral choice, and the only choice that creates incentives for investors to maximize real-economic return rather than, say, hide behind guaranteed debt and press politicians to ensure the purchasing power of that debt is sustained regardless of the cost to aggregate wealth. (Sumner makes a similar point in his excellent National Affairs piece.)

  Note that NGDP targeting doesn’t prevent the honorable Austrian remedy to credit misallocation: having creditors individually to bear losses via default and/or bankruptcy of borrowers. When it is possible to equitize or liquidate particular claims quickly and without creating terrible costs for the rest of the economy, we should do so. Every completed restructuring promotes real activity by reducing valuation uncertainty and debt overhang, and so reduces the degree to which an NGDP targeting central bank will need to tolerate inflation and spread losses to creditors generally. We should try internalize the costs of credit decisions via default and bankruptcy as much as possible, as doing so keeps investment incentives sharp. (On a stable NGDP path, we don’t have to worry so much that loans that should have been good turned bad because of a scarcity of aggregate income.) But whether it is particular bad lenders who suffer or creditors in aggregate, current producers should not be forced to bail out the bad or unlucky investment decisions of earlier claimants.

• In fact, NGDP targeting, despite the stench of sugar-high money games that Austrians perceive in it, might actually increase our ability to impose losses on foolish creditors via default and bankruptcy. This would pay a huge moral dividend, in terms of our ability to avoid the unfairness of arbitrary bail-outs. Both Nick Rowe and Scott Sumner have suggested to me that if we had sufficiently aggressive monetary stabilization, we could avoid acquiescing to “emergency” rescues that flamboyantly reward bad actors, because allowing bad actors to collapse would no longer threaten the rest of us. Rajiv Sethi has made a similar point:

  The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker’s view that Ben Bernanke “deliberately misled” Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

  Perhaps we ought to think of “liquidationism” and stimulus as complementary rather than pin them to bitterly opposed camps. The palliative of stimulus might enable the medicine of consequences to work its pain without killing the rest of us. Obviously, fiscal and monetary interventions can be used to bail out failing incumbents, and as a matter of political economy, we might find ourselves unable to prevent this misuse. But precommitting to aggressive macro stabilization via tools that don’t discriminate in favor of particular firms or sectors might allow for more liquidation of bad claims than pretending we will be laissez-faire when the consequences of nonintervention would prove catastrophic.

• In constrast to an inflation-targeting central bank, an NGDP-targeting central bank need not distort the division of income between capital and labor. Under current practice, the Fed tends to encourage asset price inflation but worries frenetically over any growth in unit labor costs, or, equivalently, labor’s share of income. Labor share of income has been collapsing since about 1970. I don’t mean to claim that the Fed has caused the collapse of labor share: globalization, automation, and deunionization would have put pressure on wages regardless of Fed action. But the credibility of the Fed’s consumer-inflation targeting regime is closely tied to moderation of wage growth. Managers, union leaders, and policymakers know that bargains whose effect would be to increase labor share might provoke contractionary monetary policy and even recession. This undoubtedly has had some effect. I don’t want to overattribute, but it seems more than coincidental that Rubinism and Clintonesque hypersensitivity to bond-market concerns arose after George H.W. Bush’s reelection was thought to have been crippled by cautious monetary policy and the jobless recovery it engendered. I think many labor-sympathetic observers view the Federal Reserve as an organization which tilts the scales against workers in subtle and unaccountable ways. I know that I do.

  An NGDP-targeting central bank trying to contract would be indifferent between restraining wage and capital income. Wage income growth puts more pressure on consumer prices than capital income growth, but under NGDP targeting it’s all nominal income. In practice, devils live in details, and how the Fed actually works to achieve its target might or might not be neutral. But labor has a better shot of being treated equitably under an NGDP-targeting regime than under an inflation target that is inherently threatened by wage growth.

It’s a bit ironic that the “market monetarists” are gaining prominence at the same time as “End the Fed” is a rallying cry of social movements across the political spectrum. It is a mistake to associate “End the Fed” solely with Ron Paul’s unpersuasive sound-money fetish. (Unpersuasive, because the Fed over its history has preserved the purchasing power of a dollar held in any financial instrument other than a mattress.) Many Americans, including me, feel a strong antipathy towards the Fed, not because of it has debauched the currency, but because we believe that it has played favorites in the economy and in politics, usually in the shadows but brazenly over the course of the financial crisis. We think the Fed behaves immorally and unfairly. An NGDP-targeting Fed could be a better Fed, in a moral as well as technocratic sense. I wish the market monetarists luck in trying to make it so.

As the MMT-ers emphasize, in aggregate bank lending is almost never reserve-constrained. Unless a central bank is willing to tolerate arbitrarily high interest rates, it must be willing supply reserves in response to increasing demand.

However, to point out that the banking system is not reserve constrained does not imply that individual banks are not reserve constrained. Macro types tend to assume there is an interest rate and an interbank market to which any bank can turn for reserves at the policy interest rate. But that’s simply not true, at least in the United States. Most banks do not regularly borrow at all on interbank markets, or at the central bank discount window. [1] The largest banks have ready access to interbank loans and use them to finance substantial portions of their balance sheets. But small banks do not. This is understandable. Borrowing in the “Federal Funds market” occurs via bilateral unsecured loan contracts. Small banks are perfectly comfortable lending to large, implicitly backstopped banks. But banks large and small are reluctant to make cheap unsecured loans to the Bank of Palookaville, whose exposure to the local Cadillac dealer is hard to evaluate from a distance. So small banks tend to amass precautionary stashes of reserves and lend them overnight to big banks, who may borrow at will. Prior to the financial crisis, the net reserve position of the largest 20% of US banks was negative. All of these banks’ reserves and then some were borrowed on the interbank market. That has changed since the Federal Reserve has flooded the banking system with cash, but small banks continue to devote a larger fraction of their balance sheets than large banks to reserves and near-reserves. While large banks happily rely upon central-bank guaranteed liquidity, small banks maintain buffers in case that abundance fails to trickle down. Aggregate lending cannot be reserve constrained, but lending by small banks may well be.

If small bank lending is reserve constrained, then policies that redirect flows of reserves from larger banks to smaller banks might be expansionary. At the margin, Bank of Palookaville is more likely to fund a loan if its reserve stockpile is well above what it requires for self-insurance. As the stockpile dwindles, a small bank’s cost of lending must include an increasing charge for the bank’s liquidity risk. There is evidence for this. In an influential paper, Kashyap and Stein famously documented a “bank lending channel” of monetary policy that operates predominantly through smaller banks.

