Breaking Windows.

The broken widow debate is raging once more through the blogosphere Dan Kuehen points us to Robert Fellner who offers in Dan Kuehen words "Higgs's critique of government spending". its reminded me of why the Higgs critique doesn't hold much water. Also, while I'm exercising some pet peeves about the Higgsian conception of GDP I would like to discuss some nuances of the Broken Window/Alien Invasion/WWII debate.

I've spent a lot of time with Higgs's thinking about GDP.  Much of his argument centers around an argument of authority invoking Simon Kuznets.  The problem is that Kuznets never really figured out how to deal with government in GDP accounting becuase it was developed before WWII and the rise of the "welfare state" proper.  In Kuznet's conception GDP was a kind of welfare accounting and that goods and services were categorized in terms whether they were welfare inducing now (C) or welfare inducing later (I).  However, some goods defied this simple categorization, in particular munitions   The issue was how do you characterize something like munitions?  If it is not welfare enhancing today or tomorrow, the argument runs, then they must be intermediate goods and thus not part of GDP*.  But of course you now run into the problem that you are arbitrarily assigning goods as intermediate and final goods based on whether you think they are welfare enhancing or not.  The solution to the problem is to adopt the approach the BEA eventually did, which is simply trace the production process of goods to their "end purchaser" and call those final goods.  However, this means that GDP is not a measure of welfare, it is an accounting identity.

Now, to the extent that one is tempted to use NIPA as a proxy for welfare the Higgsian view should be criticized because it ignores the flip side of national product: national income.  If the government pays someone to fix a broken window or dig a trench, that person's welfare has been increased regardless of whether he has produced anything strictly welfare enhancing for someone else (I'll come back to the net effect in a second).

The second prong in the Higgsian critique is that government purchases do not take place at market prices.

Here I'll let Robert Fellner explain it:

To see why, we first have to understand why spending at all can be considered a measure of wealth. Upon reflecting on this matter, we realize it has to do with prices (specifically market prices) and the information that they convey. Whereas one finds his lot improved by the purchase of 5 wheelbarrows at the market price of 10 dollars a wheelbarrow, we can conclude the individual, and thus the economy as a whole, is wealthier to the tune of the utility that 50 dollars in spending has granted him, specifically the subjective value of the additional 5 wheelbarrows. Moreover the spending of 50 dollars represents the creation of these 5 wheelbarrows and of course the additional utility they grant, hence why they were purchased. This is the key. Wealth is not measured simply by the dollar amount of spending. Wealth comes from the goods and services provided in exchange for money. This is why spending matters and is accurate as an indicator of wealth. If any part of this process is diluted, the quality of spending as an accurate indicator of wealth diminishes greatly. 

So why does consumer spending work well in this regard, where government spending fails? The answer lies in the prices. In a free market, all participants are subject to the profit and loss test. Namely, if one consistently spends more than he earns, he eventually becomes bankrupt and removed from the market altogether. In order to prevent this "death by free-market" one must learn to generate a profit; which is done by allocating resources efficiently. As all market participants engage with one another in this task, prices emerge for all the various goods and services within the economy that reflect their valuation to the economy as a whole (the price of course being derived both from the subjective valuation of the good as measured against the scarcity of the good, put more simply: supply versus demand).

This ignores three basic things.  First, it ignores the work of Alfred Chandler (And J.K. Galbraith, btw) who has in great detail explained how large firms in certain industries vertically and horizontally integrate specifically  to avoid having their production process (and prices) dictated by "the market" but rather prices are determined by negotiations between divisions of the firm.  In similar fashion, the government does not simply dictate prices but rather negotiates them with firms (when they have some degree of monopsony power at least).  Is negotiation really a less efficient means of price discovery than anonymous markets?  Are anonymous markets really the dominant free market structure anyway?  I'm less inclined to assume no to both of the questions than an Austrian is.  Anyway, I'm not denying gold plating but I am suggesting that the price the government pays is not a priori less arbitrary than the price early adopters pay for an Iphone (to illustrate this from a different angle).  


That may have been a clumsy segue but there is a more fundamental problem with the idea that "market prices" capture welfare better than government prices.  Even assuming all C and I are allocated by perfectly competitive markets competitive prices only capture the exact utility produced by the good for the last (marginal) buyer.  Everyone else in the market is accruing either a consumer surplus or a producer surplus.  To capture that involves a whole series of arbitrary assumptions that are impossible to make and best avoided taking NIPA for what it is.


Again, though, if we look at income it may be easier to make welfare statements.  If the government buys a loaf of bread from the baker it seems easier to make welfare statements (though I still advise against it even if I am as prone to do it as everyone else).  The baker's welfare is unambiguously higher if the government (or anyone) pays $100 for his loaf of bread instead of $1.  Unlike the troubles you run into with trying to make wealth/utility statements about who purchases what for who and why we can make a relatively uncontroversial statement that more income is better.


Okay, so now on to net effects.  There are definitely certain conditions under which the broken window falacy is wrong. The increase in GDP from fixing a broken window from one of the many curiosities of NIPA accounting that, again, underscore why you shouldn't act like GDP literally means total wealth, utility or welfare.  If I grow my own wheat and bake my own bread it doesn't count as GDP but if I buy it from the baker it does despite the fact that the same "utility" or wealth is created when I make my own bread (ignoring issues of scale efficencies***).  Likewise, fixing a broken window shows up as GDP even though I as an individual would be better off if the market transaction never happened and I spend my broken window money on components of GDP I  actually want to spend them on.


However, if the government borrows money to fix my window there are conditions (that aren't that ridiculous to meet and where the WWII example is instructive) where there can a net increase in GDP as income as welfare.  The relevant variable here is the Debt to GDP ratio (not the absolute level of debt, so take your Ricardain equivalence somewhere else) which allows the broken widow theory to work because there is no full redistribution through taxes.  The government can borrow today, give me the money to fix my window and then sit on the debt for as long as it needs to and let the burden of that debt shrink (under certain growth/interest rate conditions) away as nominal GDP growth increases, paying only the cost to service the debt as it shrinks.  This spending, by the way, also increases nominal GDP grow at the point in time that I pay for my new window assuming no crowding out it will directly off set itself and there will be no increase in Debt/GDP.  You can also tell a story where this could happen through the private sector provided as favorable borrowing terms as (or the ability to set interest rates like) the government.  However, one should be reminded that the likes of Paul Krugman only advocate the building of FEMA death camps when the  market has failed to produce full employment.  In which case the government is also making savers better off because it is giving individuals something to hold  that pays at least some kind of risk adjusted return in olight of a lack of investment.  Individual svaes can be made better off even though on aggregate the whole point is to finance today with something that will be insignificant tomorrow. 


Now, we can debate whether the relevant variables that determine the shrinking of the debt hold or that the inflationary bias is too much, or the size of the multiplier but the basic principle stands.


