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Again, I do not want to distract from the point that what is necessary in this crisis is for inflation to be temporarily higher. However, a reminder of why I believe a permanent moderately higher rate of inflation would be helpful.

The Wall Street Journal quotes Japanese Central Banker, Kazuo Ueda response to then Princeton Professor, Ben Bernanke’s suggestion that the Bank of Japan needed to do more:

"Do not put yourself into the position of zero rates," he said. "I tell you it will be a lot more painful than you can possibly imagine."

Low inflation rates give the Central Bank inherently less room to respond to a crisis. They make nominal losses more likely and the liquidity trap more salient. Lower inflation also means that principal payments do not effectively decline over time. Thus the thorny issue of “principal reductions” is more likely  to become an issue.

Robert Barro once estimated that a 2% higher inflation rate would shave roughly .04 to .06 percentages points off of growth. Compounded over the say 75 year interval between major financial crises and that is between 3 and 5 percentage points of GDP.

Percentages like that are not something to trifle with for sure. However, this a loss that is borne smoothly across society in the form of a lower capital-to-labor ratio. By contrast, unemployment is sharply concentrated in a few households. Thus, the utility cost – the human cost – is much higher.

If moderate inflation gives us greater insurance against severe recessions then it is a price worth paying.

You may have noticed that some elements of the blogosphere have been pushing for higher inflation, while others have been talking up structural readjustment. The Fed Minutes suggest that much the same argument is occurring within the room:

A number of participants noted that the current sluggish pace of employment growth was insufficient to reduce unemployment at a satisfactory pace. Several participants reported feedback from business contacts who were delaying hiring until the economic and regulatory outlook became more certain. Participants discussed the possible extent to which the unemployment rate was being boosted by structural factors such as mismatches between the skills of the workers who had lost their jobs and the skills needed in the sectors of the economy with vacancies, the inability of the unemployed to relocate because their homes were worth less than their mortgages, and the effects of extended unemployment benefits. Participants agreed that factors like these were pushing the unemployment rate up, but they differed in their assessments of the extent of such effects. Nevertheless, many participants saw evidence that the current unemployment rate was considerably above levels that could be explained by structural factors alone, pointing, for example, to declines in employment across a wide range of industries during the recession, job vacancy rates that were relatively low, and reports that weak demand for goods and services remained a key reason why firms were adding employees only slowly.

More over the inflation/price level/NGDP targeters seem to be winning

Meeting participants discussed several possible approaches to providing additional accommodation but focused primarily on further purchases of longer-term Treasury securities and on possible steps to affect inflation expectations. Participants reviewed the likely benefits and costs associated with a program of purchasing additional longer-term assets–with some noting that the economic benefits could be small in current circumstances–as well as the best means to calibrate and implement such purchases. A number of participants commented on the important role of inflation expectations for monetary policy: With short-term nominal interest rates constrained by the zero bound, a decline in short-term inflation expectations increases short-term real interest rates (that is, the difference between nominal interest rates and expected inflation), thereby damping aggregate demand. Conversely, in such circumstances, an increase in inflation expectations lowers short-term real interest rates, stimulating the economy. Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP. As a general matter, participants felt that any needed policy accommodation would be most effective if enacted within a framework that was clearly communicated to the public. The minutes of FOMC meetings were seen as an important channel for communicating participants’ views about monetary policy.

Oh. My. God.

• Inflation expectations to low: check
• Real Interest Rates at the ZLB: check
• Clear Commitments: check
• Temporarily Higher Target and/or Level Targeting: check

How long ago were we saddled with “expectations remain well anchored and the economy is expected to grow at a measured pace?”

Inflation expectations are already on the move. Could hit a normal rate within weeks if not days. Expectations of a return to the pre-crisis price level could be only a month or so away.

The graph below charts the difference between 10 year constant maturity treasury bond and its ten year inflation protected equivalent on the left axis. It shows payroll additions or subtractions on the right.

Normal gap is around 2.5%, we have now crossed into the 2% range. Repairing the damage would probably require making up to 3% for around 6 – 9 months and then slowly drifting back down to 2.5%

If the rough relationship between the gap and job growth held then we would reach around 500K jobs added each month. That’s a heck of prediction. However, if you buy hydrodynamic macro then its not crazy.

In any case it looks like we are either about to through the victory party of the century or have some serious splain’ to do.

