Is the ZLB an economic or legal constraint?

The so-called zero-lower-bound (ZLB) plays a prominent role in modern (and even older) macroeconomic theories. It is often introduced in a paper or at conference as a fact of life -- an unavoidable property of the physical environment, like gravity. But is it correct to view it in this way? Or is the ZLB better thought of as legal constraint--something that can potentially be circumvented by policy?

The Financial Services Regulatory Relief Act of 2006 allows the U.S. Federal Reserve (the Fed) to pay interest on reserve accounts that private banks hold at the Fed. Specifically, the Act states that:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.

The effective date of this authority was advanced to October 1, 2008, by the Emergency Economic Stabilization Act of 2008.

It is not clear (to me, at least) whether the Act grants the Fed the authority to pay a negative interest rate on reserves. Note that if the interest-on-reserves (IOR) rate is set to a negative number, then banks would in effect be paying the Fed a "service fee" for the privilege of holding reserve balances with the Fed. But if the Fed is not legally permitted to use negative interest rate policy (NIRP), then the ZLB is obviously a legal constraint.

This legal constraint, however, may not be binding if the ZLB is also an economic constraint. In fact, the traditional explanation for the ZLB is the existence of physical currency bearing zero interest. The idea that arbitrage will effectively keep interest rates from falling below zero is deeply ingrained in the minds of economists. For example, Corriea, et. al. (2012) write:

Arbitrage between money and bonds requires nominal interest to be positive. This "zero bound" constraint gives rise to a macroeconomic situation known as a liquidity trap. It presents a difficult challenge for stabilization policy.

However, we know from recent experience that the ZLB appears not to be an economic constraint.  Several central banks today have set their deposit rates into negative territory:

There is currently over $10 trillion of government debt in the world yielding a negative nominal interest rate; see here. As of this writing, even long bonds like the German 10-year Bund are in negative territory.

Well, alright, so the ZLB is evidently not an economic constraint. But surely there is some limit to how low nominal interest rates can fall? This lower limit is called the effective lower bound (ELB). And economic theory is clear: if we're at the ELB in a recession, then monetary policy has done about as much as it can be expected to do.

But what exactly is the ELB? Is it -1%, -2%, -5%, or perhaps even lower? Economists like Miles Kimball believe it to sufficiently negative to warrant NIRP as an effective policy tool; see here.  His arguments, however, did not seem to gain much traction. For example, in the present discussions concerning the Fed's new long-run monetary policy framework, the possibility of NIRP is not even mentioned. But perhaps it should be if the ELB is in fact significantly below zero. In what follows, I want to make my own (related) argument for why the ELB is probably a lot lower than most people think.

Suppose the Fed was to set the IOR to -10% (in a deep demand-driven recession, this would presumably be accompanied with a promise to raise the IOR at some point in the future). The traditional economic argument suggests that any security dominated in rate of return by cash would in this case be driven out of circulation.

The first thing we could imagine happening is banks attempting to convert their digital reserves into vault cash. Banks are presently holding over $1.6 trillion in reserves with the Fed. The largest denomination Federal Reserve note is $100. This is what $1 trillion in $100 bills apparently looks like:

That's about the size of a football field. Banks would not convert all of their reserves into cash--even if it was costless to do so--because they'd need about $20-30 billion or so to make interbank payments. Of course, managing all that cash would be far from costless. But there is a simpler reason for why banks would not make the conversion. The Fed could simply charge banks a 10% service fee on their vault cash.

Alright, well what effect is the -10% IOR rate going to have on the deposit rate (or fees) that banks offer (or charge) their depositors? Banks are not likely to pass the full cost on to their depositors, especially if they view the NIRP to be temporary, because they'll want to maintain their customer relationships.

But let us take the extreme case and suppose that NIRP is perceived to be permanent. Then surely deposit rates will decline (or bank fees will rise) significantly. Deposit rates may even decline to the point where depositors start withdrawing their money from the banking system. Banks may well let this source of funding go if they could borrow more cheaply from the Fed (banks would need to borrow reserves to honor the withdrawal requests of their customers). Of course, the Fed lending rate is also a policy variable and could, in principle, be lowered to negative territory as well.

But how realistic is it to imagine all or most bank deposits converted to cash? While this might be the case for small value accounts, it seems unlikely that the business sector would be able to manage its payments needs without the aid of the banking system. Even money market funds need to work through the banking system. I suppose one could imagine a new product created by (say) Vanguard in which they create a cash fund with equity shares redeemable for cash that is collected and stored in rented Las Vegas vault. But the moment the activity is intermediated, it becomes taxable. If the Fed is not permitted to tax (oops, charge a service fee) such entities, the fiscal authority could, in principle, implement a surcharge that is set automatically off the IOR rate in some manner.

I think in this way one can see how the ELB might easily be well below -5% (or more). This is probably low enough to allow us to disregard the ELB as a binding economic constraint. The relevant constraint is always a legal one. And laws can be changed if it is deemed to serve the public interest.

Keep in mind that in a large class of economic models, ranging from Keynes (1936) to New Keynesian, there is potentially much to be gained by eliminating the ZLB. If these models are wrong, then let's get rid of them. But if they're roughly correct, why don't we take their policy prescriptions seriously? Let's stop talking about the ZLB as if it's a force of nature. It is a policy choice. And if it's a bad policy choice, it should be changed.

The Chicago Booth Survey on MMT

I want to say a few things about Chicago Booth's recent survey questions posed to a set of economists; see here. The survey asked how strongly one believes in the following two statements:

Question A: Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt.

Question B: Countries that borrow in their own currency can finance as much real government spending as they want by creating money.

Not surprisingly, most economists surveyed disagreed with both statements. Fine. But, not fine, actually. Because the survey prefaced the two questions with 

Modern Monetary Theory

as if the the two statements constitute some core belief of MMT.  