But how could a central bank oppose the general tendency of reserves to flow from smaller to larger banks? Once the Fed buys an asset or makes a loan, the reserves are “out there”, no longer under its control. In the past, affecting patterns of reserve flow might have been difficult. But now the Fed pays interest on reserves, on terms that are entirely at its discretion. Suppose that the Fed were to cap, in absolute dollars, the quantity of reserves on which it is willing to pay interest to any single bank. Then banks with “too many” reserves would look to shed the excess, an unremunerated asset they need to finance. They might reduce the interest they pay (or raise the fees they charge) to depositors, which, at the margin, would cause funds to flow to banks whose reserve level is below the cap. Alternatively, reserve-heavy banks might lend their excess directly to smaller banks. This would allow the two banks would split the interest payment that would otherwise have been foregone, while reversing the usual direction of reserve flow in the interbank market. In either case, smaller banks might find any liquidity constraints they face substantially reduced.

The level at which reserve remuneration is capped would become a new instrument of monetary policy. The most contractionary setting would be where we are now, with no cap at all and the vast majority of excess reserves held by the largest banks. A hyperexpansionary policy would determine the cap by dividing the total quantity of excess reserves by the nearly 7000 US banks, unleashing forces of arbitrage that would inflate the balance sheet of every Podunk bank. Between these two poles there are infinite gradations, a tunable instrument of monetary policy.

Beyond the important but sterile dimension of “contraction” vs. “expansion”, there are other reasons to like this idea. Banking activity in the United States is quantitatively dominated by a small number of very large banks for whom the absence of reserve constraint is a competitive advantage. Reducing or eliminating the reserve constraint faced by small banks would even up the playing field. From a Hayekian perspective, status quo banking has devolved from an enterprise in which dispersed decisionmakers compete for advantage based on context-specific information towards a notionally private form of central planning, a Soviet backed by a few giant data-crunching hierarchies. If your inner Hayek is strong, you should applaud increasing the ability of small bankers to lend to people they know and projects they understand, while bearing much more of the risk than employees of large banks would. Smaller banks lend disproportionately to small and medium-sized enterprises, so if you think small entrepreneurs are at the heart of the economy, shifting activity towards smaller banks should help. Finally, small banks are not too big to fail. If we can’t break up the TBTF banks (I still hope we can), perhaps we can slowly deflate them by creating incentives for activity to migrate elsewhere.

Capping interest on reserves might or might not prove helpful. Quantitatively, I don’t think we have a sense of how much more lending would occur if small banks, like large banks, faced no liquidity constraint. On one hand, “the 99%” of banks currently account for only 22% of activity (measured by balance sheet size) and the smallest 90% of banks account for less than 8%. You can argue that with numbers like these, smaller banks just can’t make a difference. On the other hand, finance flows fast and the hyperconcentration of banking may prove reversible. An IOR cap has no financial cost, can be implemented at will, and would be expansionary at the margin however large or small the effect. Perhaps it is worth a try.

Note: rootless_e asks over Twitter that I “please put in some explicit indication that TARP was [enacted under] Bush/Paulson because many people don’t recall”. I am glad to do so. I bring up TARP to illustrate a policy error, not to pin that error on Barack Obama.

Ezra Klein is a wonderful writer, but I don’t love his retrospective on the financial crisis. (Kevin Drum and Brad DeLong do.) The account is far too sympathetic. The Obama administration’s response to the crisis was visibly poor in real time. Klein shrugs off the error as though it were inevitable, predestined. It was not. The administration screwed up, and they screwed up in a deeply toxic way. They defined “politically possible” to mean acceptable to powerful incumbents, and then restricted their policy advocacy to the realm of that possible. The administration could have chosen to fight for policies that would have been effective and fair rather than placate groups whose interests were opposed to good policy. They might not have succeeded, but even so, as Mike Koncazal puts it, they would have lost well. We would be better off with good policy options untried but still on the table than where we are now, with policy itself — monetary, fiscal, whatever — discredited as both ineffective and faintly corrupt.

There is a lot in Klein’s piece that I could react to, but I want to highlight one point that is particularly misguided:

But when talking about what might have worked on a massive, economy-wide scale — that is to say, what might have made this time different — you’re talking about something more drastic. You’re talking about getting rid of the debt. To do that, somebody has to pay it, or somebody has to take the loss on it.

The most politically appealing plans are the ones that force the banks to eat the debt, or at least appear to do so. “Cramdown,” in which judges simply reduce the principal owed by underwater homeowners, works this way. But any plan that leads to massive debt forgiveness would blow a massive hole in the banks. The worry would move from “What do we do about all this housing debt?” to “What do we do about all these failing banks?” And we know what we do about failing banks amid a recession: We bail them out to keep the credit markets from freezing up. There was no appetite for a second Lehman Brothers in late 2009.

Which means that the ultimate question was how much housing debt the American taxpayer was willing to shoulder. Whether that debt came in the form of nationalizing the banks and taking the bad assets off their books — a policy the administration estimated could cost taxpayers a trillion dollars — or simply paying off the debt directly was more of a political question than an economic one. And it wasn’t a political question anyone really knew how to answer.

On first blush, there are few groups more sympathetic than underwater homeowners or foreclosed families. They remain so until about two seconds after their neighbors are asked to pay their mortgages. Recall that Rick Santelli’s famous CNBC rant wasn’t about big government or high taxes or creeping socialism. It was about a modest program the White House was proposing to help certain homeowners restructure their mortgages. It had Santelli screaming bloody murder… If you believe Santelli’s rant kicked off the tea party, then that’s what the tea party was originally about: forgiving housing debt.

This all sounds very hard-nosed. There were debts. There were economic losses, such that the debts could not be serviced at initially agreed terms. The consequences of leaving those unserviceable debts in place — frozen household spending, bankruptcy courts and litigation, blown up banks — were intolerable. Therefore, the losses were going to have to be socialized, borne by taxpayers, one way or another. Ultimately, in this view, it is all a matter of dollars and cents. The taxpayer is going to eat the loss, so what’s the best sugar to make the medicine go down?

