On the Legalisation of Marijuana & the War on Drugs

One of the more exciting and reported-upon developments of the day of the 2012 Presidential election were the success of ballot initiatives legalising the recreational use of marijuana in Colorado and Washington. These initiatives seemed to set the stage for a showdown between Federal and state authorities over the legality of marijuana, as possession of marijuana remains a Federal crime. Happily for Coloradan and Washingtonian marijuana users and nascent marijuana-related businesses, the Attorney General Eric Holder announced this week that the Federal government would not challenge the new laws, and would instead focus on organised crime and preventing underage use. This is a big transition for America as a whole as it means that other states can freely legalise marijuana without worrying about getting into a fight with the Federal government. Furthermore, it is the crumbling away of a central element of the apparatus of the War on Drugs — an initiative that has resulted in an eightfold increase in the prison population since 1980. Arrest for marijuana possession is the fourth most common cause of arrest in the United States — resulting in over 750,000 arrests per year — and over 12% of the both state and Federal prison populations is in jail for offences related to marijuana possession.

Economically, the War on Drugs is a rather concerning thing. Most obviously very large amounts of resources — time, energy and money — are devoted to its pursuit. And that has opportunity costs. Every dollar spent locking up nonviolent marijuana users or killing innocent people with SWAT teams is a dollar that is not spent training doctors, or educating children, or investing in clean energy technologies, or developing cures for diseases or anything else that people have a need or want for. According to the Open Society Foundation, the costs of a drug control system mount to over $100 billion dollars per year. That is quite a large allocation of resources. And for what?

Well, drug criminalisation and since the start of the War on Drugs stronger drug enforcement hasn't stopped the use of drugs. People were using drugs before the war on drugs, and they're still using them now. There has been a modest drop in illegal drug use — from 14.1% in 1979, to 8.7% in 2011 — but this may not even be down to the War on Drugs, as there are very many other factors determining drug use beyond legality or illegality including culture, drug supply, drug discovery, etc that influence whether an individual or group of people across society will choose to use drugs.  And in terms of social harm, the illegal drugs may not even be the most harmful ones. And according to Professor David Nutt of the Lancet, the most harmful drug is an entirely legal one — alcohol:

Prohibition of alcohol, of course, was tried in the United States and was a disastrous failure. It didn't stop alcohol use, but it did empower a whole new criminal class. Protection rackets, organised crime and gangland murders were more common during Prohibition than when alcohol could be bought legally. 

More importantly, the evidence suggests that rehabilitation is superior to punishment in terms of cost effectiveness, and in terms of preventing drug users from using drugs — drugs, of course, are rife in prisons. Prison can be highly harmful to drug users due to it exacerbating or causing mental health problems and spreading sexually or needle transmitted diseases. And those who are unlucky, and are criminally prosecuted for drug use face the danger of a downward spiral, as ex-convicts find it much harder than the general population to find work. Other issues include problems of splitting up families — huge numbers of children, especially from ethnic minorities who are more likely to go to prison have grown up fatherless since the beginning of the War on Drugs — as well as the empowerment of criminal gangs and cartels whose entire business model and high profit margins are based around drugs being controlled. The United States itself is not getting the worst of it — the war between the drug cartels for territory and smuggling passages in Northern Mexico has devastated the region politically and economically and resulted in thousands of gory and gruesome deaths. Violence, protection rackets and organised crime are also active in other Latin American countries including Guatemala, Honduras, Colombia, Venezuela and Nicaragua. Once again, prohibitionism is failing.

What I think the War on Drugs is really about is not so much deterring or preventing drug use, but about making a statement that drug use is unacceptable in society. In a country where the last three Presidents are confessed  illegal drug users — who if they had been caught could have faced years in prison — the hypocrisy stinks to high heaven. Of course, drugs can have a disastrous impact on the lives of individuals and the wider community. Drug users can often become workless thieves, stealing for drugs and neglecting their families. Certain drugs consumed in higher quantities can cause brain damage, and illnesses. But evidence suggests that rehabilitation is much more effective than punishment in preventing such effects. The War on Drugs stinks of the Nixon era in which it was born — moral panic, moral hypocrisy. The legalisation of marijuana in a number of states first as a medicine, and now for recreational purposes is breaking down the failed prohibitionism and moral hypocrisy. 

