I have been giving John Taylor a lot of attention lately (see here, here, here, and here). I should probably lay off, but I think there is an important point to be made, and I am going to try one more time to get to the bottom of what I find disturbing about Taylor’s advocacy of rule-like behavior by central bankers. Some of what I want to say has already been said by Nick Rowe in his excellent post responding to Taylor’s criticism of NGDP targeting, but I want to address more directly Taylor’s actual statements than Nick did.
Taylor argues that targeting objectives, like NGDP, is not a policy rule at all, but rather a way of giving the central bank the discretion to do what it wants under the guise of what purports to be a policy rule that isn’t a rule at all. Here is how Taylor put it.
NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.
For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.
As I pointed out in my previous post, Friedman’s proposed rule for money supply growth is an exceedingly inapt example of an instrument rule, because the Fed has no more control over the money supply than it does over NGDP, as Friedman himself belatedly had to acknowledge. Now it is true that the Fed can control the short-term interest rate, so it is an instrument. The Taylor rule, a recipe for the short-term interest rate, specified in terms of the difference between the actual and the target rates of inflation and the difference between actual and potential GDP, does qualify as an instrument rule (on Taylor’s understanding of the term). But, as Nick Rowe points out, potential GDP being unobservable, it must be estimated. The higher potential GDP, the lower the implied short-term interest rate. So even the Taylor rule does not preclude an exercise of discretion by the Fed.
Perhaps the failure of the Taylor rule to preclude any exercise of discretion is why Taylor in the article by Amity Shlaes to which he refers seems to be offering a pared down version of the Taylor rule. Shlaes writes:
In response to my query about NGDP, Taylor sent a description of the reform he seeks — not widening the Fed’s growth mandate, but rather removing it [my emphasis]. Taylor says he would like to see reform happen in this order: 1) Congress enacts a single mandate for price stability; 2) Congress enacts reporting requirements for the Fed on what its strategy or policy rule is; and 3) the Fed picks a strategy relating to money and interest rates and tells the public what that strategy is.
One can’t really be sure what this means, but wouldn’t enacting “a single mandate for price stability” require the Fed to base its choice of the short-term interest rate solely on the difference between the actual and the target rates of inflation regardless of the difference between actual and potential GDP? After all, allowing the Fed to take into consideration whether actual GDP is less than potential increases the scope for the Fed to exercise discretion.
But there is something else disturbing about Taylor’s fixation on rules. I have been writing about the long-running debate about rules versus discretion in monetary policy on this blog for a while, especially the past couple of weeks, but failing to identify the critical semantic confusion that infects much of the rules versus discretion debate, and especially Taylor’s pronouncements. It was not until I read the following comment by W. Peden on my post Rules v. Discretion that the point suddenly became clear to me.
It’s a shame that there isn’t a widely used term in economics that means something like “precise orders” to distinguish from our usual use of “rule”, which means something like a restriction on possible action. A rule does not give exact and invariable instructions.
So, for example, the Taylor rule is really a kind of varying imperative, since it gives precise instructions on the short-term interest rate. In contrast, targeting NGDP along a trend is a rule because it allows for a huge variety of actions within that period; in a once-in-a-lifetime financial crisis like the early 1930s or 2008-2009, it would require quite radical discretionary actions so that the trend could be maintained.
Peden is completely right to say that the Taylor rule is not a rule at all, it is a command to a policy maker to adopt a policy of a certain kind. But policies are not rules. Rules do not prescribe specific actions they impose certain constraints on the manner in which agents can take actions in the pursuit of goals that they, not the author of the rules, have chosen. Introducing the language of rules into a discussion of policy reflects an effort (either conscious or unconscious) to borrow the authority of the political ideal of the rule of law as a support for the particular policy being advocated. The point was obliquely recognized by F. A. Hayek in a passage from the Constitution of Liberty that I quoted in my previous post. And it bears repeating.
It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals.
The political ideal of the rule of law does bear on the use of coercive powers of government, because the political ideal of the rule of law (sometimes called substantive due process by Constitutional lawyers) is meant to constrain the government in exercising coercive powers. But that political ideal has nothing to do with the formulation of policy when (e.g., in the case of setting monetary policy) it involves no exercise of coercion.
So, notwithstanding Friedman’s assertion in Capitalism and Freedom, endorsed by Taylor, there is no principled presumption in favor of formulating policies in terms of specific commands requiring the monetary authorities to set instruments under their direct control according to a recipe or formula defined in terms of an arithmetic formula. The notion that there is any political principle requiring a policy supposed to achieve some desired objective to be so formulated is based on a semantic confusion between rules and policies and on a complete misunderstanding of the political principle requiring governments to follow rules in exercising their coercive powers.
It is still conceivable that monetary policy in terms of a recipe for an instrument of monetary policy might lead to the best possible outcome. It is also conceivable that flying an airplane on automatic pilot would lead to a better outcome than having a trained pilot fly the plane. Indeed, that could be true under some circumstances, but it verges on the preposterous to suppose that it would never be desirable (or indeed imperative) for a live pilot to override the automatic pilot. But that suggests that ultimately policy ought to be formulated in terms of the objectives sought rather than in terms of what is no more than a recipe for an instrument by which the policy objective is to be pursued.
Uneasy Money 
Why oh why can’t people (even supposed learned economists like John Taylor) figure this out.
