Monday, February 9, 2015

Micro vs Macro

The difference between studying micro- and macro-economics is the difference between being easily influenced and easily influencing others.  In micro-economic studies you are looking at a small scale event, and so you can generally assume that most variables don't change much due to the event because if its small size.   Micro could be called the "all else equal" discipline because the stability of the greater economy allows you to isolate variables.  The converse is also true, you wouldn't want to conduct a microeconomic study in France from 1938-1950 because world events would dominate the data.  Macro studies should be focused on the opposite, macro events are (by definition) large and impactful, and thus macro investigation should be mostly about the feedback relationships caused by the event.  The obvious differences in how an event should be analyzed due to its size doesn't stop the overwhelming majority of experts on macro from using the tools that should be reserved for micro.

In a recent blog post Paul Krugman "investigates" the question- will a recently strong dollar be a drag on the US economy?  Let us skip to the last few paragraphs of the piece (emphasis mine).
In case #1, everyone sees the relative strength of US spending as temporary – either they see it as a one-time blip that will go away, or they expect the rest of the world to exhibit a similar surge in demand in the not-too-distant future. In that case the dollar doesn’t move, and the bulk of the demand surge stays in the US.
In case #2, everyone sees the strength of US spending relative to the rest of the world as more or less permanent. In that case the dollar rises sharply, effectively sharing the rise in US demand more or less evenly around the world. It’s important to note, by the way, that this is not just ordinary leakage via the import content of spending; it works via financial markets and the dollar, and happens even if the direct leakage through imports is fairly small.
So, what’s actually happening? The dollar is rising a lot, which suggests that markets regard the relative rise in US demand as a fairly long-term phenomenon – which in turn should mean that a lot of the rise in US demand ends up benefiting other countries. In other words, the strong dollar probably is going to be a major drag on recovery.

 You can read the rest of the piece to see that I am not taking anything out of context, but I will note that Krugman is specifically referring to a case where a country is at the zero lower bound to avoid any accusations of unfairness, though I don't think the distinction matters here.

Let me demonstrate the absurdity of the conclusion by extending the two scenarios into a future a little bit more while holding everything else constant.  In scenario 1 demand in the US rises relative to the rest of the world, and then falls back.  One way that this could happen is that there is an increase in demand in the US, with world demand staying at the same level, and then US demand declining.  Keynesians have a word for the decrease in demand, recession.  In the second scenario we would concluded that continually rising demand would cause a continually strengthening dollar.  Keynesians also have a word that starts with the letter R to describe a sustained increase in demand, recovery!  It gets stranger for the longer and stronger the growth in demand was in the US the stronger the US dollar would become, and so the more of a drag the dollar would become on recovery.  To sum up this position as succinctly as possible- a recovery (increase in US demand) will be "a major drag on recovery".

This is the extent to which micro style analysis (holding most of the world constant) can pervert your thinking in application to macro events.  Keynesians are probably the most frequent culprits of this type of error as their approach is extremely model heavy. Everything has to be aggregated and everything has to be expressed in a 1+1 = 2 type of way.  When their model predictions fail they are left reverting to "the world is different because of X", under condition A we use model B, under condition C we use model D, as we see in this piece as we swap from a normal time to a period at the zero bound.  What is conveniently ignored  is that policy makers lean more heavily Keynesian (not Keynesian enough! the cry always goes) than any other direction.  It is the adherence to model B that leads to the conditions where it no longer works.

Wednesday, February 4, 2015

Nick Rowe gets lost taking a shortcut

Nick Rowe is like the anti Tyler Cowen- lots of content, no links, tons of interaction with his commentors which explains why he will never be (wildly) popular. Marginal Revolution is the something for everyone (well everyone who likes econ) blog while Rowe's posts at Worthwhile Canadian Initiative are for everyone that wants to spend half an hour thinking about his simplest post- and trying to write a 2 line intro to a piece has totally distracted me and now I am looking up econ blog rankings.... why am I so easily dis . . .  hey look a ball!

