Tuesday, January 31, 2012

A short, scary hypothesis about credit availability

This is an incomplete thought, but one I wanted to put down.

Regional bank stocks are not very expensive right now. Entire loan books can be taken out for not much money.


Does this mean that a rational bank that has capital should be looking to take out FDIC-mediated undervalued pieces of loan books from failed banks rather than creating new loans – because functionally, new loans cost market value, and the FDIC will give them new loans for less than that?


Does that mean that only banks with the worst credit analysts create loans? Because banks on the brink of failing can try and "grow their loan book" out of the problem, but the FDIC won't work with them, and they're the ones with lousy credit analysis which is why they got into trouble in the first place? And the ones with capital cuz they're good at credit analysis don't initiate loans?


That seems like a dangerous problem. The FDIC lottery/auction system does create some weird incentive effects.

Tuesday, January 10, 2012

A Critique of Modern Monetary Theory

My friend JP and I have been talking about Modern Monetary Theory
(MMT). You can see more about what its proponents believe here:

Or just google "winterspeak" or "warren mosler" for some MMT proponents.

In some ways, MMT is the weirdest economic model I've ever seen.
Fundamentally, it holds that the government determines net savings and
interest rates based on whether it runs a deficit or surplus, and thus
government deficits directly regulate inflation, unemployment and all
the other things we usually attribute to monetary policy. An ancillary
result is that banks are not constrained by their reserve levels, but
instead by the demand for credit, because they can always just get
reserves from the Fed.

The theory starts by saying that it's impossible to do net saving
unless the government runs a budget deficit, defining net saving as
savings minus investment.  This is functionally a measure of "money
lent to the government"; there's no distinction between money holding
government bonds and reserves because reserves are deposited with the
Fed, and all money that's put into private assets is ultimately
invested. The Fed can then influence the money supply and interest
rates by running  surpluses and deficits – when the government runs a
deficit, it injects money into savings and when it runs a surplus, it
pulls money out of savings.

There are a number of separate issues I have with the resultant set of

Firstly, I'm not sure they quite understand the behavior of interest
rates. In MMT, there's no such thing as "crowding out". When the
MMT-world government runs a deficit, they're injecting more money into
the system which chases interest rates down. In more mainstream
theories, when the government runs a deficit, they're "crowding out"
private capital. In other words, they're injecting more money into the
system, and that money chases the less-elastic supply of things to
buy, which causes inflation unless interest rates go up.

In mainstream economics, a negative supply shock increases inflation
and decreases production because you have more money chasing the lower
amount of supply, so you produce less and spend more on it. Similarly,
a negative demand shock decreases inflation and decreases production
because nobody wants to buy. For example, if velocity suddenly drops
because everyone is worried about whose assets are really worthless
(hello, late 2008) and wants to save cash for the upcoming rainy day,
then spending drops, production drops, and by forcing interest rates
down (and, at the zero bound, inflation expectations up), the
government gets money moving again and restores the economy. This is
Milton Friedman-style monetarism (and, more recently, Scott
Sumner-style market monetarism).

In MMT, however, there is an important assumption. More government
spending injects more cash into the economy, and for that cash to
drive interest rates down instead of up, that cash, on net, needs to
directly chase savings. If the injected cash is instead chasing
private economy goods, some portion of the injected cash will convert
to inflation (exactly how much would be determined by the short-run
aggregate supply curve). This creates a bizarre interest rate
condition – market floating interest rates must go down as inflation
expectations go up, holding Fed action constant.*

This doesn't line up with how investors behave – market floating
interest rates go up as inflation expectations go up (which makes
quite a bit of sense – if your cash is depreciating in real spending
value, you're going to demand a better return on your cash). The only
other possibility is that all the money injected by government
spending goes directly to savings because the private sector doesn't
seek to do anything else with it. That's an unintuitive knife-edge

The fundamental issue here is that MMT looks so closely at the
mechanics of "how banks deal with excess reserves" (selling them, thus
driving down interest rates) that they ignore the much more important
supply and demand sides (eg, prices are going up and there's more
demand for things, so I'll produce more and we won't need more

Secondly, and relatedly, I have issues with how they approach real
resource constraints and spending efficiency.