*For the uninitiated:  GDP is the purchase of newly produced final goods and services.  This is distinct from intermediate goods which are inputs into the production of final goods and services.  The reason for this distinction is becuase final goods and services already contain all the costs of the inputs (and factors of production**) that went into making them.  We use final goods and services as a measure of output becuase final goods and services contain the value of everything that goes into making them and so we get a full measure of the "output" of the economy.

**A "factor of production" is something that does not get "used up" in the production of a good.  This is distinct from an "input" which does get used up.  For instance when a baker bakes a loaf of bread the wheat he uses is an input but his labor (and the oven, his capital) do not get used up are factors of production.  The price of a loaf of bread (a final good if I buy it) contains in it the cost of the wheat, the cost of the bakers labor, the interest he has to pay on the oven he bought with a loan and the profit the baker gets from owning the bakery (all payments to the factors of production).

.*** Presumably though scale inefficiencies are irreverent from a utility point of view since I must be on net gaining at least some utility from going through the trouble to bake my own bread (assuming I have the income to do it)  instead of just buying it.

On the Asymmetric Response to Inflation Data.

Headline CPI has fallen by .2%. OMG!  Its the Great Depression all over again! Sell all your gold!  The Fed needs to print more money!

I expect to hear from John Cochrane today that we should raise taxes to avoid the clearly inevitable deflationary spiral about to grip the nation.

Noahpinion: The Libertarians and their classical theory of the business cycle

Noah Smith likes Arnold Klings "PSST".

Thiis is apparently an old post by Smith, but it's something I've been thinking about a lot lately too.  Like Noah, I too am looking for some new way of thinking about economics.  Begrudgingly, I have to admit I kind of like PSST, though its more the intellectual tradition that the gentlemen over at EconLib.org appeal to that I have an affection for, not the need to find a way to insist that nature should be left to take it's course.

The reason I find PSST oddly appealing is because it is an attempt to revive a branch of economics that has been completely ignored by the dominant paradigm and even by many on the left side of the heterodox spectrum.  The basic theory underpinning PSST--Ricardian comparative advantage--used to be the basis for a much wider discourse before it was forced into the ghetto of international trade theory.  Murry Milgate draws a distinction that may not be well articulated among economists today:

...[I]n order to isolate Keynes's point of departure from orthodoxy, we will need to know from which economic theories the conventional wisdom was derived.  As is well-known, Keynes did not help to clarify matters by grouping together under one heading "The Classical Economists", not only Ricardo, but also Marshall,. Edgeworth and Pigou (J.M.K. vol. VII. p. 3, n. I).[1]

Milgate goes on to draw a distinction between the "Classical Economists": Smith, Mathus, Ricardo and Marx and the "Marginalist" or neo-classical economics of Marshall , Walras and Pigou.  The modern economist--of course--worships at the alter of the marginalists.  Kling, who's denomination is prone to apostatize for the wrong reasons has touched a nerve for all of us who sit in the back pews.

Kling may be looking in the right place, but his world view dooms him to find the wrong answer.  He wants PSST and comparative advantage to save the free market.  The simple trade theory microeconomics of it dictate that everyone does what they are most efficient at doing and so there is no need to interfere.  The intellectual tradition of Ricardo is not so one dimensional.  The textbook model of comparative advantage is one that only has labor and a very simple, inert, returnless technology.  Once you add profits to the classical model things get a little less... natural.  Underlying the relations of capital and labor in the classical theory is a political economy.  Unlike the Marginalists' idea that labor and capital get paid their market determined marginal products for the classical theorists power relationships determine the rate of profit and the wage rate.  Notwithstanding the "natural" floor to the wage rate: Malthusian subsistence.  Milgate quotes an Adam Smith Kling has probably never heard of: "though in disputes [over wages] with their workmen, masters must generally have the advantage, there is however a certain rate below which it seems impossible to reduce for any considerable time, the ordinary wage of the lowest species of labour."[2]

Oh man, now we are nowhere near where Professor Kling wants to be, now we are in Marxian territory.  Marx comes out of the classical tradition and his theory of the business cycle in many ways is an attempt to fill in the distributional theory left by the earlier classicals.  Marx takes for granted that there is no wiggle room in which workers and capital can share in the surplus but rather offers a law of pure subsistence wages ground in power relationships not Malthusian population swings.

The classical theory of capital also does not anchor capital in its marginal product or in a long term full employment.  Employment is determined by the stock of capital but there is no mechanism that guarantees the full utilization of the capital stock will mean full employment.  Murry Milgate's book, which I have quoted heavily from is actually part of a strain of intellectual inquiry that has tried to ground Keynes' insights in a tradition other than the Marginalist school, whose market mechanisms cannot abide by a truly Keynesian longterm under-employment.  It is an intellectual movement touched off by Joan Robinson's simple challenge to the Marginalists of her generation to actually define what capital, the return to capital and the production function actually are.  A question to which Samuelson et al could not come up with a satisfactory answer.

I'm way ahead of myself here.  This is something I have only begun to explore myself.  This being a more complex issue than just appealing to an undergraduate sense of comparative advantage I fully admit this will take some time to sort out.  So let me slow down and propose a book club:

Robinson, Joan. The Production Function and the Theory of Capital. Review of Economic Studies Vol 21(2) 1953-1954

Walsh, Vivian and Harvey Gram Classical and Neoclassical Theories of General Equilibrium Oxford University Press, Oxford. 1980.

Sraffa. Piero. Production of Commodities by Means of Commodities. Cambridge University Press, Cambridge, 1960.

I'm calling it a book club because I have not fully digested these books though I do see the challenge to the marginalist orthodoxy which I feel has reached its natural conclusion in General Equilibrium models in which there is not even a difference between the long run and the short run.  I don't think a return to the classicals is a panacea or should replace marginalist thinking entirely  but I do think it is a legitimate way of looking at the economics we have all been taught from the outside.  As well, while most economists seem to find indeterminacy terrifying I think the lack of a clear theory of distribution of income is kind of attractive in a post industrial world where labor does not share in productivity gains.

The Blogosphere is faster than I am.


So there are a couple of things I want to address.  First, what modeling PSST means.


Arnold Kling:

Instead, I think that the right tools to use for macro are the two-country, two-good models of international trade. The "two countries" could be two sectors within an economy. The agricultural sector and the urban sector. The housing sector and the non-housing sector. And, of course, there are many more than two sectors. But just talking about two sectors is a big improvement over the GDP factory.

The problem here is that the two good two country model is absolutely not the right model for macro.  I mean, if you want to enshrine an uber efficiency of markets then yeah two goods/two countries will work.  Ignoring the question of what two goods and what two sectors, there is an additional sleight of hand here because if you try to model say three goods and three countries with Ricardian comparative advantage you get inefficient outcomes [3]  though you can get around this problem to a degree by proposing an infinite continuum of goods [4].  This actually brings me to my next point.  I disagree with Noah (and agree with Brad Delong--sort of--on this point) that you need an overly complex model to make this work.  You can probably model fairly effectively with an infinite amount of "i"s and "j"s.  Alternatively, a comparative advantage theory is not mutually exclusive with, say, sectors that produce C, G, I and EX.  Actually, come to think of it, I would be fine with a two sector comparative advantage model if Kling would concede gains from trade between a government sector and a not-government sector.