In the long run, we are perhaps headed toward a more flexible model where most drug use is legal but controlled and regulated. Drug users can receive a controlled and uncontaminated product, so they can be surer of quality and safety — instead of having to worry about the contaminants used by criminal gangs today. With drugs being sold by regulated businesses instead of by street criminals, the selling of drugs to children and to problem users can be more easily monitored and prevented. And those who develop a drug problem can more easily receive rehabilitation — paid for through taxes on the drugs being sold. 

Further into the future, the advent of 3-D printing and molecular manufacturing means that the spread of drugs — including experimental recipes — will be completely unstoppable. Every home with an advanced 3-D printer will be able to print drugs, both traditional recipes and experimental ones. In such a context — although I am sure that authorities will try to prevent the distribution of drug recipes over the internet, as they are doing now with gun components — the only thing that can really prevent drug abuse are old-fashioned personal responsibility, parental responsibility, rehabilitation in case of addiction, and medical treatment in case of overdose.

In the even longer run, drugs may become obsolete as desire modification becomes a reality. Now that would make Richard Nixon's head spin. 

Perceiving Job Insecurity

A study in the Journal of Occupational & Environmental Medicine finds evidence linking perceived job insecurity in the Great Recession to poor health outcomes, even among workers who remain employed. The authors, Sarah Burgard, Lucie Kalousova, and Kristin Seefeldt, find that insecure workers--those that believe they are at risk of being laid off--are more likely to report poor self-rated health, symptoms of depression, and anxiety attacks. Sad, but not hugely surprising.

I originally intended to point to this study as yet more evidence of the harmful consequences of prolonged high unemployment. I intended, in particular, to write about how the anxiety and poor health consequences associated with the fear of losing a job must fall especially hard on people with low income. So I set out to gather a bit more data to back up that particular hypothesis, imagining it would be quick and simple task. Not quite.

Most of us are pretty aware of the unemployment rate in the U.S.--7.4% as of July 2013. But for people who do have a job, the more relevant statistic for their financial decision-making (and apparently also for their health) is the probability that they (and members of their household) will keep their job. This statistic is much harder to come by. How aware are workers of their risk of being laid off? How do you quantify job security?

The first place I looked was the Bureau of Labor Statistics, which provides data on layoffs and discharges. The monthly layoff and discharge rate for total nonfarm employment is around 1.3%. It peaked at 2% in early 2009 (see graph below). If we all believed we had a 1 or 2% chance of being laid off, we probably wouldn't be too stressed out about it. But the layoff and discharge rate does not directly translate into an individual worker's probability of losing a job, and it definitely does not translate into a worker's perceived probability of losing a job (the statistic most relevant for their health).

How can we get at people's perceived job insecurity? One way is to ask them. The Michigan Survey of Consumers asks survey participants, "During the next 5 years, what do you think the chances are that you (or your husband/wife) will lose a job that you wanted to keep?"

Broken down by income tercile, here is a graph of the mean responses. What initially surprised me the most is that the lowest income tercile has the lowest perceived job insecurity. In 2012, on average, people in the lowest income tercile reported a 17% chance of job loss, while people in the middle and upper terciles reported 19% and 20% chances, respectively.

Mean perceived chance of job loss by respondent or partner in next 5 years, by income tercile. Source: Carola Binder with data from Michigan Survey of Consumers. Moving-average filtered.

When you look at the distribution of responses, however, it becomes clear that you have to interpret the mean with a large grain of salt. Respondents are allowed to say any number from 0% to 100%. But they mostly just say one of two numbers: 0% or 50%. This is a common tendency across income levels, but especially among the lowest income tercile. In 2012, around 70% of respondents in the lowest income tercile chose 0% or 50% as their response. In the middle and upper income terciles, 58% and 47% of respondents chose those responses.

Percent of respondents who say that their chance of job loss in next 5 years is either 0% or 50%, by income tercile. Source: Carola Binder with data from Michigan Survey of Consumers. Moving-average filtered.