Reddit knows exactly where to dump all of those New Classicals, New Keynesians, Game Theorists and just about everyone else

For those for whom the picture doesn’t link, the category is called Non-Austrian Economics.

The former assistant editor of Columbia Journalism Review premiers a new policy site with a discussion of inflation expectations and a few quotes from yours truly.

So why might inflation help? Inflation is often defined as too much money chasing too few goods — if the amount of money in circulation goes up but the underlying value produced by the economy stays the same, prices will rise. One of the problems with our economy today, though, is that there’s too little money moving around. Beginning in fall of 2008, individuals, businesses, and banks stopped spending money and started hoarding it. In effect, that money disappeared from the economy. The result of this “excess demand in the market for money,” explains Karl Smith, an assistant professor of economics at the University of North Carolina, is “a lack of demand in all [other] markets.” One result: businesses are producing less than they could. Another result: they’re doing it with fewer workers.

He talks with Scott Sumner, Robert Shimmer, Stephen Williams, Randall Wright and others as well.

The Financial Times prints it:

. . . speculation has turned to a return to quantitative easing (QE2), or large purchases of long-term Treasury bonds.

This would be a dramatic move. But we must not kid ourselves. It would have at best a modest effect in a large, liquid market such as Treasury bonds and, therefore, is unlikely to dig the US economy out of its current hole. There is, however, another option: for the Fed to clarify its “exit strategy” from its current, unconventional monetary stance. This would mean making clear that the Fed has no plans to tighten policy through increases in the federal funds rate, even if inflation temporarily exceeds the rate regarded as consistent with the Fed’s mandate. In short, the Fed should allow a one-time-only inflation increase, with a plan to control it once the target level of prices has been reached.

He goes on to outline the core theory behind a boost in inflation. Woodford is correct that it is not necessary for inflation to be permanently higher.

I tend to think permanently higher inflation might be a good idea because it gives the Fed more room to act in a crisis but that is another argument. For the purposes of battling the current recession a temporarily higher target will work.

Also, I don’t want to confuse long term debates over optimal targeting regimes – and there is a long list of potential regimes – with the goal of increasing near term inflation expectations.

What is necessary is for the Fed to commit to higher prices in the future than people are currently expecting.

Bryan Caplan states

At this point, it’s tempting to dismiss Keynesianism as a dogmatic cult.  But in fact, there are key issues where their self-confidence is well-deserved.  The only problem: They’re too scared to admit why.  So let me answer for them: The source of Keynesian confidence is not "empirics," but introspection.

While introspection is not useless – I am a data point – I have doubts about using it as the foundation for an economic theory. Everybody lies, but mostly to themselves.

On the other hand, casual empiricism is highly useful. People queuing up en masse outside the Staples Center for a job fair is not what I would expect to observe during the Great Vacation.

A generally speaking people behave as if there is an excess supply of labor

Of course all that being said there is aggregate data that suggests the amount of work being done is closely related to the amount of work demanded.

So I just got around to watching the EPI video. Its pretty good stuff and the three gentlemen give a good summary of where we are and what the prospects look like.

A few comments I’d make.

One, I think they’re underselling the potential of monetary policy. Jan makes good points that bankers are cautious. However, he is basically calculating the amount of bond purchases that would be necessary to drive down long term interest rates.

However, long term real rates also respond to expected inflation and expected future policy. If we think that the US will be on the road to full employment within 5 years then we can bring down long rates simply by committing to higher inflation targets then. We do not have to be at full employment in 5 years simply on the road such that it would otherwise make sense for the Fed to begin raising rates.

Note also, that if the Federal Reserve promised to give 3% inflation over the next 10 years but only achieved 1% over the next five then it would be implicitly promising 5% inflation over the last five. This would give 10 year Treasuries a negative interest rate right now.

Two, even if we don’t think the Fed can get traction on its own the obvious response is massive tax cuts. Suppose that the horizon is so long that the Fed is not willing to make policy promises that will be binding even as we move to full employment. The government can still engage in enormous tax cuts and the Fed can commit to holding the interest rate near zero

My first option would be a complete payroll tax holiday. The natural response is that the effect will be muted by people saving in anticipation of future tax increases. I am still not convinced of the strength of this effect in a credit crisis but suppose that we observe this. We could gauge the response after 2 – 3 months and if it is muted we can extend the holiday by one year. If it is still muted another year and so on. It would not seem inappropriate to be willing to move to a five year holiday.