So Nick Rowe has a post - if you want to get the specifics you should read his blog. I mean honestly if you aren't related to me and simply trying to monitor my mental health state surreptitiously (I am on to you!) you shouldn't be reading this blog unless are already reading his.  So let me skip beyond a summary and get to a point already.
But that's not all there is to it. Because the demand for my autographs will also depend on whether people expect they will appreciate or depreciate in value.
Suppose the current total market value of my autographs is $100 (10 autographs at $10 each). If I want to shrink it to $50, all I need do is threaten to produce autographs in unlimited amounts if the total market value ever rises above $50. And I must be prepared to carry out my threat, to make it credible. By printing autographs at a faster rate I make them depreciate in value at a faster rate, which reduces the demand for my autographs, which reduces the total market value of my autographs.
And then later
Bits of paper with my signature are just like bits of paper plastic or silicon with the signatures of Stephen Poloz and Carolyn Wilkins (Governor and Deputy Governor of the Bank of Canada). Except we measure prices of everything else in the latter and not in the former, so a fall in the price of my autographs is equivalent to a rise in the price of everything else in terms of their autographs. And we use the latter but not the former as a medium of exchange (which is why the latter have a demand curve where quantity and price are inversely proportional).
As it happens I was recently talking to someone who was concerned with high inflation in the future, and his reaction to this worry is to increase his demand for money right now.  Crazy, right?  No, because he is on the verge of retiring and in his view dying with a million dollars in the bank is a far better outcome than living for 5 years broke, struggling and feeling like a burden on his family.  In financial terms he has asymmetrical risk.

Much of our modern economy is exposed to asymmetrical risk, banks in particular are heavily exposed to the risk of future inflation.  Lets say as CEO of a bank you are hosting a huge party to celebrate $100 billion dollars in loans, when a top financial analyst run into the room and whispers in your ear that he has crunched the numbers and, gasp, inflation is going to be 2 percentage points per year higher than you thought over the next 10 years. What, besides snide remarks about run on sentences, is your plan for future loans?  Obviously making more loans at the current rate is out of the question since you are just increasing your exposure, and you will need a healthy cushion so you can maintain your reserve ratio, and finally you want a large cash hoard to loan out after inflation has hit (and interest rates have gone up) to rebuild the portfolio and cover the losses on loans made recently.

What does this look like from a CBs point of view?   Demand for money seems to have risen, so now the CB prints (or promises to) more money, which should push our bank to expect even more inflation, so it hoards more.

What happens in the economy?  Mortgages are harder to come by, either they have higher interest rates or they are simply unavailable.  Either way home prices decline and people who are selling homes either have to pay for two places to live or take a lower price, so their consumption is likely to be cut back to compensate (people buying at "lower" prices but higher interest rates aren't gaining much, if any, purchasing power, and those that want to buy but can't- its difficult to say).  Now we have a liquidity crisis because the bank is hoarding and we have lower measured inflation due to lower consumption (and possibly just through lower housing prices depending on how housing is included), so what is a CB to do?  Why, print more!   Promise more inflation!  Scare the bank more!  Make the bank hoard more!

I put an unstated assumption in here to make it work- that inflation can happen with a lag.  Nick Rowe puts the opposite assumption- that inflation is close to immediate (we both simplified a lot as well).   The point here isn't to aruge that my scenario is correct and his isn't, it is to identify that Nick's is dependent on simplification, that there isn't a lag in inflation, that there aren't third parties exposed to moves in the prices of his autographs and a whole bunch of other (likely) things.

Monday, February 2, 2015

IOR part 2

IOR 1 is here

In IOR 1 I laid out a pretty basic outline for when interest on reserves would be inflationary/contractionary, here I am thinking about practical implications for Fed policy.