According to MMT, if there's a demand shock that decreases employment,
the government can just run a large budget deficit to drive down
interest rates.

This, unfortunately, ignores a lot of the effects of government
spending on the real economy.** MMT's prescriptions for dealing with
unemployment (run a large budget deficit) and inflation (run a large
budget surplus) completely disregard the efficiency of said spending
or taxation. MMT harps on this idea that "government deficits don't
matter because all you're going to end up doing is paying them off
with money that you either print or take out of the system." They
ignore the fact that the manner in which the money enters the money
supply affects the amount of real-resource damage you do when you pull
it back out again.

If the government pays people to dig ditches and fill them in again,
in MMT world, you're just injecting cash into the economy and forcing
interest rates down (which should stimulate credit creation). Even if
MMT were right about interest rates, the issues are at least twofold:

1) You're increasing the cost of labor for more productive purposes.
This is less important in recession scenarios but it doesn't just
disappear. This creates a negative supply shock.

2) You've incurred a debt that needs to be reversed with either
inflation or taxation down the road, and inflation and taxation
actually have real economic effects.

If you're going to inflate, interest rates no longer go down. Again,
inflation causes market rates to increase because in order to find a
buyer for your debt, you need to pay them for the inflation they
expect. Even if you grant the MMTers their claim that the short rates
will decrease, you'll increase long rates, which actually makes credit
more expensive. Long rates going up are a good thing when they're the
result of long-term optimism about the rate of economic activity.
They're a bad thing when they're the result of pessimism about the
likelihood of inflation during monetization of debt, because that has
little associated positive economic activity associated with it
outside of what you spent the initial money on.

If you're taxing, you're creating a cocktail of bad effects, also –
you're replacing  future productive activity with unproductive
activity today, exacerbating your long-term productivity issues.
You're creating crappy incentives in the future with high tax rates,
hurting labor supply. There are potentially other effects.***

Thus, the quality of government spending needs to be taken into
consideration. If the government is excellent at making sure its
spending yields a market rate of return (accounting for future
taxation/inflation, crowding out, velocity of money, etc), then these
issues aren't such a big deal – you're taxing a private economy that
can do X with its money in the future (or doing the same damage via
inflation) and doing X or better today, and you're not increasing the
cost of labor for more productive purposes because there aren't that
many more productive purposes. Fine. But if your government looks
anything like the US government, where there is a LOT of pork
spending, economically-inefficient/growth-retarding welfare spending
(sometimes justified on other moral grounds, and sometimes not, but
certainly not justified on an economic return basis), and incremental
spending tends to be much worse than average spending… these are
serious issues which can't be waved away in the mechanics of everyday
bond transactions. Believe me, the people buying bonds aren't.

Relatedly, MMTers end up hyperfocusing on flows and ignore stocks (of
debt, of capital, of anything). There are plenty of situations where
the stock of something affects the price and speed at which it can
flow. Venezuelan debt comes to mind - everyone's so concerned they're
going to default or inflate that increased government spending would
just make the problem worse – they wouldn't be able to sell their
bonds, they'd need to print money and inflation would increase their
interest rates. There's a confidence effect in a government's
willingness and ability to repay that gets ignored in the intense
focus on lending mechanics.

Thirdly, I'm not sure that they even make sense talking about the
mechanics of interest rates, holding the entire real economy constant.
MMTers argue that if the government has a net positive outflow in one
day (deficit), the short rate must be equal to the central bank's
reserve rate because banks have too much reserves and thus deposit it
with the Fed. However, the fact that the Fed can set the discount rate
implicitly gives the Fed power to tweak short rates and get the money
supply and credit creation they want based on market conditions.
Increased government spending doesn't matter in that calculus – the
Fed can just set the discount rate they want.**** No more deficit
control of interest rates.