The federal reserve sets interest rates on short term government debt. This interest rate affects the pre-tax cost of debt service in the private sector as well as the term structure of the federal government’s debt.
What the federal reserve cannot do on it’s own is dictate whether debt is used productively (building roads, factories, houses, etc.) or non-productively (waging wars, speculating on commodities, etc.).
That is where effective tax policy plays a role. Unfortunately, Mr. Taylor likes to subject monetary policy to rigorous economic analysis while leaving tax policy to luddites like Grover Norquist and social engineers like Paul Krugman.
The ultimate object of monetary / tax policy is to maximize productivity.
From the equation of exchange:
Total Debt Outstanding * Velocity = Real GDP * (1 + Inflation Rate)
Productivity = Real GDP / Total Debt Outstanding = Velocity / (1 + Inflation Rate)
If Mr. Taylor thinks that monetary policy alone can maximize productivity he is sorely mistaken.
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Thanks for the mention.
Further thoughts on this topic: a ‘rule’ is different from a ‘law’, in the sense that Hayek used the latter term in the context of legal philosophy. Hayek explicitly does NOT define a law as “The produce of the legislature”. Instead, he uses the old concept of a “law” as being a general and lasting constraint to be put on society, now and onwards, which is consistent with the political constitution of the society.
(To give an example of the type of law which Hayek is excluding, a recent UK law about discrimination excluded political parties from the law until about 2020 so that they could have all-women shortlists in their internal candidate elections. That is not a timeless principle with general application; it is an order!)
Laws have general applications. Rules usually have very specific applications. Regulations, which are rules, may have to be changed very regularly to deal with changes e.g. the invention of credit cards required new regulations on credit fraud.
Changing a law should be a very special and rare event. Changing a rule might just be part of mundane facts changing.
What does all this have to do with NGDP? Let’s imagine a central bank that follows Selgin’s productivity norm. Then some event(s) happens that introduces a permanent shift in the trend rate of total factor productivity; say some extremely powerfully self-reproducing AI develops that allows a rapid acceleration of the rate of technological progress. It makes sense for that central bank to change its rule from targeting a level of NGDP at 2% a year to, say, 3% a year.
A target of 5% or 3% or 2% a year should not be seen as a law, but as a rule to be changed in line with the facts (and our beliefs about the facts).
To move away from economics again briefly: there are two broad clusters of classical liberal constitutional theory. In one cluster are Milton Friedman, Buchanan, Acton, and allegedly Adam Smith; they think they know what the rules governing the creation laws need to be and they want a largely timeless written constitution. In another cluster are Hayek, Hume and maybe in an odd way David D. Friedman; they have a concept of constitutional arrangements which evolve over time with no moment of grand social planning.
(The former group will likely see the American constitution as the greatest example of a constitution, whereas the latter group are more likely to be attracted to unwritten and/or more changeable constitutions like the British constitution.)
What does all this have to do with economics? A proposition like “The central bank should run monetary policy such that nominal expenditure is stable” is a law. A proposition like “The central bank should target the level NGDP at a 5% growth rate” is a rule. A proposition like “The central bank should target NGDP at a 5% growth rate via targeting the short-term interest rate” is an order.
The main I disagree with Friedman’s k-percent rule is the same reason I disagree with his constitutional theory: it (a) assumes a level of knowledge on what will be appropriate that is wrong and (b) it lacks a real appreciation for changing circumstances. As so often happens when Friedman and Hayek disagree, I find myself agreeing with the Hayekian stance.
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(There’s also the excellent distinction, which Hayek revives from 19th century German jurisprudence, between constitutions and laws, but that would really be taking us away from John Taylor and NGDP targeting!)
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“Introducing the language of rules into a discussion of policy reflects an effort (either conscious or unconscious) to borrow the authority of the political ideal of the rule of law as a support for the particular policy being advocated.”
I’m not sure that’s all there is to it. Insistence on some rigid and impersonal rule seems like the position that allows you to pragmatically acknowledge the necessity of the modern central bank, while still harboring a libertarian distrust of central bankers (as part of a general distrust of government, especially centralized government). Never mind that the Federal Reserve already is bound by law (or so the law says) to observe a mandate, which sounds rather like a rule.
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Mercy, this is a high-level conversation. I think it get most of it.
If Taylor is so rule-happy, why did he gush and exult at Japan’s success with QE, in his paper of 2006? So there is a rule that governs QE? What rule?
Rules are good…but not always, Sure, you should drive under the speed limit for safety’s sake. But what if a dam is bursting behind you? Rare events call for non-rules-based actions.
Taylor’s unhealthy fixation on inflation (at least while we have a D-Party president) is pathetic. We are 13 percent below tried on GDP and our labor force is contracting through lost hope and desire, and Taylor frets about inflation? With the last PPI, CPI and unit labor cost readings in negative territory?
That said, I worry that Market Monetarists are losing traction.
Perhaps we in the Market Monetarism movement should lay out a course of action…
Such as (in the USA), the Fed buying $100 billion a month in bonds or assets not to a dollar amount target (such as $600 billion), but to a NGDP target, and wiping out IOR…and for the ECB a similar action.
Perhaps if we lay out some concrete steps and targets….develop some talking points, and get the argument into our court again…
Make Taylor argue against not an abstract idea, but against a concrete course of action with promised results. Make Taylor defend doing nothing, which is what he is doing.
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This is Krugman on Taylor.
