The Paradox of Inflexibility

In my previous blog post, I mentioned a forthcoming paper by a co-author and I. It is a simple paper that shows how one can explain to undergraduates the macroeconomic behavior of an economy that is stuck in a so-called 'liquidity trap.' At the liquidity trap, interest rates are at the 'zero lower bound;' interest rates have been reduced as far as they can be reduced and cannot be reduced any further.

At the zero lower bound, a whole raft of paradoxical results -- with names like "paradox of thrift," "paradox of flexibility," and "paradox of toil" -- appear. A new NBER working paper by David Cook and Michael B. Devereux ("The Optimal Currency Area in a Liquidity Trap," NBER Working Paper No. 19588, http://www.nber.org/papers/w19588) derives yet another paradoxical result.

Cook and Devereux argue that -- contrary to the received wisdom that a monetary union (such as the European Monetary Union) makes its member economies more vulnerable to economic shocks -- in a liquidity trap a monetary union may makes its member economies less vulnerable!

Countries that form a monetary union agree to give up their national currencies and adopt a common currency. And, as Greece, Portugal, and Ireland have discovered the hard way, not having a national currency can drastically reduce a country's ability to fight its way out of a recession.

Normally, when a country finds itself in a recession, its central bank prints a lot of money and spends it on financial assets (bonds, typically). Buying a bond from somebody and paying him cash for it is really just the same as lending him money: you pay him money now and he promises to pay you money later. Consequently, the new money printed (and spent) by the central bank essentially turns into a gusher of loans. Borrowing becomes cheap and interest rates fall. Lower interest rates lead to increased spending by households and businesses. The rise in spending leads to an economic recovery. Everybody breathes a sigh of relief.

Unfortunately, a country without its own currency would not be able to take any of the recession-fighting measures just mentioned. If the members of a monetary union are similar enough that their business cycles are perfectly aligned, then when one member is in a recession all other members would also be in a recession. In such a case, tons and tons of the common currency could be printed and used in the usual way to pull all member economies out of the recession. But when the member economies of a monetary union are vulnerable to "asymmetric shocks," a member economy that falls into a recession does so alone. And it would have no independent monetary policy to help it escape the recession. This is why, monetary unions have been frowned upon by economists, except for countries that belong to an "optimal currency area" where their economies are always in sync and economic shocks are symmetric.

Cook and Devereux argue that the above argument against monetary unions is turned upside down when interest rates reach zero and, therefore, cannot be reduced any further.

First, when interest rates reach zero and cannot be reduced any further, the lack of a national currency is no handicap; after all, monetary policy would be ineffective even in a country that does have its own currency.

Second, a country with its own currency might see the exchange value of its currency rise and thereby cripple its economy by reducing its exports and raising its imports. A country that is in a monetary union and, therefore, has no currency of its would not face such a danger.

Consider a country that has its own currency, and happens to be at the zero lower bound. Now, suppose there is a fall in demand that brings about a deeper recession. Falling demand would lead to falling inflation. With the nominal interest rate stuck at zero, falling inflation would cause the real (or, inflation-adjusted) interest rates to rise. The rising real interest rates would attract foreign lenders. All this borrowing from foreigners would -- by the balance of payments identity -- lead to a yawning trade deficit. To see this in another way, note that when foreigners, eager to earn the rising real interest rate in a country, buy the local currency in order to lend to the local residents, the country's currency would rise in value. A more expensive currency would reduce exports and increase imports.

Obviously, if a country that is already in trouble from falling demand now faces falling exports and rising imports, it would only be digging a deeper grave for itself.

Cook and Devereux explain that a country that is a member of a monetary union would not have to face the above predicament. Not having a currency of its own, it runs no danger of its currency appreciating in value and thereby crippling foreigners' demand for its products.

Cook and Devereux make an argument that is persuasive, surprising, and simple.

Inflation Puzzles

Inflation in the United States -- as measured by the annualized increase in the consumer price index -- was a paltry 0.2 percent in September. This is significantly below the 2 percent informal inflation target of the Federal Reserve, the central bank of the United States. Such low inflation came as a surprise to many. No less a figure than Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, speaking in Philadelphia last Friday (November 1), admitted to being surprised by how low and stable inflation had lately been despite the Fed's vigorous program of asset purchases (paid for with mountains of newly printed cash). For Lacker, the idea that money printing by central banks inevitably leads to rampant inflation was an article of faith, not significantly less worthy of trust than the idea that the sun rises in the east.