Was any MMT proponent included in the survey? Don't be ridiculous, of course not (there were a couple from MIT though--perhaps they thought this was close enough). How would a typical MMT proponent have answered these two questions? I am sure that most would have answered in the exact same way as other economists. If this is the case, then why does Chicago Booth preface the survey with MMT? There are many possibilities, none of which are attractive for Chicago Booth.

Let's consider Question B first. Or, better yet, let's not. This question is so ridiculous it hardly merits a response. Nobody believes that governments face no resource constraints.

O.K., so let's consider Question A, where some legitimate confusion may be present. Before I start though, I want to make clear that I don't purport to know the entire MMT academic literature very well. But I have done some reading and I have corresponded with some very smart, very thoughtful MMT proponents. I don't agree with many of their views, but I think I see how some of what they say is both valid and contrary to conventional thinking. At the very least, it seems worth exploring. What I am about to say is my own interpretation -- I am not speaking on behalf of MMTers.

Alright, so on to the question of whether deficits "matter." The more precise MMT statement reads more like this "A country that issues debt denominated in its own currency operating in a flexible exchange rate regime need not worry about defaulting in technical terms on its outstanding debt." That is, the U.S. government can always print money to pay for its maturing debt. That's because U.S. Treasury securities represent claims for U.S. dollars, and the government can (if it wants) print all the dollars it needs. 

Nobody disagrees with this statement. MMTers like to make it explicit because, first, much of the general public does not understand this basic fact, and second, this misunderstanding is sometimes (perhaps often) used to promote particular ideological views on the "proper" role of government.

Mainstream economists, like myself, like to point out what matters is not technical default but economic "default." An unexpected inflation whittles away the purchasing power of those caught holding old money as new money is printed to pay for whatever. I think it's clear that MMTers understand this too. This can be seen in their constant reference to an "inflation constraint" as defining the economic limits to government spending. I tried to formalize this idea in my previous blog post; see here: Sustainable Deficits.

But it's more complicated than this -- and in interesting ways, I think. Consider a large corporation, like General Motors. GM issues both debt and equity. The debt GM issues is denominated in dollars, so it can go bankrupt. But GM also issues a form of "money"--that is, is can use newly created equity to pay its employees or to make acquisitions.

Issuing more equity does not expose GM to greater default risk. Indeed, it may very well reduce it if the equity is used to buy back GM debt. If GM is thinking about financing an acquisition through new equity issuance, the discussion is not going to about whether GM can afford to print the new shares. Of course it can print all the shares it wants. The question is whether the acquisition is accretive or dilutive. If the former, then issuing new money will make the value of GM money go up. If the latter, then the new share issue will be inflationary (the purchasing power of GM shares will go down). In other words, "deficits don't matter" in the sense that the outstanding GM liabilities do not matter per se -- what matters is something more fundamental. Equity "over-issue" may not be desirable, but the phenomenon is symptomatic, not causal.

The U.S. government and Federal Reserve in effect issue equity. The government need not default on its debt. This is because U.S. Treasury debt is convertible into money (equity) and the Fed can do so if it so chooses. The question for the government, as with GM, is whether any new spending program is accretive or dilutive. If the economy is operating at less than full capacity, then this is like GM being presented with a positive NPV investment opportunity. The government can issue new money that, if used wisely, need not be inflationary.

There are limits to how far this can go, of course. And there was the all important qualifier "if used wisely." But this is exactly where the debate should be: how should our institutions be designed to promote the "best" allocation of resources?

I often hear that MMTers don't have a good theory of inflation. As if there is a good theory of inflation out there already. But I see in MMT a theory of inflation that overlaps (not entirely) with my own views expressed, say, here: The Failure to Inflate Japan. The MMT view seems to take a broader view over the set of instruments that monetary policy may employ to control inflation. We can have a debate about the merits of their views, but there's no reason to dismiss them outright or to pretend they don't have a theory of inflation.

Another complaint I hear: the MMTers don't want to produce a model. You know, it's true, there are not many mathematical models out there. So what? 

First, the lingua franca of policy making is English -- math is a part of a trade language. Economic ideas can be understood when expressed in the vernacular. It's also been helpful to me and others to attempt to "formalize" our thoughts in our trade language. But it seems to me that some of my colleagues can only understand an argument if it's posed in their trade language. This is a rather sad state of affairs, if true. 

Second, MMT, like any school of thought, is evolving over time and comes from a different tradition. Instead of demanding a model (now!), why not reach out and try to help formalize some of their ideas. You never know -- you may actually learn something in the process.

I could go on, but will stop here for now. 

Sustainable deficits

There's been much welcome discussion of late concerning the sustainability of government budget deficits and whether the size of the public debt is anything to worry about. I'm not going to answer this question for you here today. But what I would like to do is describe a framework that economists frequently employ to help organize their thinking on the matter. I want to begin with some simple arithmetic and then move on to a bit of theory. I'll let you judge whether the framework has any merit.

Let's start with some standard definitions.
G(t) = government spending (purchases and transfers) in year t.
T(t) = government tax revenue in year t.
R(t) = gross nominal interest rate on government debt paid in year t+1.
D(t) = nominal government debt in year t (including interest-bearing central bank reserves).

Now let's link these objects together using the following identity:

[1] G(t) + [R(t-1) - 1]*D(t-1) = T(t) + [D(t) - D(t-1)]

In words, the left-hand-side (LHS) of the identity measures the money needed to pay for government spending G(t) and the interest expense of the debt [R(t-1) - 1]*D(t-1), where [R(t-1) - 1] denotes the net nominal interest rate. The right-hand-side (RHS) of the identity measures the money collected by the government in the form of taxes T(t) and the money created through new nominal debt issuance [D(t) - D(t-1)].