Prior to answering the question, survey takers are given this brief intro to help them understand probabilities: "Your answers can range from zero to one hundred, where zero means there is absolutely no chance, and one hundred means that it is absolutely certain. For example, when weather forecasters report the chance of rain, a number like 20 percent means 'a small chance', a number around 50 percent means 'a pretty even chance,' and a number like 80 percent means 'a very good chance.'" Nonetheless, most people seem to have tremendous difficulty quantifying their probability of job loss. Over half of people choose 0% or 50% as their response.

Whether or not you will lose your job can be represented by a bernoulli random variable. A bernoulli random variable is summarized by its mean (p). The Principle of Insufficient Reason, or Principle of Indifference, says that "if we are ignorant of the ways an event can occur (and therefore have no reason to believe that one way will occur preferentially compared to another), the event will occur equally likely in any way." This principle was discussed by Bernoulli, Laplace, and Poincare, among others. For a bernoulli variable, this principle says that if we are totally ignorant about its mean, our prior is that the mean is 0.5. This has a corresponding result in information theory: the entropy of a bernoulli distribution is maximized when p=0.5 (think of a 50% chance as being the "most uncertain.") If we have absolutely no information about how likely we are to lose our job, we might just guess that we have a 50% chance of losing it.

Keynes himself summarized the Principle of Indifference in his 1921 Treatise on Probability as follows:

"if there is no known reason for predicating of our subject one rather than another of several alternatives, then relatively to such knowledge the assertions of each of these alternatives have an equal probability" (pg. 52-53).

Keynes was one of many to critique this principle. His views on probability and uncertainty remain controversial, as does the Principle of Insufficient Reason. There is actually quite a large body of literature in statistics concerning "noninformative priors" that continues to study the fascinating and controversial issue of how to represent ignorance. There are also subfields of behavioral economics that study how people treat probability, particularly when it comes to low-probability events (like job loss, usually).

This post doesn't have a real conclusion, just some open questions. What do people do when they don't know their chances of having a job in the future? Do people "underplan" or "overplan" for the possibility of job loss? Would people be better off in general if they could estimate their probability of job loss more precisely? How would you readers estimate your own probability of losing a job in the next 5 years?

Popping the "Bubble" Bubble

Without a doubt, QE has been an incredible boon for financial markets. Backed by QE3, the SP500 stock index has risen by more than 12% year to date. Yet in spite of this increase in the stock market, overall real economic conditions remain relatively stagnant. Year over year inflation as measured by the core PCE price index ticks in at only 1.2% YoY, and last quarter's real GDP grew by only 1.4% YoY. This disconnect is a bit unsettling, because it suggests that bullishness in the stock market has failed to translate into broader growth. On this basis, some commentators, such as Frances Coppola, have argued that quantitative easing does nothing for the broader economy and worsens economic inequalities. But this concern can be reduced to an even simpler question: Has recent stock market growth just been a bubble?

There are a few reasons why this question is important. First, people make a lot of noise over the financial instability hypothesis that monetary policy is just fueling speculative excess. So for the sake of practical monetary policy, it matters if signs of a bubble are appearing. Second, if it can be shown that we are not in a bubble, and that recent financial market movements are based on fundamentals, this means that monetary policy is passing through to the economy. It's not just some scheme to enrich the wealthy. Moreover, the tools that we develop to analyze this issue can help us determine in the future if certain monetary policies are passing through to the economy. Third, analyzing this issue leads to some more insights on how finance and macro can work together. While I am sympathetic with Scott that finance should be kept out of theories of money, given that financial indicators function so well as forecasts, it would be a shame to not use as much data from the financial markets as possible.

Because this is a highly charged question, I want to make the conversation as concrete as possible. When I talk about a bubble, I don't just mean "stock prices are high". Rather, I want to define a bubble as when stock prices are "out of line" with the fundamentals of the underlying companies. What this means is that if China blows up next year, and the price of stocks fall, that doesn't mean the bubble popped. A blowup in China is an exogenous event that would change fundamentals, and prices would adjust as a result. The type of bubble that I'm talking about is a noise trader, "beauty contest" bubble, in which people go into a frenzy bidding up the price of securities on the belief that everybody else will bid them up as well.