Anyway, I want to stress that I'm not overly concerned with reasserting a supply side theory of the business cycle.  The appeal of this classical line of thinking to me is that it gives us a different way of thinking about the distribution of output between capital and labor.  As well, it is an alternative way of thinking about the dynamics of investment spending beyond it being a passive response to interest rates.  And, the more modern direction of classical economics has been in the direction of trying to justify Keynes without the need for sticky wages and an inevitable return to a long run.

One more thing about Brad Delong's dismissal of PSST (which I largely agree with) in which he lumps in Marx and Hayek as liquidationists.  He also does this in his excellent Seven Sects of Macroeconomic Error  which is required reading now for my Macro 101 students.  While I appreciate the rhetorical genius of it I feel like it obscures the important difference between the two.  While both Marx and Hayek do assume that liquidation is inevitable, Hayek thinks it is desirable while Marx does not.  For Hayek, the divine hand of the market will solve its own problems.  Marx--in the classical tradition--recognizes that the solution to the problems of the market are political.  Delong is right to point out essentially Marx goes too far in assuming there is no political solutions[5] besides revolution but it is still an important fundamental difference in the "models" of the two economists.

[1] Milgate, Murry (1982) Capital and Employment Academic Press, New York  p36
[2] Milgate p37
[3]  McKenzie, Lionel W (1954). Specialization and Efficiency in the World Production, Review of Economic Studies, 21(3)
[4]Dornbusch, R., S. Fischer, and P. A. Samuelson (1977).  Comparative Advantage, Trade, Payments in a Ricardian Model with a Continuum of Goods, American Economic Review, 67(5)
[5] Since I'm doing footnotes anyway,  here I'm thinking of the work of Acemoglu and Robinson who have a great "Marxian" model in which you don't have a revolution or even much political disruption before "the bosses" make concessions : Acemoglu, Daron and James A. Robinson (2000) Why Did the West  Extend the Franchise?  Democracy, Inequality and Growth in Historical Perspective, The Quarterly Journal of Economics 115(4).

How Long Did the Housing Bubble Go On For?

Brad DeLong posts this on his blog: 

Over the four-year period 2003-2006, annual construction spending rose to a level $150 billion above and then fell back to its long-run trend. Thus by the start of 2007 United States was overbuilt: about $300 billion had been spent building buildings in excess of the long-run trend.

When this construction was undertaken these buildings were expected to more than pay their way. But the profitability of these buildings depended on two shaky foundations: a permanent fall in long-term risky real interest rates, and permanent optimism about real estate as an asset class. Both these foundations collapsed.

By 2007, therefore, it would have been reasonable to expect that construction spending in United States would be depressed for some time to come. Since construction spending had run a cumulative amount of $300 billion ahead of trend, it would have to run $300 billion behind trend over a number of years in order to get back into balance. So everybody in 2007 was expecting a slowdown to be led by construction. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years.

And starting in 2007 construction spending did indeed fall below trend. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years. Instead, it fell $300 billion a year below trend. And it has so far stayed down for four years. And there is no prospect of rapid return to anything like normal levels.

Therefore when this construction cycle will have run its course, the United States will have first have spent an excess $300 billion, and then fallen short of trend by a cumulative $2 trillion of construction spending not undertaken. The net effect will be an at least $1.7 trillion construction shortfall in the United States: $1.7 trillion of houses, apartment buildings, offices, and stores not built.

He's basically describing this graph:

I don't know if I necessarily disagree with Professor DeLong, but I am curious about his trendline decision.  He justifies it here:

Now let me briefly turn to construction. We expected a construction slump after the mid-2000s boom. Take construction spending in the United States as it stood back in 2001--when nobody thought we were overbuilding or overbuilt--and project it forward at the 3% growth rate of the American economy. We should probably project the construction trend at a slightly higher rate than that, because as people grow richer they do want to spend a greater share of their larger incomes on housing in a way that they don't for, say, food.

I'm not totally convinced by this.  Post financial crisis "nobody thought" isn't very solid ground.  So I looked at the longer annual real residential investment series:

 I see basically three separate periods here.  69-81 looks like 2 business cycle driven very volatile periods with a little growth.  After the 82 trough the expansion seems sustained a little longer and the fall off doesn't seem so steep.  The red portion, which somewhat arbitrarily begins in 1992 is the beginning of an virtually uninterrupted climb in residential housing (even during the 2001 recession) that eventually became what everybody agrees was the housing bubble of the mid-2000s in which residential investment stays above the trend of the previous years until the collapse in 2006/7.


That chart reminds me of this chart:

Bubble run ups usually have a long period of above trend growth before you hit the "mania phase".  In the case of housing, that's still above trend investment and is part of the overbuilding that still needs to be "corrected".  


I think the case that the bubble had been a long time coming can be made.  For instance, if we take 2003-2006 as the mania phase then it makes sense that this is the period where subprime mortgages arise.  There are two stories people tell about subprime.  The first is "chasing yield" story.  That is, banks were lending to risky borrowers they said were safe but still paid high interest rates.  The other story is that subprime was the last place to go because all the good borrowers had already taken out mortgages and refinanced etc.  To the extent that the second story is true, how long did it take to make it all the way through the credit worthy borrowers?  Did mortgage lenders become instantaneously aggressive in 2003 or was there a slow push of the supply curve of mortgages out further and further?


This brings me to the next argument in favor of my new pet theory.  I'm a big subscriber to the "giant pool of money" theory of the housing bubble.  However, I tend to date the capital inflow bonanza from the Asian Crisis of 1997. In the late 90s there was a sudden shift from capital flow "excess" into government deficits to "private deficits" (Private Savings - Investment < 0).  Meanwhile, the current account balance continued it's historic decline.  The dot com bubble, of course, is what everyone thought about and thinks about but a stock market bubble is not mutually exclusive with a housing bubble's infancy.


So whats the point?  Well, I want to go back to Professor DeLong's idea that housing was only over built by $300billion and that we are "missing" $1.7trillion in residential investment that will eventually come roaring back.  The increase in prices above the my trendline if measured from 1992 adds another $1.4trillion dollars to the overbuilding total.  So if we think of the housing bubble as a generational phenomenon and not just a couple of years we had over $1.7 trillion in excess housing being built.  The "correction" so far according to the 67-92 tread line is also much shallower, only about $425 billion.  Suggesting we still have a long way to go before we come out even on residential housing.

