Monday, January 22, 2018

Is Bitcoin a Waste of Resources?

If nothing else, Bitcoin gives us something to talk about. My non-monetary-theorist colleagues want to talk about it; my students want to talk about it; it's a surefire conversation-starter with strangers; it's a distraction from Donald Trump. But, should a sensible person buy the stuff? Should society tolerate it?

First, let's review what Bitcoin is. The open-source software for Bitcoin was introduced in 2009, and it represents a decentralized means for transferring ownership of digital objects, along with a decentralized system for augmenting the supply of such objects. Central to how Bitcoin works is the blockchain, which consists of a record of the entire history of ownership of the digitial objects - the "coins." The ingenious part of the system (and the hardest part to understand) is how the blockchain is updated. David Andolfatto gives a nice explanation of how the thing works. Also see this paper by Berentsen and Schar. No one owns the blockchain, but it is distributed among the community of users - it's a "distributed ledger." "Miners" (which is really not an apt description of what these people do) compete to form the next block in the chain - basically their job is the counterpart of what happens in the clearing and settlement process in a centralized monetary system, such as interbank payments. For the system to work, it has to be more costly to cheat than for the correct information to be added in the new block. Thus, the system adjusts the costs of mining over time to keep up with technology. If the costs are too low, then cheating might occur - it's important to slow the clearing and settlement process down sufficiently, and the designers of the system shoot for a time lag of 10 minutes from when a transaction is posted to when it goes into the blockchain. The mining process is costly. Being a miner requires a lot of computing capacity, and one needs to burn much electricity in order to have a chance of winning the payment you receive for successfully verifying a transaction. Harnessing more computing power, finding cheap sources of electricity, and inventing faster chips (tailor-made for this purpose) implies a higher probability of a payoff, if you want to mine.

What role could Bitcoin - and other competitors such as Ethereum - play in the economy? What good could these systems do for society as a whole? The idea seems to be that such systems could provide us with an efficient means for carrying out transactions. In principle, centralized transactions - routed through the banking system and central banks - seem costly. There are large numbers of people working in these financial institutions, they occupy a lot of real estate, they require a lot of equipment and software, and they burn electricity. But, these systems work. They handle huge volumes of transactions every day, provide protection against fraud, and provide recourse when things go bad - like when the object you bought with your Visa card turns out to be something you weren't expecting. Further, we already have a decentralized means for executing transactions - paper currency. While currency doesn't permit some of the kinds of transactions we might like to make in modern societies - you can't buy stuff from Amazon with it - it is remarkably cost-effective. Proof of ownership is just a matter of physical possession, and transfer of ownership is essentially costless. I show the Starbucks cashier my cash, and hand it over. Of course, there's a centralized system in place that maintains the currency stock, assures that counterfeiting is a high-cost activity, and stabilizes the value of currency in terms of goods and services. That's called a central bank.

The monetary system we have, consisting of central banks which issue currency and run interbank payments systems, coupled with a private banking system that clears and settles transactions using debit cards, credit cards, and old-fashioned checks, evolved from earlier commodity money systems and commodity-backed paper currency systems. As a result of that transition, substantial resources were saved. Actual commodities - gold, for example - are costly to move around in large quantities, and making both small and large commodity money transactions can be awkward. Commodity-backed paper currency systems save on those costs, but the problem then - as for example under the gold standard - is that price stability can go out the window. That is, under a gold standard, the price of goods and services in term of money will be determined in part by the costs of digging gold out of the ground, the discovery of low-cost sources of gold, and the consumption value of gold. As a reminder of what that's about, consider the following chart:
The chart shows two prices. The blue line is the price of gold in dollars, while the red line is the price of US currency in terms of goods and services, measured by the inverse of the PCE deflator. The smoothness in the red line is no accident of course. That's the outcome of many person-hours of research, analysis, and meeting time in the Fed, all aimed at managing money and payments in such a way that the value of money in terms of goods and services is predictable. Clearly the price of gold in terms of money, and by implication the price of gold in terms of goods and services, is not very predictable. That's why no one wants to use gold to make payments - the alternatives are so much better.

It has been well-understood for a long time that, in order for money to have a predictable value in terms of goods and services, its supply has to be "elastic." The demand for means of payment fluctuates from day to day, week to week, and month to month. Why? (i) Aggregate economic activity fluctuates (even within the week - there are more people in the shopping mall on Saturday than on Monday); (ii) Wholesale payment activity can fluctuate considerably due to variation in financial market activity, and large one-time interbank transactions, for example. So, if demand is fluctuating, and we want price stability, supply needs to fluctuate in tandem with demand. Elasticity also makes the whole financial system work more efficiently. For example, the framers of the Federal Reserve Act understood that inelastic money in the post-civil war era in the US helped to create banking panics and financial instability.