I understand that there is concern over the budget deficit but in some ways this doesn’t make a lot of sense to me. If we cut payroll taxes then one of two things could happen.

a) People spend the money. In that case net savings falls rapidly. The federal reserve accommodates the decrease in savings with monetary expansion and the economy grows.

b) People save much of the money. In that case net savings does not fall as rapidly. The federal debt grows but private debt shrinks. America’s total indebtedness does not move very much. We are not providing the Fed with any increased traction but we are not worsening our national account balance either. If anything we are arbitraging the high borrowing costs that citizens face against the extremely low borrowing costs that the government faces.

Three, what people need to understand is that the crisis is happening now. This is the worst recession since the Great Depression. It is the only world wide recession since the Great Depression. One does not need to worry that we are setting the stage for a future disaster: this is what a disaster looks like. We are in it. We are living it.

I think that on the one hand people do not realize how bad things are. Some of it is that folks who are comfortable don’t realize the suffering among the more vulnerable sectors. Some it is that people don’t realize that without action there is not necessarily an end in sight. Some of it is that soaring productivity is obscuring real losses. Corporate profits have recovered and hence the stock market has recovered somewhat.

However, the core reality is that there are millions of American’s who are willing to work and could be producing value for themselves and for the nation but are not. The disaster is now.

Greg has a column in the NYT where is does a case study on his own marginal tax burden. He suggests that any extra earnings on his part would be used to help his children and thus are exposed to many levels of taxation, including popular taxes such as the corporate income tax and the estate tax.

In the end his marginal tax rate is 90% and this is enough to discourage him from working.

However, Greg’s case study also highlights a point I have been trying to make. We have every reason to suspect that labor supply decisions are made at the extended family level. That is, entire families jointly decide whether to work more or work less. This choice may not always be explicit or even made without strife but at the end of the day interfamily transfers of income are commonplace and important.

There is also one thing the economics tells us almost for sure. Greg’s decision to work more is equivalent to his children’s decision to work less. He hopes in his own words that

I don’t want to move to a bigger house or buy that Ferrari, but I hope to put some money aside for my three children. They will never lead lives of leisure, but I hope they won’t have to struggle to find down payments to buy their own homes or to send their kids to college.

Struggle, however, is another word for “be incentivized to supply labor to the market.”

Greg’s bequest to his children functions as a lump-sum transfer. They get the money independent of what they, themselves earn. Such a transfer makes them unambiguously wealthier and wealthier people consume more everything including leisure.

Indeed, even if Greg’s children inherit his indifference to luxury the effect will still hold. They, like Greg, would like to leave a cushion to their kids. However, the more they inherit, the less they have to work to provide that cushion.

Compounded over generations what we wind up with is an American stereotype. A long established, prudent family builds up wealth until the point that they are so comfortable that their progeny think nothing of taking a year to backpack through China, staying in school a bit longer to double major in philosophy or even forgoing that job at a law firm to explore their love for the Sitar.

These things are wonderful intellectual opportunities that parents and grandparents are rightfully proud to bestow. However, they also represent a decline in labor supply. I suspect that effects like this are why, over the long term, the amount of hours worked per person in the US seems to be primarily determined by the unemployment rate.

Another way to say the same thing is that increases in redistribution between families simply leads to reductions in redistribution within families. The net result is that redistributive policies have little effect on incentives.

This opens up a bunch of questions, a sampling of which are

1. What’s the effect on total inequality of formal redistribution?
2. Is there a moral difference between within-family and between-family inequality?
3. What does this suggest about racial or ethnic segregation and inequality policies?
4. What does this suggest about the covariance between income inequality and traits like height, beauty, etc.

Is it just me or are articles like this in big name publications getting more numerous

Every year, as countries around the world struggle to meet the water needs of their citizens, 6.2 billion gallons of Sitka’s reserves go unused. That could soon change. In a few months, if all goes according to plan, 80 million gallons of Blue Lake water will be siphoned into the kind of tankers normally reserved for oil—and shipped to a bulk bottling facility near Mumbai.