I find it convenient to rewrite [1] as,

[2] G(t) - T(t) = D(t) - R(t-1)*D(t-1)

The LHS of [2] represents the primary government budget deficit. If the deficit is positive in period t, then the RHS of [2] tells us that the stock of debt in period t must be larger than the interest plus principal of the debt maturing from period t-1.

Next, define n(t) = D(t)/D(t-1), that is, the (gross) rate of growth of the nominal debt. Use this definition to write D(t-1) = D(t)/n(t) and substitute this expression into [2] to form,

[3] G(t) - T(t) = [1 - R(t-1)/n(t)]*D(t)

Let Y(t) denote the nominal GDP. Now define g(t) = G(t)/Y(t), τ(t)=T(t)/Y(t) and d(t) = D(t)/Y(t). Because I want to limit attention to "long run" scenarios, let me impose a stationarity restriction: g(t) = g, τ(t) = τ, d(t) = d, R(t-1) = R, and n(t) = n. Then we can write [3] as,

[4] g - τ = [1 - R/n]*d

Assuming d > 0, the identity [4] tells us that a sustained primary deficit is possible only if R < n. Recall that R represents the (gross) nominal interest rate on government debt and n represents the (gross) rate of growth of the nominal debt. Because of my stationarity assumption d = D(t)/Y(t), it follows that n also represents the (gross) rate of growth of the nominal GDP.

A lot of mainstream thinking on the matter of "fiscal sustainability" is rooted, I think, in the assumption that R > n. In the standard DSGE model (which abstracts from financial market frictions), the "real" interest rate R/n is pinned down by time-preference and productivity growth. This real interest rate is typically estimated to be a positive number. If this is the view one adopts, then condition [4] implies that budget deficits cannot be sustained into the indefinite future. It's not exactly made clear what might happen if deficit finance persists in such a case -- maybe inflation and/or default. Bond vigilantes. Something like that.

But this view is, at best, seriously flawed. First of all, as just an empirical matter, R < n seems like a better approximation than R > n. Here the year-over-year growth rate of nominal GDP and the one-year Treasury-bill rate for the U.S. economy since 1961,

Secondly, the standard DSGE model ignores the role that U.S. Treasury debt plays as an exchange medium in financial markets. The growth in the demand for Treasury debt has come from many sources over the past few decades. It is used extensively as collateral in credit-derivative and repo markets. Foreign countries have clamored to accumulate U.S. Treasuries as a store of value. Its demand was further enhance as a "flight to safety" asset during the financial crisis. And more recently, changes in financial regulations (Dodd-Frank and Basel III) have further spurred the demand for Treasuries (for example, they can be used to satisfy the Basel III liquidity-coverage-ratio requirement for banks).

Because of the special role played by nominally safe government debt in financial markets, it can trade at a premium. That is, agents and agencies are willing to hold "monetary" objects for reasons other than their pecuniary rate of return. This is why the nominal (and real) interest rate on safe government securities can be set lower than the "natural" rate of interest. If R < n, then the RHS of [4] corresponds to seigniorage revenue. (Note: seigniorage is not limited to the purchasing power created by zero-interest cash.)

Some of this discussion seems related to what the MMT folks are talking about. I'm not an expert in that area (am still reading up on it), but see, for example, Scott Fullwiler's article: The Debt Ratio and Sustainable Macroeconomic Policy. There's also this nice piece by (the more mainstream) Neil Mehrotra: Debt Sustainability in a Low Interest Rate World and, of course, Olivier Blanchard's AEA Presidential Address: Public Debt and Low Interest Rates.

Are there limits to how large a sustainable deficit might be? To answer this question, we need to go beyond the identities described above. Here's a simple theoretical restriction: Assume that the demand for real debt d is increasing in its real yield R/n. In undergraduate money-macro textbooks, we might say "assume that the demand for money is increasing in the interest rate paid on money." Note that for a given nominal interest rate R, this implies that the demand for real money balances is decreasing in the (expected) inflation rate. Let's denote this theory of money demand by the behavioral equation:

[5] d = L(R/n), with L increasing in R/n.

Combine the theoretical statement [5] with the identity in [4] to form a government budget constraint:

[6] g - τ = [1 - R/n]*L(R/n)

Now, to discover the limit of how large the deficit can get, imagine that the government wants to maximize the sustainable deficit through its choice of R/n (all that matters here is the ratio). What are the limits to seigniorage revenue?

The answer to this question has a standard "Laffer curve" property to it. Increasing R (or decreasing n) is bad because doing so increases the interest expense of the debt. On the other hand, it increases the demand for debt. Think of [1 - R/n] as the tax rate and L(R/n) as the tax base. Increasing R/n has competing effects. So, for example, increasing n has the effect of increasing the inflation tax rate. This is good for revenue purposes. But it also has the effect of decreasing the tax base (as people substitute out of government debt into competing securities). This is bad for revenue purposes. The revenue (primary deficit) maximizing interest/inflation rate equates these two margins. In short, economic behavior places a restriction on how much the government can finance its operations through money/debt issuance.

This is a very simple theory and it can be extended in many different and interesting ways. But the point of this blog post was first, to demonstrate how government budget identities can be combined with economic theory to form a meaningful government budget constraint and second, to demonstrate that there's nothing necessarily wrong or unsustainable about a government running a persistent budget deficit.


Postscript: March 12, 2019

I should have figured that Nick Rowe beat me to this post; see here. He also provides this nice Laffer curve diagram.

In the diagram above, r corresponds to my R and g corresponds to my n. I think I would have drawn the diagram with seigniorage revenue on the y-axis and the real interest rate (R/n) on the x-axis. Then (R/n)* would denote the seigniorage revenue maximizing real yield on government debt.