So let's start by talking about how monetary policy affects stock prices. On first approximation, the value of a stock should be equal to the present discounted value of all dividend payments. Sure, there's excess volatility around the edges, but this simple model of cash flows is still accurate on average. In doing so, it gives us two ceteris paribus predictions about stock prices. First, a stock price should go up in response to higher expected future cash flows. Second, a stock price should go down with higher expected real interest rates, because a higher real rate reduces the discounted value of future cash flows. These are the two main channels through which monetary policy impacts stock prices. Monetary policy can either (1) raise the cash flows by improving the economic environment, or (2) lower the discount rate by maintaining an extended period of low real rates.

These two channels split quite nicely into a positive and negative take on the effect of monetary policy. If monetary policy raises stock prices because of current and future cash flows, that should be seen as a good sign of a recovering economic environment. This corresponds to "the Fed is improving the fundamentals of the economy." On the other hand, if monetary policy affects stock prices only through a lower discount rate, that is just a sign of an "immaculate conception", with stock prices rising without an improving economy.

Most market monetarists believe it's the former, whereas some fiscalists have made an argument that it's just the latter. But here's the kicker -- we should be able to distinguish the two by looking at the actual earnings data. By comparing the earnings of companies and the stock prices, we can actually make concrete the discussion about whether the stock market is in a bubble. In particular, we can distinguish between the two stories by looking at price to earnings ratios, or the ratio between the price of a stock and the earnings per share -- both in the trailing 12 months and 1 year forward estimates. If the fundamental story is correct, then we should observe that the price to earnings ratio stays relatively constant. Yes, stock prices are rising, but that's only because earnings are stronger. If the speculative excess story is correct, then the price to earnings ratio should be rapidly rising as the price is bid up, but the underlying earnings remain unchanged.

On this note, it doesn't look good for the bubble mongers. Below I have trailing 12 month and 1 year forward price to earnings ratio plotted for the SP500 index as a whole. The index P/E ratio is calculated through a market capitalization weighting process of the underlying index securities. What this shows is that, right now, stocks are quite cheap. The trailing 12 months PE ratio is at 15.5, a far cry from the heady tech bubble days with a peak P/E of 30 or even the moderate 2002-2008 period when the PE ratio tended around 18. The trailing 12 months ratios mean that prices aren't out of line with past performance. The fact that forward ratios are also relatively low and near the trailing ratios indicates that stock prices aren't up on the back of extremely optimistic future forecasts. Even though high PE ratios aren't sufficient conditions for a bubble, they're certainly necessary ones. If this is a beauty contest, it's awfully fair.

The moderate P/E ratio signals that people are not overpaying for performance. This isn't the 1990's -- market participants are not basing valuations off of overly optimistic views of future earnings. Rather, people are just paying reasonable amounts of money to buy into each company's earnings, resulting in reasonable stock prices.

Now, in my analysis above I glossed over one more channel that's relevant for the financial stability debate. It's possible that the liquidity provided by monetary policy encourages people to take riskier investments because they're "reaching for yield." But we should differentiate two versions of this hypothesis. The first is that people are over weighting risky sectors at the expense of safe ones. But this should not be a concern of policy because it's not systemic. When the reach for yield reverses itself, some stock investors will win, others will lose, and while there may be blood, policy makers need not wash their hands. On the other hand, if people are just pouring their money into stocks in general because they are dying for yield, then policy makers might be concerned. But the low PE ratios belie this hypothesis, so policy makers can still rest easy.

So if equities aren't a bubble, this means that the recent rise in stock prices corresponds to better fundamental performance for these companies. Therefore we should expect a pass through to the overall economy and for conditions to improve. Monetary policy was certainly not futile.

This can also give us a sense of where the economy is going as well. From the P/E ratios and the actual index level of the SP500, we can back out a quarterly earnings index -- both expected future earnings and actual trailing twelve months. By comparing expected earnings with the actual earnings one year later, we can actually evaluate how accurate forecasters were. Surprisingly enough, post dot com bubble, earnings forecasts were pretty accurate during normal times, and only when there was a policy failure (in 2008), was there a significant deviation. This suggests that earnings should continue to grow, and that the real concern shouldn't be on whether the stock market is getting frothy, but on whether overly contractionary monetary policy will send the recovery off course.