But it’s not the distance that worries critics. It’s the transfer of so much water from public hands to private ones. “Water has been a public resource under public domain for more than 2,000 years,” says James Olson, an attorney who specializes in water rights. “Ceding it to private entities feels both morally wrong and dangerous.”

Proponents of privatization say markets are the best way to solve that problem: only the invisible hand can bring supply and demand into harmony, and only market pricing will drive water use down enough to make a dent in water scarcity. But the benefits of the market come at a price. By definition, a commodity is sold to the highest bidder, not the customer with the most compelling moral claim.

Recently enough for me to be quite embarrassed, I mocked fellow economists for harping on the idea that markets are a good way to distribute resources. Have you seen “Red” China I would ask. Did you notice that the Sierra Club endorsed the Coase Theorem?

We’ve won this one boys, its time to move on.

It seems more and more like I uncorked the Champaign to early. I underestimated the bandwagon effect. For the last few decades market advocates were riding high and even those suspicious of our arguments were content to ride its coattails. This phrasing from a Sierra Club policy brief makes that clear.

Cap and trade currently has the overwhelming share of political momentum in congressional consideration of strategies to control global warming. This could change, but the Sierra Club has come to the conclusion that our highest level of effectiveness lies in advocating within a cap and trade context for a program most likely to succeed and result in maximum reduction of emissions.

What advocates saw was that economists were arguing for some kind of climate control policy and policy makers seemed to be listening. The devastating impact of the Great Recession has dinged the esteem of economists in policy circles. This isn’t just about our pride or prestige, it has real consequences.

If market provision of fresh water is rejected because it feels wrong then millions of people will suffer. The better we do at solving the problem of unemployment the more people will listen to our solutions on other fronts.

I wanted to be a littler more explicit about my last post.

My core position is that the money supply is determined not only by the quantity of instruments that can be used as money, but by their quality. If a privately issued financial instrument is held in high enough regard, held by enough participants and priced quickly and easily then it is natural for it to become used as money.

What makes money “good” is that I can readily turn it into stuff. What makes legal tender really, really good is that the entire system of property rights in the United States is backed by a judiciary that will accept legal tender as payment. However, legal tender is not magic.

If for some reason people began to question the veracity of the judicial system’s enforcement of property rights settled in legal tender or, if rapidly rising prices made it next to impossible to actually establish property rights in the legal tender then its use as money would collapse.  Cash would lose its liquidity.

Consequently, it is possible for the money supply to fall even if the quantity of monetary aggregates stays constant. We could witness all the signs of severe monetary tightening even when we see no weird behavior in M1, M2, MZM, etc. This is because the quality of the components is falling.

Now alternatively one could simply argue that I am not describing a fall in the money supply but a rise in money demand. In this case we are fixing the definition of money as one of the aggregates.

Analytically this is fine so long as we now allow that money has a derived demand coming out of the market for liquidity generally. As substitutes for money collapse in supply, the price of those substitutes rises and hence the demand for money rises. You get the same answer.

However, I think it makes more sense to think of money generally as a provider of liquidity and to see a collapse in the liquidity of certain instruments as a fall in the supply of money.

The key is that we can have a monetary shock that comes not from a change in the aggregates but a change in the quality of financial instruments.

Going to the tape, we see nothing particularly abnormal going on in the aggregates leading up to the fall of 2008.

I’ll stop the chart right at September 15th, 2008 to highlight that there was no noticeable pre-Lehman change.

Now stretch the timeline to October 1st.

Certainly there is no contraction evident. This is also 5 days before the Federal Reserve announced that it would pay interest on reserves, so this looks like genuine increases in the aggregates.

Now lets look at measures of the quality of some instruments. Here is the interest rate on financial paper vs. the Fed Funds rate.  Again this first graph stops on September 15th, 2008.

As we can see they traditionally move in lock step. Indeed, part of the reason there is any offset at all prior to the crisis is that these are weekly series and one counts the week ending Friday, while the other counts the week ending Wednesday.

However, we do see trouble brewing as we move through the Summer and into the Fall of 2008. Financial Paper is trading consistently higher than reserves. Questions about its quality are being raised.

Now lets move to Oct 1st, 2008.

Oh, now that’s not good. They are moving in completely opposite directions. The quality gap between financial paper and cash is exploding. Financial paper is losing its money like properties.

Another way we could say this is that there was a run on the financial paper markets. I don’t see this as being in any different than a traditional run on a depository institution or traditional bank. Runs on the banking system occur when checkable deposits lose their money like properties.

