Topic: Finance, Banking & Monetary Policy

The Fed Is Overestimating Economic Growth

In her speech yesterday at the Federal Reserve’s annual conference in Jackson Hole, Wyoming, Fed Chair Janet Yellen stated that “the case for an increase in the federal funds rate has strengthened in recent months.” She based that view on “the continued solid performance in the labor market” and “our outlook for economic output and inflation.”

As documented by Jon Hilsenrath in yesterday’s Wall Street Journal,the Fed has consistently overestimated economic growth since 2004. The Fed’s economic model is wrong and there is no reason to believe it will suddenly produce reliable predictions. The model also does poorly in predicting inflation, though it does not show such a bias one way or another. Continuing to rely on the Fed’s flawed model to determine policy would be foolish.

Characterizing the labor market as “solid” is misleading in the extreme. Much of the decline in the unemployment rate to which Yellen directs our attention has been due to the decline in the civilian labor market participation rate. If people give up on the labor market, they are not counted as unemployed. Far from being a sign of strength, a fall in the unemployment rate for that reason is arguably a sign of weakness in labor markets. Since the unemployment rate is no longer a reliable indicator of labor market conditions, it should be dropped as a policy gauge.

For these and other reasons, I stand by my post of August 9th that the Fed will not be able to raise rates. My only hedge on that prediction is that Yellen is putting the Fed’s credibility on the line with her continued predictions of raising interest rates. Loss of face is a poor justification for raising interest rates, but the human factor cannot be dismissed in policy making.

MetLife v. Financial Stability Oversight Council

Under Dodd-Frank, the new Financial Stability Oversight Council (FSOC) has the authority to designate companies as “systemically important financial institutions” or “SIFIs.” By identifying and branding these companies as systemically important, we’ve been told, the government will end “too big to fail.” Dodd-Frank’s supporters claim bailouts like the one we saw in 2008 are a thing of the past, in part because of the heightened oversight of SIFIs. Except FSOC hasn’t fully thought through the whole SIFI designation concept. In March, a court found that FSOC’s designation of insurance giant MetLife failed to consider the impact the designation would have on MetLife and the U.S. financial system as a whole and therefore was “arbitrary and capricious,” that is, unlawful.

FSOC was created by Dodd-Frank and, as an agency of the federal government, it exists to “further some public interest or policy which [Congress] has embodied in law.” This interest, Dodd-Frank tells us, is to “promote the financial stability of the United States…to end too big to fail, [and] to protect the American taxpayer by ending bailouts[.]” Whether FSOC  is capable of any of these things and whether the legislation that created it will ultimately promote anything like stability is not the point (although our vote on these questions is “no”). The point is that, in exercising this delegated authority, FSOC must always act to forward the goal of promoting the financial stability of the United States.

It is surprising, then, that in determining whether MetLife should be designated as a SIFI, FSOC not only failed but flat out refused to consider whether the cost of compliance with this increased burden might actually weaken the company. If FSOC designates a company as a SIFI it means that FSOC has determined that “material financial distress” at the company “could pose a threat to the financial stability of the United States.” That is, that anything that weakens it would undermine the express goal of Dodd-Frank. It seems clear that FSOC should at least ask the question: would complying with these new rules make the company stronger or weaker?

And yet FSOC claimed that this question, which goes to the very heart of its authorizing statute, is not one it has to ask. Following its loss in the district court, FSOC appealed the case to the D.C. Circuit Court. On Monday, Cato filed an amicus brief arguing that it was unreasonable for FSOC to fail to consider whether its action in designating MetLife as a SIFI promoted or instead frustrated the goal of Dodd-Frank in promoting financial stability in the U.S. Cato also argued that, far from reducing the risk of bailout, designating MetLife as a SIFI could in fact increase the likelihood of taxpayer-funded rescue.

Ultimately the question is whether an agency must grapple with the possible negative effects of its actions, or whether it may simply wave these costs away, saying “that’s not our concern.” We hope the court decides that federal agencies, like everyone else, must consider the costs of their actions.

[Cross-posted from Alt-M.org]

The Fiscal Theory of the Price Level: True and False

There are two versions of the fiscal theory of the price level (FTPL); one true, the other false.  The true version holds that if the fiscal authority dominates the policy space, then fiscal deficits could be monetized by the central bank. This version is consistent with the quantity theory of money, because inflation is ultimately determined by excess growth in the money supply.  If money growth were constant, inflation could not occur—that is, there could not be a sustained rise in the average level of money prices. In this sense, Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” cannot be refuted (Friedman 1970: 11).