But human affairs are not about dollars and cents. Santelli’s rant and the tea party it kind-of inspired were not borne of a financial calculation — “Oh my God! My tax bill is going to be $600 higher if we refinance underwater mortgages!” Santelli’s rant, quite legitimately, reflected a fairness concern. The core political issue has never been the quantity of debt the government would incur to mitigate the crisis. It was and remains the fairness of the transfers all that debt would finance. A fact of human affairs that proved unfortunately consequential during the crisis is that people perceive injustice more powerfully on a personal scale than at an institutional level. Bailing out the dude next door who cashed out home equity to build a Jacuzzi is a crime. Bailing out the “financial system” is just a statistic. So the anger Santelli channeled led to economically stupid bail-outs of intermediaries rather than end-debtors.

Once you understand that the problem is a fairness issue rather than a dollars-and-cents issue, the policy space grows wider. Holding constant the level of expenditure, one can make bail-outs more or less fair by the degree to which you demand sacrifice from the people you are bailing out. TARP was deeply stupid not because it meant socializing risks and costs created by bankers. TARP was terrible public policy because it socialized risks and costs while demanding almost no sacrifice at all from the people most responsible for those risks. The alternative to TARP was never “let the banks fail, and see how the bankruptcy system deals with it.” The alternative would have been to inject public capital (socialize risks and costs!) while also haircutting creditors, writing-off equityholders, firing management, and aggressively investigating past behavior. It was not the money that made TARP unpopular. It was the unfairness. And the unfairness was not at all necessary to resolve the financial problem.

If the Obama administration, or any administration, decided to encourage principal writedowns by having the government simply cover half the loss, that would be unfair. The Rick Santellis of the world might object more than I would, but that would be to my discredit more than theirs. Fairness should never be a policy afterthought. Widely adhered norms of fair play are among the most valuable public goods a society can hold. A large part of why the financial crisis has been so corrosive is that people understand that major financial institutions violated these norms and got away with it, which leaves all of us uncertain about what our own standards of behavior should be and what we can reasonably expect from others. When policy wonks, however well meaning, treat fairness as a public relations matter, they are corroding social infrastructure that is more important than the particular problems they mean to fix.

The good news is that there are lots of ways to craft good economic policy without doing violence to widely shared norms of fairness. See, for example, Ashwin Parameswaran’s “simple policy program“. On a less grand-scale, you’ll find that very few fairness concerns arise if underwater borrowers enjoy principal writedowns in the context of bankruptcy. Such “cramdowns” are consistent with a widely shared social norm, that society will grant (and creditors must fund) some relief from past poor choices to individuals who go through a costly and somewhat shameful legal process. Including mortgages and student loans in that uncontroversial bargain will piss-off bankers who wish to avoid responsibility for bad credit decisions. But it won’t provoke a revolution in Peoria.

The Obama administration campaigned on “cramdowns”, but ultimately decided not to push them. I wonder why? Perhaps Ezra Klein will explain how research by Reinhart and Rogoff shows that this too was inevitable.

I write, or at least I start to write, lots more blog posts than I ever publish. The paragraph below is from a post I began over the summer during the debt ceiling fracas. Intellectually, I did not consider gratuitous default on US debt to be wise policy. But throughout the period, I felt a strange sympathy for the people who were, very clearly, gunning for default. I was trying to articulate why.

For some reason, today seems like a good day to publish this.

I no longer trust my own government to be the provider of a civilized society. No government is perfect or without corruptions. But in 2007, I thought I lived in a remarkably well-governed nation that had gone off-kilter under a small and mean administration. In 2011, I view my government as the sharp edge of an entrenched kleptocracy, engaged in ever more expansive schemes of surveillance and arrogating powers of ever less restrained brutality. At a visceral level, I dislike President Obama more than I have disliked any politician in my lifetime, not because he is objectively worse than most of the others — he is not — but because he disproved my hypothesis that we are a country with basically good institutions brought low by poor quality leadership. Whenever I hear the President speak and am impressed by the quality of his intellect, by his instinct towards diplomacy and finding common ground and rising above petty struggles, I despair more deeply. Not just because a leader of high quality failed to restore passably clean and beneficient government. It is worse than that. The kleptocracy has harnassed this man’s most admirable qualities and made them a powerful weapon for its own ends. He has rebranded as “moderate”, “adult”, “reasonable”, practices such as unaccountable assassination lists and Orwellian nonhostilities. He has demostrated that the way grown-ups get things done in Washington is by continually paying off thieves in suits. Perhaps it is unfair to blame Barack Obama for all this. Maybe he has done the very best a person could do under our present institutions. But then it is not unfair to detest the institutions, to wish to see them clipped, contained, or starved.

Yields on long-term US bonds have been falling like a rock since August. On the demand side, there’s no great mystery to this. Stock markets have done poorly, which tends to support Treasuries as a “flight to safety” asset. Other “safe havens” have looked wobbly. European debt in general has been tarnished by the sovereign financial crisis. The Swiss Central Bank just made violently clear its discomfort with flight-to-safety investment flows. Gold and silver’s prices have seemed “bubblicious” for some time, and have duly lived up and down to that characterization by crashing. Only the US Treasury remains willing and able to bear the “exorbitant burden”, in Michael Pettis’ coinage, of providing sanctuary to refugee capital.

The latest collapse in long-term yields followed the announcement by the Federal Reserve of an “Operation Twist” intervention, under which it will sell short-term US debt and purchase long-term debt. At first blush, it is obvious why this might drive down long-term bond yields. Holding all else constant, if the Fed enters the long bond market as a large-scale buyer, it seems natural that it would bid up prices and push down yields on long-term bonds. But this account is unsatisfying. First, “operation twist” had been widely anticipated by market participants, so why the sudden earthquake? More importantly, “holding all else constant” is a ridiculous assumption when thinking about “operation twist”.

US Treasury bonds are issued by the US Treasury, which pays a great deal of attention to the structure of its liabilities, and has been working to lengthen their maturity. (See the discussion in this presentation, which is rather extraordinary in its candor, ht Bond Girl.) The US Treasury is the beneficial owner of the Federal Reserve. The Fed’s profits and losses eventually flow to the Treasury. If the Treasury wishes to manage its liability structure in order to manage future costs and risks, it will consolidate the Fed’s portfolio with its own as it targets a maturity structure. If the Fed sells short maturity and buys long maturity bonds, a rational Treasury will issue more long bonds and fewer short bonds than it otherwise would. (As indeed it has, see Jim Hamilton.) The central bank may “act last”, in Tyler Cowen’s quip, in the sense that monetary policy shifts can be made on a much higher frequency than acts of Congress that alter fiscal policy. But the Treasury issues and redeems debt continually. The Fed has no institutional advantage over the Treasury in determining the maturity structure of US debt. Unless there is a secret “Fed / Treasury” accord, the Treasury wins this fight. And Treasury seems resolute (and wise, in my opinion) in its intention to lengthen the maturity of its liabilities.