Fourthly, their loan creation dynamics only make sense in a very, very
technical reading. Banks need to be able to physically give money to
someone for a loan, and for them to do that, they need to get the
money – which means they're pulling it out of their excess reserves or
off the interbank market, and when the Fed is willing to supply
unlimited capital, they can borrow whatever they want to create loans.

But one major role of  Fed discount rates and other monetary
intervention is to set the opportunity cost of lending for banks at an
appropriate level. The Fed can tweak short rates or to get the money
supply and credit creation the Fed wants based on market conditions.
Loan creation isn't a function of some abstract version of credit
demand and the desire of banks to underwrite loans, it's a function of
the credit demand and the desire of banks to underwrite loans at the
interest rate that is the opportunity cost of a bank's funds plus a
spread for risk (and profit).

Finally, as Scott Sumner points out here -
http://www.themoneyillusion.com/?p=10178 – and here -
http://www.themoneyillusion.com/?p=10238 -the MMT theory of credit
creation, in which money supply is endogenous, would make the price
level indeterminate. In the extremely short run, credit creation may
make money supply endogenous, but ultimately, rates will be moved by
the Fed to change the money supply and thus credit creation and the
price level. If money supply is endogenous to credit creation, then
why do countries with more credit per capita not have higher prices
per capita? I understand how the price level works when money supply
is exogenous, but when it's endogenous, it's a much more nebulous
concept. To quote the second article above, "MMTers forgot that the
nominal interest rate is the price of credit, not money. The Fed can't
determine that rate, it reflects the forces of saving supply and
investment demand." (note that this aligns with my first footnote

There are a number of other issues that I either feel unqualified to
talk about*^* or are merely "very common" pieces of MMT rather than
fundamental to the ideology.*^*^* In general, I've tried to wrap my
head around MMT and am having issues. Am I missing something? If I am,
please let me know.


*Note that market floating interest rates are different from the rates
the Fed can use in a response – in both cases, you'd expect the Fed to
respond to high inflation expectations by raising the interest rates
it controls to pull money out of the economy. In MMT-world, that could
mean higher inflation expectations have indeterminate effects on
interest rates, whereas in mainstream-world, higher inflation
expectations lead to higher interest rates.

** Note that MMTers are not alone in making this mistake; many of the
Keynesians do, too. I wrote a post on this here:

***Again, I spend a lot of time on related topics here:

****Even ignoring that – it's possible I'm misunderstanding the
argument because I can't imagine MMTers would miss something that
simple – I'll refer back to the crowding out problem. They implicitly
(and in some cases, explicitly) deny the existence of crowding out,
where the government has a net positive change in outflow because the
private sector buys their bonds and removes its money from the money
supply. If I save more and the government spends more, the effect on
interest rates will depend on a lot of things -  the short-run
aggregate supply curve and resulting elasticity in how much the
private sector spends, the velocity of money and the relative economic
efficiency and velocity of private vs. public spending. It also
depends on how the private sector is allowed to lend against the bonds
they hold, but that's outside my area of expertise.

*^* You may need to integrate "bank expectations of the future path of
interest rates" into their treatment of bank behavior at the zero
interest rate bound, for example, because if I read MMTers correctly,
banks should lend to every positive NPV project that comes along at
the zero bound, but I'll posit that consumers aren't seeing interest
rates quite THAT low, even adjusting for risk. All of that assessment
should be left to someone more qualified to talk about it.

*^*^* One I find particularly obtuse is the "Job Guarantee", which
comes up a lot as an MMT solution to many things (in the program, the
Federal Government would guarantee a job at a fixed wage to the
unemployed). This site here:
http://bilbo.economicoutlook.net/blog/?p=10554 seems to indicate that
a job guarantee would anchor demand-side inflation because people who
had those jobs would have a fixed wage. I find this confusing; we had
demand-side inflation when they had no wages to spend. Why would
giving them wages to spend – fixed or flexible - mitigate demand-side

Thursday, January 5, 2012

Frustrating Responses by the Famous Keynesians

Brad DeLong responds to John Cochrane, and Krugman approves of
DeLong's argument and comments Krugmanly on those who disagree with




