Topic: Finance, Banking & Monetary Policy

A Monetary Policy Primer, Part 10: Discretion, or a Rule?

A Class Camping Trip

Forget about monetary policy for a moment or two, and imagine, instead, that you’re back in 6th grade. You and your classmates are about to go on a camping trip, involving some strenuous hiking, and lasting several days.

Somehow, your teacher must see to it that all of you are kept well fed. To do so, she plans to appoint one of you Class Quartermaster. The school’s budget is limited, and rations can get heavy, so there will only be so much food to go around — so many hotdogs, baked beans, scrambled eggs, peanut butter sandwiches, and granola bars. The Quartermaster’s job will be to make sure it all gets divvied-up fairly and efficiently.

The catch is that your classmates are a motley bunch. Pete Smith, the football team captain, is even taller than the teacher, and otherwise built like an old oak tree. His body goes through fuel like a small steam locomotive. Mary Beth Johnson, on the other hand, looks like a gust of wind might carry her off, and eats so little that she doesn’t mind Peter grabbing her grilled cheese sandwich on tomato soup day. The rest generally fall between those two extremes. But just how several days of hiking will affect all their needs is anybody’s guess.

Still the food has got to be rationed somehow. And the class must decide how before a drawing of straws determines who will be Quartermaster. Will it be Jane “Goody Two Shoes” Miller, the teachers’ pet, or Wesley “The Weasel” Jones, who, though never caught red-handed, is widely suspected of cheating on his tests? Or could it — perish the thought! — turn out to be the ravenous Pete Smith himself? Whatever the choice, the class will have to live with it once the straw poll has been taken.

After some discussion, the class decides to vote for one of two options for rationing the food. The first is to simply let the Quartermaster dole out food according to his or her best judgement. That option will allow the limited provisions to be used as efficiently as possible, with Pete Smith getting the bigger helpings he needs, and Mary Beth getting less, assuming that less suffices. The second option is to insist that the Quartermaster give equal rations to everyone, big, small, or in-between. That’s bound to be inefficient, of course. Still, it can easily beat having Wesley or Peter decide!

So, which option will you vote for? If you settle for the first, you favor a “discretionary” rationing policy; if the second, you favor a rationing “rule” over discretion.

Allan Meltzer Remembered

Like Allan Meltzer, I received my Ph.D. from UCLA. He and his major professor, Karl Brunner, had both left by the time I arrived. UCLA is an important intellectual connection. At the time, UCLA was informally known as “Chicago West,” for its intellectual affinity to the University of Chicago Economics Department.

The characterization was misleading if not wrong. UCLA was where Chicago and Vienna (the Austrian School) intersected. UCLA’s professors and their students were influenced by both traditions. That explains positions taken by them over the years on many issues. For instance, in their work, Brunner and Meltzer adhered to a conception of Knightian (after Frank Knight) or true uncertainty. That type of uncertainty is not readily modeled with definitive results.

For a long time, I had minimal interaction with Allan. When he came to Washington, D.C., to begin writing his multi-volume history of the Federal Reserve System, however, that began to change. AEI supported the research, and its president, Chris DeMuth, provided Allan with an office and association. Early on, Allan invited me over to AEI for lunch.

Importantly, he began inviting me to attend the meetings of the Shadow Open Market Committee as an observer. They were very instructive and illuminating. Aside from the substance, I marveled at his performance as Chairman. Getting academics to agree is like herding cats. Allan had the skill.

Later, I worked at the Heritage Foundation. Ed Feulner, Heritage’s President, was appointed to the Congressionally mandated International Financial Institutions Advisory Commission (IFIAC). In the wake of multiple global financial crises, Congress wanted a review of the IMF, World Bank, and other international agencies. The Commission’s original Chairman withdrew before the Commission began meeting. Ed asked my advice on a replacement. Without hesitation, I replied “Allan Meltzer.” “Why?” I was asked. “He can herd cats,” I replied.

Allan accepted on the condition I would be his Chief of Staff. Now I had two full-time jobs, each with lots of overtime.

Allan’s domination of the Commission soon led the press to rename IFIAC as “The Meltzer Commission.” From the beginning, Allan was determined that the commission would arrive at a nonpartisan set of recommendations. The membership had 6 Republican and 5 Democratic members and was expected to divide along those partisan lines.