Nick points out that in the OLG model, the introduction of (say) land eliminates the possibility that R < n in equiilbrium. This is true only if government debt serves only as a store of value. My paper with Fernando Martin uses a standard macro model where debt has a liquidity role and coexists with a higher yielding alternative asset. It also has a diagram like Nick's (Figure 1).

A final thought. One often hears MMTers say something like "we replace the government budget constraint with an inflation constraint." I interpret this statement in the following way. Imagine setting the nominal interest rate to its lower bound R = 1 (I actually think it can go lower). Then the real rate of return on government debt (zero-interest money) is 1/n. If the real GDP is constant, then n represents the equilibrium inflation rate (in a model where we impose the additional market-clearing restriction). Assuming we are on the LHS of the Laffer curve, increasing the inflation rate increases the primary deficit. An inflation constraint n < n* then limits how large the primary deficit can be.

Is Neo-Fisherism Nuts?

According to my friend and former colleague Steve Williamson, inflation is low in Japan because of the Bank of Japan's policy of keeping its policy rate low. Accordingly, if the BOJ wants to hit its 2% inflation target, it should raise its policy rate and keep it persistently higher. This is what I've called the NeoFisherian proposition. It's a provocative idea because it flies in the face of conventional wisdom. But is it correct? Does it serve as a practical guide for monetary policy? My feeling is that the answers to these questions are "no" and "no." In what follows, I explain why.

At some point in their undergraduate career, students of macroeconomics are introduced to the Fisher equation. The Fisher equation usually stated as R = r + π or, in words:

Nominal Rate of Interest = Real Rate of Interest + Expected Rate of Inflation

For simplicity, think of the real rate of interest as the rate of return an investor can achieve by storing goods across time. For squirrels storing nuts, the real rate of interest is negative. For humans planting corn, it is positive. Whatever its value, let's just fix it at some number and assume it remains invariant over time (this is not a critical assumption for the arguments I want to develop below). Then, the Fisher hypothesis is that the nominal rate of interest should move one-for-one with the expected rate of inflation.

How does the Fisher equation hold up in the data? Let's just say that the evidence is mixed. Fisher himself famously rejected it as being empirically relevant. But over long periods of time, and also across countries, various nominal interest rates do appear positively correlated with the measured inflation rate (taken as a proxy for expected inflation).

Well, correlation is one thing, explanation is another. What is the theoretical underpinning of the Fisher equation? One way to view it is as a no-arbitrage-condition. Suppose that planting a bushel of corn yields 1.02 bushels at harvest (2% real rate of interest). Suppose that the nominal price of corn (its price measured in dollars) is expected to rise 10% by harvest time. What rate of return would an investor demand of a bond promising to deliver money at harvest time? The Fisher equation says that the investor should demand a rate of return of at least 12%. The bond would then deliver 12% more dollars that, if spent on corn at harvest, would leave an inflation-adjusted return of 2%. In this case, the investor would be just indifferent between investing in a corn planting venture and the nominal security.

Viewed in this light, the Fisher equation can be interpreted as the interest rate bond-holders demand, given their outlook on inflation. And, indeed, the standard textbook explanation for why nominal interest rates tend to rise with inflation provides a clear causal link, starting with monetary policy in the form of base-money growth rate:

    [1] increase in money supply growth (spent on goods or delivered as tax cuts or transfers);
    [2] causes increase in demand, which causes prices to rise;
    [3] inflation expectations adjust upwards accordingly;
    [4] bondholders demand higher interest rate to compensate for higher expected inflation.

The interpretation above assumes that monetary policy does not target the interest rate on bonds. Instead, it grows the money supply and lets the market determine the nominal interest rate. But note that monetary policy is targeting an interest rate in this explanation. In particular, the nominal interest rate on central bank money (reserves and currency) is set to zero. This policy goes by the acronym ZIRP (zero-interest-rate-policy). Moreover, there is a Fisher equation that holds for money. It looks like this R_m + LP = r + π, or in words:

Nominal interest rate on money + Liquidity premium = Real interest rate + Expected inflation 

If the nominal interest rate on money is zero, then money must be held for its non-pecuniary benefits (liquidity). The liquidity premium on money is in this case equal to the nominal interest rate on an illiquid bond; i.e., LP = R = r + π. 

Now, if the nominal security yielding a positive interest rate in the story above consists of government bonds (denominated in the domestic currency), then the only way to explain the apparent discount on government bonds is by appealing to an explicit government policy that renders these bonds illiquid relative to central bank money. And indeed, we see restrictions like this in place throughout history. For example, convenient low-denomination zero-interest notes (cash)  versus inconvenient large-denomination notes (bonds) trading at discount. Or consider today, where interest-bearing accounts at the U.S. Treasury are deliberately rendered useless for making payments. Or the Fed's apparent aversion to setting up a repo facility for U.S. Treasury debt in order to enforce a ceiling on its interest rate target path (such a facility would serve to reduce the demand for reserves).

Monetary theorists like Neil Wallace have puzzled forever over the phenomenon of why government bonds should trade at a discount (the so-called, coexistence puzzle). Others, like former Minneapolis Fed president Narayana Kocherlakota, have attempted to rationalize policies that render government bonds illiquid; see here. At the end of the day what is true is the following: the nominal interest rate on government bonds is, one way or another, a deliberate policy choice (for governments that issue debt denominated in the money they issue). This goes for default risk as well. There is no reason to default on debt that constitutes a promise to deliver money that one can costlessly produce. If default takes place in such circumstances, it is a policy choice, not an economic necessity.