The second version of the FTPL, the so-called strong version, holds that even if the money supply is held constant, inflation can occur if the fiscal authority is passive.[1] All that is needed is for the public to expect prices to rise. People will then spend their given money balances at a faster rate — increasing the velocity of money — and prices will rise until expectations change. If the fiscal authority is passive, velocity can explode, producing hyperinflation (see McCallum and Nelson 2005). This feature of the strong version is referred to as “speculative inflation” and is independent of monetary policy (Tutino and Zarazaga 2014: 3). The strong version also implies that fiscal action—not monetary reform—is the primary tool for ending a hyperinflation. This version of the FTPL is false: it ignores historical evidence that shows the determining factor in generating hyperinflations is explosive growth in the money supply (or the expectation that such growth will occur); and it fails to recognize that stabilization  results from credible monetary reform.[2]

Expectations about future inflation don’t appear like manna from heaven — businesses and households know that excess money growth causes inflation. They also know that large unfunded government liabilities and budget deficits risk having the central bank monetize debt. Although the strong version of the FTPL assumes away that possibility, history does not.

Reforming Last-Resort Lending: The Flexible Open Market Alternative

Having spent the last month or so poring over writings on last-resort lending,* and especially writings dealing with the recent crisis and its aftermath, with the particular aim of discovering the best means for supplying last-resort credit when it’s called for, and for not supplying it when it isn’t, I’ve reached a number of tentative conclusions that seem worth reporting. I report them despite their tentative nature so that I might be convinced sooner rather than later that I’m barking up the wrong tree, and also because, if I’m actually on to something, I might get others to help me flesh-out my ideas.

I hasten to add that I regard any need for last-resort lending as reflecting, not the inherent shortcomings of private financial markets, but the debilitating effects of misguided regulatory interference with the free development of those markets. Some of the least regulated banking systems of the past, including systems that lacked central banks, were also famously crisis-free, or close to it.

Modern banking systems are, sadly, a far cry from those ideal arrangements. It’s quite impossible, for that reason, to suppose that we might safely dispense altogether with central bank last-resort lending, without first undertaking other, major reforms. In the meantime, we can strive to  reform last-resort lending arrangements, so that they might lower the risk of future crises, instead of making them more likely by contributing to moral hazard, or by otherwise misallocating credit.

There Are Worse Things than Libertarian Fantasies

So says I, in commenting on Amar Bhidé’s ill-informed opinion piece in yesterday’s FT.

Here, with some minor edits (which I failed to fix on time in the original), is what I wrote:

Were Mr. Bhidé’s own suggestions for monetary policy reforms sound, his swipe at fundamental criticisms of central banking as “libertarian fantasies” would be perfectly gratuitous, but no worse than that. In fact, the idea that we’d be better off starting with a clean slate than trying to fix central banks seems to me considerably less fantastic than Mr. Bhidé’s suggestion that the Fed might manage money responsibly simply by checking commercial banks’ imprudent lending. That the Fed has a miserable track record when it comes to detecting, much less discouraging, imprudent lending, is the least of it: Bhidé’s more fundamental error consists of not imagining that merely by keeping an eye on imprudent lending the Fed would also avoid gross mismanagement of the money supply, and the macroeconomic disturbances consequences thereof. If there’s a theory that supports this view, I’d like to see it!

Nor is it true, despite what Mr. Bhidé claims, that the Fed managed the money supply in its early years merely by discouraging imprudent bank lending. It isn’t true, first, because the Fed’s management of the U.S. money stock was in fact notoriously irresponsible in its first decades (consider the rampant post-WWI inflation, the depression of 1920-21, the boom of the late 1920s, and the Great Monetary Contraction of the early 1930s); second, because “checking imprudent lending” wasn’t the Fed’s mandate then (it was “providing an elastic currency” — an entirely different matter); and third, because the long-run behavior of the money stock was constrained by the working of the gold standard.

Mr. Bhidé is right in one respect: he is right to regard the Fed’s dual mandate as supplying an insufficient check against imprudent Fed actions. The fix, though, isn’t Mr. Bhidé’s even more unsound prescription. It consists of replacing the dual mandate with a single stable spending growth mandate. Unlike Mr. Bhidé’s proposal, such a mandate would place definite limits on inflation, though ones that would vary with the economy’s productivity. It would, to be sure, not suffice to rule out imprudent actions by commercial bankers. But then, no monetary policy mandate should be expected to serve that purpose.