Thus, a credit crisis that destroys trust in the financial system spawns a liquidity crisis because the financial system generates privately produced liquidity. This is why the idea of separating out excess demand for money, bonds and credit quality seems inappropriate to me. These properties are mixed up and depend on each other.

I am over a week late, but Brad Delong writes

What Is This “Demand for Money” of Which You Speak?

If our big macroeconomic problem of deficient demand for currently-produced goods and services were the result of a deficient supply of liquid cash money–the stuff you keep in your pockets and use for clearing and functions as a medium of exchange–then the prices of all alternatives to money would be very low: people would be trying to dump their holdings of other assets to build up their stocks of liquid cash money, and only very low prices of and very high expected rates of return on those alternatives could check that desire. Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.

I am sympathetic to Brad’s position. I think the focus on the medium-of-exchange can be excessive. The liquidity of an instrument – and thus how well it stands in for the medium-of-exchange – is a fluctuating quantity. For example, until Lehman crashed and Reserve Primary Fund broke the buck, Money Market Funds were very medium-of-exchangey. One can even use them to pay for stuff.

However, those check writing privileges don’t look so good when you are watching your account balance fall.

In addition my HELOC was source of liquidity. I wrote checks against it until late 2008 when watching the financial crises explode I decided that I needed to race against Wells Fargo’s legal team to cash-out into money before they cut the line.

Funds, Credit and Money are all forms of promises that are held in expectation of turning them into goods and services on demand. What I saw in 2008 was that the quality of some of these promises was deteriorating rapidly.  This is a de facto decline in the “Money Supply” even if those things aren’t actually cash.  The result was a scramble to replace lost liquidity that showed up even in the price of very safe assets. It also showed up in a decline of purchasing.

Here is the interest rate on 5 year Treasury Inflation Indexed Securities as well as Year-over-Year Retail Sales Growth (Inverted)

Throughout there is a weak correlation between the two, with the correlation tightening during the Fall collapse. This isn’t because people were running for pure safety. TIPS are about as safe as you can get. They were running towards liquidity, something that TIPS aren’t.

I would say that people wanted to keep their promises and were afraid that because Lehman couldn’t keep theirs the whole system of promise keeping was going to be screwed.

Picking up on Adam’s posts on the Tenn. Firefighters and Japan’s Phillips Curve, I couldn’t help but post this. Let me be clear I think this obscures some very serious and very important macroeconomic realities. However, I like to air opposition views and I appreciate good geek humor.

From MacroMania:

The rest under the fold

Read the rest of this entry »

Tyler Cowen suggests that we might look back on Japan’s experience with zero percent growth as a Golden Age. He notes advantages over the US

1. Japan has seen numerous quality improvements over the last twenty years, and Japanese consumers are renowned for valuing quality.  The CPI mismeasurement problem may be greater for Japan and real Japanese living standards perhaps have risen a bit more rapidly than the numbers indicate.

2. Japanese politics is less competitive and Japanese rent-seeking is less competitive than in the United States.  Sustained near-zero growth in the United States would mean that interest groups tear apart the social fabric and grab too lustily at the social surplus.  Whether we like it or not, we are "built to grow" and we use the fruits of that growth to buy off interest groups as we go along.  Japan in contrast has greater capacity to stifle these grabs for new redistributions because their politics is more of an insider’s game.

I’m not sure if the Japanese see it that way

Its important to remember that the trade-off is not between inflation and growth. It is between inflation and unemployment. Unemployment is a particularly devastating way to loose production.

Also, to the extent we underestimate quality improvements in Japanese products we also underestimate Japanese deflation.

Ezra Klein apparently asks for the difference between the models that Krugman and Delong use and the models that their opponents use.

So first there are some different Schools out there. I’ll give a rough and ready estimate of what I think they are.

Real Business Cycle

I think there are still some people who essentially believe that Real Business Cycles are correct. I assume Casey Mulligan is in this camp. I think Cochrane and Fama are implicitly in this camp though I don’t know if they have stated as much.

In this world markets always clear, government spending must reduce private spending and running up the deficit always leads to lower investment and growth.

For these guys recessions represent people for various reasons deciding not to work. It might be a productivity shock. It might be government disincentives.