If the Fed wants to use IOR as a tightening tool we have to expect that inflation or expectations of future inflation are getting to high.  Since the Fed seems perfectly happy with inflation in the 2-2.5% range I assume it would take something more than that for them to try out a new program on a large scale (the Fed is frequently viewed as conservative, especially by MMs).  Also for it to impact inflation the transmission of price increases has to be primarily through bank loans, otherwise paying interest on reserves won't accomplish much if anything.

in 2014 the Fed remitted ~80 billion to the Treasury, and excess reserves are currently over 2.5 trillion dollars. Going back to IOR #1- IOR should expand the MS when payments exceed Fed profits (ie remittences)- so if the Fed tries to tighten with IOR it will start fighting itself with those ratios around a 3.2% interest rate.  The Fed isn't jacking up IOR anything soon according to its guidance, and its remittances have been relatively flat since 2010 while excess reserves have increased at over 300 billion per year during that span.  5 more years of those trends (Japanese "lost decade" range) and the Fed would be facing issues at a 2% rate, and another 5 years to 1.5%.  Japan is currently 25 years into an environment like this, which would put the Fed in a pickle before it hit the 1% mark.

Point #2 is that IOR is only effective if the rate is high enough to convince banks not to lend.  Well if inflation is significantly above 3% then deposit rates should be in that range, so banks are unlikely to willingly take less than that from the Fed to lend* as they would slowly be bleeding out even while getting "free money" from the Fed.

This isn't a definitive treatment, but it is a substantial blow to those who think the Fed should and could push for a return to trend growth.  A big push to get multiyear inflation (or nGDP if you prefer) above the historical trend to bring the curve back up is likely to put the Fed in position where its attempts to tighten lead to a larger money supply- and unlike most of QE a MS in which it holds no claims against.  If inflation were to push into the 4-5% range the Fed would be playing with fire and would risk losing control of the MS.

*The effective rate the Fed has to set to curtail lending will likely be higher than the deposit rate as the portfolios of banks will be heavily weighted to loans made over the past 5+ years with extremely generous terms to borrowers, and banks will have to make up those losses in the event of a substantial increase in rates.


I have the impression that a few of the blogs I read regularly have offhandedly remarked that interest on reserves is contrationary.  The logic being that if you pay banks enough to hold money they will do so at the expense of lending money.  Let us look at this from a couple of angles.

From a base perspective IOR is inflationary.  If the Fed pays banks not to make loans those banks then distribute that money to their employees/bondholders/equity holders.  Of course the Fed is an insanely profitable institution- remitting tens of billions to the Treasury each year- if total IOR payments are less than or equal to those received by the Treasury then the Fed doesn't have to print, they just distribute those dollars differently, but when total IOR payments are > that line the Fed must increase the MS to make them.  Furthermore that would be a permenant increase.  The important ratios would be the IOR rate vs the rate on the assets on the Fed's balance sheet and the balance sheet to total reserves.  

From an incentive perspective IOR would "encourage" banks to hold deposits and so it is contractionary in terms of velocity.  How impactful this would be is dependant on the relative size of IOR vs the market rate, and the direction the market rate is moving.  If IOR is making banks less likely to make loans you would expect rates to increase until they felt that they were compensated for passing on IOR.  At 0.25% it is highly unlikely that IOR is discouraging major investments, just as a 0.25% reduction in the funds rate is unlikely to generate a large amount of economic activity.  With rates hanging out at or near historical lows since IOR was initiated it is highly unlikely that it has had a significant contractionary effect.  

There is a 3rd possible angle- liquidity.  Lets say banks didn't want to loan at all- economic conditions are deteriorting quickly enough that the likelyhood of default becomes the dominant factor over opportunity cost. If a bank was in this position they would not expect to make any loans at any price (higher interest rates could increase default probability more than the extra points are worth- hypothetically).  In this scenario a bank would be tempted to lay off employees, and shutter locations.  If conditions improved and loans flowed freely again then banks would scramble to catch up, rehire and retrain employees.  IOR could, possibly, give them enough return to retain them and allow banks to react to positive news faster.  

This third angle, along with just establishing the precedent and mechanisms for IOR, is probably what the Fed had in mind when they instituted such a paltry percent.  Just enough to allow banks to maintain operations without really holding back any quality loans.