Alright, what does all this have to do with Neo-Fisherism and the Neo-Fisherian proposition? I hope everything will fall together in due course. In the meantime, let's assume that the Fisher equation is sound theoretically and holds approximately well in the data. Would this support the proposition? It's clearly not enough because the proposition has to do with causality. The conventional view outlined above is also consistent with theory and evidence. Moreover, the conventional view as expressed through [1]-[4] provides a simple, coherent, easy-to-understand story for why we'd expect to see a positive correlation between interest rates and inflation in the data. It may not be correct, but at least it's understandable. Can the Neo-Fisherian proposition be explained in a similarly simple and compelling way? I think it's important for ideas to expressed in clear and simple terms. If policymakers are going to take the proposition seriously, the underlying economic mechanisms will have to be explained in a simple and straightforward manner. It will have to resonate with listeners at some level.

I've only heard of one mechanism that I find semi-plausible: the idea that a higher policy rate increases the interest expense of government debt which, if not met with a tax increase, must be met by an acceleration in money/bond printing (some empirical evidence here). Alternatively, could it be that an increase in the policy rate serves as a type of cost-push shock that propagates itself forward through some adaptive inflation expectations mechanism? I don't know, but it seems worth exploring.

But this is not how Neo-Fisherians explain the mechanism. You can listen to Steve explaining the mechanism in this David Beckworth podcast beginning at the 21 minute mark. There is also this piece published in the St. Louis Fed's Regional Economist: Neo-Fisherism: A Radical Idea or the Most Obvious Solution to the Low-Inflation Problem? Here is how he explains it (boldfont text representing my emphasis):

But, what if we turn this idea on its head, and we think of the causation running from the nominal interest rate targeted by the central bank to inflation? This, basically, is what Neo-Fisherism is all about [...] But how would this work? [...] To simplify, think of a world in which there is perfect certainty and where everyone knows what future inflation will be. Then, the nominal interest rate R can be expressed as R = r + π, where r is the real (inflation-adjusted) rate of interest and π is future inflation. 

Then, suppose that the central bank increases the nominal interest rate R by raising its nominal interest rate target by 1 percent and uses its tools (intervention in financial markets) to sustain this forever. What happens? [...] after a long period of time, the increase in the nominal interest rate will have no effect on r and will be reflected only in a one-for-one increase in the inflation rate, π. In other words, in the long run, the only effect of the nominal interest rate on inflation comes through the Fisher effect; so, if the nominal interest rate went up by 1 percent, so should the inflation rate—in the long run.

First, I wonder  what "tools and interventions" he has in mind. If the tool involves a sustained increase in the money growth rate, then there's nothing new here--this would just be standard Monetarist reasoning consistent with the textbook explanation [1]-[4] above.

But I think he means something else. As I explained above, the "Fisher effect" is a statement about how expected inflation affects the interest rate, not the other way around. The interest rate in Steve's thought experiment is fixed. Therefore, the "Fisher effect" here must relate to the economic force that causes inflation expectations to rise. What is this force? He doesn't say. One is left with the feeling that, well, since the Fisher equation holds in theory (and to Steve, in the data as well), inflation expectations somehow must adjust to make this true. Ergo, raising the interest rate will eventually lead to an increase in inflation. Central bankers need more than this to go on. In any case, I think that the logic is flawed. Let me explain.

How Neo-Fisherism Leads to Bad Monetary Policy Advice 

Let's take the case of Japan. Japan's inflation rate has been close to zero for a long time. Although I do not know why, Japan wants a higher inflation rate. How is to achieve this objective? 

I laid out my case here: The Failure to Inflate Japan. In a nutshell, the argument is this. [1] Peg the policy rate to zero all along the maturity structure of government debt (the BOJ is doing this); [2] Grow the nominal debt more rapidly until the desired inflation occurs (the government is not doing this).

Steve roundly rejects my line of reasoning--which is, of course, fine--except that (my apologies, but) I don't understand what he's saying (see here):

(i) How does the CB keep R=0 "along the yield curve." How could you have a flat yield curve at zero with positive inflation? (ii) If you're eliminating all taxes and the fiscal authority is financing everything by issuing debt, and the CB is trying to sustain R=0, then something has to give. For example, people start anticipating that fiscal authority can't roll over the debt, default premia rise on the government debt, and CB is forced to increase R to generate the CB profits required to keep the government afloat.

To answer (i), I think the BOJ has shown how it can be done. If the market is discounting JGBs, the BOJ can just buy (or threaten to buy) them up at par. To answer (ii), there is no nominal default risk to consider for Japan--at least, there's no economic reason to default: Japan can print the money it's  promising its bond holders. (And if one is worried about the real default implicit in inflation, remember that increasing the inflation rate is exactly the policy goal here.)

Steve has also pointed out that Japan's nominal debt has already grown substantially, so where's the inflation? The answer is that one cannot just look at supply--one must also consider demand. Evidently, the demand for JGBs has been increasing rapidly as well. If the supply had not accommodated this growing demand, Japan may very well have experienced the mother of all deflations (that demand is not observed and has to be inferred from price and quantity is a key weakness in this story).

Alright, so Steve does not like my way of increasing inflation. What does he recommend as an alternative? The BOJ should raise its policy rate, say from 0 to 400bp, and keep it there. There may be a short-run "liquidity effect," but the inflation will eventually come. How do we know? The Fisher equation. Can you elaborate? The Fisher effect will mean that inflation expectations will rise and inflation will follow. Why should inflation expectations rise? Because ... well, rational expectations ... and the Fisher equation. Can you elaborate? (Rinse and repeat.)

In any case, even if one accepts "rational expectations," the argument is not correct. As I explained above, there are really two Fisher equations:

[Fisher 1]: R = r + π
[Fisher 2]: R_m + LP = r + π

where, in case you forgot, r is real interest rate, π is expected inflation, R is nominal rate on illiquid bond, R_m is nominal rate on liquid bond (including reserves) and LP is a liquidity premium.

