Determinacy and Identification with Taylor Rules

Journal of Political Economy, Vol. 119, No. 3 (June 2011), pp. 565-615. Online Appendix B. JSTOR link, including html, pdf, and online appendix. Manuscript with Technical Appendix The technical appendix documents a few calculations. Don't miss starting on Technical Appendix page 6 a full analytical solution to the standard three equation model. I include the manuscript just so equation references in the Technical Appendix will work, the previous links to the published version are better.

Most people think Taylor rules stabilize inflation: Inflation rises, the Fed raises interest rates; this lowers “demand’’ and lowers future inflation. New-Keynesian models don’t work this way. In the models, the Fed reacts to inflation by setting interest rates in a way that ends up increasing future inflation. Inflation is “determined” as the unique initial value that doesn't set off accelerating inflation. Alas, there is nothing in economics to rule out accelerating inflation or deflation. I conclude that new-Keynesian models with Taylor rules don’t determine the price level any better than classic fixed interest rate targets. Price level determinacy requires ingredients beyond the Taylor principle, such as a non-Ricaridan fiscal regime. I survey the new-Keynesian literature to verify that no simple answer to this problem exists. All of the fixes slip in a commitment by the government to blow up the world at some point.

Even if the new-Keynesian model did work, The parameters of the Taylor rule relating interest rates to inflation and other variables are not identified. You can't measure "off equilibrium" behavior from data in an equilibrium. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.

The appendix uncovers an interesting mistake in the classic Obstfeld and Rogoff (1983) attempt to prune inflationary equilibria, but also shows that reversion to a price level target can do the trick. The Techical Appendix has algebra for determinacy regions and solutions of the three-equation New-Keynesian model, as well as other issues.

This article supersedes the two papers titled "Inflation Determination with Taylor Rules: A Critical Review"and "Identification with Taylor Rules: A Critical Review" (September 2007).

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Quantitative Easing 2

March 3 2011 Comments on Jim Hamilton and Jing Wu, 2011, "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment", at the spring NBER Monetary Economics meeting. Slides. (The Op-ed section contains several op-eds and blog posts on qe2.)

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Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic.

European Economic Review 55 2-30 ScienceDirect Link.
Why there was a big recession; will we face inflation or deflation, can the Fed do anything about it? Many facets of the current situation and policy make sense if you ask about joint fiscal and monetary policy. A fiscal inflation will look much different than most people think.  Slides that go with the paper. Appendix with the algebra for government debt valuation equations. A short simple version, my presentation at the Fall NBER EFG conference. A video of a short presentation given to the University Alumni Club in New York, October 2010. Slides for the New York talk if you were there

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Fiscal Stimulus, RIP

Was “fiscal stimulus” the central idea that saved us from a second great depression, with our only regret that is was not bigger? Or is this an old fallacy, tried and failed, and ready finally for the ash-heap of history?

Let’s be clear what this issue is not about.  Governments should run deficits in recessions, and pay off the resulting debt in good times. Tax revenues fall temporarily in recessions. Governments should borrow (or dip into savings), to keep spending relatively steady. Moreover, many of the things government spends money on, like helping the unfortunate, naturally rise in recessions, justifying even larger deficits.  Recessions are also a good time to build needed infrastructure or engage in other good investments, properly funded by borrowing.  For all these reasons, it is good economics to see deficits in recessions – and surpluses in booms.

We can argue whether the overall level of spending is too high; whether particular kinds of recession-related spending are useful or not; whether particular infrastructure really is needed; and we certainly face a structural deficit problem. But those are not the issue either.

The stimulus question is whether, beyond all this, the government should intentionally borrow and spend, or even give money away, on the belief that each dollar so borrowed and spent will raise output by $1.50, and therefore lower unemployment. This, and only this, is the Keynesian “multiplier” argument, and the true meaning of “fiscal stimulus.”

Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work.  Spending supported by taxes pretty obviously won’t work:  If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off2. 

“Stimulus” supposes that if the government borrows $1 from A and gives it to B we get a fundamentally different result, and we all are $1.50 better off.