Brad DeLong points us to Dan Kuehn who points us to DARPA

Brad DeLong:

Dan Kuehn points us to DARPA:

Facts & other stubborn things: The Defense Advanced Research Projects Agency (DARPA) has initiated a study to inspire the first steps in the next era of space exploration—a journey between the stars. Neither the vagaries of the modern fiscal cycle, nor net-present-value calculations over reasonably foreseeable futures, have lent themselves to the kinds of century-long patronage and persistence needed to definitively transform mankind into a space-faring species.... We are seeking ideas for an organization, business model and approach appropriate for a self-sustaining investment vehicle. The respondent must focus on flexible yet robust mechanisms by which an endowment can be created and sustained, wholly devoid of government subsidy or control, and by which worthwhile undertakings—in the sciences, engineering, humanities, or the arts—may be awarded in pursuit of the vision of interstellar flight...

I kinda think this problem has already been solved: all you need to do is draw the corporate charter to insulate the corporation's decisions from speculative short-termism, and you are there.

I disagree with  Prof. DeLong, I dont think it can be solved (Kuehn seems to agree with me).  Here is Keynes (General Theory; Ch12) on why the problem is deeper than corporate structure:

 Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun.

It is particularly heart breaking--though not unsurprising--that this is the direction DARPA is so explicitly moving in.  It was the public/private/academic long term goal oriented partnerships fostered by DARPA that... well... gave us virtually everything that has made this blog possible (except the transistor,which was developed by another unique mid-20th century institution).

I have an underdeveloped theory about this.  My argument essentially runs that there is a class of "public goods"  that the market either cannot deliver as efficiently as possible or even at all because they are "outcome" (or quantity) goods and not "price" goods.  That is, they are things that are goals that have to be met irrespective of price or rather that their social benefits outweigh their private benefits (ala Keynes).

The development of the computer was only made possible because both the Census Bureau and the military were "outcome" oriented organizations (with relatively deep pockets) that were willing to finance failures.  Had were relied on the "price" (rate of return) mechanism in a world of uncertainty it seems highly unlikely that any one private firm would have thought it worth it's while.  In fact, the poster child of the mid-century computer IBM essentially only picked up the computer in any real way after it had been proven profitable and IBM's success with the computer had  more to do with the way it the marketed and combined the various aspect of the computer than anything else.

I also think medical care and higher education fall into this class of "outcome" goods, but their problems are demand side problems and not supply side problems like the one DARPA seems no longer willing to help solve.

Wage Growth Targeting.

Mike Konczal at Rortybomb talks about a Makiw and Reis paper that came to his attention through a post made by Matt Rognile at mattrognile.com. I've been thinking a lot about inflation recently becuase I've been reading about the late 60s/70 recently and there was a flare up over inflation targeting in the blogosphere after Bernanke's press conference.  Matt posts a lot about inflation that I disagree with, but it's definitely to his credit that disagreeing with him means whipping out google scholar.


Anyway, the thing from the paper Mike picks up:

Mankiw writes about his ideal target using that criterion and brought up an interesting historical story:

Our results suggest that a central bank that wants to achieve maximum stability of economic activity should give substantial weight to the growth in nominal wages when monitoring inflation…

 An example of this phenomenon occurred in the United States during the second half of the 1990s. Here are the U.S. inflation rates as measured by the consumer price index and an index of compensation per hour:
1995 2.8 2.1
1996 2.9 3.1
1997 2.3 3.0
1998 1.5 5.4
1999 2.2 4.4
2000 3.3 6.3
2001 2.8 5.8

Consider how a monetary policymaker in 1998 would have reacted to these data. Under conventional inflation targeting, inflation would have seemed very much in control, as the CPI inflation rate of 1.5 percent was the lowest in many years. By contrast, a policymaker trying to target a stability price index would have observed accelerating wage inflation. He would have reacted by slowing money growth and raising interest rates (a policy move that in fact occurred two years later). Would such attention to a stability price index have restrained the exuberance of the 1990s boom and avoided the recession that began the next decade? There is no way to know for sure, but the hypothesis is intriguing.

It’s things like this that make me worried about being creative with inflation targeting. No notable inflation in the economy and the only period of sustained wage growth in my lifetime – better get the central bank to choke that off immediately.  Can some Republican officially propose “price stability and minimal wage growth” as the new dual mandate for the Fed?

First Mike already kind of makes this point but in the Mankiw and Ries paper they say that the central bank in their model targets inflation, so it's sort of confused to then present the example above as a way in which their model suggests central banks can smooth output.  Second, the evidence is mixed at best (here is a short paper by Hess and Schwietzer at the Chicago Fed) that wage increase cause price increase and not the other way around.  So, while the theory may point to wage targeting does it even make a difference in practice?  .


For me, it comes down to the idea of who enjoys the fruits of productivity gains in the real world.  It is conventional wisdom (that may be wrong!) that wages have not been keeping up with productivity gains over the last 30 or 40 years.  In fact, the late 90s were one of the few periods where there was a chance for labor to "catch up" because unemployment was so low.  Price inflation targeting--while not my favorite way to do monetary policy--at least forces (ideally) both capital and labor to "share the pain" with wage growth it seems to be you would just be capping wages without capping profits.


I mean, it seems like the market has been doing this anyway but it's not quite clear what you get from enshrining that as policy.

Isn't Ben Bernanke what the New Keynesians want?

Paul Krugman made me think of one thing that has always bothered me about New Keynesian economics when he said that Bernanke is being intimidated by inflation hawks the other day. The idea of the conservative central banker.

I have never really liked the claim that you need an overly conservative central banker to maximize social welfare because your normal run of the mill central banker will over inflate. This always bothered me. There always seemed to me to be a fair amount of intellectual path dependence to that finding in the 1999 "Science of Monetary Policy" paper. I'm just not sure how you come to that conclusion without looking for it. Like, it seemed to me the New Keynesians were looking to prove the ad hoc finding that you need a central banker who's DNA tells him to keep inflation low.

Speculation on the history of economic thought aside, I never really understood that proposition in a general equilibrium model. I mean, I know the math works, but I can't help but feel like in a perfectly rational world of perfectly rational agents the perfectly rational central banker will figure out the optimal way to manage inflation. For instance, Ben Bernanke has probably seen and can probably solve the equation that tells him to be overly conservative and he can act on it, whether or not he was beaten with the inflation stick when he was a boy.

Of course, that's the problem. There is a clear penalty for not being conservative but no clear penalty for being too conservative. That's a serious asymmetry and I don't think Ben Bernanke is being forced to do anything, listening to the hawks is welfare maximizing.

A Brief History of the Fed and the Financial Crisis Part II: QE I and II

Here is Part I.

This post I'm going to talk about Quantitative Easing, which the Fed pursued with two different programs over the course of the last 2 1/2 years.

Quantitative Easing 1 (QEI):

Here are two other useful timelines that were written when the second round of quantitative easing (QEII) was expected:

Calculated Risk: A QE1 Timeline
WeeklyBasis: Quantitative Easing 101

Now, the model we use in class of the fed funds market predicts that once the Fed is on the flat part of the reserve demand curve (i.e. at the rate where the Fed pays interest on reserves) there is nothing left for the fed to do vis-1a-vis interest rates. If the Fed did not pay interest on reserves then the "floor" on the Fed funds rate would be at 0% because no bank will loan money at a rate lower than zero ( a negative interest rate) because then you are paying someone to borrow from you. In either case this is know as the "liquidity trap". By December of 2008 the Fed was fully "caught" in the liquidity trap.