Now, this recovery may not be pretty. It's entirely possible for median household incomes to continue their stagnation. Remember, stable nominal GDP is consistent with almost any configuration of the real economy. You can have severe inequality, a low labor share, and inefficient labor markets and still have a monetary policy that keeps nominal GDP on track.

So if you want to avoid those bad, unequal, configurations, then you will earn my respect as you fight for targeted fiscal interventions. Just keep your hands off my monetary policy, because the most dangerous idea you can have is that it doesn't matter.

Update: Fixed some typos. Changed "monetary policy" in fifth sentence of first paragraph to "quantitative easing"

Macroeconomics: The Illustrated Edition

This post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to spend their cash and apple balances. Apples are transacted, bellies are filled, and life is good.

But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.

But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras' law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples. Not everybody spends all their wealth on apples. Instead, some people may put their wealth into money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to macroeconomics.

If there is an excess supply of goods, it must be the result of excess demand for money.

The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "deep magic" of macro.

While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the only representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.

The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So we get a corollary to the first diagnosis of recessions:

If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.

Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.

In particular, the second approach gives a clear reason why monetary policy solves recessions. Microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.

If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, tries to change the relative price of consumption today and tomorrow to resolve the general glut. But this means that just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of a more general political problem. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.

Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.

So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).

Now we get to the fun part -- applying this framework to some of the policy debates of the day.

Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.

Interestingly enough, quantitative easing is not in this picture. The only way to integrate quantitative easing is to think of it as a signal for the future path of rates. This has indeed been found to be a powerful channel through which QE has an effect.

We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more transfers today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.

The Ricardian critique of fiscal policy also pops out. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.

In this context, the Federal Lines of Credit proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.

I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal production. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.

Pictures were drawn in Paper 53.


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The above post was cross-posted (with edits) from my personal blog, Synthenomics. I wanted to post it here so that all of our readers could get an idea of how I think about General Equilibrium, as I plan on using it to discuss several other issues in monetary policy. But as it is a cross-post, I have the opportunity to address an interesting issue that Basil brought up in the comments:

It looks to me that if the two models are equivalent, then a rise in demand for money is the same thing as a rise in the demand for future goods/services. 

But that's not (necessarily) the case. Sure, as you note, money is a store of value, but lots of things are stores of value. What makes money unique is its role as medium of exchange/unit of account. Seems like most increases in the demand for money are increases in the demand for the *liquidity* that money provides, not for the store of value service that it provides. 

I think the fact that you can't fit quantitative easing into the second model is telling. It can be explained very simply in the first model: QE is an increase in the supply of money to match the increase in demand, in an attempt to restore equilibrium. 

Recessions (defined as output below potential, not as negative GDP growth) cannot occur in pure barter economies. You need money to disrupt things. A recession can occur in your second interpretation, and there's no money.

In sum, Basil argues that thinking about current and future markets cannot replicate all of the features of money. In particular, the notion of claims on future goods leaves no role for a special "unit of account". While I am sympathetic to this view, I wonder if we can't come incredibly close to a money economy through an interest rate construction.

As Basil points out, the real question is whether the interest rate story matches up with the role of money as a unit of account. Well, the reason money's status as a unit of account matters is because of some kind of nominal stickiness - whether through wages or prices. Therefore money's role as a unit of account means that when you print more of it, you can actually get more real expenditures.

But I would argue that a nominal interest rate captures the same dynamic. In the derivation of the New Keynesian Philips Curve (which you can follow along at home with my notes here), a critical step is that firms set price in order to maximize their profits across expected future price levels. In effect, firms set their price on the basis of how much more expensive the future will be relative to the present.

This maps directly into the interest rate framework. By lowering the interest rate between today and tomorrow, this means the relative price of today should be much higher. But since firms are anchored by the Calvo fairy, this means that firms are stuck at a price lower than what the interest rate would suggest. Since consumption in the present is now too cheap, this increases current aggregate demand and the recession is solved. So even though the interest rate is not a unit of account, it does capture the key reason why being a unit of account matters: nominal stickiness.