But here’s the catch: to borrow today, the government must raise taxes tomorrow to repay that debt. If we borrow $1 from A, but tell him his taxes will be $1 higher (with interest) tomorrow, he reduces spending exactly as if we had taxed him today! If we tell both A and B that C (“the rich”) will pay the taxes, C will spend $1 less today.

Worse, C will work less hard, hire a bunch of lawyers, lobby for loopholes, or move to Switzerland. A will hire a lobbyist to get more stimulus. All this is wasted effort, so we’re worse off than before! The question for the “multiplier” is not whether it is greater than one, it’s how on earth it can be greater than zero? (Conversely, so far my arguments for the ineffectiveness of spending apply equally to tax cuts. But tax cuts can cut rates, which improves incentives.)

These statements are a theorem not a theory. I’m explaining (in very simple terms) Robert Barro’s (1974) famous “Ricardian Equivalence” theorem. “Theorem” means that if a bunch of assumptions, then borrowing has exactly the same effect as taxing. That doesn’t mean it’s true of the world, but it means that if you want to defend stimulus, you have to tell us which of the “ifs” you disagree with. That discipline changes everything.

Thoughtful stimulus advocates respond. Well, maybe people don’t notice future taxes. Does the man or woman on the street really understand that more spending today means more taxes tomorrow?

That’s an interesting position, but at this point, most of the battle is lost. Stimulus is no longer an “always and everywhere” law, it’s at best a “if people don’t notice that deficits today mean taxes tomorrow” idea. This qualification has deep implications.

First, it means that a “stimulus” policy can only work by fooling people. Is wise policy really predicated on fooling people? Also, people are unlikely to be fooled over and over again. If that’s how stimulus works, you can’t use it too often.

Second, it means that stimulus will work sometimes and not other times. Are American voters right now really unaware that larger deficits mean higher future taxes? Or is the zeitgeist of the moment exactly the opposite: Americans are positively aghast at the future taxes they think they’ll be paying? If you think people can be “irrational” they can be irrational in both directions. They can pay too much attention to future taxes corresponding to current deficits, and stimulus can have a negative effect!  When I compare tea party rhetoric to the actual reforms needed to cure America’s deficits, I think there’s a good chance we’re in this range.

Third, if this is the reason that stimulus works, then the current policy attempt, consisting of  stimulus now, but strong promises to address the deficit in the future, can have no effect whatsoever. If you think stimulus works by fooling people to ignore future tax hikes or spending cuts, then loudly announcing such tax hikes and spending cuts must undermine stimulus!  Augustinian policy, “give me chastity, but not yet,” will not work. Casanova is needed.

Well, maybe some other Barro assumption is wrong. Yes, there are many. (“Liquidity constraints” are a common complaint, keeping people from acting based on their estimation of the future.) But if you take any of them seriously, the case for stimulus becomes similarly circumscribed. Each specifies a channel, a “friction,” something fundamentally wrong with the economy that matters some times more or less than others, that restricts what kinds of stimulus will work, and that can be independently checked.  And in many cases, these “frictions” that falsify Barro’s theorem suggest much better direct remedies, rather than exploitation by fiscal stimulus.

Relaxing Barro’s assumptions can also lead to negative multipliers. For example, Barro assumed perfectly-efficient “lump-sum” taxes. In fact, we have proportional taxes with lots of loopholes. In the real economy, raising tax rates is an inefficient process, as is spending money. Recognizing this fact leads to my guess of a negative multiplier.  

So the biggest impact of Barro’s theorem is not whether it is “right” or “wrong” as a description of the world. The biggest impact is that, if you are at all intellectually honest, it forces you to deal with why it is wrong.  Many proponents do not do this; they just cite one assumption they don’t like, on the basis of intuition rather than real evidence, and go back to simplistic always-and-everywhere mulitipliers.  

There is a deeper problem with stimulus. Even if nobody notices future taxes, A was going to do something with the money.  Suppose, for example, A was a small business owner, and he was going to buy a forklift3. The government borrows the money instead, and gives it to B who buys a car.  Now the composition of spending has changed towards more “consumption.” But does the economy really care if B buys a car rather than A buying a forklift?  Barro’s theorem gives conditions in which nothing changes, including the split between consumption and investment. But his real point is deeper: Borrowing does not alter the “intertemporal budget constraint,” society’s overall wealth.