Taylor is likely letting his deeply partisan nature get the best of his judgement.
Taylor Rules
Via Mark Thoma, Noah Smith reports on a conference held at Hoover in which right-wing economists reached right-wing conclusions. Surprise!
But what’s really remarkable, and what I find a bit shocking even after all we’ve been through, is the way John Taylor misrepresents other peoples’ work. Reading Taylor’s summary, you’d think that Bloom, Baker and Davis had showed that fear of Obama was holding the economy down; if you actually read their paper, while they do conclude that “uncertainty” is an important factor, the biggest sources of uncertainty are Republican brinksmanship over the budget, the situation in Europe, and the legal challenges to health care reform. Not exactly what the GOP ordered.
Worse yet, Taylor makes it seem as if Bob Hall showed that fiscal expansion is ineffective. Yet if you have actually been following Hall — which I have, carefully — you’d know that he has been producing extensive evidence that fiscal expansion does, indeed, work; he argues (pdf) that the Obama stimulus made the slump considerably less severe. His complaint is that the stimulus wasn’t big enough — which is the same argument I made from the beginning.
You have to wonder why Taylor thinks he can get away with this. Does he think that other economists can’t actually read research papers, and catch the misrepresentation? Or does he think of himself as writing solely for people so politicized that they don’t care if he gets it wrong?
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Frank, Sorry, but I don’t follow your algebra. What does it mean for productivity to be equal to Real GDP divided by total outstanding debt. Productivity is measure in output per man or machine hour. Real GDP divided by total outstanding debt seems to be measured in the inverse of units of time. I also don’t think that Taylor believes monetary policy can maximize productivity all by itself (the point is not necessarily to maximize productivity either). He believes that tax cuts are important for doing that as well.
I was going to quote from a wonderful essay on the Rule of Law in a volume called On History and Other Essays by Michael Oakeshott, but did not want get get bogged down in too many quotations. In that essay, Oakeshott provides a philosophical analysis of the rule of law and its relationship to other kinds of rules like rules of a game or rules of grammar, arriving at very similar conclusions (I think) to Hayek’s, but by a very different philosophical approach. There are also some significant differences, Oakeshott believing in the necessity for establishing some procedure for ascertaining the authenticity of any rule, while Hayek is much more inclined to accept what has emerged from custom or common law rather than legislation, which Oakeshott seems to regard as the essential source of law. At any rate, laws and rules govern (in Oakeshott’s terminology) the self-chosen actions of individuals seeking to advance their own particular interests (as opposed to joining together to achieve a shared goal) by imposing adverbial conditions (i.e., restricting the means that can be used to accomplish their ends without specifying what those ends may be). Rules and laws have to objective, because objectives are chosen by individuals and rules and laws merely say if you want to pursue an objective you must do so while satisfying certain conditions, e.g., if you want to acquire a piece of property you must do so by complying with the relevant rules for the acquisition of property. A policy is an articulation of a common goal or of a method of achieving that common goal. So, in Oakeshott’s usage, which I was implicitly adopting, an NGDP target or a price level target is a policy not a rule. And the Taylor rule is a command given to someone charged with the responsibility for executing a monetary policy to follow a certain recipe in setting an instrument that is supposed to bring about the successful execution of a policy.
Will, I think that you have correctly identified at least one ideological motive behind the attempt to eliminate any exercise of discretion or judgment by the central bank or the monetary authority.
Benjamin, In his reply to my post criticizing his Wall Street Journal op-ed last month, Taylor claimed that his support for monetary expansion by Japan was merely designed to implement a Friedman rule for making sure that the money supply not fall. I thought that that was a pretty weak defense, because Friedman himself had already abandoned his own money-supply rule by that time. So my impression is that he is not sharing with us all the considerations that he is taking into account when offering policy advice these days. It may even be the case that he himself is not fully aware of all the implicit judgments that he is making in reaching policy conclusions. Nevertheless, as Krugman’s piece shows, Taylor is certainly inviting suspicion that he has an a political agenda that he is trying to promote in making his policy pronouncements and that the agenda is skewing his analysis.
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David, Taylor is doing a lot of work to convince people that he is a hack, in the end.
To all – isn’t supporting certain policies for Japan, back in the day, but not for the USA today, a standard right-wing economic position?
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“Frank, Sorry, but I don’t follow your algebra. What does it mean for productivity to be equal to Real GDP divided by total outstanding debt. Productivity is a measure in output per man or machine hour. Real GDP divided by total outstanding debt seems to be measured in the inverse of units of time.”
And this is why the “Alan Greenspan” definition of productivity is wrong. Is a person productive when he / she receives 99 weeks of unemployment insurance? By your definition (output / total hours worked) productivity improves when the federal government pays someone not to work. GDP (aka output) will improve based upon the income that the person receives for not working and hours worked will fall. So if we all quit our jobs, and the federal government pays all of us to sit on our buts to do nothing we reach economic nervana?!?! Maybe in Paul Krugman’s world.
Debt (Dollars) * Velocity (1 / years) = Real GDP (Dollars / year) * (1 + Inflation Rate (no units))
Productivity = Real GDP (Dollars / year) / Debt (Dollars) = Velocity (1 / years) / (1 + Inflation Rate (no units))
The units for productivity are the same as the units for money velocity. In velocity the units represent how quickly money (which begins as debt) flows through the economy.
In productivity, the units represent how efficiently money flows through the economy.