Because of an informal alliance the Chairman struck with Jeffrey Sachs, the deliberations of the Commission were largely nonpartisan. With a few exceptions, the deliberations were conducted in a collegial atmosphere. The final vote was 8-3 in favor of the findings. It was a remarkable result because the Democratic members were under extreme pressure not to sign the majority report. It was all a testimony to the Chairman’s remarkable political skills.

Allan passed away early Tuesday. He will be remembered. He will be missed.

[Cross-posted from]

Shrinking the Balance Sheet: Where Fed Officials Stand

In March, the Federal Open Market Committee (FOMC) signaled it could begin shrinking the Fed’s balance sheet sometime later this year. However, with limited official details about what that means and none forthcoming from last week’s FOMC press release, many questions remain:

  • How will the Fed decide exactly when to begin shrinking its balance sheet, and will the move be data or date dependent?
  • Once the wind-down begins, how rapidly will the balance sheet shrink and to what new normal level?
  • How will the Fed dispose of its assets: by simply refraining from reinvesting the proceeds from maturing securities, passively shrinkage the balance sheet, or by actively disposing of some assets to ensure a smoother path for balance sheet reduction?
  • And would asset sales, should they occur, include both mortgage-backed securities (MBS) and Treasuries or would the Fed initially focus on a single asset class?

Back in September 2014, the FOMC released its Policy Normalization Principles and Plans (henceforth “the Framework”), its official statement outlining a three-step normalization strategy, including balance sheet reduction. First, the Fed would raise policy rates[1] to “normal levels.” Second, the Fed would begin to shrink the balance sheet in a “gradual and predictable manner” by ending the reinvestment policy. And third, the wind down would continue until the Fed holds only enough securities to conduct monetary policy “efficiently and effectively” with a portfolio consisting primarily of Treasuries. There is, of course, a caveat that the Fed can deviate from the Framework as economic conditions change. Since December 2015 the Fed has raised policy rates three times, but it has yet to update the Framework to provide further details on the next steps for balance sheet normalization.

Misconceptions of the Efficiency Wage Hypothesis

In an otherwise largely fair write-up of the disagreements and controversies surrounding the economics of minimum wage laws, a blog I was cited in yesterday made a common error in discussing the so-called “efficiency wage hypothesis.” Here’s the extract (my emphasis):

But if employers have monopsony power (they have enough market power to influence the wage rate in their industry) then the impact of a minimum wage is to raise employment (up to a point). Furthermore, the efficiency wage theory suggests that a minimum wage could help raise employment by increasing productivity and lowering turnover.

This last sentence is a misreading of economic theory.

Many do claim that higher minimum wages can lead firms and workers to improve productivity in ways that avoid job losses, whether that be through more worker effort, less staff turnover or whatever. And there’s no doubt that in some cases, firms and workers adjust in this way.

But the efficiency wage theory itself is actually a market failure theory of unemployment. It does not suggest that raising the minimum wage could increase employment. It suggests that in certain sectors where the costs of replacing labor are high, firms pay above market wages out of fear that lowering them would reduce their workers’ productivity substantially. The consequence is that the specific sectoral labor market does not clear, resulting in at best excess supply of workers in that sector (who subsequently have to find employment in other sectors at lower wages) or at worst more unemployment in the economy as a whole.

No, an Above-Average P/E Ratio Does Not Show Stocks Are Overpriced

Writing in The Wall Street Journal on April 27–making another last-ditch pitch for a 20% border tax on business imports–Martin Feldstein asserts that unless corporate tax rate cuts are “offset” by tax increases on imports or payrolls then larger projected deficits would crash the stock market by raising long-term interest rates. “The markets’ current fragility,” he writes, “reflects overpriced assets–the S&P 500 price/earnings ratio is now 70% above its historical average–after a decade of excessively low long-term interest rates engineered by the Federal Reserve.” 

The odd notion that the Fed could somehow depress bond yields for a decade is an irrelevant ambiguity, since the whole point of Feldstein’s story is to claim budget deficits raise bond yields and higher bond yields threaten “overpriced” stocks.

In a recent blog, I found no evidence to support the dogma that bond yields rise and fall with rising or falling budget deficits (actual or projected). Wall Street Journal columnist Greg Ip opines that “interest rates haven’t responded to deficits lately because private investment has been so lackluster.” But that excuse makes interest rates dependent on private investment, not deficits, and leaves us tangled in circular illogic. If interest rates depend on private investment and deficits “crowd out private investment,” then interest rates could never respond to deficits because private investment would always be lackluster when deficits were large (which would also make deficits the opposite of a “fiscal stimulus”).