Here's what's been happening to the price of Bitcoin, in dollars, lately:
That is, Bitcoin is worth about five times what it was in the middle of last year, but about half of what it was last month. This makes gold look stable. There's been a lot of talk about whether or not this represents a "bubble." Whenever someone talks to me about bubbles, I ask them to define it. The answer they give typically puts them into three camps: (i) irrational bubble people; (ii) rational bubble people; (iii) people who haven't the foggiest idea which end is up. Robert Shiller is probably the best-known irrational bubble person. He's written books like this one, coauthored with George Akerlof. An irrational bubble is supported by irrational behavior on the part of at least some market participants. For example, suppose there is an asset that will, with certainty, be valueless at some future date. But, people bid up the price of the asset, in the belief that there are some stupid people in the market who they can sell to before the price crashes. Sure enough, some stupid people enter the market, and they end up holding the bag when the price goes to zero, according to the irrational bubble folks. Shiller doesn't quite know what to make of Bitcoin. As far as he's concerned it could be gone tomorrow, or in a hundred years. But he seems to think it's a bubble, which isn't saying much, as Shiller sees irrational bubbles in essentially all asset markets.

Rational bubbles are all too familiar to any monetary theorist. A rational bubble occurs when an asset's value exceeds the present value of the expected future payoffs on the asset, appropriately discounted. To evaluate whether a rational bubble exists requires a model - in part to tell us what "appropriately discounted" means. Fiat money is a bubble, as it has no explicit future payoffs, yet people value it in exchange. There are other types of rational bubbles, for example the currently-observed low real interest rate on government debt can be considered a bubble phenomenon. Government debt is used in exchange, and as collateral in financial markets, so that its price exceeds the present value of its future payoffs - high prices imply low interest rates.

Is Bitcoin an irrational bubble? How would we tell? In some sense, going the irrational bubble route is a copout - we're abandoning any attempt to put structure on what is going on so we can understand it. Clearly the irrational bubble approach isn't helping Shiller - he can't tell us when the collapse will come. Could be tomorrow. Could be in 100 years.

Is Bitcoin a rational bubble phenomenon? One explanation for the appreciation in the Bitcoin price is that people are betting on Bitcoin's future as a means of payment. In the event that Bitcoin becomes widely acceptable as a means of payment, its value will be enormous - there is an upper limit on the supply of Bitcoin after all. Even if I think the probability of that happening is small, the expected value can be high, and if I buy a small quantity I'm bearing a small amount of risk for a huge expected payoff. But, the probability that Bitcoin becomes a serious means of payment looks like zero to me, as the system is fundamentally flawed. Transactions costs are too high, the price is far too volatile, and the system does not permit a large enough volume of transactions.

But, in spite of Bitcoin's price volatility, maybe people will ultimately treat it as a safe asset, like gold. Gold is an asset that people can flee to when the returns on financial assets are highly uncertain, and maybe it bears a premium above its "fundamental" value, because people coordinate on it for that purpose. I'm not sure if anyone has studied that. So, maybe Bitcoin can serve the same function? But precious metals have the virtue of having no competitors - there is only so much of the stuff. Though Bitcoin is ultimately limited in supply, the supply of potential competitors is unlimited, and we're currently seeing a flood of close substitutes for it.

So, I've run out of options for Bitcoin's future. It represents a poor payments system, and the ability to replicate it means that it can't survive as a safe store of value like gold. Advice: Don't buy that stuff, its value is going to zero - far short of a hundred years from now, I think. But does that mean this is an irrational bubble? Let's think harder. Not everyone is as certain about Bitcoin's demise as I am, and people are working with incomplete information and limited knowledge of how the world works. As with the Dot-Com "bubble" it takes a while for people to understand the market and to sort out which ventures are going to pay off. That doesn't look like the simple asset valuation models we have, but there it is.

But, we should give Bitcoin advocates a chance to defend themselves. What do they have to say? Well, Marc Bevand, who is apparently a miner, wrote a piece a couple of years ago, arguing that "Bitcoin Mining is Not Wasteful." He has five arguements, which I'll go through one-by-one:

Argument 1: Miners currently use approximately only 0.0012% of the energy consumed by the world. Most are forced to use hydroelectric power (zero carbon footprint!) because using cheap renewable energy is a necessity to win in the ultra-competitive mining industry.
It's true that .0012% seems like a small number. But this is for a would-be monetary system that hasn't even got off the ground yet. Some people claim that a Bitcoin transaction currently requires 80,000 times more electricity than a Visa transaction. If that high cost is a "necessity" in this system, maybe we can do without it.

Argument 2: Even in the future, economic modeling predicts that if Bitcoin's market capitalization reaches $1 trillion, then miners will still not account for more than 0.74% of the energy consumed by the world. If Bitcoin becomes this successful, it would have probably directly or indirectly increased the world's GDP by at least 0.74%, therefore it will be worthwhile to spend 0.74% of the energy on it.
Bitcoin's current market capitalization is about $180 billion. My estimate of its current contribution to world GDP: negative. There are plenty of economic activities that burn resources and contribute negatively to GDP - theft, for example.

Argument 3: Mining would be a waste if there was another more efficient way to implement a Bitcoin-like currency without proof-of-work. But current research has so far been unable to demonstrate a viable alternative.
But we don't have to implement a "Bitcoin-like currency." The relevant alternative is the monetary system we have.

Argument 4: Bitcoin is already a net benefit to the economy. Venture capitalists invested more than $1 billion into at least 729 Bitcoin companies which created thousands of jobs. You may disregard the first three arguments, but the bottom line is that spending an estimated 150 megawatt in a system that so far created thousands of jobs is a valuable economic move, not a waste.
Bevand either hasn't had economics, or he went to the class where they talked about Keynes, and missed the class on opportunity cost. The fact that people are spending time in activities associated with Bitcoin - designing it, trading it, mining, designing new chips, maintaining dedicated hardware, etc., is in fact a waste of resources. All those people could be doing something more productive with their time, assuming the opportunity cost of their time is not zero. To the extent we can learn something, the time spent is useful. But I think we are done with that. Time to stop.