The interest rate controlled directly by the central bank is R_m. The central bank can easily set R_m = 0 and then monetize all the tax-cuts that are necessary to increase π. As π increases, so will R, in accordance with the Fisher equation. Could it be that Neo-Fisherians are confusing R with R_m? (This seems unlikely as I know that Steve knows the difference.)

What then is the effect of raising R_m? Well, it's complicated. Much depends on the structure of fiscal policy (Ricardian vs. Non-Ricardian); see here. In some models, raising R_m leaves r and π unchanged, which implies that the liquidity premium on government money LP falls. Eliminating the liquidity premium on government money/bonds is the famous Friedman rule prescription (convention version sets R_m = 0 and π = -r, but R_m = r + π for any π > 0 also works). But in other models, increasing R_m puts upward pressure on the real rate of interest, reducing the demand for investment, leading to economic contraction with no change in long-run inflation; see here.

The point of all this is, IF higher inflation is desired (and I am by no means advocating any such policy), THEN why not keep the policy rate low and use "free lunch" fiscal policies as long as inflation remains below target? Why bother experimenting with the Neo-Fisherian prescription of raising the policy rate that's somehow supposed to make people magically expect higher inflation?

When is more competition bad?

Contrary to popular belief, standard economic theory does not provide a theoretical foundation for the notion that "competition is everywhere and always good." It turns out that legislation that promotes competition among producers may improve consumer welfare. Or it may not. As so many things in economics (and in life), it all depends.

I recently came across an interesting paper demonstrating this idea by Ben Lester, Ali Shourideh, Venky Venkateswaran, and Ariel Zetlin-Jones with the title "Screening and Adverse Selection in Frictional Markets," forthcoming in the Journal of Political Economy.The paper is written in the standard trade language. Like any trade language, it's difficult to understand if you're not in the trade! But I thought the idea sufficiently important that I asked Ben to translate the basic results and findings for a lay audience. I'm glad to say he was very happy to oblige.

And so, without further ado, today's guest post by Ben Lester, my colleague at the Philadelphia Fed.
You can follow Ben on Twitter :  @benjamminlester 

Competition in Markets with Asymmetric Information

By Benjamin Lester

Background

In many basic economic models, competition is good – it increases welfare.  As a result, policy makers often introduce reforms that they hope will reduce barriers or “frictions” in order to increase competition.  For example, the Dodd-Frank Act contains regulations aimed at promoting more competition in certain financial markets, such as derivatives and swaps, while the Affordable Care Act contained provisions that were intended to promote competition across health insurance providers.

In a recent paper with Ali Shourideh, Venky Venkateswaran, and Ariel Zetlin-Jones, we re-examine the question of whether more competition is welfare-improving in markets with a particular feature – what economists call “asymmetric information.”  These are markets where one side has information that is relevant for a potential trade, but the other side can’t see it. Classic examples include insurance markets, where an individual knows more about his own health than an insurer; loan markets, where a borrower knows more about her ability to repay than a lender; and financial markets, where the owner of an asset (like a mortgage-backed security) may know more about the value of the underlying assets than a potential buyer.

Unfortunately, understanding the effects of more or less competition in markets with asymmetric information has been constrained by a shortage of appropriate theoretical frameworks.  As Chiappori et al. (2006) put it, there is a “crying need for [a model] devoted to the interaction between imperfect competition and adverse selection.”

What we do

We develop a mathematical model of a market – to fix ideas, let’s call it an insurance market – that has three key ingredients.  The first ingredient is adverse selection: one side of the market (consumers) know more about their health than the other side of the market (insurers).  Second, we allow the two sides of the market to trade sophisticated contracts: as in the real world, insurers can offer consumers a rich set of options to choose from, consisting of different levels of coverage that can be purchased at different prices.  Last, we introduce imperfect competition by assuming that consumers don’t always have access to multiple insurers: in particular, each consumer will get offers from multiple insurers with some probability, but there is also a chance of receiving only one offer.[1]  Hence, our model allows us to capture the case of perfect competition (where all consumers get multiple offers), monopoly (where all consumers get only one offer), and everything in between.

What we find

One of our main results is that increasing competition can actually make people worse off.[2]  To understand why, it’s important to understand the types of contracts that our model predicts will be offered by insurers.  Let’s say that there are two types of consumers: those who are likely to require large medical expenses (“sick” consumers), and those who are not (“healthy” consumers).  Then insurers will often find it optimal to offer two different plans: one that is expensive but provides more coverage, and one that is cheaper but provides less coverage.[3]  Designed correctly, these two options will induce consumers to self-select into the plan intended for them, so that sick consumers will pay a higher price for more coverage and healthy consumers will pay a lower price for less coverage.

An important property of these contracts is that they fully insure sick consumers, but they under-insure healthy consumers.  Ideally, insurers would like to offer healthy patients more coverage, but they can’t: given the lower price, sick consumers would choose this new plan, making it no longer profitable for insurers to offer it.  This theoretical result – that separating the sick from the healthy requires under-insuring healthy consumers – is a fundamental result in markets where asymmetric information is present.  The relevant question for us is: how does the amount of competition determine the extent to which healthy consumers are under-insured? The answer we find is that some competition can induce insurers to provide healthy consumers with more insurance, but too much competition can have the opposite effect. 