Switching from bonds to stocks in this blog, I find no evidence that the S&P 500 stock index is “overpriced” relative to long-term interest rates (which is the only meaning of “overpriced” that relates to Feldstein’s argument about deficits and bond yields).

Feldstein claims stocks are “overpriced” because “the S&P 500 price/earnings ratio is now 70% above its historical average.” But there is no reason to expect the p/e ratio to revert to its long-term average unless bonds yields revert to their long-term average.

Inverted P/E ratio Tracks Bond Yield

New Paper Shows Workers Commute Away From Minimum Wage Rises

The beauty of the United States where policy is concerned is that state variations allow for lots of decent analysis. Nowhere is this more clear than on the minimum wage, where a fascinating new empirical paper by Terra McKinnish from the University of Colorado Boulder adds further light as to whether Econ 101 holds in regards to raising statutory pay rates.

Remember, there are (to simplify) two main theoretical stories of the labor market. In an ordinary competitive model, imposing a minimum wage above the equilibrium wage rate leads to an increase in the quantity of labor supplied (more people want to work at the higher wage) and a reduction in the quantity demanded (employers want fewer worker hours at the higher price). The difference between the two is the increase in “unemployment” – i.e. the difference between the worker hours people are willing to work and the demand for worker hours at that wage rate. Raising the minimum wage in a competitive labor market is said to have “disemployment effects.”

In the past decade though, some academics have posited a different theory of the labor market, implying that all or many employers have “monopsony power” - monopoly power but in the purchase of labor. Profit maximization would lead firms to pay less than the value of the marginal product of labor and employ less labor-hours than would be the case in a competitive market. The implication is that when there is a strong element of monopsony in the labor market, the imposition of a higher minimum wage can lead to both an increase in pay per hour and an increase in hours of employment. Workers would gain unequivocally from the minimum wage, while previously exploitative employers would lose.

Let’s put aside for a second that in reality the labor market is complex, dynamic, and there could be elements of both. Empirically, the question is which provides a better explanation of the real labor market we see.

Here’s where McKinnish’s new study comes in. She seeks to exploit the variation in minimum wage rates between states and the compressing effect of the 2009 federal minimum wage increase to analyze whether a relative increase in a minimum wage within a state led to more commuting into that state to work for under 30s or more commuting out of the state to work.

No, Higher Deficits Don’t Raise Long-Term Interest Rates

According to former Reagan adviser Martin Feldstein, “Higher projected budget deficits could raise long-term interest rates, potentially triggering… a serious economic downturn.”

Has that ever happened?

From 1977 to 1981 10-year bond yields nearly doubled, rising from about 7.4% to 13.9%, but budget deficits were relatively small, around 2.5% of GDP.  Budget deficits were doubled from 1984 to 1993 (about 5% of GDP), yet bond yields were nearly cut in half, falling from 12.4% to 5.9%. Bond yields were no lower from 1997 to 2000 when the budget moved into surplus. But yields fell dramatically in 2008-2012, a period of record budget deficits.

One possible objection is that larger budget deficits were caused by recessions, which is why bond yields did not rise with larger deficits or fall with surpluses.  The graph addresses this concern by using CBO estimates [.xls] of cyclically-adjusted budgets (“with automatic stabilizers,” in CBO vocabulary). Deficits and Bond Yields

Still, there is clearly no correlation between bond yields and any measure of yearly budget deficits and surpluses. And that is also true in other times and places – Japan’s chronic large deficits and debt being an obvious example.

Another possible objection centers on Feldstein’s use of the phrase “projected budget deficits,” as though the CBO’s notoriously inaccurate long-run projections could somehow have an entirely different effect from actual deficits. I criticized the analysis and evidence behind that conjecture in a Treasury Department presentation which was condensed and simplified in a Cato Institute paper. I found the underlying analysis illogical and contradictory and the evidence worthless.

There is no need to make up stories about alleged effects of deficits on bond yields in order to make a strong case for minimizing frivolous government borrowing (e.g., to pay for transfer payments or government employee compensation).

Chronic deficits add to accumulated debt, and that debt will have to be serviced with future taxes even if it is rolled-over indefinitely. That is reason enough for Congress to keep growth of federal spending below the growth of the private economy – a task which requires frugality in spending but also a tax and regulatory climate which minimizes impediments to investment, entrepreneurship, education and work.