So I think “operation twist” is a side-show, perhaps a clever marketing scheme coordinated between the Fed and Treasury to help the US get high prices for the long-term debt it wants to issue. A more fundamental factor is the scale of issuance. And that has been interesting.

Over the first three quarters of 2011 (through last week), the net issuance of Treasury debt to the public has been very small, once you take into account purchases by the Fed. The US government has run a large deficit. In round numbers, total US debt increased by $700B over the period. Yet there was only a $40B increase in US Treasury debt to nongovernment entities. The rest of the deficit was financed by the Fed, which purchased roughly $440B of Treasury debt; by the Treasury itself, which spent down deposits it had at the Fed (as part of the crisis-related “supplementary financing program”) by about $200B; and ~$20B by other “intragovernment” lenders (like Social Security). The Federal government ran a sizable deficit, yet almost no net new issuance found its way to the public. Instead, most of the new debt was monetized as part of QE2. And interest rates, long-term as well as short-term, are lower than they’ve ever been.

One theory of long-term interest rates is, I think, definitively refuted. This is the joint hypothesis that 1) long-term real rates include a mostly stable real yield plus a premium for expected inflation; and 2) expected inflation is a function of the growth of the monetary base. If you believe in a stable real yield, then you’ve got to concede that investors’ now expect deflation despite an explosion of the monetary base.

The facts strike me as consistent with two different views. In one account, long rates are pinned by arbitrage to the expected path of short-rates plus a risk premium, and market participants have become increasingly certain that nominal interest rates will be very low for a very extended period. In a second account, important clienteles of investors do not consider money issued by the Fed and debt issued by the Treasury, particularly long-term debt, to be close substitutes. These investors have basically been starved of new Treasury supply, and so have bid up bond prices, in order to draw supply from the inventory of investors less wedded to maturity. [*]

These two stories are not contradictory: they might both be true to some degree. But they have different implications. Under the arbitrage-pinned expectations account, the only thing that could cause long yields to rise are changes in the expected path of short yields (or the uncertainty surrounding that expectation). Expected short yields might increase because of good economic news, or they might increase because the Fed is expected to fight inflationary pressures even in the absence of good news. Under the flow-to-clienteles story, yields would be expected to rise as Treasury issuance to the non-Fed public increases in the absence of quantitative easing, regardless of any change in economic outlook.

Expectations or flow? We still don’t know. But we might have a natural experiment pretty soon, as the net, unmonetized issue of Treasury securities to the public ramps back up after a restrained nine months.

Update: Browsing around, I’ve just noticed a headline very similar to mine on a Reuters article published Friday: “Operation Twist to make Treasuries do limbo”, by Emily Fitter. My apologies to Ms. Fitter or her headline writer for unintentionally stealing the line.

———

[*] Note: long maturity bond clienteles have had some net new supply, as the Treasury has been lengthening the maturity of its existing indebtedness via the Treasury’s operation anti-twist. But there would be substantially more supply, if the Treasury had been issuing more debt.

FD: I have a longstanding short futures position in 30-year Treasuries, which I maintain both as a portfolio diversifier and for speculative reasons. I frequently purchase hedges against large adverse moves, which have been helpful lately.

The financial scandal du jour is a $2 billion dollar loss at UBS blamed on a “rogue trader”. You’d think the whole “rogue trader” problem would have been solved by giant, sophisticated investment banks. After all, it was way back in 1995 that Nick Leeson brought down a 233 year-old global institution. Since then we’ve had John Rusnak at my hometown bank, Jérôme Kerviel at Société Générale, and others.

Kid Dynamite, a former trader himself, notes that “losing $2B without anyone knowing about it is much harder than you think“. To generate a $2 billion dollar loss in a short period, a trading position has to be gargantuan. Some dude on a trading desk can’t just put on that kind of trade. He’d have to get buy-in from superiors and risk managers, which probably means making up justifications or falsifying hedged positions. Derivatives trades require collateral posting, and securities trades settle in cash. You’d think the bean counters would take note when large sums come and go through the accounts. Perhaps these “rogue traders” are supergeniuses who reroute the accounting ledgers through the lavatory plumbing at the exact critical moment. Otherwise you’d think that detecting unauthorized positions of $10B-ish would be the sort of thing that masters of the universe would be capable of doing.

This is the Green Room has a delightfully wry take on the affair:

The revelation that yet another rogue trader has been pulling the levers at a major bank…makes me wonder about all the rogue traders we’re not hearing about — the ones who aren’t big, stupid or aggressive enough to get caught… Perhaps banks should start reporting “income from rogue trading” in their financial statements. It would seem naive to presume that it isn’t contributing to the bottom line.

It is a commonplace now to talk about troubled banks’ incentives to “gamble for redemption”. It has also become cliché to talk about how traders’ asymmetrical incentives encourage risk taking: If we take a big risk and make a lot of money, we get huge bonuses. If it doesn’t work out, worst case scenario is we lose our jobs. Of course, regulators discourage gambling for redemption, at least in theory. And all else equal, nobody wants to lose their job, not to mention the deferred compensation that is supposed to discourage this sort of thing. Still, there is a sense in which the bank “wants” big risks to be taken, as do a variety of employees with exposure to the upside in their bonuses. But it would be better if the risks were taken in some manner that, if things go south, no one could be blamed. Well, almost no one.

I am reminded of a wonderful post by Tanta at Calculated Risk, on stated-income loans:

I have said before that stated income is a way of letting borrowers be underwriters, instead of making lenders be underwriters… What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.

We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scarpered. I’m really amazed by all these self-employed folks who keep popping up in our comments to defend stated income lending. It is a way for you to get a loan on terms that mean you potentially face prosecution if something goes wrong. Your enthusiasm for taking this risk is making a lot of marginal lenders happy, because you’re helping them hide the true risk in their loan portfolios from auditors, examiners, and counterparties. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.