But the Great Recession has been a stern teacher. It has taught us that the connection between the rate at which the Fed prints (and spends) money and the rate at which prices rise breaks down when unemployment is above the rate consistent with full employment. Lacker should have relied on an alternative theory: the expectations-augmented Phillips curve.

This theory says that inflation in the short run consists of three parts: expectations-driven inflation, demand-pull inflation, and cost-push inflation. First, when firms expect rapid inflation, they expect the prices they'd have to pay for raw materials and labor to rise rapidly, and consequently they raise their own prices rapidly in order to remain profitable. Second, when -- as a consequence of the heavy pull of demand -- the economy's production is close to its potential, and unemployment is close to the rate consistent with full employment, incipient labor scarcity raises wages rapidly, which in turn leads to rapidly rising prices. And third, if droughts, other productivity failures, and/or rising prices of imported oil lead to rising production costs, prices would again have to rise rapidly in order to ensure profitability. [See this.]

The Phillips curve theory does not say that money printing and asset purchases by a central bank cannot cause inflation. It only says that if money printing is to cause inflation, it would first have to instigate either expectations-driven inflation, or demand-pull inflation, or cost-push inflation. Therefore, the theory says, there is no point in watching the rate at which the Fed is printing money in the hope of predicting inflation. One should instead watch data on inflation expectations, the rate of economic growth, unemployment, oil prices, and so on.

A new NBER working paper ("Is the Phillips Curve Alive and Well After All? Inflation Expectations and the Missing Disinflation", NBER Working Paper No. 19598, http://www.nber.org/papers/w19598) by Olivier Coibion and Yuriy Gorodnichenko argues that with a tweak or two the Phillips curve can explain inflation during the Great Recession quite well. Unlike Lacker who relied on the money-printing-causes-inflation theory and was surprised that inflation during the Great Recession was so much lower than he had expected, Coibion and Gorodnichenko had relied on the Phillips curve and were surprised that inflation was higher than they had expected.

But all was not lost for the Phillips curve. Coibion and Gorodnichenko found that when traditional measures of inflation expectations (such as the "TIPS spread" obtained from financial markets or surveys of professional forecasters) are replaced by the measure of inflation expectations in the Michigan Survey of Consumers, the Phillips curve does well in explaining inflation. During the Great Recession, households surveyed by the Michigan Survey consistently expected higher inflation than the financial markets and the professional forecasters.

Coibion and Gorodnichenko also propose an interesting explanation of why households consistently expected higher inflation than bond traders and forecasters. They argue that households tend to be keenly aware of oil prices, which had risen sharply since 2009. And this sensitivity to prices at the gas pump influences households' expectations of inflation. (As a fan of behavioral economics, I see here the presence of the concept of 'salience.')

More provocatively, Coibion and Gorodnichenko argue that it was actually a stroke of luck that rising oil prices kept inflation expectations -- and, therefore, inflation itself -- above dangerously low levels that could have pulled the US economy into deflation. (In a tangential remark in a soon-to-be-published paper, Sebastien Buttet and I briefly pointed out the other side of this very coin: falling oil prices -- normally a reason for rejoicing -- can push a sluggish economy into a deflationary spiral and cause a lot of mayhem.)

Finally, Coibion and Gorodnichenko made me wonder about the wisdom of the Fed's reliance on the so-called core inflation measure that strips out food and energy prices as a guide to policy making. The Fed's argument is that it needs to predict inflation nine months or so down the road because any policy measure adopted today would take nine months or so to take effect, and, as food and energy prices are extremely volatile, a consumer price index that excludes them would be better at predicting inflation nine months ahead. The Fed's argument makes sense. But Coibion and Gorodnichenko's paper makes me worry a bit. Food and energy prices are highly salient for households. As a result, food and energy prices are likely to have a huge impact on inflation expectations. Therefore, today's food and energy inflation is likely to drive future inflation through the expectations-driven inflation in the Phillips curve. Maybe the Fed should take another look at its position on the usefulness of paying attention to food and energy prices.