The Fed however was not necessarily out of bullets. I'm going to repeat figure 1 from part 1:

Figure 1 (from part 1)

Again, you will notice that the fed funds rate has a very direct effect on short term rates but less of an obvious or direct effect on longer rates. Since there was clearly a problem brewing in the mortgage/housing industry the Fed set about trying to solve the problem directly. In November of 2008 the Fed announced that it would buy $600 billion in "agency backed" (top of the line?) mortgages starting in January of 2009. As the WeekBasis post above points out, before the fed bought any mortgages mortgages rates dropped by 1% in anticipation of the purchase.

Figure 2

Figure 2 shows the interest on prime mortgages. There is a very clear decline in the interest rates of mortgages. There was also a very clear decline in AAA corporate bonds and 10 year treasury bonds which are close subsitutes for mortgages (important for QEII).

It's important to understand what is going on here. The Fed is simply preforming open market purchases--which means increasing the money supply--but instead of buyin short term treasury bonds the fed is simply buying longer terms private instruments. That is to say, there is (literally) no law that says that the Fed's only focus should be on the single fed funds interest rate. Since the fed funds rate had essentially become useless as an instrument of monetary policy the Fed went directly to the source of the problem and changed mortgages rates directly. It bought down mortgages rates in an attempt to make it cheaper and easier for people to buy and/or (probably more importantly) refinance their homes.

In March the Fed announced the would purchase a total of $1.2 trillion in "agency backed" (guaranteed by Fannie and Freddie) mortgages.

QEII

The Fed had finished its mortgages purchases by March 2010. In late August Bernanke started talking about a second round of quantitative easing. In early November the Fed officially announced that it would purchase another $600 billion ($75 a month) in securities. However, QEII is slightly different that QEI. While QEI was a direct purchase of mortgages QEII is a program to purchase 10-year treasury bonds. Why? Well, the interest rate on 30-year mortgages is actually based on 10-year treasury bonds. The average mortgages is held for 10 years so fixed rate "conforming" mortgages rates are based on the 10-year treasury rate with a risk premium. That is why they track so closely to the 10-year treasury bond in figure 2.

However, it looks at least from the above graph that QEII has not had the kind of pronounced effect as QEI, at least not on mortgage rates. If anything it looks like the expectation of QEII was most of its effect. Mortgages rates went slightly lower at the end of 2010. However, the QEII effect may also be beyond an interest rate decrease. The Fed forcasting that it QEII will create 700k jobs. It is after all still increasing the money supply.

QEII is expected to end (without a commitment of more money by the Fed) in June of this year.

The Devil is in the Deflator.

At Econospeak Barkley Rosser brings up WWII:

This curiously relates to a matter that has been much argued about previously on various blogs, namely the nature of the short and sharp post-WW-I recession of 1919-20. Some have argued that this shows how wrong Keynes was, because laissez-faire was followed, including letting prices (and some wages) fall sharply in 1921, with the economy bouncing back very nicely, after having the unemployment rate soar from 5% in 1920 to 9% in 1921. Most economic historians have attributed this recession to "postwar adjustment problems."

OTOH, some of those making a big fuss about that recession somehow fail to notice that in fact there was a post-WW-II recession, if also very brief, if sharp. It occurred in 1945 with the sharpest decline in wartime spending, although not much remembered. However, the official stats have US declining in GDP by a whopping -12.7% in that year, although that number must be taken with some grains of salt due to all kinds of measurement issues and restructurings. Some say this exaggerates things as the unemployment rate only went from 1.5% to about 3.6%, a rise, but not all that much to get worked up about.

Two points. The first is that this latter event does not account for the massive decline in female labor force participation that occurred in 1945, from about 38% to about 30%. We all know (or should) that those withdrawing from the labor force do not count in the unemployment rate. That not very large increase in the UR does not disprove that there was a sharp (if short) decline in GDP.  The second point I'm not going to deal with, it is about the Federal Reserve and interest rates after the war. The point above though I'm more than happy to write about. While I do believe Prof. Rosser is mistaken, those that are challenging him in his comments section are right for the wrong reason.

Robert Higgs was mentioned about a dozen times as providing the basis for the idea that there was no post war recession. However, that claim is somewhat dubious. Higgs starts from the presumption that all government spending is useless and wasteful and with that eliminates the decline in government spending from consideration when he declares that there was no post war recession. Essentially Higgs' argument revolves around assuming that "legitimate" or "welfare enhancing" GDP = C + I + NX. What Higgs focuses on is the extraordinary jump in investment in 1946 (the end of war spending shows up in BEA data mostly in 1946, not 1945) which is actually quite remarkable and which Higgs attributes to the "pro-businesst" policies of the new Truman Administration and the general go-gettingness of the supply side.

The conclusion you reach about the depth of the recession when using NIPA data--as Higgs does--depends very heavily on which deflator you choose to use. A cottage industry has sprung up around producing WWII deflators:

Table 1 shows real GDP and real GDP growth given a bunch of different deflators:

Table 2 shows real "private" GDP and real private gdp growth

Starting from the "Hayekian" assumption that there was no business cycle downturn after the war does not disprove that there was no Keynesian effect at work. One of Prof. Higgs' most important insights is that savings was not "spent down" after the war as the traditional Keyensian story tells and that is much of his basis for declaring a supply side explanation to the post war boom . However, the demand side story holds up if one thinks of that pool of savings as the basis for the financing that allowed a returning G.I. an his new bride Rosie the Riveter to fill up there new house with the durable goods that the war spending had crowded out. Much more importantly, that pool of savings provided those new families with the financing to buy the house they bought and needed to fill with modern conveniences.

Another way of putting this that is more in line with the point Rosser is making is that Keynesian theory does not dictated an endless stream of government spending to prop up the economy. One can think of the post-war boom as a delayed multiplier effect. War production crowded out the production of durable goods (most importantly housing and cars) but increased incomes (though, yes, nominal disposable incomes did "stagnate" from 1942-1945 after a 30% increase between 1939 and 1942). These increased incomes became savings without the normal platter of goods available. That savings became goods after the war when the swelled balance sheets of financial institutions looked for new assets to replace wartime assets.

In fact, WWII as a "Keynesian Event" is unique in how dramatically it parses out the effect of government spending increases and then the secondary multiplier effect that provides the autonomous engine of growth that Keynes clearly saw as being at the heart of the capitalist system, the debate over the preface to German edition of _The General Theory_ aside.

A Brief History of the Fed and the Financial Crisis Part I: The Federal Funds Market and the Alphabet Soup of Programs.

Lets start out by establishing what it is the Fed actually does. It is a kind of short hand for commentators to say "The Fed is lowering/raising interest rates". More careful reporters and commentators will call the federal funds (fed funds) rate what it is or call it a policy rate.

