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April 18, 2011
Can Keynesians be anti-Keynesian?
Follow any policy debate, and you are sure to find a list of economists who support or inspire those on both sides of the issue. In The Economist, we find some of those on the roster for the new Republican leadership in the House of Representatives, and why:
"When Republicans proposed slashing billions of dollars from federal spending this year, Democrats circulated predictions by economists that jobs and growth would be hit. John Boehner, the Republican speaker in the House of Representatives, countered with an economic expert of his own: John Taylor of Stanford University. 'Nothing could be more contrary to basic economics, experience and facts,' Mr. Taylor asserted on his blog, which Mr. Boehner cited. By cutting government spending, he said, the Republicans would 'crowd in' private investment and create jobs.
"… if there is one ideology that unites today's Republicans, it is Keynesianism, whose nefarious influence they are determined to stamp out. 'Young Guns,' the book-sized manifesto of Eric Cantor, Kevin McCarthy and Paul Ryan, leading Republican House members, devotes several pages to the evils of Keynesian activism and its exponents in the administration."
One of the interesting things about the article is that among the economists cited as being among the critics of "Keynesianism," you find the names John Taylor, Robert Mundell, and Kenneth Rogoff. I find that list interesting because if you follow the links I attached to those names you will find work with models that are decidedly Keynesian in structure. Works by Taylor and Rogoff are, in fact, seminal contributions to the "New Keynesian" paradigm that dominates macroeconomics today.
As far as I know, none of these men have repudiated the basic worldview that motivates the referenced work. In fact, as recently as last year John Taylor approvingly described, as he has many times, a key characteristic of the paradigm for monetary policy that was in place the decades before the financial crisis:
"… the central bank has a strategy, or rule, to adjust the interest rate depending on economic conditions: In general, the interest rate rises by a certain amount when inflation increases above its target and the interest rate falls when by a certain amount when the economy goes into a recession."
I added the emphasis to the last part of that passage as it is a feature of the so-called Taylor rule that is entirely built on the foundation of the New Keynesian model.
How, then, to explain the Keynesian predilections of the economists mentioned as presumed carriers of the anti-Keynesian mantle? The source of the confusion, I think, goes back to the historical, but somewhat obsolete, distinction between so-called Keynesianism and monetarism. The latter was, of course, personified in Milton Friedman and his dispute with what was the orthodoxy in the three decades following the Great Depression. Lost in the early-days labeling, however, was the fact that the disputes were more about the empirical details of theory rather than the theory itself.
In particular, Friedman did not deny the effectiveness of policy in principle but rather its wisdom or impact in practice. This sentiment is exactly the one he expressed in his prescient and transformative 1968 presidential address to the American Economics Association:
"In the United States the revival of belief in the potency of monetary policy was strengthened also by the increasing disillusionment with fiscal policy, not so much by its potential to increase aggregate demand as with the practical and political feasibility of so using it."
In a recent essay on Friedman's views about the ineffectiveness of fiscal policy, Tim Congdon notes Friedman's views on the issue:
"Friedman offered two informal theoretical arguments for the virtual irrelevance of fiscal policy, as he saw it. The second was that fiscal policy is much harder to adjust in a sensitive short-term way than monetary policy. But the first was the more telling and deserves detailed discussion.… In Friedman's words, 'I believe it to be true… that the Keynesian view that a government deficit is stimulating is simply wrong.' The explanation was the wider effects of the way the budget deficit is financed. To quote again, 'A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.' "
Though Congdon emphasizes different channels (associated with the mix of monetary and fiscal policy associated with deficit spending), those who follow such things may recognize in Friedman's remarks the notion of Ricardian equivalence:
"This is the idea that increased government borrowing may have no impact on consumer spending because consumers predict tax cuts or higher spending will lead to future tax increases to pay back the debt.
"If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases."