“The point is not necessarily to maximize productivity either.”
Then what exactly was the point of the Humphrey Hawkins act? You know that act of Congress that gave the federal reserve it’s dual mandate of full employment (increased productivity) and low inflation (increased productivity).
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Frank, It’s not Alan Greenspan’s definition, it’s the definition in any econ text book. Paying people not to work doesn’t directly affect the productivity of those who are working, so whether paying someone not to work raises or reduces productivity depends on whether the one paid not to work is more or less productive than average.
Humphrey Hawkins was an attempt to make the Fed take into account the level of employment in making monetary policy. Full employment is not the same as maximizing productivity because the people who are unemployed at any moment may or may not be more productive than those who are already working. That’s why I said that the point is not necessarily to maximize productivity (which is just a number) but to enable everyone who want to work to find a job.
Barry, I am not accusing Taylor of bad faith. I am not defending him either. You are entitled to draw your own conclusions about that based on his current and past statements.
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“Frank, It’s not Alan Greenspan’s definition, it’s the definition in any econ text book.”
I presume that you are referring to this text book definition:
http://en.wikipedia.org/wiki/Total_factor_productivity
Y = A * K^a * L^b (a is greek alpha, b is greek beta)
The units for total factor productivity are widgets / year (or widgets per hour)
What I am referring to is the more general definition of productivity:
http://en.wikipedia.org/wiki/Productivity
“Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it.”
Efficiency is the ratio of what is put into a system and what comes out of the system. This holds true is any type of system (electrical, mechanical, fluid, and economic). Productivity is simply the efficiency of the production of goods. In an economic system, the input is money which begins as debt. The output is the goods and services that money facilitates the production of.
Hence
Debt (Input) * Velocity = Real GDP (Output) * (1 + Inflation Rate)
Productivity = Real GDP (Output) / Debt (Input)
“Paying people not to work doesn’t directly affect the productivity of those who are working”
Paying people not to work lowers the aggregate productivity of a nation.
“Whether paying someone not to work raises or reduces productivity depends on whether the one paid not to work is more or less productive than average.”
Huh?!?! Where is this in any economic textbook? Even if a person is “less productive” than average, paying him / her for some output will increase aggregate productivity while paying him / her for no output will likely decrease aggregate productivity.
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“Humphrey Hawkins was an attempt to make the Fed take into account the level of employment in making monetary policy.”
BALD FACED LIE.
The 1946 Full Employment Act concentrated on employment
http://en.wikipedia.org/wiki/Employment_Act
Humphrey-Hawkins, by specifying four goals, de-emphasized full employment as the sole primary national economic goal.
http://en.wikipedia.org/wiki/Humphrey–Hawkins_Full_Employment_Act
The Humphrey Hawkins Act was more than directions for the federal reserve. It was a blue print on what economic goals the federal government AND federal reserve should achieve:
1. Balanced federal budget
2. Balance of trade (no surpluses or deficits)
3. Full employment
4. Low inflation
What does this have to do with productivity
Productivity = Real GDP / Debt
1. Balance of federal budget means that federal debt does not grow or possibly even contracts (Clinton 1992-2000).
2. Balance of trade means our trading partners are buying more goods PRODUCED by the private sector and less federal government debt
3. Full employment, more people are being payed to PRODUCE goods and services
4. Low inflation means that real GDP rises (not necessarily nominal GDP like you seem to be advocating).
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Frank, First of all, you don’t need to shout. Second, please don’t accuse me of lying. I make mistakes all the time, but I try really, really hard not to tell lies on the internet.
You said:
“In an economic system, the input is money which begins as debt. The output is the goods and services that money facilitates the production of.”
I am sorry, I just don’t accept that definition. I don’t accept the premise that money is “the input” in an economic system. The inputs are land, labor, raw materials, energy, capital goods, etc. Money may figure as an input in some situations, but only as one input among many. So that’s a deal breaker for me.
“Even if a person is “less productive” than average, paying him / her for some output will increase aggregate productivity while paying him / her for no output will likely decrease aggregate productivity.”
Yes it increases aggregate output, but productivity is the ratio either at the margin or in total of output to input, so eliminating an input that is less productive than average must, as a matter of arithmetic, increase the ratio of output to input. That doesn’t mean it’s a good idea to do so, it’s just a statement of an arithmetic relationship.
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“I am sorry, I just don’t accept that definition. I don’t accept the premise that money is “the input” in an economic system.”
I put that badly, and I apologize.
Money in its most basic form is a standardized unit of account (not some pretty pictures on paper). As such, it is a way to measure the relative value of one item (for instance a horse) versus another item (for instance a car). And so, money establishes the relative value of land, labor, raw materials, capital goods, and any other input you can possibly mention. It also establishes the relative value of all outputs.
And once you establish the relative value of all inputs and outputs in terms of money, you can then compare the ratio of all inputs valued in money versus all outputs valued in money and calculate economic efficiency (aka productivity).
“Yes it increases aggregate output, but productivity is the ratio either at the margin or in total of output to input, so eliminating an input that is less productive than average must, as a matter of arithmetic, increase the ratio of output to input.”
Except that paying a person not to work does NOT eliminate an input. Those dollars either came from taxing someone who is working or borrowing money to pay for it. This is why I measure my inputs and outputs in dollars – it brings common units to both.