Argument 5: The energy cost per transaction is currently declining thanks to the transaction rate increasing faster than the network's energy consumption.
I'm not sure this is true, but even if it were, this isn't the right metric. If the transactions aren't accomplishing anything socially useful, all we're worried about is the total economic cost of this project - electricity, time, hardware, software, buildings - which looks to be a significant waste.

Digital currencies could indeed be useful, but current technological constraints do not seem to permit a decentralized currency system using blockchain. It's certainly likely that central banks will get into the business of offering digital means of payment, but my best guess is that those systems will be centralized.

Wednesday, January 17, 2018

Bank of Canada meeting

As expected (see my post from yesterday), the Bank of Canada increased its target interest rate to 1.25% today. The risk they see on the horizon is a potential collapse in NAFTA.

In the first paragraph of the press release, the Committee summarizes its reasons:
Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity.
This might seem like a justification for doing nothing. The Bank has achieved its goals, so no action is warranted. This only makes sense if Bank people are forecasting that an economy operating "roughly at capacity" will wake up the Phillips curve and cause more inflation, which they think they should tamp down with higher interest rates - now, not when the inflation happens.

But, further on in the press release is this:
Recent data show that labour market slack is being absorbed more quickly than anticipated.
That seems inconsistent with the quote above. How can the economy be operating "roughly at capacity," with labor market slack? I'm running roughly as fast as I can, but I continue to run faster!

Finally, the forward guidance hasn't changed:
While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target.
Still no clarification as to why these higher interest rates should be warranted, and under what conditions rates will or will not rise in the future. And why is the current policy seen as "accommodative?" Short-term nominal interest rates may be unusually low, but it's generally accepted that the real effects of monetary policy actions dissipate over time. So, the real effects of monetary policy we should be seeing now are the effects of interest rate hikes last year. Certainly that's not accommodative. In terms of the effects on inflation of interest rate increases, again I think the Bank of Canada has the sign wrong - though they have good company in that belief. Inflation control is about moving the central bank's nominal interest rate target in the direction you want inflation to go. That's what the weight of theory and empirical evidence tells us.

Tuesday, January 16, 2018

Canadian Monetary Policy

The Bank of Canada's Governing Council will be meeting on Wednesday to decide on a setting for the Bank of Canada's policy rate target, so now is as good a time as any to get you (and me) up to speed on Canadian monetary policy. We'll start with basics. In Canada, the Bank of Canada operates under the Bank of Canada Act, passed in 1935, and amended since then. Policy decisions are made 8 times per year, at pre-specified dates, roughly 2 to 3 weeks before each FOMC meeting in the US. US monetary policy is important for what the Bank of Canada does, thus the synchronization of policy meetings, but presumably the Bank of Canada does not want to look like it is always following the Fed.

The decision making body at the Bank of Canada is the Governing Council, which consists of the Governor, the Senior Deputy Governor, and four Deputy Governors. All of those people are appointed by the Bank's Board of Directors. The Board of Directors, in turn, consists of the Governor, the Senior Deputy Governor, and a group of people appointed by the cabinet of the federal government. The mandate of the Bank as specified in the Bank of Canada Act, is to "promote the economic and financial welfare of Canada." That's of course pretty vague, but since 1991 the Bank has had an explicit inflation target, worked out as an agreement with the Government of Canada. This agreement is reviewed and renewed every five years. Currently, the inflation target is specified as a 2% target for CPI headline inflation, with a range of 1-3%.

Some critical differences between the Bank of Canada and the Fed:

1. The public doesn't know what happens in a Governing Council meeting. There are no minutes or transcripts, and no reported vote. After the meeting, a statement is issued, and at every other meeting there is a press conference.

2. The top Bank of Canada officials are somewhat shy. They don't speak in public as much as, for example, Jim Bullard, the President of the St. Louis Fed. As well, Bank of Canada officials generally speak with one voice. Public dissent is not a thing.

3. To properly deal with the public in Canada, Bank of Canada officials have to be bilingual. So, when they stand up in public, they'll talk to you in both English and French.

4. The actual mechanics of monetary policy implementation are considerably different. There is an overnight market in which the Bank of Canada intervenes, but there is a small number of participants in this market. As well, the Bank operates in an environment in which overnight reserves are essentially zero. The Bank of Canada never went in for a large balance sheet and large-scale asset purchases after the financial crisis, in contrast to the US, the Euro area, Japan, the UK, etc.

Let's review the state of the Canadian economy. Here's the recent time series for real GDP in Canada, normalized to 100 in first quarter 2007, so that we can compare this to the US:
As you may have expected, the behavior of real GDP is not so different in Canada and the US. North America is a highly interconnected economy, given the high volume of trade in goods, services, and assets. However Canada has a somewhat different sectoral composition of output from the US, for example Canada depends more on natural resource industries. That's what the slowdown from 2014-16 is about, which follows the drop in the price of crude oil. But recently, real GDP growth has been strong. Here's what year-over-year growth rates of real GDP look like, since 2010:
Growth rates are roughly synchronized in Canada and the US, over this period, but you can see somewhat more volatility in Canadian growth rates. As well, the average growth rate over this period is somewhat higher in Canada. Recently, growth has been quite strong in Canada, particularly in the second and third quarters of 2017 (in the 3-3.5% ballpark).