Liquidity is also a red herring. Assets become illiquid because they aren't being transacted. But if monetary policy can get current demand for goods and services higher, then these assets will become liquid and there's no more demand for money.

As I mentioned above, I will expand on this framework in later posts. Let me know if you have any suggestions on what I should try to draw next!

Update: As a commentator noted, this model is really just a model of demand side recessions. I do apologize for not making that more clear, as I was not really thinking about the supply side when writing this post. For a more interesting take on the supply side, take a look at Frances Coppola's post.

Religion and Monetary Policy: Is There a Difference?

 

According to former Moody’s VP Chris Mahoney, certain religious groups are simply incapable of understanding monetary policy: 

Why is the Right so in love with hard money, low inflation, and high unemployment? Here is my answer: because they do not believe that there is such a thing as a free lunch. You could spread out a smorgasbord of caviar, salmon, lobster and Dom Perignon, and they would turn their heads and eat a cheese sandwich. Reflation is easy and thus sinful. It’s that Protestant thing. The only people who understand monetary policy are Jews and Catholics.

As a Catholic, I certainly find this theory flattering. But I wouldn’t carry the religious angle too far. William JenningsBryan, for example, somehow managed to be both a devoted Protestant and a firm advocate of expansionary monetary policy, while the two biggest defenders of the Austrian School approach to monetary policy (Mises and Rothbard) were both Jewish.

Still, I do think Mahoney has put his finger on one reason why many conservatives and libertarians view monetary expansion with such a jaundiced eye. If there is one economic lesson the Right has internalized, it is Heinlein’s aphorism that There Ain’t No Such Thing As AFree Lunch. And attempts to improve the economy by what is often derisively described as “printing money” can at first blush seem like, if not a free lunch, then at least as free lunch money.

Appearances, though, can be deceiving. Heinlein excepted, there is probably no figure more responsible for popularizing TANSTAAFL than Milton Friedman. And Milton Friedman, firm libertarian that he was, also urgedJapan to engage in quantitative easing, condemned the Austrian School, and arguedthat a lack of monetary action was responsible for the Great Depression.

So what gives? On one level, the idea that you can make a society richer by printing out green pieces of paper (or, even worse, by changing a few digits on a computer screen) sounds absurd. But then, the idea that a giant metal tube could float through the air sounds pretty absurd too. Technology is like that, and money (including fiat money) is a technology just as much as air travel.

I don’t think opponents of “money printing” would deny that the existence of money can make a society richer. Barter is inconvenient, after all, and societies that don’t have a commonly accepted medium of exchange tend to be a lot poorer, for obvious reasons, than those that do.

Likewise, just as the use of money can make society wealthier, a well-functioning monetary system can result in a society that is wealthier than if the monetary system is somehow out of whack. On some level opponents of QE get this too. Hence the references to Zimbabwe. But where they often seem to fall short is in realizing that just as a monetary system can get out of whack if there is too much money, so can it be suboptimal if there isn’t enough money.

Suppose, for example, that America was hit with a computer virus that substantially lowered the balance of checking and savings accounts throughout the U.S. If nothing was done to counteract this, businesses throughout the country would find themselves unable to meet payroll, and would be forced to lay off workers or declare bankruptcy. Individuals would be unable to make their mortgage payments, and even those not directly affected would be harmed as the effects of this deflationary virus rippled through the economy.

Of course, eventually prices and wages would adjust downward to reflect the lower quantity of money. But this would be a long and painful process. It would be much better, if possible, to simply counter-act the effects of the virus, by “printing money” to cover the losses. Far from being a “free lunch,” things like QEWhatever are simply an attempt to avoid the disinflationary impact of the financial crisis and its aftermath.

Can You Solve A Debt Problem With More Debt?

It is often said — particularly in Austerian circles, and most recently by British Prime Minister David Cameron — that “you can’t solve a debt problem with more debt”. 