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One of my favorite movies of all time is “Back to School” with Rodney Dangerfield. There is a classic scene between the scholarly Dean of the Business School – Dr. Philip Barbay and Thorton Melon (played by Dangerfield). In that scene, Thorton asks Barbay what a widget is. And the answer from Dr. Barbay is basically don’t worry about it.
Except that to define productivity as widgets / hour, it is crucial to know exactly what one widget represents. Does it represent something as small as a hex nut or as large as an airplane?
That is where money comes in. It establishes the relative value of both the hex nut and the airplane.
How can you possibly establish an economic system and define productivity within that system without a method of establishing the relative value of all inputs and outputs within that system (also known as a monetary system)?
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Frank, you can convert output to dollars and then measure productivity as dollars per unit of input, say labor hours. That’s how its usually done. If workers are unemployed their input is not measured for your productivity to be measured you have to be working. That’s just the usual convention, you are free to define productivity any way you like, but I will stick to the convention.
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“Frank, you can convert output to dollars and then measure productivity as dollars per unit of input, say labor hours. That’s how its usually done. If workers are unemployed their input is not measured for your productivity to be measured you have to be working.”
1. Or you can convert both output (value of goods produced) and input (labor and material cost of goods produced) to arrive at a more consistent measure of productivity.
2. You are assuming that 0 is a non-measurement. If you are non-working, and not getting paid, your contribution to aggregate productivity is measured to be 0. If you are non-working, and getting paid not to work, your contribution to aggregate productivity is measured to be negative.
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Frank, Your method 1) measures something like the rate of profit. As for 2) if output is produced without the benefit of someone’s input (for whatever reason) it makes sense to me not to include the unused input in the calculation. But you may use whatever method you like.
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“Frank, Your method 1) measures something like the rate of profit.”
Under 1), I did not list all of the possible inputs (capital cost and taxes for instance) for the sake of brevity. Profit is a difference and can be calculated this way:
Profit = Gross Sales – Capital Cost – Material Cost – Labor Cost – Taxes
Productivity is a ratio and can be defined this way:
Productivity = (Gross Sales – Labor Cost – Material Cost) / (Capital Cost + Taxes)
Now why would I not define productivity as Gross Sales / Sum of all Costs?
The reason is that capital costs and taxes are costs that do not add value to the product being produced. If I pay more for labor, I hope to get better quality workmanship in the product that I am producing. If I pay more for material, I hope to be using higher quality materials that will last longer, look better, and generally be more appealing to people who buy my product. Capital cost and taxes are exogenous costs that do not add value.
If I am a company owner solely interested in increasing profits, I really would not care which costs are cut. If I am a company owner interested in productivity, I would want my exogenous costs cut more than my value added costs.
Bringing this back to what I have been talking about all along – The after tax cost of capital (aka debt service) in the private sector can be less than 0%. Paul Krugman is wrong – 0% is not the lower bound.
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“As for 2) if output is produced without the benefit of someone’s input (for whatever reason) it makes sense to me not to include the unused input in the calculation.”
Again, you assume that the input is either positive or zero, when it can in fact be negative. Taking things a step further, suppose a lot of out of work potential producers turn to criminal activities to get by. Then the government in its mandate, must offer protection of its citizenry from the criminal element. In doing so, it pays another group of people (policemen) to catch the first group. Neither group is producing anything, and both are getting paid for producing nothing – one group by stealing, the other through taxation and government debt.
In your line of thinking, if we all turn to into criminals and policemen, productivity improves? I think they call that either a police state or a civil war depending on whose history book you read.
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Frank, The lower bound refers to the presumption that someone will not lend his money at a negative interest rate, i.e., lend money now and contract to receive less in return when the term of the loan expires than he hands over now. It is not an assertion that the after-tax cost of capital cannot be negative.
On your second point, I have not been making any assertions about causal relationships, I have simply been commenting on whether your definitions of terms correspond to the definitions that I am familiar with as an economist. Definitions stipulate the meanings assigned to the terms being defined, they are about the use of language; they are not descriptions of reality or assertions about causal relationships. At least that is my understanding of what definitions are for.
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“Frank, The lower bound refers to the presumption that someone will not lend his money at a negative interest rate, i.e., lend money now and contract to receive less in return when the term of the loan expires than he hands over now.”
The lower bound that Paul Krugman is referring to is the short term interest rate that the federal reserve sets. The federal reserve sets this interest rate by buying and selling federal government bonds. Two problems with this approach – 1. The federal government does not use debt productively (Iraq War, Afghanistan War, Vietnam War, etc.) 2. The federal government literally cannot go bankrupt.
Any other lender can do whatever they want. If they want to make “liar loans”, “no doc” loans, “stated income” loans, etc., there is not much to stop them other than better informed market participants. Someone would be glad to make a loan that has little chance of being paid off (aka lending at a negative interest rate), as long as that person can sell the loan to an unsuspecting third party.
The federal reserve, however, is obligated to Congress to maintain price stability and as such would be in willful dereliction of its responsibilities if it should chose to knowingly make fraudulent loans.
Understand this, the lower bound (from the lender’s point of view) applies only to the federal reserve. It does not apply to any other lender.
From the borrower’s point of view, as I have said previously, the cost of debt service on an after tax basis can in fact be negative without resorting to fraud.
The lower bound for interest on lending money has a legal implication that I don’t think you grasp.