What about the labor market? The unemployment rate looks like this:
So, the unemployment rate is the lowest it's been for the last 18 years - indicating a tight labor market. We could go deeper into some other labor market variables, for example the participation rate:
As you can see, labor force participation has dropped somewhat in Canada since 2008, but not to the same degree as in the United States. Indeed, the Canadian population has a similar age structure to the US population - for example the post-WWII baby boom phenomenon is similar in the two countries. Yet, the Canadian participation rate is currently three percentage points higher than in the US. It's not clear what explains this or if, for example, one can explain all of the decline in the Canadian participation rate with demographic factors.

The employment/population ratio looks like this:
Again, Canada experienced a one-time drop in the employment/population ratio during the last recession, but the drop was not as large as in the US, and Canadians currently work harder than Americans, to the tune of about two percentage points in the employment/population ratio. In terms of employment growth rates, here is how it looks in Canada, year-over-year, along with growth in the labor force:
So, recent employment growth rates, year-over-year, have been in the vicinity of 2%, but with labor force growth hovering around 1%, that sort of rapid employment growth cannot be sustained.

Finally here is how the Bank of Canada is doing with respect to its inflation target:
With respect to headline CPI inflation, the Bank of Canada has tended to miss on the low side for the last five years, though inflation is current right at target. I've included a core measure inflation (excluding food and energy prices), but I'm not a big fan of stripping prices out of the index - better to have an idea how persistent the effects of particular shocks are on inflation.

The Bank of Canada increased its policy target twice during 2017. The target for the overnight interest rate went from 0.5% to 0.75% in July and then to 1.00% in August. So what will the Bank do on Wednesday? Given the data I showed you, it looks like the Canadian economy is performing well - somewhat better than the US economy, with relatively strong real GDP growth and employment growth, and a labor market that looks fairly tight. And the Bank is hitting its inflation target. So why should the Bank do anything?

Well, how do Bank of Canada officials look at the world? To figure this out, the press release after the December meeting might help. The two last paragraphs are important, I think:
Inflation has been slightly higher than anticipated and will continue to be boosted in the short term by temporary factors, particularly gasoline prices. Measures of core inflation have edged up in recent months, reflecting the continued absorption of economic slack. Revisions to past quarterly national accounts have resulted in a higher level of GDP. However, this is unlikely to have significant implications for the output gap because the revisions also imply a higher level of potential output. Meanwhile, despite rising employment and participation rates, other indicators point to ongoing­ – albeit diminishing – slack in the labour market.

Based on the outlook for inflation and the evolution of the risks and uncertainties identified in October’s MPR, Governing Council judges that the current stance of monetary policy remains appropriate. While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.
That's certainly Phillips curve language, so the Bank thinks that measures of excess capacity or slack tell us something about where inflation should be going. Here are some such measures that the Bank likes to look at, apparently. Like all Phillips curve believers, Bank officials have to be puzzled by their recent tendency to undershoot their inflation target in the face low unemployment. That's why they think there's still slack in the economy. Like the Fed, people at the Bank of Canada have gone on a slack hunt, looking for labor market variables that might justify a view that the economy is still underperforming. But, the statement above also says that "higher interest rates will be required over time." That is a form of forward guidance, but what's it telling us? The statement doesn't tell us why these higher interest rates might be required, or under what conditions increases might happen.

But, to fill in the gaps, my best guess is that Steve Poloz thinks like Janet Yellen, who believes that interest rate hikes are justified so as to head off higher future inflation. That's a convenient fiction that allows interest rates to go up - otherwise true Phillips-curve-believer central bankers would just get stuck in a policy trap with low nominal interest rates and low inflation forever - everyone turns into Japan, basically. In this instance, a Neo-Fisherian approach might justify another increase. On average, inflation has been below the target somewhat, so another 25 basis points north won't hurt - it'll make inflation go up. The Governing Council, using a get-ahead-of-the-curve approach - basically Phillips curve wakes up and asserts itself - will likely go for the 25 basis point increase in the policy rate, which of course will be self-fulfilling. News since the last meeting has been good in terms of labor market performance for example - the unemployment rate dropped two points - and inflation has gone up. Best guess is that the policy rate goes up tomorrow.

Friday, December 29, 2017

The Corporate Tax Rate, Part 2

John Cochrane posted a reply to my previous post on how changes in the corporate tax rate might affect investment. The key issues seem to relate to the specifics of what the tax code will allow as an expense. In my analysis, I treated investment spending by the firm as fully-expensed, which is not correct. However, the tax code does permit businesses to deduct interest on their debt, and depreciation, which I didn't include. What I'll do here follows - I think - a comment by Francois Gourio (Chicago Fed) on Twitter.