My point is not to dispute or defend the truth of the Ricardian proposition. My point is that it has absolutely nothing to do with whether one believes (or does not believe) that the New Keynesian framework is the right way to view the world. The essential policy implications of the New Keynesian idea (like the old Keynesian idea) is that changes in gross domestic product can be driven by changes in desired spending by households, businesses, foreigners, and the government in sum. You can believe that and still believe in fiscal policy ineffectiveness, as long as you believe that total spending is unaltered by a particular policy intervention.
There are, of course, plenty of arguments against fiscal policy activism that do not require adherence to Ricardian equivalence, in total or in part. The most obvious would be the position that any short-term rush from stimulative policies is more than reversed in the long run by the negative consequences of higher tax rates on productive activity, or the redirection of private investment to lower return public spending. Again, the point is that a self-professed adherent to a Keynesian reality need suffer no doubts about the coherence of his or her intellectual framework if he or she objects to fiscal policies aimed at juicing the economy through greater government spending.
This whole discussion may seem like a bit of inside baseball, and perhaps it is. But the stakes in this debate are high, as clearly illustrated by today's announcement from rating agency Standard & Poor's that it reduced its outlook to negative on the triple-A credit rating of the United States. In my view, productive discussions about the truly pressing issues of our day are unlikely unless we understand where the disagreements lie—and where they do not.
By Dave Altig
senior vice president and research director at the Atlanta Fed
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April 13, 2011
How has the financial system changed? (And what to do about it)
The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:
"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."
Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:
"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."
If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants—Viral Acharya, for example—looked to greater capital buffers as a key to greater financial stability. Others—George Kaufman commenting on Boot's paper, for instance—were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:
"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."
Earlier in the paper, Boot puts forward:
"We believe that heavy handed intervention in the structure of the banking industry—building on the Volcker Rule—might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."
With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:
"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."
Credit and bank capital—along with sound fiscal policy and a little good luck—do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:
"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."
As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.
By Dave Altig
senior vice president and research director at the Atlanta Fed
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April 08, 2011
Monetary policy exit: Is a bad bank the solution?
It is not difficult to find people who espouse the following belief:
"One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its 'quantitative easing' policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?"
I dare say that I hear that criticism, in one form or another, nearly every day. So the claim above might only merit notice here because it comes from a Wall Street Journal op-ed penned by Professor Allan Meltzer, the eminent monetary macroeconomist and chronicler of Federal Reserve history. But what really distinguishes the critique is that it comes with a fairly novel and creative way of resolving the perceived problem:
"One idea is for the Fed to create its own version of a 'bad bank.' The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created 'excess' bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)
"The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable."
Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.
It should not go unmentioned that these criteria are also features of exit plans that have been sketched by Federal Reserve officials—by Chairman Bernanke last year and by Philadelphia Fed President Charles Plosser more recently, for example. What distinguishes the Meltzer plan is less in approach and more in timing.
In fact, the Meltzer approach is similar in spirit to the Fed's Term Deposit Facility that became operational last summer. The simplified description of this facility is that it involves the Federal Reserve temporarily taking onto its own accounts the excess reserves of banks. If you want to call that account a "bad bank," you're getting close to the Meltzer plan.
Expanding just a bit, in a term deposit facility the private banking system deposits its excess reserves—an asset of private banks—with the Fed. In exchange, banks receive an asset in the form of interest-bearing "accounts," the analog of a time deposit that you might purchase from your bank. Just as you cannot spend the funds you put into a time deposit you own, banks cannot use funds deposited in the Term Deposit Facility to support credit expansion (at least not until the term of the deposit expires).
Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks? My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?
On this conversation, I will, as I often do, give the last word to Dennis Lockhart, our Bank's president, who spoke earlier today in Knoxville, Tenn.:
"My view of the future permits a degree of patience as regards monetary policy. There is still a halting and fragile quality to the economy. I think the process of restoration of full economic strength with higher employment continues to require support. That said, planning for an eventual change of course is completely appropriate as long as public discussion about planning deliberations and the plan itself don't create premature expectations of tightening."
By Dave Altig
Senior vice president and research director at the Atlanta Fed
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