Anyway, Figure 1 shows the relationship between the fed funds rate and a couple other rates.

Figure 1: Fed Funds and Selected Rates

Figure 1 should give you an idea of the kind of effect the federal funds rate has on "interest rates" over all. It is obvious that the rate on 3-month treasury bonds tracks the fed funds rates very closely. As well, the "prime rate"--the rate at which large banks lend to their best customers-- tracks the fed funds rate very closely but has a very clear risk/liquidity premium.

The effect of the fed funds rate is less obvious for the other rates. There seems to be a general pull downwards on 10-year yields, AAA bonds, and mortgages at least until the financial meltdown. You'll also notice that these three things move together pretty closely. That will be more important in part II.

Figure2: The Federal Funds Market

Here we have the federal funds market during the 21st century. The Federal funds rate being graphed here is the effective federal Funds rate not the target rate. You can get a pretty clear idea of what the target rate is from the effective rate. However we have also a little bit of added information. Notice the two big downward spikes. The first is at the very beginning of the graph (Jan 1, 2000) and the other is around the end of the year in 2001 (9/11/2001 to be exact).

Those two spikes represent huge injections of reserves into the fed funds market. The first was an intervention by the Fed to help prevent problems from the Y2K bug that never materialized. The other is of course in response to the massive disruption to the financial system when lower Manhattan was shut down for several days.

Figure 2 also tells the story of the Federal Reserve's role in the Financial crisis. We see a very, very sharp drop in the Federal Funds rate in 2001. In January of 2001 the Fed cut the fed funds rate from 6% to 5.50%. By the end of 2001 the rate was 1.25%. In Nov 2002 the Fed cut the rate all the way down to .75%. In 2003 the Fed raised rates to 2% and then keeps rates at that level until mid 2004 when it gradually starts (best illustrated by the step pattern in the discount rate) to increase interest rates to a peak of 6.25% in mid 2006.

Those low rates from 2001 to mid 2004 along with the quantity of reserves needed to keep rates that low many people say is a big part of the creation of the housing bubble. Initially, of course, the low rates were intended to juice the economy during the 2001 recession but critics say the Fed kept rates down too long.

I'm actually somewhat agnostic about the Fed's role. They must have had something to do with the housing bubble, but I'm not sure low rates were a sufficient condition. The giant increase in global savings during this period (it basically doubled)--as far as I'm concerned--is the central player in the housing bubble. Maybe we can think of the Fed as the yeast and the global savings glut as the flour. You can make bread without yeast, but it' won't rise. Of course, there are like a million other ways to blame the Fed beyond interest rate policy, such as thier role as a regulator and their refusal to use their ability to jawbone markets.

Also included this graph is the discount rate which, as we discussed in class is supposed to be a kind of "cap" on the federal funds rate. You'll notice several upward spikes. Lets zoom in a little bit:

Figure 3: Fed Funds Market Jan 2007 to March 2011

In late 2008 there are two significant spikes above the discount rate. This is indicative of the beginning of a financial panic. Banks are all scrambling to increase their excess reserves either "just in case" or because they legitimately need them. However some financial institutions may not have wanted to seem as though they needed discount loans and so borrowed at a rate above the discount rate from other banks, not the Fed. The expansion of discount loans through 2008 like the expansion of the fed balance sheet in general is really remarkable. The Fed had already increased its discount loans by about 1800% through 2007, from 27 million to $48.7 billion. From the 4th quarter of 2007 to its peak in 2009q1 the Fed increased the borrowed monetary base to $536.3 billion, an over 100% increase. All told, of course, the Fed increased its direct lending to the financial system by 20,000%!

This is a good place to talk about some of the unprecedented things the Fed did to try to stem the financial panic. It is important to point out that much of the lending the Fed did was not necessarily about maintain the target fed funds rate but was rather the fed fulfilling it's role as "lender of last resort". Credit markets in a financial panic seize up and banks and other financial institutions find it difficult or impossible to find funding. The Fed then steps in to make sure financial institutions can stay afloat. As well, the Fed greases the wheels of the financial system to get it running again.

A portion of the increase in discount loans I'm talking about were not loans to banks per se but were rather loans to money market mutual funds through banks. The Fed instituted a loan program (AMLF) in which they loaned money to banks so that they could buy commercial paper (corporate bills) from these mutual funds. This was intended to keep the commercial paper market operating in a time when no one wanted to loan money to anyone (especially financial companies) .

Not reflected in the loans above were a variety of programs such as the Term Auction Liquidity Facility or TALF. TALF loans were loans in which the collateral is an AAA rated asset backed securities (ABS). ABS of course tipped off the crisis through mortgage backed securities, but the ABS market is much bigger than just mortgages. ABSes finance credit cards, student loans, car loans and other things. Asset backed securities are fundamental to the "shadow banking system" the segment of the financial system that does many of the things banks do (make loans) but aren't actually banks. This market was also in a state of panic which was the justification for the TALF. Related (and a much bigger program) was the Commercial Paper Funding Facility (CPFF) which was similar to AMLF, but much much bigger.

Finally, there are the Maiden Lane programs (I, II and III). Essentially, these are "shell" companies the Fed created in order to buy assets from Bear Sterns and AIG. The Fed bought some of the uglier holdings of Bear Sterns to make the sale to JP Morgan Chase more attractive (Maiden Lane I) and the Fed bought a bunch of AIG's Mortgage Back Securities (MBS) in order to give AIG the cash needed to meet their obligations (Maiden Lane II). This was over and above the $85 billion line of credit the Fed set up for AIG. Finally, Maiden Lane III was another LLC set up by the Fed (partially owned by AIG). Maiden Lane III was created to buy up the Collateralized Debt Obligations (CDO) that several banks had take out insurance policies (Credit Default Swaps, or CDOs) on. As the value of the CDOs fell, AIG was obligated to pay these banks the difference between the market value of the CDOs and "par" (what the banks paid for them) value. AIG had already paid about $35 billion (mostly out of the $85 billion the Fed had lent them), the purchase of the CDOs from the banks by the Fed made up another $29 billion or so.

Now during 2008 the Fed isn't only making loans. The Fed is also rapidly slashing the federal funds rate. The Fed had begun cutting interest rates in September of 2007 (from it's peak of 5.25%), in response to what became the recession that started in December of 2007. Just real quick: I want to point out that the financial crisis was the result of the recession not it's cause, though it certainly made the recession worse. Anyway, in January of 2008 the Fed took the dramatic step of cutting the fed funds rate by .75%, there were several other cuts from January to March but on March 18th in the wake of the Bear Sterns collapse the Fed made another dramatic cut of 75 basis points off the fed funds rate. Long story short, from September 2007 to December 2008 the Fed cut the fed funds rate from 5.25% to a "target" of 0 to 25 basis points.