These two stories capture the central logical errors of Keynesian economics, and central advance of “equilibrium” or “inetertemporal” thinking that destroyed it and revolutionized macroeconomics in the 1970s. Some other big names in this effort are Friedman (1957), Lucas (1975), with Sargent (1979), Kydland, Prescott (1982). They pointed out two big mistakes in Keynesian economics:

First, Keynesian economics treats each moment in time in isolation. People’s consumption depends on their current income, not their future prospects. Investment decisions depend on current sales and interest rates, not whether companies expect future sales to be any good.  Modern macroeconomics extends across time. It recognizes that what people expect of the future is central to how they behave now.   Now, maybe people don’t “perfectly” or “rationally” evaluate the future. But that’s a far cry from saying they don’t consider the future at all!  And budget constraints – the fact that debt today must be paid off – are independent of your feelings.

Second, the “plans” of Keynesian economics4 ; how much we suppose people want to consume, invest, etc.; don’t automatically add up to their income, unlike the “demands” of regular economics  that must do so.  Keynesian economics ignores budget realities at each moment in time as well as the “intertemporal budget constraint” emphasized by Barro.

For these and other reasons, Keynesian ISLM models have not been taught in any serious graduate school since at least 1980, except as interesting fallacies or history of thought. I include my own graduate education at very liberal Berkeley starting in 1979. Even sympathetic textbooks, like David Romer’s Advanced Macroeconomics, cannot bring themselves to integrate Keynesian thinking into modern macro.  The “new Keynesian” economics, epitomized by Mike Woodford’s Interest and Prices has nothing to do with standard Keynesian thinking5 . Not a single policy simulation from a Keynesian model has appeared in any respectable academic journal since 1980. Not one. The whole business was simply discredited as being logically incoherent 30 years ago.

Now stimulus advocates may say “all academia lost its mind in about 1975.”  Paul Krugman’s New York Times article pretty much took that view. Maybe so.  I think most of academic macroeconomics lost its mind about 1935 and only started to regain it in the 1960s, so it certainly can happen.   But the claim “all academic economics from the last 35 years is wrong” is a far different form of scientific advice to policy-makers than is “sensible well-understood and widely-accepted economics supports my view.”  

I will admit to a bit of disappointment that so many economists revert to archaic Keynesian fallacies when under pressure. I have seen far too many well-trained Chicago Ph.D.s, whose entire professional career consists of exquisite intertemporal equilibrium modeling, fall apart when asked to explain policy, say to a Fed governor. Suddenly output becomes the sum of consumption “demand”, investent “demand” and government “demand,” ignoring that there is a supply in each case, and demand for one thing must come a the expense of another. I have seen the same economists forget that high interest rates are as likely to be a symptom of good times (high marginal product of capital) as a cause of bad times. In this sense, modern economics has indeed failed – we have failed to train our graduate students to really understand, apply and use the tools of modern macroeconomics, and to explain that analysis to slightly older economists trained in the ISLM tradition. But that doesn’t mean that good policy results by reverting to theories that were proved logically incoherent in the 1970s. 

Can’t the facts settle this argument? Alas, not easily – and both policy and economics would be better if they acknowledged this fact.  Some stimulus skeptics say “well, unemployment hit 10% after your stimulus,” and cite CEA chair Christina Romer and Jared Bernstein’s (2009) unlucky forecast that unemployment would stay below 8% if the ARRA “stimulus” package were passed.  This is unfair.  Stimulus advocates counter “without us, unemployment would have hit 15%” (or 20%, or pick your number, these are all made up out of thin air.)  Alas, cause and effect are hard to tease out in economics, because so much else is going on.

Stimulus buffs point to World War II, when the US borrowed and spent a lot, and output boomed. But skeptics point out that “everything else” is hardly kept constant in the middle of the greatest war ever fought, with price controls, production controls, direct command of much of the economy, rationing and a draft.  War economies can produce a lot, for a short while, and that fact is not only due to deficit spending.  Countries like the USSR that try to permanently run war economies don’t do so well.   