I think I understand the model they're thinking about this with, but
it seems to me to be obsessively short-term focused. They take
Cochrane to task on some technical things, but a "best argument
possible" read of Cochrane's fiscal argument, tweaking some of the
stuff he gets wrong, is something they do not think about (and,
reading them regularly, don't ever respond to, which aligns with Alex
Tabarrok's issue with Krugman's argument style at Marginal

This isn't to say that I agree with all of Cochrane's statements. I
think Cochrane misses that some substitution occurs intertemporally in
a world that's not perfectly rational expectations – but Krugman and
DeLong seem to indicate no substitution at all when they take him to
task for this.

Cochrane's argument is best summarized with these two paragraphs:

"[L]et's think of a "fiscal stimulus" in which the government borrows
money and spends it, but with the clear plan that the debt will
eventually be repaid with future taxes, not just by printing money.
Can this kind of stimulus work, and if so how?… First, if money is not
going to be printed, it has to come from somewhere. If the government
borrows a dollar from you, that is a dollar that you do not spend, or
that you do not lend to a company to spend on new investment. Every
dollar of increased government spending must correspond to one less
dollar of private spending. Jobs created by stimulus spending are
offset by jobs lost from the decline in private spending. We can build
roads instead of factories, but fiscal stimulus can't help us to build
more of both. This form of "crowding out" is just accounting, and
doesn't rest on any perceptions or behavioral assumptions.*… Third,
people must ignore the fact that the government will raise future
taxes to pay back the debt. If you know your taxes will go up in the
future, the right thing to do with a stimulus check is to buy
government bonds so you can pay those higher taxes. Now the net effect
of fiscal stimulus is exactly zero except to raise future tax
distortions. The classic arguments for fiscal stimulus presume that
the government can systematically fool people [This is the Ricardian
Equivalence argument].

The government should borrow to finance worthy projects, whose rate of
return is greater than projects the private sector would undertake
with the same money, spreading the taxes that pay for them over many
years, after making sure its existing spending meets the same
cost-benefit tradeoff. Just don't call it "stimulus," don't claim it
will solve our current credit problems, "create jobs" on net, or do
anything to help the economy in the short run, and don't insist that
we have to pass this monstrous bill in a day without thinking about

The pieces of DeLong's response most relevant to these paragraphs can
be summarized:

1) "[C]rowding out only happens "if we are in a cash-in-advance
economy with a technologically-fixed velocity of money. But we

2) "The government purchases $100 billion of goods, issues $100
billion of bonds, and raises taxes by $3 billion a year in order to
amortize the bonds. Government purchases go up by $100 billion this
year. Private consumption goes down by $3 billion this year. Net
fiscal impetus is not $0 but rather $97 billion. Cochrane doesn't
understand the Ricardian Equivalence argument he is trying to make."

My responses to these:

1) I fall into the Scott Sumner camp - fiscal spending is endogenous
to the Fed's reaction function, which means that a perfect Fed is
going to result in a fiscal multiplier of zero outside of supply-side
effects. Or, in lay terms, you can't stimulate the economy with
government spending very well, because the Fed's going to offset any
demand-side stimulus or slowdown and it's hard to find any government
spending on top of what we already do that helps the supply side. Tax
cuts hold slightly more promise, but still, the effects would be small
in the short-term (though potentially bigger in the long-term).

This is less true if you believe in liquidity traps (which mean the
Fed can't stimulate well). Market reaction to unconventional Fed
action makes me skeptical that we're in a liquidity trap, but I know
that Krugman and DeLong believe we are, so for the purposes of this
debate, let's assume they're right, and we are in a liquidity trap.

2) Let's grant, for a moment, DeLong's point that crowding out of
private savings and investment don't matter here. I have trouble
intuiting how relevant the "cash-in-advance economy" part is because
generally speaking, you do pay cash pretty quickly – within a couple
months – but the velocity point is important, and what DeLong doesn't
say is that for the purposes of this crisis, credit intermediation is
clearly having problems, hence lots of (seemingly) excess reserves.
There's also the possibility that you're selling part of that 97
billion in bonds to foreigners who would otherwise sit on the cash
rather than spend it immediately (hello, political ramifications of
seizing foreign currency held at the central bank in China / other
Asian growth model countries). So we'll give DeLong the crowding out
argument, for purposes here.