Maybe “rogue traders” aren’t devious supergeniuses after all. Maybe they’re just the stated-income borrowers of high finance, people willing to indemnify their quietly enthusiastic “victims” by being the one to tell a lie.

One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed. [1] There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be “liquidated”. A “bankrupt” state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health.

Greece’s problems are extreme, but by no means unique. European states in general are crippled by overleveraged, fragile capital structures. What Europe requires, in financial terms, is a means of converting some part of member states’ sovereign debt into equity. One solution would be to redenominate the debt of European sovereigns into unredeemable fiat currencies. But that is a particularly extreme solution, and would represent a large setback to the European project. What follows is a more modest proposal to equitize part of European states’ capital structures. The proposal is not original. It is an elaboration of a suggestion by Warren Mosler. It seems politically impossible. But very recently, so did outright default and/or exit of a Eurozone sovereign, yet that political impossibility suddenly looks very likely. The boundaries of the possible are very much in flux. European governance, to its deep discredit, tends to disparage populism in favor of elite technocracy. This proposal intentionally includes a strong populist element.

Without further ado, the proposal:

1. European governments would define a new class of security: European Sovereign Equity Shares. Governments would issue and sell these securities at par. Dividends would accrue at the Eurozone inflation rate (and negative accruals could occur in the event of outright deflation). However, these would be true equity securities. The timing of any redemptions, whether of principal or accrued dividends, in part or in full, would be at the discretion of the issuing sovereign.
2. Under certain circumstances (like the current circumstances), member states and the ECB would agree that issuance of sovereign equity would serve the economic interest of the Union. The ECB would agree to purchase up to a certain quantity of each states’ equity shares, which it would carry on its books at par. With any purchase offer, the Bank would announce a maximum balance that the ECB would be willing to accept from each state. This limit would be equal for all states in per capita terms. For example, the ECB might set the maximum equity balance might at €20000 per capita. If that announcement were made today, it would mean that Greece could issue roughly €226 billion of shares, while Germany could issue roughly €1.6T. The maximum balance per country would be set at the time of an offer, and would not automatically change with population shifts. However, up to that balance, the policy would amount to a standing offer to purchase shares. Even if a sovereign has redeemed shares, should it have the need, it may issue new shares, and the ECB would purchase them, up to the ECB’s current limit for that country.
3. Purchase of equity by the ECB would be contingent upon member states agreeing to use the proceeds precisely as follows:
   1. First and foremost, any proceeds must be used to retire or repurchase the sovereign’s debt.
   2. Should the proceeds of any sale exceed the sovereign’s outstanding debt, the excess must be distributed directly to citizens in equal amounts.
   3. Distributions to citizens would be under analogous terms. Before receiving any cash benefit, citizens would be required to apply their allotments to retiring or defeasing outstanding debts. Only once all debts are retired would citizens receive a check, with which they could do as they please.

That’s basically it. This sounds opaque and technocratic. Why do I claim that it’s a good idea and also populist?

The reason it’s a good idea is because it does what obviously needs to be done in Europe, which is to eliminate the tyranny of zero. Suppose that Germany’s net financial position (however you want to compute that) is €30000 per capita while Greece’s is €5000 per capita, because Greeks have consistently consumed a greater fraction of their income than Germans. That’s fine and right: for whatever reason, the Greeks have saved less than the Germans, and therefore have a lesser claim on future consumption. But now suppose Germany’s net financial position is €10000 per capita while Greece’s is negative €15000. The difference in wealth, in absolute terms, is identical, but around and beneath zero all kinds of “distress costs” kick in. Loans go unpaid, interest rates spike, politics get ugly, etc. etc. (You don’t have to imagine. Just read the news.) The effect of this proposal, in practical terms, would be to shift the zero point. If Greece and Germany both issue €20000 per capita of sovereign equity, the non-equity financial position of both states shifts upwards, reproducing the first hypothetical. The operation keeps the absolute wealth difference intact but eliminates distress costs. Of course, a sovereign’s issued equity represents a liability to the ECB, so each sovereign’s overall financial position has not changed at all. But equity, redeemable at the discretion of the issuer, does not provoke distress costs, while a debt position very much does. For sovereigns as for corporates, capital structure matters in the real world. The long-term value of a distressed enterprise can increase dramatically if it is able to convert an unserviceable debt position to equity.

But why is this a populist proposal? What pisses off ordinary humans, quite legitimately, about bailouts is that they undermine the moral environment, the “karma” if you will, that we try to construct in our communities in order to preserve and sustain the social norms that is the “secret sauce” of every good society. It is corrosive if policy interventions render those who are industrious and prudent no better off than those who are reckless, indolent, or predatory. However, we needn’t (and ordinary humans don’t) demand that people who are reckless or disorganized be condemned to starvation or misery. What matters is that the industrious fare significantly better than the indolent. If an ordinary German citizen gets a €15000 check (or €15000 of burdensome personal debt forgiven) while an ordinary Greek gets nothing other than the vague knowledge that politicians have squirmed out of the debt they have accrued, that sustains the difference in reward. Ordinary people in rich countries are likely to be more open to a proposal that involves their receiving a nice check (while their counterparts in less disciplined countries get nothing at all) than they would be to a “transfers union” that implies their cutting a check to those who behaved poorly while seeming to get nothing in return.

But what about inflation? Does this just amount to a scheme to hide transfers from rich countries to poor behind a money veil? No, or not entirely. First off, many of the distress costs associated with insolvency are deadweight losses, not transfers. The benefit of preventing the burning of Athens does not impose any offsetting cost on Berliners. Shifting the zero point is just a good idea. Second, for the Eurozone as a whole, inflation need not rise at all. The ECB has the tools to combat a general inflation, if it wishes to. When inflationary pressures arise, the ECB can raise interest rates. In terms of Eurozone-wide consumption, the value of Germans’ new Euros can be sustained. The distribution of inflation rates across the Eurozone would likely be affected, in a way that disadvantages citizens of rich countries. Status quo inflation targeting across the Eurozone tends to distribute inflation towards current-account deficit countries, reducing their relative competitiveness and exacerbating the imbalance. Cash grants to citizens in rich countries reverse the maldistribution of inflation, raising income and prices in countries that are generating unsustainable current-accunt surpluses. If Germans but not Greeks receive €15000 grants, prices of German goods will rise relative to prices of Greek goods. At the margin, this will increase Germans’ propensity to spend their newfound wealth in Greece and help restore financial balance.