So, let's write down the firm's problem again, assuming a constant real interest rate r, which the firm's shareholders face (an important assumption - I'm neglecting taxes affecting the sharelholders). We'll assume that dividends are paid period-by-period to the firm's shareholders, with the firm maximizing the present value of dividends:
Here, K is the capital stock, N is the labor input, w is the wage rate, b is the firm's debt, and d is the depreciation rate. The firm's debt comes due in one period. Net proceeds for the firm in the current period consist of output minus the wage bill plus new debt issued, minus interest and principal on the debt issued in the previous period, minus investment, minus corporate taxes. The corporate tax rate t applies to output minus the wage bill, minus the interest payments on the debt, minus depreciation.

If the firm were to fund investment out of retained earnings (provided this does not violate a nonnegativity constraint) then a reduction in the corporate tax rate will indeed raise the after-tax marginal net payoff to investing. Alternatively, suppose that the firm always funds new investment by issuing debt, then pays the interest on the debt, retires debt as capital depreciates, and otherwise rolls the debt over. This implies that the firm's outstanding debt is always backed one-for-one by the firm's capital, or
Then, we can rewrite the first equation as
So, the firm's choice of labor input in each period, and its choice of capital in periods 1,2,3,... (equivalent to choosing investment) is independent of the tax rate t. Essentially, debt financing of investment permits full expensing of the investment expenditure - indirectly, through expensing of interest on the debt and depreciation.


1. We need to worry about how the household is taxed, which in this formulation determines what the objective function is for the firm.
2. To do a proper job here, we need to determine the optimal financial structure for the firm.

This is potentially quite complicated (not blog material), though I'm sure someone has addressed related problems in the taxation literature. To do the problem justice, we need a complete general equilibrium model. That said,

1. There's no presumption that the corporate tax rate reduction is going to matter much for intensive-margin decisions of the firm - decisions about labor input and investment.
2. Where the change in the corporate tax rate should matter is for entry decisions - here we need to start worrying about nonconvexities - e.g. fixed costs of entry. But some entry, relating to the treatment of pass-throughs, would just be a renaming of the productive unit - call yourself a business and you can be taxed at a lower rate. As well, firms may choose to relocate from other countries to the U.S., though as I mentioned in my previous post, those other countries won't give up without at fight.
3. There's a clear redistributive effect, as I mentioned in my previous post. Owners of stocks will benefit, and they tend to be richer people. Long-term, government transfers and expenditures on goods and services have to fall, and the burden of those reductions will be borne by the relatively poor.
4. If the Republican Congress actually wanted to increase investment spending, there are straightforward ways to do this through the tax code - an investment tax credit, for example.

Wednesday, December 27, 2017

Where's the Fallacy?

Here's John Cochrane, writing about the "buyback fallacy:"
Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.
But, John concludes:
Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.
But, suppose that we use a simple model of firm behavior, along the lines of what we teach to undergraduates (see for example, Chapter 11, of this fine intermediate macro book). In each period i = 0,1,2,..., the firm hires labor and invests in new capital. Output is produced using labor and capital each period, using a constant-returns-to-scale technology. Each period the firm hires labor on a competitive market, produces output, and invests in new capital. The firm's profits (the return to capital, not economic profits) are P(i) in periods i = 0,1,2,..., and the firm maximizes the present value of profits. Suppose no uncertainty, and that the real interest rate is a constant r forever. Capital depreciates at a constant rate. The firm maximizes the after-tax present value of profits
Profits are ultimately distributed as dividends to the firm's shareholders, but the firm can borrow and lend freely at the interest rate r, so the timing of the dividend payments is irrelevant.

What happens if the corporate tax rate goes up permanently, with the tax rate constant forever, or t(i)=t? This has no effect on investment or on the firm's hiring decisions in any period. That is, if VB is before tax profits, then (1-t)VB = V, so maximizing VB is the same as maximizing V, and the tax rate is irrelevant, not only for investment decisions, but for the firm's hiring decision. In the aggregate, there is no effect on labor demand, and therefore no effect on wages.

Basically, investment is an intertemporal decision for the firm. But the corporate tax rate affects per-period after-tax profits in exactly the same way in every period, so there is no effect on the after tax rate of return on investment the firm is facing. Therefore, the firm won't invest more with a lower corporate tax rate - if it's permanent. How can a change in the corporate tax rate make investment go up in 2018? If the corporate tax rate were temporarily higher in 2018, returning to its former level permanently in 2019, that would do the trick.

I could be missing some subtlety in the tax code, for example in how the firm's financing decisions are affected by taxation, but I don't think so. Please fill me in if you think there's something important I've left out.

So, I don't think there's any fallacious thinking in the popular view of the effect of changes in corporate taxation included in the tax bill. The primary effect is redistributive. Ownership of stocks is concentrated among the relatively wealthy, and a permanently lower corporate tax rate will show up immediately in higher stock prices, as we've seen. Owners of stocks can hold them and receive their higher future dividends, or they can sell their stocks at any time and realize their capital gain. As more GDP doesn't magically come out of nothing, higher spending by these richer folks has to be offset by less spending by poorer folks.

If there are effects of changes in the corporate tax rate, these could come from two places. First, the change in the US rate relative to corporate tax rates elsewhere in the world matters. In some instances, this will have no implications for the location of production for the firm (e.g. management consulting done in various locations in the world), but will matter for the firm's choice of corporate tax home. The tax rate goes down, which reduces tax revenue, but more firms choose the US as a corporate tax home, which increases tax revenue. The net effect on tax revenue depends on how elastic corporate tax home is with respect to the US corporate tax rate. Also, some firms producing tangible goods may choose to relocate production to the US. This necessarily implies some increase in domestic investment expenditure, but the effect is temporary, and probably small, particularly as we can't take for granted that other countries will not provide inducements to prevent firms from moving production to the US.