3) For Cochrane's Ricardian equivalence argument to happen, you need a
world that is very, very rational expectations – and while I have no
papers off the top of my head to confirm this, the empirics probably
don't back up the fact that if the government threatens to tax you 100
billion in the future in the private sector, you pull back 100 billion
of spending into savings right now. DeLong ignores this rational
expectations argument entirely in his response about Ricardian
Equivalence, and I think the right answer is probably somewhere in the
middle.** This, itself, is also not damning of DeLong's response; it
weakens the argument but doesn't ruin it.

Which finally brings me to my big issue with how Krugman and DeLong
are approaching Cochrane's arguments.

To an extent, the multiplier of spending is going to be based on the
productivity of whatever you're spending on. This is pretty simple.
Your unproductive spending is not going to multiply as much because it
won't have a positive impact on the economy outside of the first order
employment boost and associated consumption spending. Building a
subway from New York to New Jersey allows trade and labor mobility
that stimulates further economic growth; digging a ditch doesn't do

If you impose large future taxes to pay for unproductive investments
today, you certainly do create some fiscal impetus today (ignoring Fed
endogeneity from point 1 and assuming a liquidity trap). But you're
doing this by reducing economic productivity tomorrow with tax
increases. This is what Cochrane is alluding to when he talks about
governments funding projects with a rate of return above the market's
- you're going to harm the economy if you transfer projects from
market-rate productivity projects to below-market-rate productivity
projects. Instead of pandemic protection or useful highways, you're
building a bridge to nowhere, or a high speed rail in areas that won't
use it, or solar panel factories that aren't efficient enough to

So if the items you're buying today are unproductive (say, ditch
digging, or at least a portion of the fiscal stimulus passed), and the
activity you're taxing is productive (like the US private economy),
then you're creating a cocktail of bad long term outcomes:

1) You've replaced future productive activity with unproductive activity today.

2) You've created crappy incentives in the future with high tax
rates, hurting the supply side.***

3) There's also a temptation to reallocate funds to the places that
"need it most", which may be the areas that overbuilt and misbehaved
the most (in this recession, housing-related areas). This is very
Austrian, but on the supply side, the Austrians could have a point
(even if I disagree with them on the demand side). Look at GSE
funding, for example. This creates not only long-run moral hazard but
also inefficiently continues the misallocation (credit for housing
remained cheap throughout the downturn. Even if you believe, as I do,
that household formation is the big housing issue now and excess
housing supply is no longer the problem, it certainly was the problem
for a long time). I don't know how applicable this Austrian argument
is by magnitude but it's at least plausibly a measurable factor.

4) You reduce skill-damaging long-term unemployment today, but unless
you believe the economy will get a LOT more dynamic, it's going to be
hard not to increase long-term unemployment by even more tomorrow as
overall cyclically-adjusted (ie, structural) unemployment goes up
during deleveraging but unproductive investments haven't paid for

Basically, you're trading more than 1 job in the future for 1 job
today. Maybe the economy is in such rough shape right now that it has
no choice but to be way more dynamic tomorrow, but you still think
long-term unemployment is going to be super damaging for each
individual****, so you're willing to trade 2 jobs tomorrow for 1 job
today because you think long-term unemployment (and misallocation)
will disappear in the more dynamic economy. But you need a really,
really large effect of long-run unemployment to make that happen, and
you need to be a major optimist about the effects of technology and
policy on the supply side. Because otherwise, fiscal stimulus may be
stimulating in the short-term, but the intertemporal substitution
means you're damaging the economy in the medium or long term. In my
opinion, that's the "best possible interpretation" of Cochrane's
argument, and in my opinion, it's a persistent weakness in Krugman's
and DeLong's arguments for fiscal stimulus. I wish they'd address it
instead of consistently brushing it aside like it doesn't matter.