Skeptics might point to the Great Depression and Japan’s lost decade, in which stimulus seemed not to do much. But here advocates can point to other things going on, and claim again that things would have been worse without stimulus.

I can’t think of a single example in which a country attained prosperity and sustained growth by large deficit-funded social programs, make-work programs, or salaries and pensions for government workers, which is the issue here and a better precedent than WWII.  European and Latin American sclerosis come more to mind in this context. If stimulus leads to “growth,” why is Greece not superbly rich?

I am also dubious about empirical work in the absence of theory. If you don’t know how stimulus can work, can you productively look for it?  Is this like empirical work on the existence of UFOs?  Seriously, the violations of Barro’s theorem that might make stimulus work at one time or place are surely different than those which make it work in another time or place. Surely empirical evaluation must tie to measurement of which of Barro’s assumptions one feels does not hold.  

But the bottom line is that empirical work is hard.  21st century Economics is a lot like 18th century  medicine. The patient gets sick. The doctors come in, and bleed him, give leeches, and awful “medicines.”  “The Humors [“demand”] are out of whack.” “What humors?” “Oh, shut up and go read Galen [Keynes].” The patient gets worse, “we didn’t do enough,” and they bleed him some more.  He gets better, “we saved him.” Or maybe it was the toast with the strange mold that did it? Telling cause from effect is really hard.

And when you really don’t know,  “the patient is sick, we have to do something” is not wise policy or medicine.

Stimulus has all the telltale signs of bad, crackpot ideas. Already, I’ve mentioned repudiation of literally all macroeconomics taught in every Ph.D. program since 1980. Here are some more  “Bad Science Detectors:”

1. Stimulus supporters never say how it will work, and just cite authority. Ok, there’s this Barro theorem that says stimulus can’t work. Which one of the assumptions did administration economists or popular advocates disagree with? Let’s check. Instead, they simply assert it will work not even mentioning the classic theorem to the contrary.

2. They don’t take their own ideas seriously. Here are some examples.

a) If you really believe Keynesian Stimulus, you think Bernie Medoff is a hero. Seriously. He took money from people who were saving it, and gave it to people who were going to consume it. In return he gave the savers worthless promises that look a lot like government debt.

b) If you really believe in Keynesian Stimulus, then you don’t care if the money is spent properly or simply stolen. In fact, it would be better if it were stolen: thieves have a notoriously high propensity to consume, and their “spending” doesn’t wait for environmental impact statements unlike the unfortunate “shovel-ready” projects.   Keynesian Stimulus believers should advocate leaving the money around with the doors open.

c) Keynesian stimulus has nothing to do with “creating” or “saving jobs” directly, “green” industrial policy, or “infrastructure.”  If they believe their model, they should say loudly that it doesn’t matter how the money is spent. (And even here, there seems to be a view that the electorate can’t divide. Even if you believe that $800 billion saved something like 2 million jobs, that’s $400,000 per job!)

d) Berstein and Romer’s CEA report on the stimulus famously used a multiplier of 1.5 to evaluate the effects of the stimulus. They took this multiplier from models (p.12). But the multiplier is baked in to these models as an assumption. They might as well have just said “we assume a multiplier of 1.5.”

More deeply, why use the multiplier from the model, and not the model itself? These “models” are after all, full-blown Keynesian models designed purposely for policy evaluation. They have been refined continuously for 40 years, and they epitomize the best that Keyesian thinking can do. So if you believe in Keynesian stimulus, why use the multiplier and not the model?

The answer, of course, is that they would have been laughed at – nobody has believed the policy predictions of large Keynesian models since Bob Lucas (1975) destroyed them.  But how is it that one multiplier from the model still is a valid answer to the “what if” question, when the whole model is ludicrously flawed? If you believe the Keynesian model, let’s see its full predictions. If you don’t believe it, why do you believe its multiplier?