Second, there is another effect on the extensive margin. Some economic activity that would formerly show up as labor income will now be classed as business income, so as to qualify for the lower tax rate. As I showed, there are no implications for investment expenditure. The effects are lower tax revenue and redistribution to the rich from the poor, who either can't do this, or can't afford to pay an accountant.

If the intent of the tax bill had been to increase investment spending, there are obvious ways to to that - an investment tax credit for example. But, the tax bill is not about investment. The primary effect is redistribution. In the short run, the tax bill makes the rich richer and the poor poorer, and it lowers tax revenue. Permanently lower tax revenue has to show up, in the long run, as permanently lower government transfers and lower spending on government-provided goods and services. This will hit the poor disproportionately. So, this isn't tax legislation that appears to work on marginal anything - it's just wealth redistribution.

Sunday, November 5, 2017


Will Jay Powell do a good job of running the Board of Governors and the FOMC? He's certainly not an obvious choice. If Powell had not been appointed to the Board in 2011, nobody would be thinking of him as a candidate for the Chair's job now. Powell is a lawyer, with no formal training in economics (beyond the odd undergrad course), which puts him at a disadvantage in the Fed system. On the up side, he has a willingness to learn:
“When he showed up at the Fed, he basically did not know much about macroeconomics or monetary policy,” says Seth Carpenter, chief U.S. economist at UBS who spent 15 years at the Fed, including time overlapping with Powell. “He made a conscious decision to spend a lot of time with staff and colleagues to learn as deeply and completely as possible.”
So, Powell appears to be conscientious in seeking advice about things he doesn't know much about. But, the Board may actually not be a great place to learn macroeconomics - the Board staff aren't known for their independent thinking, for example. Further, a Board Governor is not in the best position to learn, as he or she does not have a staff, and is dependent on more-or-less randomly assigned economists to get their work done. Indeed, a Governor's job is thankless in more ways than one. He or she currently earns $179,700 per year, which is less than what a good Associate Professor in Economics is paid at a top research school. And the Presidents of the regional Feds are much better remunerated. Dudley (New York Fed) earns $469,500, Williams (San Francisco Fed) earns $468,600, and Bullard (St. Louis Fed) earns $359,100, for example.

But any of those salaries pale in comparison to what Powell had to be earning in the private sector, judging from his accumulated wealth, which appears to be between $20 million and $55 million. So, to his credit, we can infer that Powell is genuinely interested in public service, otherwise he would still be in the private sector, further feathering his own nest. At six years in, he has been at the job longer than is typical for Board Governors, who are appointed for 14 years, but rarely serve the full term, or anything close.

What are Powell's views on monetary policy? He certainly has not been outspoken about it. Brainard and Tarullo have had differences with the consensus view on the FOMC, and weren't shy about talking about it. Stan Fischer, given his long experience as an academic economist and central banker, certainly had a lot to say, and clearly had his own views on policy. Powell, not so much. A quick look through some of Powell's speeches indicates that he typically did not speak specifically on monetary policy. When he did, for example in a 2016 speech, it's boilerplate - basically the consensus FOMC view. I've seen Powell in action only once. I know he said something, but I can't remember what it was. You might say my memory isn't so great, but from the same occasion, I can remember key details of what Kocherlakota, Evans, Brainard, Lacker, Fischer, and Yellen were talking about. Powell, in the general view, is collegial, reasonable, and intelligent. But in instances where we need depth of experience in central banking and knowledge of economics, he'll have to be looking to other people. That's worrisome.

So why was Powell chosen? Some have suggested that, relative to Yellen, Powell leans more toward less financial regulation. That's too deep for Trump, though, I think. Most official high-level Trump appointments are of three types: (i) person bent on destroying the institution he or she is assigned to run; (ii) General - either active or retired; (iii) rich white male. Powell is type (iii). Just be thankful he isn't type (i) or (ii).

But why didn't Trump just stick with Janet Yellen? After all, he claimed he liked her, right? Well, Yellen is neither male nor rich, so she has two strikes against her, in Trump's mind. Further, Trump seems convinced that people he appoints owe him favors. In Trumpland, an Obama appointee just can't have the right predilections.

But is Yellen a great loss? The New York Times editorial board thinks so. Adam Davidson, in the New Yorker, says that Janet Yellen is a "master of thinking in public." Jena McGregor, in the Washington Post, collects a lot of favorable quotes relating to Yellen's record as Fed Chair, and remarks on the loss of a woman in a position of power, where there currently are few.