Once upon a time there was an upper bound on interest rates. Theoretically (which is where your definitions seem to fit) there is no upper bound to interest rates. Legally, there were usury laws in several states that limited the amount of interest a bank could charge on the loans that it made. And so what definition of “upper bound” do you prefer – theoretical or practical?
And this statement has me baffled:
“Definitions… they are not descriptions of reality or assertions about causal relationships.”
Huh??? Definitions may not identify causal relationships, but what good is language and definition that does not factor in realities (like usury laws)?
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Frank, I agree that Krugman is referring to the Federal Funds rate, but the lower bound stems from the unwillingness of lenders to lend cash at an interest rate below what they could earn by just holding the cash, namely, zero. That is an economic lower bound and has nothing to do with special legal requirements imposed on the Federal Reserve, so I don’t see the relevance of your entire discussion. But you may be right that I don’t get it. My point about definitions is that they are instruments (and therefore may change depending on context and purpose of a conversation) that we use to communicate our ideas about causal relationships; they do not embody absolute intrinsic properties of reality.
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“Frank, I agree that Krugman is referring to the Federal Funds rate, but the lower bound stems from the unwillingness of lenders to lend cash at an interest rate below what they could earn by just holding the cash, namely, zero. That is an economic lower bound and has nothing to do with special legal requirements imposed on the Federal Reserve, so I don’t see the relevance of your entire discussion.”
Again, you are missing something critical here. Lending money that has little to no chance of being paid back is the same thing as lending money at an interest rate less than 0%. Taken to the extreme, it is called charity (aka giving money away). And the perverse effect of charity is that it tends to destroy productivity.
Suppose I leant you money at a stated interest rate of 5%, but I did Not check on your INcome, your Job status, or your other Assets (aka I gave you a NINJA loan). If I were forced to hold onto the loan, I would never do such a thing. If I were allowed to repackage the loan with a bunch of others and sell it to an unsuspecting third party, then in fact I could.
In legal terms, I would be committing fraud – not from making the loan, but from selling the loan without disclosing the terms under which the loan was made.
The federal reserve is legally prohibited from making fraudulent loans.
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Frank, I agree with everything you just said, but I don’t see how what you say relates to our discussion of the zero lower bound. You need to connect the dots for me.
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Okay, let me try to connect the dots:
1. The zero lower bound is a strict limitation on the federal reserve, and by extension, the federal government. The federal reserve buys and sell federal government debt to adjust interest rates on that debt. By buying government bonds, the federal reserve creates a demand for them which pushes prices up and yields down. The opposite happens when the federal reserve sells them. The interest rates on government debt affects the stated cost of debt service in the private sector.
2. The realized cost of debt service in the private sector is a function of ability and willingness to repay a loan. The ability to service a loan is primarily a function of the after tax income that the borrower has.
If I borrow money at 5% and then either refuse or am unable to pay the money back, the effective interest rate that I pay is significantly less – and in fact can be negative. Hence, the zero bound from the borrower’s point of view does not necessarily apply.
What I am advocating (and have been advocating this whole time) is for the federal government to sell tax breaks to any American (rich or poor) through the Treasury Department – rather than giving them away through connected lobbyist groups. By doing this, the after tax cost of debt service throughout the private sector is lowered (and in fact can be negative).
You define the lower bound as this:
“the lower bound stems from the unwillingness of lenders to lend cash at an interest rate below what they could earn by just holding the cash, namely, zero”
From the lender’s point of view, the only lender that cannot lend cash at interest rates below zero is the federal reserve. As I previously mentioned, a private individual can lend money at any interest rate he or she likes or could in fact just give money away (aka charity).
From the borrower’s point of view, the cost of debt service can be less than zero through default (unwilling or unable to pay back loan) or through tax policy.
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One more thing on the zero bound…
I have mentioned after tax income as the predominant determinant in the ability to service debt. The housing bubble was primarily a debt bubble that tried to outpace the cost of debt service with higher asset valuations. If you borrow at 5% to buy an asset that gains in price at 10% annually, then from an asset / liability standpoint your realized cost of debt service is negative.
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Frank, You have an interesting proposal concerning the sale of tax breaks. I don’t understand why you are so hung up on the “zero lower bound,” which is used by economists to describe a very different phenomenon from the one that concerns you. You are just confusing me (and perhaps others) by insisting that you are talking about the zero lower bound when I (and perhaps others) think about it very differently from the way you think about it.
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Mr. Glasner,
It is as simple as this, if the after tax cost of debt service in the private sector is negative why would we need inflation – ever?
Consumer Price Index:
http://research.stlouisfed.org/fred2/series/CPIAUCSL/
Can you imagine a scenario where this graph tops out and trends down over say the next hundred years? Can you imagine this scenario with the unemployment rate falling back to the 4-5% range?
I can.
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“You are just confusing me (and perhaps others) by insisting that you are talking about the zero lower bound when I (and perhaps others) think about it very differently from the way you think about it.”
I think of interest rates ultimately as a cost (in this cast the cost of money aka capital). And so even a very low nominal cost can be very high in real terms (see Great Depression). You would prefer higher inflation to lower the real cost of money, I would prefer low inflation or even deflation with a tax policy that accommodates it.
Defining productivity as Real GDP / Total Debt Outstanding, I would prefer high productivity (high real growth, falling federal debt, no trade deficit, etc.). It seems the rest of the economic community prefers what we have today – low real growth, rising federal debt, large trade deficit.