The intuition is as follows.  When consumers are more likely to receive multiple offers, insurers respond by making more attractive offers to consumers, as they try to retain market share.  The key question turns out to be: does increasing competition make them sweeten the deal more for sick consumers, or for healthy consumers? On the one hand, as the offer intended for sick consumers gets better, they have less incentive to take the offer intended for healthy consumers – in the parlance of economics, their “incentive constraint” loosens.  Hence, as insurers sweeten the offer intended for sick consumers, they are able to offer healthy consumers more coverage, and welfare rises.[4]  On the other hand, however, as the offer intended for healthy consumers become more attractive, sick consumers are more tempted to take it – their incentive constraint tightens – and the only way to keep the two separate is to reduce the amount of coverage being offered to healthy consumers, causing welfare to decline.

In the paper, we show that the former, positive effect dominates in markets where insurers have a lot of market power, while the latter, negative effect dominates when the market is relatively competitive. Hence, in markets with asymmetric information, welfare is maximized at some interior point, where there is some competition, but not too much!

Other results and future research

In the paper, we also show that increasing transparency has ambiguous effects on welfare.  In particular, we study the effects of a noisy signal about a consumer’s type – in the insurance example, this could be a blood test or information about an individual’s pre-existing conditions.  We show that increasing transparency is typically beneficial when insurers have a lot of market power, but it can be detrimental to welfare in highly competitive environments.

More generally, our model provides a tractable framework to confront a variety of theoretical questions regarding markets that suffer from asymmetric information, and offers a number of insights into existing empirical studies, too.[5]  For example, there is a large literature that tests for the presence of asymmetric information by studying the quantitative relationship between, e.g., the amount of insurance that consumers buy and their tendency to get sick.[6]  However, according to our analysis, insurers find it optimal to offer menus that separate consumers only when markets are sufficiently competitive, and when there is a sufficiently large number of sick consumers in the population.  Otherwise, they find it best to offer a single insurance plan.  This finding implies that, when insurers have sufficient market power, there will be no relationship between the quantity of insurance a consumer buys and his health status.  In other words, one can’t empirically test for asymmetric information without controlling for the market structure.  This is just one of many positive predictions of our model that we plan to test in the data.

References:

Burdett, K., and K. L. Judd (1983) “Equilibrium Price Dispersion,” Econometrica, 51, pages 955–69.

Chiappori, P.-A., B. Jullien, B. Salanié, and F. Salanié (2006) “Asymmetric Information in Insurance: General Testable Implications,” RAND Journal of Economics, 37, pages 783–98.

Chiappori, P.-A., and B. Salanié  (2000) “Testing for Asymmetric Information in Insurance Markets” Journal of Political Economy,  108, pages 56–78.

Lester, B., A. Shourideh, V. Venkateswaran, and A. Zetlin-Jones (2018) “Screening and Adverse Selection in Frictional Markets,” Journal of Political Economy, forthcoming.

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[1] We borrow this modeling device from the paper by Burdett and Judd (1983).

[2] At a high level, the idea that reducing frictions can sometimes make people worse off is not unique to our paper; these types of results are known from the theory of the second best. What distinguishes our result is the context in which it arises, and our ability to characterize precisely when and why reducing frictions (or increasing competition) is harmful.

[3] The negative relationship between price and coverage should be familiar to most readers; see, e.g., the metal tiers (platinum, gold, silver, bronze) offered at https://www.healthcare.gov/choose-a-plan/plans-categories/.

[4] Since sick consumers are always fully insured, consumers’ welfare always rises when healthy consumers are offered more insurance.  On a more technical level, all of our statements about welfare are based on a measure of ex ante, utilitarian welfare.
[5] As a technical aside, unlike many models of asymmetric information and screening, we find that an equilibrium always exists in our environment, that the equilibrium is unique, and that the equilibrium does not rely on any assumptions regarding “off-path beliefs.”

[6] See the seminal paper by Chiappori and Selanie (2000).

Disclaimer

The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Racial Diversity in the Supply of U.S. Econ PhDs

This post is motivated by Eshe Nelson's column "The Dismal Cost of Economics' Lack of Racial Diversity." I was especially struck by this data -- out of the 539 economics doctorates awarded to U.S. citizens and permanent residents (by U.S. institutions), only 18 of the recipients were African-American.

I thought it would be of some interest to see what the data looks like more broadly over other groups and over a longer period of time. I thank my research assistant, Andrew Spewak, for gathering this data (from the National Science Foundation). 

Let's start with the raw numbers first. The data is aggregated into 5-year bins beginning in 1965 and up to 2014. The orange bars represent the number of econ PhDs awarded to U.S. citizens and permanent residents (by U.S. institutions) over a given 5-year period. The blue bars represent the total number of doctorates awarded.

Seems like the number of econ PhDs awarded to U.S. citizens is on the decline and that this decline has been partially made up by the number of PhDs awarded to foreign students.

Now, let's stick with citizens for the moment and decompose the data across various "racial" categories. The following figure reports the share of econ doctorates earned by various groups.

The most dramatic pattern is the relative decline of PhDs awarded to Whites and the increasing share of degrees awarded to Asians (there is also a noticeable uptick in the "Other" category which includes groups like Native Americans). Blacks and Hispanics have made some gains since the early years, but have since stabilized to about a 5% share.

I now reproduce the picture above, but this time looking at total PhDs awarded.

The relative decline of Whites here is even more evident, as is the increasing share of Asians. It is interesting to note that while the share of Hispanics has increased noticeably by including foreign (non PR) recipients, the same is not true for Blacks. One possibility here is that English-speaking foreign black students may be more likely to target the U.K. over the U.S. and that French-speaking blacks may be more likely to target French-speaking institutions in France or former French colonies, like Quebec. (It would be interesting to examine these statistics for Canadian universities). 

Finally, let's take a look at how the share of PhDs across groups lines up with their share of the total population. Here is what the data looks like for the period 2010-2014. 

While White citizens are over-represented, Whites as a whole are under-represented (relative to the domestic U.S. population). Blacks are significantly under-represented both as citizens and including foreigners. Asians, on the other hand, are significantly over-represented--both as citizens and especially if one includes foreigners. Only the "Other" category seems to be roughly representative of the population.