From my point of view, Yellen was successful in forging consensus on the FOMC. Apparently, she didn't force her views on others (unlike Greenspan, for example), and the FOMC seems to have operated in a collegial fashion for the last four years. There were some dissents, but given the context there really wasn't that much friction. After all, the Fed was dealing with a unique situation - the large balance sheet that had been built up under Bernanke, and an unprecedentedly long period of essentially-zero overnight nominal interest rates. Deciding when and how to unwind that was no easy task. That said, Yellen's training (PhD 1971) put her out of touch with modern macroeconomics, and she appeared to have a religious devotion to the Phillips curve. With respect to the latter, she has plenty of company in the rest of the central banking community, but that's no excuse. As well, Yellen is well-known for her reluctance to appear in public - Adam Davidson's characterization of her as a "master of thinking in public" is nonsense, I think. As far as I can tell, thinking in public and walking on hot coals are more or less equivalent for Janet Yellen. This is, I think, why Yellen persisted in holding press conferences only after every other FOMC meeting - a decision that implied that nothing would ever happen at FOMC meetings held in January, May, July, or October. Yellen always insisted that all meetings were live, but the off meetings were live in the sense that a person who is unconscious and on a respirator is live - he or she isn't about to get up and run around.

That said, it's hard to see how the Fed will be better-run under Powell than Yellen. The failure to reappoint Yellen is just another instance in this administration of a break with precedent that weakens American institutions - this time the damage is to Fed independence. Further, our progress toward being a gender-blind society has been set back, and that's a big deal.

Thursday, October 5, 2017

U.S. Monetary Policy: What's Up?

To frame the issues, let's look at some objective measures of the Fed's performance. Just to be fair, we'll evaluate performance in terms of the objectives laid out in the FOMC's January 2017 goals statement.

1. "...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." Note that the price index the Fed has chosen as most appropriate is the raw, headline pce deflator, not the pce deflator stripping out food and energy, the cpi, the core cpi, or any other measure. So we should hold them to that choice. Here's year-over-year inflation rates, since the last recession:
Obviously the Fed hasn't been hitting 2% inflation spot on, but what's actually feasible, or even desirable? The Bank of Canada, to take an example that's close at hand for me, actually sets a target band of 1-3% for inflation, so by that criterion the Fed has done pretty well - within the 1-3% band for most of the last seven years, except during 2015 after the fall in energy prices, which perhaps is understandable. The current inflation rate is 1.4%, which is tolerably close to the Fed's ideal. But the the Fed also has a "symmetric inflation goal." Missing the target sometimes is OK, but the FOMC would like to miss on the high side about as much as it misses on the low side - roughly, average inflation should be close to 2%. Over the last year, inflation was above 2% for two months, and below for 10 months, with an average of 1.6%. Not quite symmetric, but not so bad.

2. "... it would not be appropriate to specify a fixed goal for employment...Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published...For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent." For good reasons, the FOMC doesn't want to be specific about numerical goals related to the second part of its mandate - sometimes called "maximum employment," whatever that is. There's a hint though, about what the FOMC members might care about, which is the "long run normal" or natural rate of unemployment. This is rather ill-defined and hard to measure. To my mind, the economics profession would be better off if we refrained from mention of "natural" anything. One danger associated with the natural rate, as for any other ill-defined and hard-to-measure variable, is that a policymaker can start making stuff up, so as to manipulate the policy discussion. In the FOMC's most recent projections, the range of estimates for a long-run unemployment rate fall in a range of 4.4%-5.0%, with a median of 4.6%, so notions of what is normal have fallen since January 2017, when the FOMC put together its long-run plans revision. Here's what the actual unemployment rate looks like:
The current unemployment rate, at 4.4%, is as low as any FOMC participant thinks is normal over the long run, conditional on things going really well, apparently. So, by that measure the Fed is doing great.

Just to check, we can look at another measure, which is a measure of labor market tightness (or it's inverse, as conventionally measured in the labor literature). This is the ratio of the number of unemployed to total job openings:
Shortly after the last recession ended, this measure peaked at about 6.6 unemployed people per job opening, and it's now down to close to 1 unemployed person per job opening. Indeed, that's close to the lowest reading since the BLS started collecting this particular job vacancy data. So, by conventional measures the job market is very tight, which should be viewed as extremely good performance on the Fed's part.

What about growth in real GDP?
If we think that part of the Fed's job is to smooth growth in real GDP, then that chart looks pretty good. I've put in a 2% growth path, and the deviations from that growth path are small. Of course, people might complain that 2% growth is lower than the 3% (roughly) post-WWII average, but that shouldn't be the Fed's concern. Received wisdom in the economics profession is that monetary policy can't do much for long-run growth, other than keeping inflation low and predictable.

So, what's to fix here? Inflation is tolerably close to 2%, the unemployment rate is very low, the labor market is extremely tight, and real GDP is growing smoothly. The only improvement to be made is some fine tuning so that inflation fluctuates symmetrically around the 2% target. How should that be done? I'll assume, consistent with my last post, that QE doesn't matter. So the only issue is what should be done to the fed funds target range (or, more accurately, the interest rate on reserves and the interest rate on overnight reverse repurchase agreements), so that the average inflation rate is 2%? Well, you don't have to be a neo-Fisherite to understand that, if inflation is persistently lower than what you want, on average, then the nominal interest rate needs to be, on average, higher in the future. What's needed here is some tweaking of the Fed's policy interest rate target. How much? As mentioned above, the average inflation rate over the last year is 1.6%, so one or two more interest rate hikes will do the trick. Twenty five to fifty basis points' increase in overnight interest rates is small potatoes for real economic activity - note that the labor market continued to improve in the face of the last four interest rate increases.