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Frank, Off the top of my head, I see two problems. First, there is already a tax break to business for borrowing which is generally regarded by economists as an inefficient subsidy to debt financing relative to equity financing, inducing businesses and financial institutions to increase leverage, thereby increasing systemic instability. Your proposal would increase the bias in favor of debt financing as opposed to equity financing. Second, how would the tax break you advocate be adjusted when the expected yield on real capital assets rises?
I don’t want inflation to reduce the real cost of money except in circumstances when the expected real return on capital is negative over some relevant time horizon. To me and most other economists the most intuitively obvious way to accomplish that is via adjustments in the value of money not by tinkering with tax system. It has nothing to do with one’s preferences about economic growth and other economic variables.
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“Frank, Off the top of my head, I see two problems. First, there is already a tax break to business for borrowing which is generally regarded by economists as an inefficient subsidy to debt financing relative to equity financing, inducing businesses and financial institutions to increase leverage, thereby increasing systemic instability.”
Wrong. What increases systemic instability is reliance on short term versus long term financing. Picture the yield curve. For any financing operation it is typically more expensive to borrow long term than it is to borrow short term. If you want to increase stability you reverse that situation through tax policy – make it less expensive to borrow long term versus short term.
“Your proposal would increase the bias in favor of debt financing as opposed to equity financing.”
Wrong again. The choice between debt and equity financing is more than just the cost of financing. For starters, not all companies have equity financing at their disposal (too small or too regulated). Second, I am advocating selling tax breaks that are realizable against all taxation including capital gains and dividends. And so, the relative cost of debt versus equity financing is unchanged when the tax breaks can be used to offset either financing cost. I only mentioned debt financing because the discussion centered around interest rates and debt.
“Second, how would the tax break you advocate be adjusted when the expected yield on real capital assets rises?”
Good question. This is what I have pictured in my head (though some refinements may be needed).
First, the U. S. Treasury must be more actively involved in macroeconomic policy. It does this by setting the long end Treasury Yield (right now 30 years) at auction as well as the long end rate for forward year tax receipts (FYTR’s), presumably also 30 years also at auction.
Second, the 30 year Treasury rate is set to equal the Real Potential GDP Growth Rate + the Inflation Rate by the Treasury Department. The 30 year FYTR rate is set to the Real Potential GDP Growth Rate + Inflation Rate + Trade Deficit / GDP also by the Treasury Department.
Meaning that absent a trade deficit, the after tax cost of debt service is 0% out to 30 years under all conditions (inflation and mild deflation). In time of a trade deficit, this rate drops even further.
During severe deflation (Deflation > Real GDP Growth Rate), an investigation into the cause is warranted. Is it a surge in technological productivity advancement (for instance the Star Trek transporter beam is invented rendering all freight transport obsolete), is it a surge in savings rates (http://research.stlouisfed.org/fred2/series/PSAVERT), or is it something else?
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Frank, I agree borrowing short-term is more risky than borrowing long-term, but holding long-term debt is more risky than holding short-term debt. The systemic risk of debt encompasses the risk on both sides of the transaction.
I also don’t understand what you mean by the Treasury setting a rate at auction. How does the Treasury control the rate determined in an auction process. I think you need to write your ideas down systematically so that novices like me can digest them rather than try to pick it up piece by piece in episodic exchanges of comments. But don’t let that deter you from continuing to post your interesting comments here.
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“I also don’t understand what you mean by the Treasury setting a rate at auction. How does the Treasury control the rate determined in an auction process.”
Government bonds have two parameters – a yield and a duration. Under current auction protocol, the U. S. Treasury selects the duration of the debt it is trying to sell, and the market bids on the yield. That protocol can be reversed by having the U. S. Treasury set the yield and the market bid on the duration.
And yes governments have sold debt in durations longer than the typical 30 years. I believe that Japan has sold 50 year debt in the past.
“Frank, I agree borrowing short-term is more risky than borrowing long-term, but holding long-term debt is more risky than holding short-term debt. The systemic risk of debt encompasses the risk on both sides of the transaction.”
The risks associated with borrowing short term versus long term depend on the assets being purchased with the debt. If the assets are fairly liquid (equities, options, futures, etc.), then the risk to the short term borrower is minimal. The risk to the borrower is ultimately one of liquidity – how quickly can an asset financed with debt be sold, when the cost of debt service exceeds the expected price gain (or loss) in the asset.
Therefor, I disagree with your statement that borrowing short term is necessarily more risky than borrowing long term.
The economic instability that borrowing short term creates is two fold:
1. Short term interest rates tend to be more volatile than long term interest rates. And so, the prices of the assets being purchased with debt, tend to fluctuate more wildly when they are bought and sold based upon swings in short term interest rates.
2. It offers the incentive to gamble on price swings rather than commit to a long term investment strategy. For instance – oil = $30.00 per barrel 2002, $130.00 per barrel 2008, $40.00 per barrel 2009, $100.00 per barrel 2011.
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“I think you need to write your ideas down systematically so that novices like me can digest them rather than try to pick it up piece by piece in episodic exchanges of comments.”
There is really only one idea, and everything is just explanatory.
The Great Depression was an extreme case of the limitation of monetary policy. The nominal cost of debt service cannot fall below zero, but the real (inflation adjusted) cost can prohibitively high even with near zero nominal rates.
Some policy makers believe that the solution is higher inflation. Some policy makers believe that the solution is increased government spending. I believe that the solution lies in tax policy.