Further, the proposal creates a new policy tool by which countries can individually take some control over their own price level, helping remedy the “one size fits all” limitation of European monetary policy. Remember, the German government would have the right, but not the obligation, to issue sovereign equity in excess of its debt and distribute the proceeds to its citizens. To whatever degree the German polity values price stability over access to wealth on very easy terms, the German polity can choose not to issue. It loses nothing by doing this: it retains the right to issue equity and distribute the proceeds whenever it judges that its domestic economy would be helped more than harmed by a bit of “helicopter drop”. As a matter of political economy, when the ECB’s equity limits are raised due to a crisis in some corner of the Eurozone, solvent countries might wish to issue some equity and distribute the proceeds, to buy the support of citizens and sustain the sense of reward for collective prudence. But they could leave much of their capacity in reserve for a future domestic slump.

One genuine downside of this scheme is that it fails to distribute losses to foolish rich-country lenders, and therefore might encourage reckless lending to and borrowing from spendthrift countries going forward. Persistent current account imbalance is, I think, very dangerous and corrosive, and should absolutely be discouraged. Very few proposals credibly address this. Under current arrangements, trying to punish foolish lenders generates a crisis that threatens the existence of the Euro. The leading maybe-reform, a European stabilization fund financed by “Eurobonds”, would bail out creditors and impose deadweight austerity costs on debtors. It is naive to think that imposing harsh austerity on debtors will prevent intra-European debt crises going forward. In human affairs at every level, it is creditors, not debtors, who provide or fail to provide practical limits on bad lending. An individual person or government may be prudent and refuse to borrow funds they’ll be unable to invest and repay. But in any population of humans, and in most countries as governments change over time, there will always be people willing to take loans and consume the proceeds recklessly. The only way to prevent that behavior from causing systemic problems is to insist that creditors take responsibility for their loans. (Note that the roles of creditor and debtor are asymmetrical. Many humans have an innate impulse to spend recklessly that is not matched by an innate impulse to lend recklessly. Trying to punish foolish borrowing is fighting human nature in a way that insisting reckless creditors bear losses is not.)

The current proposal punishes creditors insufficiently. But it does punish them some, by reducing their relative advantage over debtors. Going forward, if it were up to me, I’d insist that bank loans to sovereigns other than a bank’s “home” sovereign carry the same risk weighting as corporate equity, and I’d tax cross-border fixed-income investment. But those are topics for another time.

This proposal would defuse the current crisis. And it would create a permanent mechanism for dealing with future crises. It does not pretend (absurdly) that interventions are “one-offs” that absolutely, positively, will never be repeated. The ECB can purchase sovereign equity whenever a systemic debt crisis threatens the Eurozone.

Enabling sovereign equity issuance would enlarge the space of macroeconomic policy options, both at the level of the Union and at the level of individual member states. Distributing the proceeds of equity sales (after debt retirement) directly to citizens means that crises get resolved in a manner that is comprehensible and fair to ordinary people. Nothing explodes. Citizens of countries that adequately discipline their governments and banks occasionally receive large checks. Citizens of less careful countries do not, and look across their borders with envy.

[1] If you don’t get this, think about it. The sine qua non distinction between debt and equity is involuntary redemption. The issuer of a debt security must redeem it for something else, either on a fixed schedule or on demand. Equity securities are redeemable only at the issuer’s discretion. Great Britain and the US finance themselves by issuing 1) fiat currency, which is plainly a form of equity; and 2) securities that convert to fiat currency on a fixed timetable, or “mandatory convertibles” to equity. In both cases, bearers have no right to demand redemption of the issuer’s paper for anything other than, well, the issuer’s paper. Just as firms that issue equity work to maintain the value of their equity despite the absence of any right to redeem, Great Britain and the US work to ensure that their paper is valuable in secondary markets by a wide variety of techniques, including taxation and the payment of interest. But all of those manipulations are at the discretion of the issuing sovereign. Great Britain and the United States have all-equity capital structures. Greece, France, and Germany finance themselves by issuing securities that are redeemable on a fixed time table for Euros, an asset which those states cannot issue at will. Greece’s sovereign debt is in fact debt, while the United States’ “sovereign debt” is a form of equity.

I read too much from monetarists and quasimonetarists and progressive monetarists and what not that monetary policy is what we need, that fiscal is unnecessary.

For the moment, let’s put aside the big disputes about whether macro demand-side remedies are a good idea. Let’s stipulate that they are, that increasing aggregate demand or accommodating people’s elevated demand for the medium of exchange or whatever would be a good thing. Woo hoo!

Here’s Bryan Caplan Arnold Kling, stipulating exactly that, despite some skepticism:

Intuitively, the equilibrium effect of a one-shot helicopter drop that doubles the money supply is to permanently double nominal income. If this leads to a stealthy, stable reduction in real wages, then output and employment go up permanently, too. Otherwise the price level doubles. Either way, there’s no reason for nominal income to recede as time goes on.

In short, if you think that boosting nominal income is the cure for recession, here’s yet another reason to prefer monetary to fiscal stimulus. One burst of expansionary monetary policy increases nominal income forever. One burst of expansionary fiscal policy increases nominal income for as long as the extra spending continues. At best.

I’m not sure Caplan is right on the economics here. His post seems to assume a world in which base money and bonds are imperfect substitutes. Some people might say that’s normal, and call the other situation a liquidity trap. But if so, liquidity trap is probably the new normal. The Fed has signaled (ht Aaron Krowne) they may pay interest on reserves at the overnight interest rate indefinitely under a so-called “floor” regime. I wish more economists would update their models for a world in which interest is paid on reserves as a matter of course. Interest on reserves represents a permanent policy shift that had been planned since 2006. It was not an ad hoc crisis response that can be expected to disappear. If interest is paid on reserves at the overnight rate and short-term bond markets are liquid, then short-term bonds and base money are perfect substitutes and a helicopter drop performed by the Tim Geithner dropping bonds from an F-16 would be as effective (or ineffective) as Ben Bernanke dropping dollar bills from his flying lawnmower.