3.  More “Bad Science” detectors. One should always distrust advocates that have one fix (“more stimulus”) for everything, like the proverbial two-year-old with a hammer to whom everything looks like a nail. It sounds a lot like the old patent-medicine salesmen: “Recession got you down? Take some fiscal stimulus. Oh, a banking crisis is causing problems? Why it’s fiscal stimulus you need, son! Sclerotic labor markets? No problem, some fiscal stimulus will perk you right up. Nasty trade dispute? Why old Dr. Paul’s fiscal stimulus will perk you right up! Foreclosures giving a you headache? Why fiscal stimulus will solve that any day.”

A modern economy is a lot more complex than a car, and the answer to car troubles is not always “more gas.” If you see a solution being advocated for every problem, you begin to wonder how serious is the analysis that it solves any problem.

4. Finally, the desperation of recent arguments Keynesian stimulus advocates is a good indication of empty ideas.

Krugman and DeLong are blogging the idea that there is no model under which fiscal stimulus does not work. Well, how about Barro (1974) ? How about Kydland and Prescott (1981)? How about Baxter and King (1993)? These certainly are models, and classic models to boot. They are logically coherent – the “then” follows from the “if” and all the budget constraints and equilibrium conditions are right. The “if” might not describe the real world, so they might be wrong models. But they are models, they exist. And they are hardly obscure. They have been on every first year Ph.D. reading list since 1980, even at Princeton and Berkeley. The hard part has been to find on graduate reading lists any model in which stimulus does work.

How can one digest Krugman and DeLong’s “no model” assertions in light of this fact? There are only two logical possibilities: a) They don’t know about these classic works. b) They are deliberately lying to slander their opponents and mislead their readers.  As far as the strength of their argument, it does not really matter much which it is.

Similarly, Krugman now writes in his New York Times column that stimulus “wasn’t tried.” After $1.5 billion of deficit per year with $800 labeled “stimulus,” this claim is simply breathtaking. ($1.5 trillion: In the Keynesian model, all deficits count, not just the parts labeled “stimulus.”) It is obviously a feeble attempt to evade the overwhelming judgment of history that it was tried, in spades, threatening a second sovereign default crisis, and came up short.

5.  Most of all, you can tell a bad idea when you can tell the economics is cooked up after the fact to serve a political agenda.  A politician wants to spend a lot of money. “Hey economist, give me some talking points.”  “Sure,” says the economist, “we’ll defend it as fiscal stimulus.” That’s the only view that makes sense to me of the above inconsistencies, and it explains why this old idea is still bandied around in policy circles.

I am here to save good economic ideas, not to argue an alternative political agenda. Maybe it is a good idea to borrow, hire people, (in US, mostly state and local government workers), start a “green” industrial policy, give lump-sum or temporary tax rebates, and so on. I don’t think so, but we can have a good argument.  Just don’t justify it by “stimulus,” the proposition that each dollar so borrowed and spent makes us all $1.50 better off!  Doing so debases economics’ genuine ability to analyze policy and give us a credible menu of cause-and-effect statements! 

Keynes famously said, “Practical men… are usually the slaves of some defunct economist.” He was right (for once). Now he is the defunct economist. But we need not be his slaves!

References

Barro, Robert J. 1974,. "Are Government Bonds Net Wealth?" Journal of Political Economy 82 (6): 1095–1117.

Barro, Robert J. , 1981, “Output Effects of Government Purchases,” Journal of Political
Economy, 89: 1115.

Baxter, Marianne and Robert G. King, 1993,  “Fiscal policy in general equilibrium,” The American Economic Review, 83: 315-334.

Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo, 2009, “When is the Government Spending Multiplier Large?” Manuscript, Northwestern University

Friedman, Milton, 1957, A Theory of the Consumption Function Princeton: Princeton University Press

Lucas, Robert E. Jr. 1975, “Econometric Policy Evaluation: A Critique,” in K. Brunner and A. Meltzer, eds., The Phillips Curve and Labor Markets, North-Holland.

Lucas, Robert E. Jr, and Thomas J. Sargent, 1979 "After Keynesian Macroeconometrics"  in After the Phillips Curve, Federal Reserve Bank of Boston, Conference Series No. 19: 49-72; reprinted in
the Federal Reserve Bank of Minneapolis Quarterly Review 3 (1979): 1-6

Kydland, Finn and Prescott, Edward C. (1982). “Time to Build and Aggregate Fluctuations” Econometrica  50 (6): 1345–1370.

Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, Janua

Footnotes

1 John H. Cochrane is a professor of Finance at the University of Chicago Booth School of Business http://faculty.chicagobooth.edu/john.cochrane/research/Papers/

2 Yes, I’m aware that old Keynesian models do give a multiplier to tax financed spending. Also, some new Keynesian models such as Christiano, Eichenbaum and Rebelo (2009) predict huge government spending multipliers whether financed by taxes or by borrowing. However, tax-financed spending is usually thought to have a weaker (if any) effect, which is why the current policy debate is only about borrowing to spend.

3 Advocates will go nuts here, and complain that A might be putting money in the bank, and “banks aren’t lending,” or stuffing the money in mattresses. As you can tell, this line of argument leads us into “something’s wrong” with the banking system, and confusion between fiscal and monetary policy.

4 I take the “plans” language from Greg Mankiw’s textbook “Macroeconomics.” 

5 Explaining “new-Keynesian” economics is too big a task for this essay. My paper “Determinacy and Identification with Taylor Rules” and its references are the best place I can recommend for this question. 

Nova/Atrium Lecture in Macro/Finance (Video)

(Also web page on the event) Lecture given at NOVA school of business and economics in Lisbon, Portugal, 2010. Thinking through fiscal and monetary policy, along the lines later written up in Inflation and Debt and Understanding fiscal and monetary policy in the great recession.

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The Squam Lake Report: Fixing the Financial System

Princeton: Princeton University Press 2010. With Kenneth R. French, Martin N. Baily, John Y. Campbell, Douglas W. Diamond, Darrell Duffie, Anil K. Kashyap, Frederic S. Mishkin, Raghuram G. Rajan, David S. Scharfstein, Robert J. Shiller, Hyun Song Shin, Matthew J. Slaughter, Jeremy C. Stein, and Rene M. Stultz

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Lessons from the financial crisis

Jan 2010 Regulation 32(4), 34-37. The financial crisis is mainly about too big to fail expectations. The only way out is to limit the government’s authority to bail out.   

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Can Learnability Save New-Keynesian Models?

Journal of Monetary Economics 56 (2009) 1109–1113.  JME link .This is a response to Bennett McCallum’s “is the New-Keynesian Analysis Critically Flawed” which says yes. I think McCallum got it backwards -- the bounded equilibrium is not learnable, the explosive ones are learnable. Furthermore, I’m not convinced that a hypothetical threat by the Fed to take us to an “unlearnable” equilibrium is a satisfactory foundation for price level determination.

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Health-Status Insurance

Feb. 18 2009. In Cato's Policy Analysis No 633. If you get sick and lose health insurance you are stuck -- your premiums skyrocket or you may not be able to get insurance at all. The article shows how private markets can solve this problem. If you get sick, your health premiums go up but a separate "premium increase insurance contract" pays a lump sum so that you can afford the higher health premiums. The big advantage is freedom and competition: now health insurance can freely compete for all customers all the time. This piece is written for a nontechnical popular audience, with a lot of policy discussion. This paper explains the basic framework of Time-Consistent Health Insurance (next) and thinks through lots of real-world issues and answers to "what ifs." "What to do about pre-existing conditions" in the Wall Street Journal August 14 2009 and Health Status insurance Investors Business Daily (local link)  April 2 2009 are op-eds explaining the basic idea.

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The monster returns

Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the Government. But this plan is fundamentally flawed.  It won’t even work, leaving aside its horrendous cost and long-lasting damage to the financial system. Every argument for it appeals at some point to magic. Buy a few mortgages and magically the value of all of them will rise. Spend $700 billion to "do something," without stating how that action will help, and by magic "confidence" will be restored. The additions and sweeteners in the Senate version, and those on the table in the house, are counterproductive, horrendously expensive, or a comical pinata. Counterproductive: protecting homeowners and renters may or may not be a good policy idea, but if you don't make people pay back mortgages, the value of those mortgages falls even further. Horrendously expensive: The bill mandates that purchases be made to preserve tha value of retirement accounts. The uncertainty that this bill introduces is already making matters worse.