If you want a nice little nerd rundown you can check this out:

http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc.pdf

Recalculation

There are some people, I am thinking Arnold Kling here, who believe in what I might call a neo-Austrian view. I don’t think there are any formal models here and I might be mistaken but I think many in this camp eschew formal models. What there is, is a basic sense that markets work as an evolutionary process.

Within that process transitional pains are to be expected and recessions are just a big version of that.  Arnold is currently the most vocal intellectual in this School but if you had to nail down what the Peter Schiffs of the world are thinking, its probably closest to something like Recalculation.

If anyone says that the government caused a bunch of people to buy houses they couldn’t afford and now we are working through the pains of that, they are effectively a Recalculationist.

In summary, for these guys recessions are caused by mistakes which take time to be corrected. There is no treatise as such but you can try:

http://bit.ly/93uTMM

Mismatch

There are some people who think that the problem is matching the right workers with the right jobs. Kocherlakota and Stephen Williams are in this camp.

For them a recession is basically a giant shift in priorities. What makes them different from recalculationist is that there need be no “mistake.”

There might have been mistakes but that’s not the key. The key is that the economy is shifting. Some will say that the recession is just an inflection point in a long trend. Some will cite the housing bubble but not make a big deal out of it being an error, just that priorities have changed.

For the super nerd version check out

http://home.uchicago.edu/~shimer/wp/mismatch-print.pdf

New Keynesians

Then there is basically everyone else who is some version of a New Keynesian. This literature is much bigger than I am but the bedtime story that we are told in graduate school is that the modern models began with this guy. You might have heard of him.

http://www.economics.harvard.edu/files/faculty/40_Small_Menu_Costs.pdf

For these guys recessions are about an excess demand for some type of financial instrument.

Some people see it as explicitly bonds. This means everyone is trying to save at the same time but this is impossible.

Some people see it as explicitly money. This means everyone is trying to build up cash reserves at the same time but this is impossible.

Some people see it as explicitly high credit instruments. This means everyone is trying to run away from risky investments at the same time but this leads to a cascade that makes moderately risky investments very risky, which in turn makes mildly risky investments very risky and so forth.

I tend to think that all three work together as an agglomeration because of a host of transaction cost and principle-agent problems. But that is beyond the scope of this post.

For the most part the central issue in this line of thinking is: how can swapping around financial instruments which are in some sense just pieces of paper have these huge effects on the real economy? For this to work the connection between the real economy and the financial economy has got to be sticky in some way. The bedtime story is that Greg offered one of the first consistent reasons why.

By and large most economists are working with some type of New Keynesian model. The difference is the focus or the details. In terms of policy, however, I think political economy concerns dominate.

My thoughts tend this way: look this all about money (or bonds or credit) and so the focus of everything is the Fed.

I was a stimulus skeptic. I could see the reasoning but I thought it better to focus all of our attention on monetary policy. I also suggested then and now that if fiscal stimulus must be done, that it should consist entirely of tax cuts or increases in direct assistance to the poor.

However, this was for political economy reasons. Not model reasons. If someone asked whether I thought GDP was higher or lower as a result of the Obama stimulus, I would answer: higher.

On the other hand, Brad and Paul like to focus on spending. I suspect this is in no small part because they think government spending is too low anyway. Why not kill two birds with one stone: build some roads and get some jobs.

A lot of the spending guys like to focus on the higher multiplier of spending when compared to tax cuts. I think this is to some extent a red-herring. We get more bang for the buck with spending but we can also move more bucks with tax cuts. For example, a complete payroll tax holiday in 2009 would have resulted in something like 900B in stimulus in a single year.   With ARRA I think we got something like 300B and even then much of that was from the tax cut portion. Spending money just takes time.

At the end of the day, your choice of New Keynesian instruments: monetary policy, government spending or tax cuts depends mostly on political economy concerns. That is, your view of the fundamental relationship between the government and the economy.

Additional Readings: Two simple but powerful pieces that are worth reading in my mind.

Barro’s Critique of all things Keynesian:

http://www.sjes.ch/papers/1989-III-7.pdf

Mankiw’s Defense of the Basic Keynesian Observation:

http://www.economics.harvard.edu/files/faculty/40_royalpap.pdf

Dallas Fed Governor Fisher speaks about the potential for more easing from the Fed. Key excerpts:

The excess reserves of private banks sitting on the balance sheets of the 12 Federal Reserve Banks exceed $1 trillion. Nonfinancial corporations have an aggregate liquid asset ratio running at a seven-year high; cash flow from current production is running above total investment expenditure; and cash as a percentage of market cap is extraordinarily high.