But there is one big difference. Timothy Geithner is legally allowed to give away money for nothing. He does it all the time! He writes checks to Social Security recipients, gives money to welfare recipients and oil companies and big pharma. He even writes checks to me when my accountant or George W. Bush decide I’ve paid too much in taxes! Ben Bernanke, on the other hand, would go to jail for stuff like that. Sure, he has the printing press. “Operationally”, as the MMT-ers like to put it, he is entirely unconstrained. His checks never bounce. Why can’t he devalue the dollar, or use the threat thereof to upgrade inflation expectations? The economic law of supply an demand has not been repealed, but neither has US law. By law, the Federal Reserve can only engage in financial asset swaps. It shoves money out the door in exchange for some financial asset that colorably has the same value as the money it has dished.

Helicopter drops by the Federal Reserve are illegal. Helicopter drops by the Treasury happen all the time. Every law ever passed that overpays for anything, that has some manner of a transfer component, is a helicopter drop. I think all of us, left and right, delightful-smelling and stinky, can come together in a big Kumbaya and agree that most Federal spending has a transfer component, and is therefore a helicopter drop to some degree. It would not be a big deal for Congress to pass some law with even bigger, badder transfer components. They love to outdo themselves.

I think on the technocratic right, monetarists tend to think that helicopter drops by the Fed would be fairer than fiscal policy that launders transfers through expenditures. On the left and hard-crank right are people who don’t see the Fed as very fair at all, and emphasize the institution’s inclination to support certain interest groups when it does find ways of sneaking transfers through its legal shackles. My view is, a pox on both your houses, but it sucks that we are roommates. Macroeconomic policy by fiscal expenditures directed to politically favored groups is awful, unfair, and corrosive of the body politic. Macroeconomic policy by asset swaps that are quietly mispriced is awful, unfair, and corrosive of the body politic.

That’s the way it is here on Planet Earth (or at least on Planet USA, which is arguably at some remove from Planet Earth). Of course, we could change things. We could enact a law that instructed the Fed to engage in fair, perfectly transparent, helicopter drops as an instrument of macroeconomic policy. And boy would I support that! We could, as Matt Yglesias suggests (riffing on the work of Beowolf and the MMT-ers), have the Treasury issue some giant platinum coins and give them out to everyone. The difference between those two policies would be, well, no difference at all.

To the degree that our problem is on the demand-side and stems from private-debt-overhang-induced risk aversion or a desire to hoard money, we know the solution. That problem, if it exists, will go away if we give everyone money. But giving everyone money is not conventional, authorized, monetary policy. It requires new law. Politically, the law it requires would be hard law, because it shifts the distribution of risk in our very unequal polity. If we were to give everyone $20,000 tomorrow, whether it’s Ben or Timothy signing the checks, debt-overhang goes away as a macroeconomic concern. I believe, to some degree, in the demand-side story, so I’d wager that real GDP and employment would rise as well. But we would risk a step up in the price level, and therefore a devaluation in real terms of fixed-income claims and bank equity. Under status quo policy stagnation, near-term macroeconomic risks are borne primarily by the poor and marginally employed. With demand-side stimulus, whether designed by Scott Sumner via the Fed or Matt Yglesias via the Treasury, those risks would shift to financial savers, who in aggregate hold the bulk of their portfolio in the form of fixed-income securities, and who also hold the testicles of members of Congress.

The fiscal vs. monetary policy debate has gotten tiresome and distracting. If you think we need demand-side action, say specifically what you think we should do. If it’s a helicopter drop, whether by Fed or Treasury, then we need new law. Push it, and tell the self-styled realists and pragmatists to fuck off. If you think the Fed’s existing toolkit of running asset swaps and controlling the rate of interest on reserves would be enough if only they set expectations properly, then we still need new law. The Fed is not going to target NGDP or a price level path over any relevant time frame without a change in governance structure or mandate. People on the left and right and especially the technocratic center who like to see the Fed as a loophole through a dysfunctional Congress are kidding themselves. The Fed is a political creature, not some haven for philosopher-economists in togas who will openly consider your ideas. Get over it and get your hands dirty.

Update: Oops! I originally confused one of the excellent bloggers over at Econlog for another, misattributing Bryan Caplan’s post to Arnold Kling. Huge apologies to both, and many thanks to @derridative for pointing out the error.

Tyler Cowen has a tag line he’s been using for a while. Here’s the latest example:

Just to review briefly, I find the most plausible structural interpretations of the recent downturn to be based in the “we thought we were wealthier than we were” mechanism, leading to excess enthusiasm, excess leverage, and an eventual series of painful contractions, both AS and AD-driven, to correct the previous mistakes. I view this hypothesis as the intersection of Fischer Black, Hyman Minsky, and Michael Mandel.

In what sense is it true that “we thought we were wealthier than we were”? It is not obvious, for example, that we have encountered some unexpected scarcity in real factors that has forced us to downgrade our perception of our collective wealth. I don’t think that is what Cowen claims has happened, exactly. So what does he mean? We get some clues from his list of names. Fisher Black, as Cowen has interpreted him, suggests that since investors’ views over the short-term are not independent of one another, patterns of aggregate investment can be systematically mistaken for a while in ways that seem surprisingly obvious in retrospect. Hyman Minsky famously argued that the dynamics of financial capitalism encourage and even require ever more fragile and optimistic means of finance, leading inexorably to crisis. Michael Mandel claims that US productivity measures exaggerate domestic capabilities by failing to distinguish between domestic production efficiencies and gains due to outsourcing and production efficiencies elsewhere.

I’d like to add another name to the list, for Cowen’s consideration. Here’s John Kenneth Galbraith (grateful ht to commenter groucho, long ago):

To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s businesses and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always people who need more. Under the circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. The bezzle shrinks.

In any case, a common thread behind all of these stories is that our “overestimate” of wealth is not a random phenomenon. We did not just have a collective “oops!”. In Galbraith’s version, it is outright embezzlers who contrive to keep our accounts inflated. In Mandel’s, it is well-meaning but mistaken government economists (as well as those who unskeptically rely upon them). In Minsky, it is the interplay of competitive dynamics and financing arrangements. The Black/Cowen account is the least specific, but requires some common signal that causes investors’ judgments to be correlated, so their errors do not cancel.

What has been our actual, lived experience of the past decade or so? What were the common signals that rendered investors decisions to be both correlated and mistaken?

I don’t wish to denigrate Mandel’s work, which I consider useful and insightful. Certainly overestimates of domestic productivity contributed to a general sense of optimism, and as Mandel has argued, probably contributed to policy errors during the crisis as apparent high productivity helped policymakers to mistake a chronic economic crisis for a transient distortion in response to a financial shock. Robust apparent productivity growth might well have helped rationalize consumer and housing credit decisions that now seem questionable.