A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short – term credit markets. These are not new and untested ideas; these are the tools that governments have used for a hundred years to get through financial turmoil.  However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes. Since the bailout plan won't work, we will be back to these steps eventually. We might as well start now.

The problem

The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose value has fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent.  Credit market problems are a symptom of this underlying problem.  Nobody knows really which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.

A “credit crunch” is the danger for the economy from this situation. Banks need capital to operate.  In order to borrow another dollar and make a new loan, a bank needs an extra (say) 10 cents of its own money (capital), so that if the loan declines in value by 10 cents the bank can still pay back the dollar it borrowed.  If a bank doesn’t have enough capital – because declines in asset values wiped out the 10 cents from the last loan -- it can’t make new loans, even to credit-worthy customers.  If all banks are in this position (a much less likely event) we have a “credit crunch.”   People want to save and earn interest; other people want to borrow to finance houses and businesses, but the banking system is not able to do its match-maker job. 

Solving the problem

Ok, if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real business can borrow money again and start lending it out.  The core of any plan must be to recapitalize the banking system. How?

Issue stock, either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffet last week, or by merging or selling the whole company.  There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock, because it seems to “dilute” current stockholders, and might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so.  In many previous “bailouts” the Government has added small (relative to $700 billion!) sweeteners to get deals like this to work.

Let banks fail, in an orderly fashion.  When a bank “fails,” we do not leave a huge crater in the ground.  The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual.  A new sign goes on the window, new capital comes in the back door, and new loans go out the front door.  Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back.  They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system.  They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.

We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days.  At the end of the week, JP Morgan took over Washington Mutual.   Depositors and loan customers didn’t even notice. As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.

This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging.  Until that gets fixed, we have to muddle through.  An important long-run  project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.”  But not now.

What is simple to describe economically –wipe out shareholders, write-down debt, marry the operations to new capital – is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.

Fancy ideas.  The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps, and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes. See http://research.chicagogsb.edu/igm/.)

The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But  banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks.  (And the “other banks” are still there with excess deposits.)   If the Fed is worried about commercial paper rates, it can support those.

The one good part of the current proposals is a temporary extension of federal deposit insurance.  The last thing we need is panicky individuals rushing needlessly to ATM machines.

By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, leading quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for Government to smooth failures.  In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.   

Banks vs. the Banking system

Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.

I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys.  If one bank failed in the 1930s, a big out of state bank could not come in and take it over.   Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock.  If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers.  JP Morgan could not have taken over WaMu.  But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.

There is a temptation for regulators and  government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up. 

The Treasury Plan

The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury  buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again.   To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We  bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed  instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs.

There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging. Someone has a great idea: let’s blow up the dam and drain the lake! Ok, it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.

Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents.  If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.

There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;”  the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience.  Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.

Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring.  No, we need more transparency, not less.

Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.”  That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse.  Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise. 

Yes, we need to do something. But “doing something” that will not work, with potentially dire consequences, is not the right course, especially when sensible and well-understood options remain.

State-Space vs. VAR models for Stock Returns

Manuscript July 24 2008. In a “state-space” model, you write a process for expected returns and another one for expected dividend growth, and then you find prices (dividend yields) and returns by present value relations. I connect state-space models with VAR models for expected returns. What are the VAR or return-forecast-regression implications of a state-space model? What state-space model does a VAR imply? I start optimistic. An AR(1) state-space model gives a nice return-forecasting formula, in which you use both the dividend yield and a moving average of past returns to forecast future returns. The general formulas leave me pessimistic however. One can write any VAR in state-space form, and we don’t really have solid economic reasons to restrict either VAR or state-space representations. Still, the connections between the two representations are worth exploring, and if you’re doing that this paper might save you weeks of algebra.

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Two Trees

(with Francis Longstaff and Pedro Santa-Clara), Review of Financial Studies 21 (1) 2008 347-385. We solve the model with two Lucas trees, iid dividends and log utility. Surprise: it has interesting dynamics. If one stock goes up it is a larger share of the market. Its expected return must rise so that people are willing to hold it despite its now larger share. Typo: Equation 39 (page 363), the numerator should read (1-s/(1-s))ln(s)/V, not 1-s/(1-s)ln(s)/V. Thanks to Egor Malkov.