To conclude, there are some clear racial imbalances here. I think most people would agree that increasing Black and Hispanic representation in the U.S. economics profession is a good idea (for many of the reasons highlighted in Eshe's column). Future research into this matter should be informed by the fact that not all minority groups have fared in the same way. It would also be interesting to see how these patterns have evolved in other countries. 

Does the Fed have a symmetric inflation target?

It's well-known that the Fed has been undershooting its inflation 2% target every year since 2012 (ironically, the year it formally adopted a 2% inflation target). This has led some to speculate whether 2% is being viewed more as a ceiling, rather than a target, as it is with the ECB. The Fed, however, continues to insist that not only is 2% a target, it is a symmetric target.  But what does this mean, exactly? And how can we judge whether the Fed has a symmetric inflation target or not?

These questions came to me while listening to Jay Powell's recent press conference following the FOMC's decision to follow through with a widely anticipated rate hike. At the 16:15 mark, reporter Binyamin Appelbaum (NY Times) asked Powell the following question:

BA: You're about to undershoot your inflation target for the seventh straight year and you forecast that you're going to undershoot it for the eighth straight year...Can you help us to understand why people would be advocating restrictive monetary policy at a time of persistent inflation undershoots? 

Here is how Powell responded:

JP: Well, we as a committee do not desire inflation undershoots and you're right -- inflation has continued to surprise to the downside -- not by a lot though -- I think we're very close to 2% and, you know, we do believe it's a symmetric goal for us -- symmetric around 2% -- and that's how we're going to look at it. We're not trying to be under 2% -- we're trying to be symmetrically around 2% -- and, you know, I've never said that I feel like we've achieved that goal yet. The only way to achieve inflation symmetrically around 2% is to have inflation symmetrically around 2% -- and we've been close to that but we haven't gotten there yet and we haven't declared victory on that yet. So, that remains to be accomplished. 

While this answer sounded reasonable on some level, it did not satisfy the very next inquisitor, Jeanna Smialek (Bloomberg):

JS: Just following up on Binya's question...I guess if you haven't achieved 2% and you don't see an overshoot -- which would sort of be implied by a symmetrical target -- what's the point of raising rates at all? 

Powell replied to this by making reference to the strength of the economy -- growth well above trend, unemployment falling, inflation moving up to 2%, and a positive forecast. In this context, the rate hike seemed appropriate. Again, a sensible sounding answer -- but did it answer the question actually posed?

As I reflected on this exchange, I felt something amiss. And then it occurred to me that people might be mixing up the notion of a symmetric inflation target with a price-level target.

In her question above, Jeanna suggested that if the Fed has a symmetrical inflation, then we should be expecting an overshoot of inflation. But the intentional overshooting of inflation is not inflation targeting -- it is price-level targeting. With an inflation target, one should be expecting inflation to return to the target--not beyond the target.

This would have been a fine answer to Jeanna's question, but isn't it inconsistent with the earlier reply to Binyamin? In that response, Powell left us with the impression that the FOMC has failed to achieve its symmetric inflation goal -- that success along this dimension would consist of actually observing inflation vary symmetrically around 2%. I'm not sure this is entirely correct.

To my way of thinking, an inflation target means getting people to expect that inflation will eventually return to target (from below, if inflation is presently undershooting, and from above, if inflation is presently overshooting). A symmetric inflation target simply means that the rate at which inflation is expected to return to target is the same whether inflation is presently above or below target. To put it another way, symmetry implies that the FOMC should feel equally bad about inflation being 50bp above or below target. Along the same line, persistent inflation overshoots and overshoots should be equally tolerated (given appropriate conditions).
 
Should a successful symmetric inflation targeting regime generate inflation rates that average around target? It's hard to see how it would not in the long run and if the shocks hitting the economy are themselves symmetric (this is not so obviously a given, but let me set it aside for now). Does missing the inflation target from below for roughly a decade imply that the FOMC has failed to implement a symmetric inflation targeting regime? Powell's mea culpa above suggests yes. But again, I am not so sure.

As I said above, the success of an inflation targeting regime should be measured by how well inflation expectations are anchored around target. By this measure, the FOMC has managed, in my mind, a reasonable level of success (2015-16 looks weak). The following diagram plots the PCE inflation rate (blue) against expected inflation (TIPS breakevens) five years (red) and ten years (green) out.

In my view, the fact that realized inflation has persistently remained below target does not necessarily imply the absence of a symmetric inflation target. Let's take a look at the FOMC's official view on the matter, originally made public on January 24, 2012 in its Statement of Longer-Run Goals and Monetary Policy Strategy. Let me quote the relevant passage and highlight the key phrases:

The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability...

It seems clear enough that the real goal here is to keep longer-term inflation expectations anchored at 2%.  The idea is that if inflation expectations are anchored in this manner, then the actual inflation rate today shouldn't matter that much for longer-term plans (like investment decisions). If inflation turns out to be low, you should be expecting it to rise. If it turns out to be high, you should be expecting it to fall. Nowhere does the statement suggest we should be expecting under or over shooting -- a characteristic we would associate with a price-level target. As for the phenomenon of persistent under or over shoots, the statement makes clear that the Committee would be equally (symmetrically) concerned in either case.

If one accepts my definition of symmetric inflation target then, unfortunately, we do not yet have enough data to judge whether the Fed's inflation target is symmetric. The policy was only formally implemented in 2012. Since then we've only observed a persistent undershoot and the conditions leading to these persistent downward surprises. Would the FOMC be equally tolerant of letting inflation surprise to the upside for several years should economic conditions warrant? It seems that we'll have to wait and see.