But I think we know something about the investors of the last decade. There was, as This American Life / Planet Money famously put it a “giant pool of money”, specifically sovereign and institutional money, that was seeking out ultra-safe, “Triple A” investment, and sometimes agitating for yield within that category. We really don’t need to look for subtle information cascades in order to explain investors’ “errors”. The investors in question weren’t, in fact, investors at all in an informational sense. To a first approximation, they paid no attention at all to the real projects in which they were investing. They were simply trying to put money in the bank, and competitively shopping for good rates on investments they could defend as broadly equivalent to a savings account.

But how did this “giant pool of money” come to be? The overestimate of wealth occurred prior to as well as during the investment process, a fact which can’t readily be explained by the Black/Cowen story. There was too much income to be invested, income which took the form not of speculative securities but of money, visible flows of central bank reserves and bank deposits. When ordinary investors make mistakes, however correlated, what we observe is a mere overpricing of questionable securities. Under current institutional arrangements, there is only one kind of investor who can convert investors’ mistakes into cash income growth (holding “velocity”, the reciprocal of peoples’ desire to hold income as cash or bank deposits, roughly constant). Only mistakes by banks can explain the increase of money income. (Note that the relevant income here, for the US, is not NGDP, but US dollar income worldwide, including e.g. income generated from exports by China and oil producers.)

It would be plausible to argue that banks were not at the vanguard of the error, that they were only caught up in a general zeitgeist of malinvestment, if other classes of investors were making the same misjudgment. That roughly describes what happened during the dot-com boom. But during second boom, other classes of investors were, to a first approximation, making no judgments at all. Institutional investors were simply buying the securities that banks were willing to treat as “money good” and reaching nihilistically for yield without a care in the world about how it might be generated.

Even the most careful and independent population of investors is likely to have its aggregate expectation disappointed if those investors’ incomes correspond to a lower quality of real resources than is suggested by the number of dollars that alight in their bank accounts. And any rational investor will choose to forego direct participation in risky real projects if intermediaries offer sufficient yield on securities that banks are willing to monetize at will. The primary mistake of non-bank investors was to fail to foresee that banks would change their willingness to accept as “money good” securities that core institutions were designing for precisely that acceptance. The “overestimate” of wealth from which we are now suffering occurred first as an exaggeration of value within the core financial system and then as a willingness of institutional investors to take values given by core financial intermediaries as durably sound. “We” did not decide we were wealthier than we are. Two groups of people whose economic role is precisely to evaluate the quality of our wealth misjudged, one directly by neglecting risk, the other indirectly by trusting the first when it should have known better. The broad public or taxpayers or the polity erred only and precisely by trusting these professionals.

Why were banks so easily persuaded that, via the magicks of tranching and diversification, lending into obviously questionable real projects was so safe that any downside risk could safely be socialized? The banking sector’s job is to convert a portfolio of real investment into money that is ultimately backed by the state, and its responsibility is to do so in a manner such that the likelihood realized values will in aggregate undershoot funds advanced is negligible, without recourse, directly or indirectly, to any heroic government stabilization. “Mistake” is not a remotely sufficient characterization of what occurred. There were discernible incentives behind the banking sector’s misbehavior. Throughout the securitization chain, conservative valuation practices were entirely inconsistent with maximizing employee and shareholder wealth. And why did institutional money trust bank and rating agency valuations when money managers were not too stupid to understand that high yield and low risk make for a fishy combination? Again, the answer is not some kind of sunspot. Agents were well paid not to question “money center banks”, for whose misjudgments and misrepresentations they could never reasonably be blamed.

The broad public did err, by accepting an absurdly and dangerously arranged financial system. If we want to prevent a recurrence going forward, if (qua Black/Cowen) we want to enter a world where it would even be possible for investors’ judgments to be reasonably independent, we have to undo a financial system designed around the delegation of investment decisions from the broad public through several tiers of professionals to a semi-socialized “money center” core. Yes, we also have to attend to the public sector’s role in generating “money good” securities not-necessarily-backed by reliable value. But that’s an implausible account of the lead-up to 2008, and we should be cognizant of the fact that, absent debt-ceiling own goals, public sector securities fail more gracefully than bank advances against private assets. (The costs of public sector over-issue would be experienced either as inflation or economic depression due to tight monetary policy required to avoid inflation even in the face of underemployment and not, at least initially, as a banking crisis.)

Despite all these errors, we have no reason to believe that, in real terms, we are unable to consume or produce today at levels suggested by the pre-2008 trendline. Yes, we’ve recently experienced price spikes that might suggest scarcity of some commodities. But we experienced large spikes prior to the crisis and kept on growing. Over the longer haul, we may be able to grow around emerging scarcities via technological ingenuity or we might have to redefine growth so that we value less resource-intensive consumption more highly in order to sustain the almighty trendline. But at this moment, we are not discouraged by a physical bottleneck, but by increased uncertainty about the future value of our resources, skills, organizations, and political arrangements. The only coherent way to understand Cowen’s tag line is that we currently believe the future to be less bright than we believed it to be in 2007, and this change in collective expectation has altered our behavior. We are not, today, forced to produce or consume less than we expected to in 2007. We are choosing to do so, perhaps pathologically as a Keynesian output gap, perhaps wisely in order to conserve and regroup given diminished expectations going forward. (Even if you buy the latter story, conservation of human resources implies providing education or employment. No true Austrian would characterize involuntary idleness, misery, and decay as desirable no matter how badly we discover we have malinvested.)

If Cowen is right, it has caused us a great deal of misery that “we thought we were wealthier than we were”. We should attend very carefully to the details of how we came to think what we thought, of who told us we were wealthy when we weren’t. (Shades of Galbraith…) More importantly, if we cannot evaluate the quality of our wealth going forward, we are unlikely to make decisions conducive to sustaining and expanding that wealth. There is something in the tone of Cowen’s tagline that suggests an “oops!”, a shrug of the shoulders. Whether he intends that or not, it’s precisely the wrong response to the events of the last decade. “Our” misjudgments were not some random perturbation spiraled out of control. They were the result of a set of arrangements that systematically bribed gatekeepers to make and accept incautious estimates, and to circumvent control systems intended to keep valuations in check. As of this writing, those arrangements remain largely in place.