On a separate note, I do wish that Mr. Bhidé and other persons inclined to dismiss arguments to the effect that we’d be better off without central banks as “libertarian fantasies,” or the equivalent (besides Mr. Bhidé, Paul Tucker comes to mind), would grapple with the actual arguments of central bank critics, instead of merely labeling them. As for economists calling things “fantasies” because they seem far from politically possible, it seems to me that by making such pronouncements they shirk their proper duty, which consists of altering the boundaries of the politically possible through their influence upon people’s beliefs. Where would we be today had Adam Smith chosen, not to elaborate upon the potential benefits of free trade, but to dismiss the idea as a “libertarian fantasy?”

[Cross-posted from Alt-M.org]

New College Regs: Accusation = Sentence

It’s no secret that war has been declared on for-profit colleges. The question is whether the war is justifiable. I don’t think it is—the evidence strongly suggests that all of higher ed is broken—but I also think it is very hard for the public, in any individual case, to know whether a college accused of wrongdoing is really awful, or the target of politicians trying to make names for themselves. But just accusing a school of predatory behavior hurts it, generating lots of bad press, encouraging more suits and investigations, and usually resulting in schools settling with government accusers without admitting guilt, maybe to stop the PR and financial bleeding, maybe because they think they’re guilty and that’s the best they can get. Regardless, there is clearly an imbalance of power between taxpayer-funded accusers and the accused.

New federal regulations look like they’ll make the problem of accusation-equals-sentence worse. The Wall Street Journal has a lengthy piece looking at the broad potential ramifications of the regs, but one part of the US Department of Education regulation summary caught my eye: Schools would have to automatically “put up funds, in the form of letters of credit (LOCs), that total at least 10 percent of the amount of Title IV funds received by the school over the previous year” if “a state or federal government entity such as an attorney general, the CFPB, or the FTC brings a major suit against the school.” In other words, the moment any government entity, including the unchained Consumer Financial Protection Bureau, accuses a school of wrongdoing, the punishment begins.

This punishment could easily trigger a cascade of trouble, with the need for a letter of credit scaring off investors, bad publicity scaring off students, and a school suffering financially as a result. That school could then be targeted by the Department of Education for being even more of a financial risk, and the death spiral would become inescapable. This is not too far off from what seems to have happened to Corinthian College. Corinthian was, importantly, ultimately found guilty of fraud, but that rare guilty verdict was rendered after Corinthian was no more and had no one to defend it in court.

It is, to be sure, hard to feel too sorry for the for-profit sector. It does have poor outcomes, and is heavily dependent on students paying with government dough. That said, there is also a good bit of evidence that it is no worse, controlling for student challenges, than other higher ed sectors. And it is very easy to imagine politicians—human beings likely as self-interested as the average for-profit school owner or employee—going after for-profit schools because it is politically easy.

These proposed regulations look like they will stack the deck even more against for-profit colleges.

CBO Projections Are No Basis for Claiming Tax Reform “Loses Trillions”

I recently wrote in The Hill on Donald Trump’s fiscal plan. The graph below clarifies some of my comments.

CBO REVENUE PROJECTIONS

Estimates purporting to show the new, evolving Trump/Ryan Tax Reform must “lose trillions” over 10-20 years are usually static – meaning they assume lower marginal tax rates on labor and capital have zero effect on economic growth or tax avoidance.  Yet that is a relatively small part of the problem.

Even if static estimates made any sense, the alleged revenue losses would still be wildly exaggerated because they compare estimated revenues from reform plans with “baseline” revenues projections from the Congressional Budget Office (CBO).  

As the graph shows, CBO projections pretend that revenues from the existing individual income tax will somehow rise as a share of GDP every year –forever– reaching levels never before seen in U.S. history, even in World War II. 

Real wages in the CBO forecast supposedly rise so rapidly that more and more middle-income taxpayers are pushed into higher and higher tax brackets.  Since tax reform eliminates the highest tax brackets, it thwarts these sneaky tax increases and thus appears to “lose money.” But the CBO’s phantom projections are sheer fantasy and no basis for rejecting sensible tax reforms to encourage more business investment and greater labor force participation.