To wrap up, the expectations-augmented Phillips curve is a pretty good guide to short-run inflation. Mr. Lacker should take note.

Ants, Grasshoppers, and Food Stamps

This evening's PBS Newshour had a report followed by right-v-left debate on the expansion of the food stamps program during the recession -- and the slow recovery -- of recent years. (The video is available below.)

The food stamps program (formally, SNAP or Supplemental Nutrition Assistance Program) was expanded four years ago. However, the expansion was intended by the U.S. Congress to be temporary. In fact, it was today that the expansion came to an end, thereby occasioning the Newshour's program.

The debate, moderated by Jeffrey Brown of the Newshour, was between Ellen Teller of the Food Research and Action Center, an anti-hunger nonprofit, and Robert Rector of the Heritage Foundation.

At one point in the debate, Rector denounces the food stamps program as follows:

Another thing that they have done is get rid of the asset limits which were traditionally part of this program. You can have a million dollars in the bank. You're unemployed, you can get into food stamps. Now, that's an outrage.

Jeffrey Brown, seemingly impressed by Rector's thrust, turned to Teller and asked, "Is that true about the million dollars, first?"

Teller totally avoided Rector's specific complaint and instead argued -- quite accurately -- that the reason for the recent increase in the number of people getting food stamps was not fraud but the worsening economy. Rector picked up on Teller's evasion and came right back:

She just ignored the fact that they have removed the asset test. ... There's no meaningful asset test. One of the things that the Republicans are doing is restoring the asset test.

Even the mild-mannered Jeffrey Brown would not let Teller go: "All right, answer that," he said, turning to Teller. All that Teller could manage in reply was that Congress's decision to not insist on an assets test had been bipartisan, and that the current Republican objections were a reversal of their previous position.

The whole issue of whether people with little or no income should be showered with food stamps if they happen to have a million dollars in the bank needs to be dealt with directly, not evaded. Sure, it looks terrible if a millionaire who happens to have a meager current income is given money by the government to buy food. Nevertheless, appearances aside, there actually is a good reason why there should be no assets test for food stamps.

There once were two people: Mr. Ant and Ms. Grasshopper. They earned the same income in the years before the economic crisis. However, Mr. Ant led a frugal life and managed to accumulate a million dollars in savings, whereas the prodigal Ms. Grasshopper flagrantly spent most of her income on travel, entertainment, etc., and accumulated no wealth at all. Then came an economic crisis, and both Mr. Ant and Ms. Grasshopper lost their jobs.

Would it be a good idea to assist Ms. Grasshopper with food stamps and deny them to Mr. Ant? Ms. Grasshopper deserves help because she has lost her job and has no savings to fall back on. But Mr. Ant deserves not to be denied assistance simply because he lived a frugal life. They should both be helped, irrespective of their wealth. The food stamps law should not have the assets test that the Republicans of today and Mr. Rector have demanded. An assets test would provide a perverse incentive to be profligate: why save, if, when you are in trouble, your savings will be held against you?

Finally, I should mention that the argument I am using to oppose the right wing demand for an assets test in the allocation of food stamps (and other government assistance), is also the argument that people on the right use to argue against taxes on capital income, such as interest income, dividends, and capital gains. To see why, assume as before that Mr. Ant and Ms. Grasshopper earned the same income for the same number of years, and that, while Mr. Ant saved a lot of money, Ms. Grasshopper did not. Consequently, Mr. Ant will be earning a substantial amount of income in interest, dividends, and capital gains, whereas Ms. Grasshopper will not. Therefore, under current income tax systems, which tax interest, dividends, and capital gains, Mr. Ant will be paying taxes on both current income from work and current income from his wealth, whereas Ms. Grasshopper will be paying taxes only on current labor income. They both earned the same income from work every year, and yet Mr. Ant ends up paying more in income taxes simply because he was frugal. Therefore, say people on the right, taxes on income from wealth punish frugal behavior and should be done away with.

I actually enjoy this irony. The fact that the same argument can be used to make both the left and the right uncomfortable tells me that it is the real deal; it's not sophistry.

Robert Rector probably knows the argument inside out. He has probably used it once or twice to argue against taxes on capital income. But he will turn a blind eye to it when it implies that food stamps should be given liberally, without some stupid assets test.