As an aside:

Just so I'm not criticized for ignoring the rest of DeLong's
arguments, DeLong also notes: "There is nothing in "traditional
Keynesian" thinking to say that you ought to boost consumption rather
than, say, infrastructure investment. Nothing at all." I suspect,
though of course cannot confirm, that Cochrane and DeLong are talking
past each other a bit on investment/consumption. In the private
sector, if financial intermediation isn't working, then government
policy stimulating private consumption pumps more into the economy
than government policy stimulating private investment, because money
gets saved and not lent out. I'm pretty sure that's the (in my opinion
incorrect) Econ 101 argument for government spending rather than tax
cuts as fiscal stimulus. The government doesn't need to worry about
this, so for direct government spending, investment and consumption
should be equivalent.

DeLong also criticizes Cochrane's interpretation of monetary policy.
Largely, I agree with DeLong's criticisms in this arena and will thus
let them go, although I think it's ludicrous to use that as evidence
against his fiscal arguments just via "he doesn't get how the world
works". Argumentation doesn't work like that.

*I've redacted this: "Second, investment is "spending" every bit as
much as is consumption. Keynesian fiscal stimulus advocates want money
spent on consumption, not saved….". It distracts from the main point
but I address it in an aside at the end.

** DeLong assumes that there's no rational expectations in effect at
all – if 100 billion is spent and 3 is paid for, that doesn't mean
you'll get 97 in stimulus right now, if there's some additional
savings. Plenty of people worry about what their future tax rates are
going to be when making savings decisions. I save more knowing that
I'll probably be taxed more on my income in the future than today's
rates. Maybe I'm the only one, but even if I am the only one… you're
no longer at a perfect 97 billion. Less on topic, there's a pretty big
debate going on in the financial planning community about whether to
use Roth IRAs or normal IRAs for young people – if you trusted the
government not to need to raise tax revenue, the long-horizon tax-free
nature of a Roth is wonderful, but for that you have to trust the
government not to remove their tax advantage, which not everyone does.
Rationally, we should be splitting between Roth and Traditional for
planning purposes. Megan McArdle wrote about this recently, as well.
But fine, let's say people don't fully consider future tax rates in
current savings decisions and allow only partially rational
expectations to say there's some fiscal impetus today. I'd agree with
that, even if it's not 97 billion worth in that example.

I'll note that I think the $100 billion argument (DeLong point two)
was directed at the Ricardian Equivalence argument but I think it's
actually an (incorrect) response to crowding out (incorrect because
you're also putting $97 billion into bonds). But again, I grant him
crowding out on velocity and credit intermediation grounds.

***and, following up on the second footnote, possibly mitigated some
of your own current fiscal stimulus' effectiveness through rational
expectations channels – which should be exacerbated by unproductive
investments because people know that what you're spending on will not
grow the economy in the long run much to offset the spending.

Also worth pointing out (or not) for students reading this that you
could create toy economies with tax systems where increased tax
revenues don't impact labor supply decisions, but that economy is not,
should not be and will never be America.

**** also worth noting that there's an argument to be made that
long-term unemployment is less damaging to an individual's prospects
to get back into the labor force when there are lots of people in the
same boat, because a) in a better economy, employers will need to hire
someone, and if long-term unemployed are their only choice, that's who
gets hired, and b) there should be more training programs available
with a critical mass of people who need them.

This isn't to say that long-term unemployment isn't catastrophic to
the economy in a way short-term unemployment isn't – but on a
skill-erosion level, it's probably the same to have 10 additional
units of long run employment today as to have 5 today and 5 tomorrow,
and on a job prospects/retraining level, I'd much rather not be the
only one screwed, which kind of happens if you redistribute long-term
unemployment between today and tomorrow from just today. Thus, it's
slightly better from a labor supply perspective to have more long-term
unemployment in one period than to have the same human-years of
unemployment stretched over two periods, as long as you see an overall
economic recovery. I hope this is clear… if it's not, I'm happy to
follow up.