About this this target of 0 to 25 basis points: Importantly missing from Figure 2 is the interest rate the fed pays on deposits by banks at the Fed. When first instituted in October of 2008 the Fed made a distinction between what it would pay for required reserves and for excess reserves but later started paying 25 basis points on all reserves. Now, it may not be obvious from figure 3, but the fed funds rate has actually been below 25 basis points (roughly speaking around 15 basis points). Using the model of the market for reserves in class we came to the conclusion that no one would lend at less than 25 basis points. However, in the real fed funds market there are non-banks that buy and sell reserves (most notably Fannie Mae and Freddie Mac). These non-banks do not have deposits at the Fed though they make overnight loans and they are apparently willing to lend reserves at around 15 basis points.

I'm going to break this post up into two posts:

Part II: Quantitative easing.

After Reading Hyman Minksy's "Stabilizing an Unstable Economy".

I made my way through Hyman Minsky's "Stabilizing an Unstable Economy". While I don't 100% agree with Minsky--or rather I dont think Minsky 100% applied to the current Recession--I have to say the book is astoundingly prescient and much of what Minsky says seems more appropriate now than it did in 1986 when the book was published.

Anyway, I go a couple of things from Minksy:

First, I obviously got a better fleshed out version of the Minsky business cycle.

Second, is that he has "complete" theory of post-war stability (in the US) which is something I have been looking for since I had read Rogoff and Reinhart's "This Time is Different" which has some really interesting contrasts between the first 30 years of the post war era and the secon 30 years. I also have been wondering about this because Charles Calomiris dismissed the post-war stability. Gary Gorton has also dismissed the stability of the whole FDIC period from it's creation to 2007 as an accident of history.

Anyway, Minsky seems to agree with with Gorton and Calomiris in that FDIC essentially existed as something to be innovated around. I also thing Calomiris is right about the problems with FDIC though I think Gorton's "21st Century bank run" in repo markets story--which has nothing to do with FDIC is more relevent to the Great Recession. Anyway, Minsky places the stability of the post-war era not in how banks were operating but in the fact that corporations were not terribly reliant on banks. Minsky's basic claim is that it took about 20 years for the corporate sector to work through the savings it had accumulated in the 40s. It was only when corporations had in increase demand for external finance that innovation and instability started to set in. Minsky also places the beginning of post-war financial instability in 1966 with the Credit Crunch. I'm betraying my ignorance here, but I would have named the S&L crisis as the start of modern era of financial instability.

Third, Minsky also pretty clearly articulated what I believe is the Keynesian theory of finance. In a nutshell the Minskian/Keynesian theory of finance is a demand side theory of finance. The financial system will come up with the funds the investment sector asks for provided it can earn a positive return. I find this interesting because it is essentially the opposite way of thinking about savings/investment as the baseline "General Equilibrium Model" in the GE model the infinitely forward looking household makes all of the decision for the economy based on it intertemporal consumption preferences. This is a strictly supply side model in which investment is passive warehouse for future consumption. GE models also lead to Ricardian equivelence--the indifference between financing government with taxes and debt--because financing government spending through debt simply cause the supply side to adjust their savings behavior 1 to 1 in anticipation of a future decline in consumption brought on by the eventually higher taxes needed to pay back the debt.

On the other hand a more holistic was of looking at savings/investment is by using the simple "loanable funds" simple supply and demand. The problem with the simple supply and demand model is that--as Keynes points out in the "General Theory"--there is no phenomenon that will only shift one curve. If your econ 101 professor was responsible he would have hammered into your brain the limitations of using supply and demand to make predictions when both curves shift. Depending on the direction of the shifts, either the price (the interest rate) or the quantity of loanable funds will be indeterminate. Usually shocks to the loanable funds market shift both supply and demand in the same direction, which makes the direction of the change in the interest rate indeterminate.

So one either gets a holistic model or opposing models that you can make predictions with because one curve is either constant, vertical, horizontal or irrelevant (or some combination of the 4). I don't have a lot to say about this except to say that this seems like the central empirical issue of what kind of influence government can have over the economy.

Finally--and I'm burring this-- I started reading Minsky because my search for a good explanation of Keynes' "General Theory" because I was completely confused about what Keynes was talking about. Turns out the reason I didn't understand was because I was looking for the Aggregate Supply/Demand and the IS/LM models that I teach to undergraduates. Minsky has a great chapter about the intellectual history of my confusion and so I could go back to reading "The General Theory" without wondering where the hell the sticky wages and the self correcting mechanims were.

The Demand For Treasuries.

There have been a number of things lately such as the SS debate, reading both the General Theory and Hyman Minsky's "Stabilizing and Unstable Economy", and--not least of all--my dissertation that have got me thinking about the demand for treasuries. We are used to thinking about government debt as a supply side phenomenon, simply politicians turning on the printing presses so to speak.

To illustrate, here is a question from my final (both Marco and Money and Banking) that I asked:

In the US right now corporate investment is extremely low as corporations are now holding historically high levels of liquid assets instead of spending their profits. As well, foreign savings continues to flow into the US because US assets/investments increasingly looks good compared to European assets. Finally, private savings rates are increasing as American households try to "repair their balance sheets" and make up for wealth lost when the housing bubble popped. Use the “Savings/Investment Identity” to show what must happen if capital inflows and households savings are increasing while at the same time investment is decreasing.

To answer this question you need this identity:

Investment (I) = Private Savings (PS) + Capital Inflows (KI) +Government Savings (GS)

Necessarily, if the events I outlined are true, Government Savings has to fall, that is, the government has to run a deficit. Now, this is an idenity and it doesn't tell you anything about what is driving what. But the way I framed the identity it is all about the demand side for treasuries. In a weird way, the extension of the Bush tax cuts following on the heals of the Eurozone crisis can be seen as a kind of market response to demand.

Anyway, I decided to dig around in the Fed's Flow of Funds and the Federal Government's Budget data to see what the demand side has looked like historically.

Right away I'm gonna deal with the mot controversial part of this little exercise. I am including the Social Securty Trust Fund as part of the demand for debt. Here is my version of a graph I'm sure you've seen a million times:

Figure 1

So Social Security is about half of the debt that the federal government owes itself. The reason I have included social security is because even though it is classified as debt that the government owes itself it also represents (potentially) future public debt. Social Security debt is held in special "non-marketable" treasuries and so currently they aren't part of the market for treasury bonds and to that extent the debt is actually different than debt to the public.

However, as the Social Security system starts to take in less money than gets paid into it the Social Security Administration will cash in those bonds. In order to pay back those bonds the federal government will have to pay that back with taxes or issue new debt issued to the open market. Social Security is "postponed debt to the public". I need to be careful and point out that this is not a problem with SS. I'm not much of a deficit/debt hawk and to the extent the debt is worrisome the issue is how we manage the debt/GDP ratio. The shift of trust fund debt to the public would have no effect on the debt/GDP ratio. Depending on how rapidly the trust fund got used up it may have an effect on treasury bond yields but that seems to me like mostly a secondary concern.