So, that's what I'd do. What does the FOMC have on its mind? In the last FOMC projections, the median long-run prediction of Committee members for the fed funds rate is 2.8%, with a range of 2.3%-3.5%. That's come down considerably, with recognition by the committee that the low real rates of return on government debt we are observing are likely to persist. A persistently low real rate of return on short-term safe assets implies of course that the nominal short term interest rate consistent with 2% inflation is low. I'm saying that what Janet Yellen would call the "neutral interest rate" (the interest rate target at which the Fed achieves its goals in the long run) is more like 1.5%, and not 2.3%-3.5%.

To get more information on what the FOMC is likely to do over the near future, we'll look at Janet Yellen's last speech on "Inflation, Uncertainty, and Monetary Policy." First, Yellen tells us how inflation has been low, and then says why she thinks low inflation is bad:
Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions. In addition, a persistent undershoot of our stated 2 percent goal could undermine the FOMC's credibility, causing inflation expectations to drift and actual inflation and economic activity to become more volatile.
The second sentence is important. The Fed committed to a 2% inflation target because the assurance of predictable inflation minimizes uncertainty, and makes credit markets, and (by some accounts) the markets for goods and services work more efficiently. If the Fed consistently undershoots its inflation target, people will either think the Fed is incompetent, or that it is willfully abandoning its promises, neither of which is good - for the institution or the economy. But in this instance, the Fed isn't missing by much, so what's the big worry? As I mentioned above, this requires some fine-tuning, but don't get bent out of shape about it.

The first sentence in the quote was really interesting. She's got the causality backward. Pretty much all of us now accept that it's the central bank that controls inflation. That is, central bank actions or, more accurately, the central bank's policy rule, causes inflation to be what it is, combined of course with other factors outside the Fed's control - including the factors determining the long-run real rate of interest on government debt. So, low inflation does not lead to "low settings of the federal funds rate." It's the low settings for the fed funds rate that lead to the low inflation. In a world in which the central bank targets the nominal interest rate to control inflation, that's how it works, and central bankers would be wise to absorb that idea. Stop the neo-Fisherian denial, and get with the program!

The speech uses a two-equation model (written down in the appendix) to frame the issues. It's a Phillips curve model. Arrgghh. Even Larry Summers recognizes that Phillips curves are unreliable. As he says:
The Phillips curve is at most barely present in data for the past 25 years.
For example, in the recent post-recession period, here's what we get when we plot inflation against the measure of labor market tightness I used above (ratio of unemployed to job seekers):
The line connects the observations in temporal sequence from right to left. Over this period of time, I think the Fed would claim that inflation expectations are more or less "anchored." So, what we should see in the chart, if the Phillips curve is to be at all useful, is a set of observations tracing out a downward-sloping relationship. But, more often than not, inflation and my "slackness" measure are moving in the same direction. There's nothing new about macroeconomists raising issues with the Phillips curve as a cornerstone for policy. It's been in disrepute for much of the last 45 years or so, both on theoretical and empirical grounds. Unfortunately, the Phillips curve was dragged out of the gutter, dressed up, and rehabilitated by New Keynesians, which is another story altogether.

But, like a lot of people, Janet Yellen is a true believer, and her staff will aid her in that belief by going on a fishing expedition and finding a Phillips curve, and a sample period, for which all the signs in the regressions (if not the magnitudes) come out "right." Here, "right" is whatever conforms to the beliefs of the boss. Sure enough, in the appendix to Yellen's speech, there is a two-equation Phillips curve model. Core inflation is determined by past core inflation, inflation expectations, resource slack, and the relative price of imported goods, and core inflation, energy price inflation, and food inflation determine headline inflation. Yellen's worries about future inflation outcomes are essentially those of the true believer. Do we have the right slackness measure, or the right inflation expectations measure, and how much should we worry if expected inflation falls?

Though Yellen lays out an explicit model of inflation, she doesn't exactly tell us how policy is supposed to work within that framework. Even true believers will sometimes tell you that "the Phillips curve is now very flat," meaning that they think a tighter labor market will put little or no upward pressure on inflation. If we want to stick with the Phillips curve framework, what's left then? The Fed has to focus on anticipated inflation. But how do they move that around? Modern macroeconomics tells us that our views about future outcomes are shaped by what we know about policy rules, in a manner consistent with what we know about how the world works. I got no sense from Yellen's talk of how the Fed thinks its policy rule affects inflation expectations.

But here's the essence of the FOMC's current policy view:
...without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.
So, in spite of the fact that the Phillips curve doesn't fit the data, the most recent manifestation being the failure of the very tight labor market to make inflation go up, policy going forward will be driven by the fear that the Phillips curve will somehow wake up and re-assert itself. Summers thinks that's wrong, and rightly so.

But, I think Yellen and her colleagues are actually following the right policy. Modest increases in the Fed's interest rate target in this context is the correct prescription. But doing the right thing for the wrong reason won't help you in the long run. We're fortunate, though, that not much is likely to go wrong here. If inflation stays low, and the FOMC loses its appetite for interest rate increases, so what? Low inflation is fine, and it's close enough to 2% as not to be embarrassing. No big deal.

Monetary policy is the least of our now-staggering problems. Unfortunately, the wingnut in the White House is busy creating more difficulty for us, and making the problems we have worse. Fortunately, he has as yet not screwed up the Fed, and the slate of would-be Fed Chairs doesn't include anyone outlandish. More on that later.