This is, I think, an entirely tautological definition. It is definitional that you can’t solve a drowning problem with more water. You can’t solve a burning problem with more fire. But what exactly is a debt problem? What does that even mean? Austerians seem to think that it means rising levels of debt, and those that charge that we have a debt problem often use scary-looking non-inflation adjusted charts that show soaring levels of nominal debt as an illustration that debt levels are out of control:

But that is not the same as a debt problem. As Frances Coppola notes, unless the level of debt is shown as a proportion of total economic activity, a nominal debt figure is totally meaningless. And as a proportion of GDP, British government debt levels are very low relative to the historical norm:

That tiny blip upward toward the end is what David Cameron calls a “debt problem”? Seriously? Yes, debt levels have reached new nominal highs, but those nominal highs are supported by a proportionately larger level of nominal economic activity. Using the current British situation as an example of a “debt problem” is intellectually dishonest — and using this totally arbitrary definition of a “debt problem” as a justification for austerity doubly so.

Yet even debt as a percentage of economic activity is not flexible enough to really define a “debt problem”. Reinhart & Rogoff's 90% threshold for lowered growth is dead; every country and situation is different. The truest kind of "debt problem" is a solvency crisis, where a debtor can no longer service its debts and thus forced deleveraging. Of course, before hitting a solvency crisis there are warning signs. The best measure of a growing “debt problem” is interest rates. Rising interest rates — like we see in Greece, and to a lesser extent Italy, Spain and Portugal would indicate falling confidence in the government’s ability to repay its debts in a timely and non-inflationary fashion. Yet that is not what we see today in Britain. 

Quite the opposite:

Interest rates on government debt are still close to all-time lows. So, the notion that the British government has a debt problem is not just wrong, but absurd. Cameron is just repeating unrealistic assumptions in the face of massive evidence to the contrary. The relevant aphorism here is not “you can’t solve a debt problem with more debt”, but “you can’t solve a derp problem with more derp”.

In the private sector, we see something much more like the aftermath of a debt problem —  mass deleveraging. In 2008 private sector debt in many Western nations including the USA and the UK hit all-time highs as a percentage of GDP, and since then both nations’ private sectors have been deleveraging. This has depressed private investment and consumption. In this context, the UK does have an unemployment problem, with over 8% unemployment for most of the last five years and currently over 2.51 million individuals looking for work. This is a serious market failure, and evidence shows that the long-term effects of mass unemployment are deleterious and lingering.That problem could easily be solved with more borrowing and job creation, using debt-financed fiscal policy to bring down unemployment until the private sector begins expanding again. This would kill multiple birds with one stone, as evidence shows both the US and the UK are chronically under-invested in infrastructure. 

Do Savers Need to be Saved?

The Bank of England is following the Federal Reserve and the ECB in adopting forward guidance. Bank of England Governor Mark Carney announced that the Bank will not raise interest rates until the jobless rate--currently 7.8%-- falls to 7% or below. According to the Monetary Policy Committee (MPC), this state-contingent forward guidance implies that interest rates are likely to remain at the current 0.5% rate for about three years.

The backlash against this announcement of continued low rates is particularly strong and vocal in the UK, where an organization called Save our Savers is campaigning against "artificially low interest rates." The organization writes, "Although the financial crisis was caused by debt, the Bank’s policy continues to favour borrowing at the expense of saving." This sentiment appears, sometimes in more subtle forms, in the US too. Perhaps the most notable counterpoint to Save our Savers is Frances Coppola, who has this to say about low interest rates and savers:

"The desire of savers to be compensated for loss of purchasing power is understandable but wrong...Savers have no right whatsoever to expect to receive a higher rate of return than the ability of the economy to generate that return. If the economy is growing at 0.6%, the risk-free rate of return cannot be any higher than that. If savers want higher returns they have to put their money at risk.

At the moment savers have unreasonable expectations. They expect to have returns on their savings far above the current level of economic growth, and they also expect to have their savings protected from loss. But the only way savers can have risk-free returns above the growth rate of the economy is by others - most likely government - taking on debt. It's rent-seeking, frankly... In calling for higher interest rates, savers are effectively demanding that there should be no recovery. And in killing off such unreasonable expectations, Carney is doing us all a favour."