I don't want to dwell on Social Security. The dudes (gender neutral!) over at Planet Money have a really good podcast about social security. Maybe my next post will be about Social Security. Anyway, I do need to admit a couple of things. First, it's a little unfair to single out social security for my analysis but I had to make my graphs intelligible. The social security trust fund made up about $2.6 trillion of the $4.3 in debt the government owes itself at the end of 2009. So I'm ignoring $1.7 trillion which is a lot even when talking about an $11.8 trillion deficit.

That $1.7 is mostly made up of the:

Civil Service Retirement Fund ($750 billion)
Department of Defense retirement and Medicare funds ($144+ $295 billion)
The Medicare trust fund ($390 billion)

Anyway, the vast majority of the debt the government owes itself is the investment of retirement entitlements of one kind or another. But like I said, i had to keep my graphs reasonably clear so I'm ignoring $1.7 trillion!

Alright so here is the first graph:

Figure 2

This graph is included for completeness but its kind of hard to read because the Great Recession kind of explodes the graph. It's a good place though to look to explain a few things. First, of all these are "flows" which means what is being shown here are either new (net) purchases or sales of treasuries by each sector for each year. Secondly, the "Remainder" line represents the total new treasury issued in each year minus the sectors show in the graph. It just shows how much of the new treasury debt issued was bought by the sectors I'm looking at. If the Remainder is positive it means the sectors shown under account for new treasury issues in each year. If the Remainder is negative the sectors shown over account for new treasuries. Finally, I chose 1975 as the starting point because that's around when the post-war debt/GDP ratio bottomed out.

I'm going to chop off the Great Recession (and come back to it later. Here we have a picture of what should probably be called the structural deficit that started in the early 80s:

Figure 3

In figure 3 I have lopped off 2007-2010 or, roughly speaking, the Great Recession. I have also put everything into 2005 prices. I am not so sure that was a good idea but I felt like keeping it in nominal dollars distorted the relative importance of each sector over time. I would have preferred to make this a logarithmic chart, but I can't because there are negative values. Anyway, this this is essentially unreadable and won't make sense until after looking at figure 4. However, two things are pretty clear. First, the financial industry seems pretty important to the demand side through the 80s. Second, while state and local government (includes "regular budget" and pension funds) sell off a lot of treasuries in the 90s their purchases seem to recover in the mid 2000s. However, in the 90s households start dumping treasuries and don't look back (until 2008!). Did all the money wind up in the stock market? Did treasuries become a quaint, old timey way to save?

Okay so Figure 4 can help make sense of Figure 3:

Figure 4

So figure 4 is not really "to scale" in any way. Each bar represents 100% of treasury purchases by the sectors I'm looking at (plus the remainder) for each year. However, this does not give any sense of the relative scale of each year. For that look at figures 1 and figures 2.

What's interesting about this chart is that there seems to be a clear shift in the demand for treasury bonds that takes place in the mid 90s. It looks to me like "core demand" shifts from the financial industry to foreign demand. As well in the 90s there seems to be shift of demand from state and local government to Social Security. However, remember these are all shares of a pie that is growing every year. If you look back at figure 2 it seems more that state and local demand remains steady (though falls a little) while SS demand starts to take off in the late 80 due to the 1983 Social Security Amendment.

I found the results from figure 5 to be pretty surprising:

Figure 5

I chose 1971 because that's when the US went off the gold standard (officially) and I was curious to see if that meant anything. Now what'ss obvious here is how important foreign "official" institutions (mostly foreign central banks) are as a source of treasury demand. I had taken the role of the US dollar as a "reserve currency"--as a currency other central banks hold as a way of managing their own currencies-- for granted. However, it is quite striking how important our role as a reserve currency is in creating demand for our treasury bonds. Other countries prefer to hold treasury bonds instead of dollars because they are essentially as safe as dollars and they pay a return.


I want to go over two things. First, I don't think this post would be complete without a graph of the last couple of years (at least through 2009, which is all I have numbers for):

Figure 5

The scale of figure 5 is nominal dollars. The Fed sold off a whole bunch of treasury bonds in 2008 in order to purchase (or sometimes exchange) for things that were not treasury bonds like a Mall in Oklahoma (Planet Money Again). Foreign demand went through the roof and financial business came back to buying treasuries. Foreign demand is probably going to get stronger now that Europe is becoming more and more of a mess, a phenomenon called "flight to quality". As far as the financial industry buying treasuries that's a function of the Fed loaning tons of money to banks basically for free. Banks and other financial intermediaries then take the money and buy safe as houses treasury bonds and take home the difference. It helps keep treasury bond yields low and Wall Street bonuses flowing.

Finally, I'm not 100% sure I've done a good job making it clear how important governments are to the demand for treasuries. Here is one more homemade chart:

Figure 6

I double checked this graph after I made it because I find it really surprising. I feel that this really makes it clear how important political entities are to the demand side of the treasury debt market. I know I'm trying to play both sides of the fence here by saying that SS should be thought of as simply postponed debt to the public and then putting it up here as part of "political" debt. But I think its justifiable because a lot of the discussion these days is about "the market" for treasury bonds and how market bond vigilantes may soon send us the way of Greece and Ireland. However, the vast majority of treasury debt is dependent on political decisions and political entities (in 2009, the gray area of figure 6 was only $3.4 trillion of 11.9 trillion). Here again Social Security is useful as illustration. While I do believe Social Security is "real debt" the political debate today seems to be all about trying to avoid having to turn these non-marketable securities into "general fund" debt very quickly or at all either by cutting benefits or by raising current taxes. As well, it seems highly unlikely that the Chinese are going to stop pegging the Yuan to the dollar any time soon even if they are going to tweak it here and there. As well, the Fed is obviously extremely sensitive to what it does to the treasury market and even a good portion of the private market debt are essentially back door "open market purchases" made through arbitraging financial intermediaries.

Now, I'm not willing necessarily to call demand based on political decisions more stable, but it's not obvious that even if the fantasy of bond vigilantism came true that they would have necessarily that much of an effect.

Oh and also on the "we aren't Greece or Ireland" tip. I feel like this is a good place to put this graph from the Financial Times:

Figure 7

The basic point to be made here is that the analogy is not between the US and the second tier developed nations of the Eurozone. The proper comparison is the comparison between the US, the financial center of the world with the world's reserve currency is with the UK when it held that position. However, I do have to admit it's not entirely clear which UK we are talking about. The post Napoleon UK was an empire experiencing very robust growth on the whole. The post Hitler UK on the other hand was the shell of a collapsed empire that eventually needed to be bailed out by the IMF in the mid 70s.

it should be pointed out that the post WWII UK had lost it's prominent position as the worlds financial center with the world's reserve currency. The US remains strong on both fronts. While there is much talk of China, their financial markets are still in their infancy and you aren't even allowed to trade Yuan. Before their own subprime crises the EU looked like it could possibly be a contender but that seems far more remote now although this crisis may bring the Eurozone closer to a fiscal union which they would need to compete effectively with treasury bonds. At any rate the US seems pretty secure as the worlds tallest midget.