Ultimately a government bond is a claim on future tax revenue. The federal reserve buys and sells those government bonds to adjust interest rates throughout the spectrum of public and private debt. Interest rates are one way that the federal government regulates the velocity of money through an economy. The other way the federal government does this is through taxation and spending.
A government bond (courtesy of the 14th amendment) is a guaranteed claim on future tax revenue. Similar to a corporate bond, it sits atop the capital structure of the federal government. The federal government (like a corporation), could sell lesser claims on the same future tax revenue (similar to equities in the corporate world). If the federal government chose to sell those lesser claims with a duration and a rate of appreciation, the rate of appreciation could be sufficiently high that the after tax cost of debt service realized by the private sector is negative.
I cannot believe how many posts I have read that basically say that some inflation is good or even required. What I am positing here is that with the right policy, inflation (a rise in the price level) is totally unnecessary.
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I ran a quick calculation of the volatility of short term versus long term interest rates from the data taken here:
http://research.stlouisfed.org/fred2/series/FEDFUNDS
and
http://research.stlouisfed.org/fred2/series/GS30
I downloaded both sets of data using monthly values into an excel spreadsheet. I then calculated the monthly percent change in each interest rate. I summed the absolute value of the changes and divided by the number of months to come up with an average monthly change in interest rate (February 1977 to November 2011).
30 Year Treasury Average Monthly Change: 2.58%
Fed Funds Rate Average Monthly Change: 5.73%
And so interest rates on short term debt can be said to be twice as volatile as interest rates on long term debt. Hence, price swings in assets financed with short term debt also will exhibit this volatility. This volatility is the source of the economic instability that you mention.
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Frank, I know that the Treasury can set a yield and a duration, but it can’t set an interest rate. The yield is whatever the coupon rate is relative to the face value of the bond, but it is the market that is determining how much the stream of payments represented by the bond (and hence the interest rate) is worth.
The risk associated with holding a long-term debt instrument is that it’s value is sensitive to small changes in the interest rate, so unlike a short-term instrument you don’t necessarily know in advance how much you will realize on the instrument if you want to cash it in before maturity.
You said:
“Therefor, I disagree with your statement that borrowing short term is necessarily more risky than borrowing long term.”
But before you said:
“What increases systemic instability is reliance on short term versus long term financing.”
Well, when figure out which side you are on, let me know and we can continue the discussion.
As for your one idea, can you explain the exact process by which tax breaks would be sold. What is the instrument in which a tax break is embodied, how is the size of the tax break specified, what is the means by which the instrument is sold?
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“You said: Therefor, I disagree with your statement that borrowing short term is necessarily more risky than borrowing long term.”
But before you said: What increases systemic instability is reliance on short term versus long term financing.”
When I said that borrowing short term is not necessarily more risky than borrowing long term, I was referring only to risks that the borrower encounters. When I say that systemic instability increases with an increased reliance on short term debt, I am addressing the broader risks to the economy as a whole (price volatility). These two statements are not mutually exclusive.
“The yield is whatever the coupon rate is relative to the face value of the bond, but it is the market that is determining how much the stream of payments represented by the bond (and hence the interest rate) is worth.”
Agreed. The market determines the probability that the payments are made in full (in the private debt market). This is reflected in the price of the bond and thus the market interest rate. In the public (federal government debt) market, default risk is not an issue, and so instead other factors affect market interest rates (supply and demand for federal debt, inflation expectations, federal reserve expectations, etc.).
“As for your one idea, can you explain the exact process by which tax breaks would be sold. What is the instrument in which a tax break is embodied, how is the size of the tax break specified, what is the means by which the instrument is sold?”
The instrument that embodies the a tax break is a forward year tax receipt. In essence, it is a paper (or electronic) receipt for taxes paid today that are due some time in the future. Like a government bond, it has a duration (1 year, 5 years, 10 years, 30 years) and a rate of appreciation (3%, 5%, 15%, etc.). At maturity, the receipt is filed with the individual or corporate tax return. The value of the receipt at maturity offsets that amount of tax liability for the owner. If the value of the receipt at maturity is greater than the tax liability of the owner, the balance is rolled over to another receipt. The rollover feature is crucial from an incentive standpoint – otherwise the receipt is just a bond in disguise.
The exact process and the means by which the instrument is sold is very similar to the federal government bond auction process with one important distinction – the U. S. Treasury Secretary sets the long end rate of appreciation as a matter of macroeconomic policy. In essence, the Treasury Secretary plays drums to the the Federal Reserve’s fife.
I am not sure what you mean by how is the size of the tax break specified. If you are referring to the rate of appreciation, initially I would imagine that all receipts would be non-marketable until a deep enough secondary market for them was constructed by private investment firms. After that point, the long end rate would be maintained by the U. S. Treasury while shorter durations would be market determined.
If by size you mean the amount to be sold by the U. S. Treasury and bought by private individuals, again macroeconomic consideration must be given. There are good reasons the federal government should never reduce its total outstanding debt to zero. However, reducing our externally held federal debt should be given worthwhile consideration (balance of trade). Also, market participants (individuals and corporations) should be able to venture reasonable approximations on their tax liability in the future if Congress and its army of lobbyist groups can get out of the way (I realize that is a big IF). That means, set current year tax rates to cover current year expenditures, always. Then let the markets buy tax breaks as a financing tool.
Happy New Year
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