Note that the result that Coppola alludes to about the risk-free interest rate equaling the growth rate applies either to nominal interest rates and nominal growth rates, or to real interest rates and real growth rates. The UK actually has a 0.6% real growth rate, and 0.5% nominal interest rate. The nominal growth rate is over 3%. Also note that this is an equilibrium result--it holds when the economy is in "steady state," i.e. not always and not now. The UK nominal interest rate is several percentage points lower than the nominal growth rate. This has savers up in arms, and that's kind of the point. In theory, some of the savers who dislike earning the ultra-low risk-free rate could shift some of their consumption from the future to the present. That would raise current consumption relative to future consumption, reducing the growth rate of consumption, bringing the economy nearer to equilibrium. That is part of the goal of low interest rate policy. But it depends on how willing people are to substitute consumption "intertemporally," and how much utility they lose by doing so. To explain:

Interest rates theoretically have two opposing effects on savings decisions. On one hand, a higher real interest rate makes future consumption cheaper relative to current consumption, leading people to save more-- the substitution effect. On the other hand, a higher real interest rate increases the return on saving, giving some consumers more lifetime income--the income effect. The combination of the income and substitution effects means that the effect of higher real interest rates on consumption is theoretically ambiguous (see this survey or Chapter 7 of David Romer's Macroeconomics). An important parameter in models of consumption is the intertemporal elasticity of substitution, which tells us which effect dominates.

Savers who have low intertemporal elasticity of substitution are not very willing or able to shift their consumption forward in time to benefit from the fact that current consumption has been made cheaper relative to future consumption. Thus they have special reason to hate low interest rates because they amount to lower income. The most commonly cited example of this type of saver is a person who is retired or nearly retired:

"Obviously, for retirees who are living in part on investment income, low rates have an immediate impact on their standard of living. With few prospects to add to whatever they've managed to set aside in their retirement nest eggs, retirees are largely at the mercy of banks and other financial providers that determine how much interest they're willing to pay their customers on their investment balances."

Hearing about these retirees is particularly compelling and makes it seem like low interest rates are violating an implicit social contract. Coppola says that "savers have unreasonable expectations." Is it unreasonable for for people who have worked and saved for years to expect a decent standard of living in retirement? Well no, it is not unreasonable, but higher interest rates are not the way to meet that expectation. Decent standards of living for retirees should be part of the social contract, but should be promoted through programs that target retirement security and/or consumer protection directly, and not through interest rate policy. (Just as financial stability should be promoted directly through regulatory policy, not through interest rate policy.)

Plus, not all savers are in the same boat as these retirees. For some people, the substitution effect dominates. Higher interest rates would encourage the more intertemporally elastic folks to spend less today, which would have majorly bad implications. Being unemployed hurts your income even more than getting a low return on your savings does.

A question on the the European Commission Consumer Survey asks consumers whether this is a good time to save, and a "good time to save" index is constructed by computing a balance statistic from the positive and negative responses. Here's a graph of the UK discount rate (downloaded from FRED) compared to the UK "good time to save" index. The correlation coefficient is 0.70.

Constructed by Binder with data from FRED (INTDSRGBM193N) and EC Consumer Survey (Q10 Balance Statistic)

The general tendency is that when interest rates are higher, people think it's a good time to save. But we don't know exactly what people mean when they say it is a good time to save; people can think it's a good time to save for multiple reasons. Most straightforward, high interest rates mean a higher return to saving. You might say it's a good time to save if you have a lot more income than you want to spend-- in good times, save some of the excess. In this case you would think it was both a good time to save and a good time to spend. But you might say it's a good time to save if you are trying to deleverage, or if your net worth has fallen and you are trying to build wealth back up to some target level, or if you fear losing a job soon. In these cases you would think it was a good time to save and a bad time to spend.

To get a clearer picture, it is useful to plot the "good time to save" index along with the "good time to spend" index, also from the EC Consumer Survey. Before 2008, the two indices had a mildly negative correlation coefficient of -0.34. Very roughly speaking, in bad times people favored saving and in good times they favored spending. But now? After 2008, the correlation coefficient is 0.40. Now it's so bad that both indices are low. It's a bad time to be a saver, and it's also a bad time to be a spender. People don't have extra money to save or to spend, and until the labor market improves, they won't. Raising the interest rates cannot possibly be helpful in this situation.

Constructed by Binder with EC Consumer Survey data