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Bond Supply and Excess Bond Returns

May 2008. Comments on Robin Greenwood and Dimitri Vayanos’ paper for the IGM “Beyond Liquidity ” conference at the GSB Gleacher center, May 9-10 2008. The paper from Dimitri’s website . I learned two important lessons in reading and thinking about this paper. 1) When arbitrageurs are limited by risk-bearing capacity, “downward-sloping” demands depend on correlations. The paper and my comments have a lovely example in which arbitrageurs are asked to hold more long-term bonds and less short-term bonds. The result is that all yields go up! Why don’t long yields go up and short yields go down? Because risks are described by a one-factor model, so all that matters is how much overall duration risk arbitrageurs have to hold.  2) We’re probably doing a bad job of correcting for serial correlation in all predictive regressions. Typically, we think expected returns move slowly over time. The right hand variable also moves slowly over time, but doesn’t capture all of the expected return variation. This situation means that residuals have a slow-moving AR(1) plus an unforecastable component, which is the same thing as an ARMA(1,1).  This structure will be very poorly captured by standard “nonparametric” procedures such as Newey-West, since you’re unlikely to put in enough lags to capture the long-run component, and also poorly captured by parametric procedures like fitting an AR(1). “Short” samples make the problem worse. More in the comments. 

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Risks and Regimes in the Bond Market

April 2008. Comments on Atkeson and Kehoe’s paper for the 2008 Macroeconomics Annual. Risk premia are important for understanding interest rates, and monetary policy. I see no evidence for “anchored expectations” in interest rate data. Once you take account of risk premiums, expected long run interest rates are still very volatile. The yield curve has not become more downward sloping on average, as it should if inflation risks have decreased. If anything, risk premia in long-term bonds are increasing. Atkeson and Kehoe advocate a fascinating view that risk premia cause monetary policy, not vice versa.

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Decomposing the Yield Curve

Manuscript, first big revision, March 14 2008. With Monika Piazzesi. We work out an affine term structure model that incorporates our bond risk premia from “Bond Risk Premia” in the AER. There are lots of interesting dynamics – level, slope and curvature forecast future bond risk premia, and we discover that market prices of risk are really simple. We use the model to decompose the yield curve – given a yield (forward) curve today, how much is expected future interest rates, and how much is risk premium? How does the yield or forward rate premium correspond to the term structure of expected return premia? Was the conundrum a conundrum? Slides from 2010 AFA meetings Data and Programs.

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Financial markets and the Real Economy

In Rajnish Mehra, Ed. Handbook of the Equity Premium Elsevier 2007, 237-325. Everything you wanted to know, but didn’t have time to read, about equity premium, consumption-based models, investment-based models, general equilibrium in asset pricing, labor income and idiosyncratic risk. 

This article appeared four times, getting better each time. (Why waste a good article by only publishing it once?) The link above is the last and the best. The previous versions were NBER Working paper 11193,  Financial Markets and the Real Economy Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006, and in Foundations and Trends in Finance 1, 1-101, 2005.

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What ends recessions?

By David and Christina Romer, 1994 NBER Macroeconomics Annual 58-74. JSTOR What are monetary policy shocks? The fed never says “and another 50 bp for the heck of it.” This led to “What do the VARs mean?”

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Daily Monetary Policy Shocks and the Delayed Response of New Home Sales

By James D. Hamilton. April 2007  Comments given at NBER Monetary Economics program meeting, NY. Includes some new thoughts on what a monetary policy shock is.

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Portfolio theory

Feb. 20 2007 This is a draft of a portfolio theory chapter for the next revision of Asset Pricing. I (of course) take a p = E(mx) approach to portfolio theory before covering the classic Merton-style direct approach. I emphasize the importance of outside income.

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“The Returns to Currency Speculation”

by Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski and Sergio Rebelo. Comments given at Jan 2007 AEA/AFA meetings. (Slides only)

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