The vexing question is: Why isn’t this liquidity being utilized to hire new workers and reduce unemployment? If current dramatically high levels of liquidity and low interest rates are not being harnessed to add to payrolls, would driving interest rates further down and adding further liquidity to the system through Fed purchases of Treasury securities induce businesses and consumers to get on with spending it?

The intrepid economist would argue in the affirmative, the logic being that there is a tipping point at which the market becomes convinced that money held in reserve earning negligible returns is at risk of being debased through some inflation and, thus, should be spent rather than hoarded. Hence, the appeal of the Fed’s showing a little leg of inflationary permissiveness.

I am personally wary of this argument, despite its theoretical logic. My soundings among those who actually do the work of creating sustainable jobs and making productive capital investments―private businesses big and small―indicate that few are willing to commit to expanding U.S. payrolls or to undertaking significant commitments to expand capital expenditures in the U.S. other than in areas that enhance productivity of the current workforce. Without exception, all the business leaders I interview cite nonmonetary factors―fiscal policy and regulatory constraints or, worse, uncertainty going forward―and better opportunities for earning a return on investment elsewhere as inhibiting their willingness to commit to expansion in the U.S.

First, the good news is that this represents a move away from where Fisher was a few months ago. At that point he was telling us that money would be fundamentally ineffective in this environment. Broken pipes was the analogy I think he used.

Now he recognizes that cash hoarding is taking place and he recognizes the correct theoretical prescription is higher inflation.

Second, he notes that dangers with QE2. I agree. I also think that balance sheet movements are inherently dangerous. This is why I prefer communication techniques. There is strong reason to suspect that communication strategies work. In part because they create certainty about the future monetary environment.

Lastly, I would note that Fisher points to political uncertainty as a key reason for not hiring. This may or may not be true. However, what is certainly true is that there exists SOME real interest rate at which investment is profitable.

There exists some real interest rate where investment in profitable in the Russia. Is Fisher suggesting that the regulatory environment in the US is less certain than Russia?

There existed some interest rate at which it was profitable to get in bed with the newly reformed Chinese government. Is Fisher suggesting that the US contains more uncertainty that China in the late 1970s.

There existed some interest rate where it was profitable to invest in Botswana during the 1990s. Is Fisher suggesting the US has more uncertainty than Botswana in 1990?

So, in short I appreciate his concerns. I especially appreciate his fears regarding the size of the balance sheet. However, the Fed is not impotent in the face of Congressional Gridlock.

I mentioned last time that there were stronger trends in the Mortgage data. In the comments Mike Konczal asks me to include HELOCs.  I can’t easily break out HELOCs from mortgages. I am not saying the data doesn’t exist, I am just saying I don’t know how to get it three clicks off of FRED.

However, I can give you the mortgages and total liabilities and it tells an interesting tale. All of this data is from Federal Reserve Flow of Funds by the way.

The red line is total liabilities as a fraction of total assets.The purple is mortgages and home equity as a fraction of total assets and the green is the difference between the two.

Non-mortgage liabilities have been steady. Where Americans have gotten deep into debt is in their homes. That’s a trend that took off in the 1950s and then leveled off around the mid 1960s. In 1981 it took a little bounce that landed in the 1990s but since then there has been a whole new paradigm shift.

That the housing-debt paradigm began in 1998 is interesting. I am not sure how that accords with my general theory of the credit bubble. Under my formulation technological changes which occurred in the early 2000s contributed to a radical increase in Collateralized Credit availability. It was no surprise that houses, or more accurate land, being a strong source of collateral saw huge booms in demand.

This data might cast doubt on that, pulling the date back to 1999 –2000. If this is accurate this might give more credibility to John Taylor’s story that this was all about the Fed.

In any case its important to point out that the rapid rise in household indebtedness is a phenomenon of the mortgagee and HELOC market. Non-mortgage debt-asset has been rock solid.

UPDATE: I think commenter James Bailey is right that the up-tick really begins in 2000.  Though of course there is was an asset effect in 2000. Careful analysis would need to take all of this into account.