Inequality and the Fourth Estate

I have been slow to chime in on Thomas Piketty’s book, Capital in the 21st Century, but it is hard to ignore the chatter that the book has generated from those on all sides of the political spectrum. The book sheds welcome light on the topic of income and wealth inequality and it has rekindled a debate in the United States and Europe on an age-old question: Should we care if some individuals earn much more than others?

As individuals in a modern democracy we make social decisions about how much of each good to produce and consume through free trade in a market economy. The rules by which we trade with others are determined through democratic elections in which we give power to our representatives to transfer resources from one human being to another. And we interact with each other through conversations, free association and social media or through more organized forms of persuasion such as newspapers and television stations. 

As economists, we are sometimes justly accused by other social scientists of taking a narrow view of human nature. A human being, to the neoclassical economist, is a preference ordering over all possible actions that he or she may take over the course of a lifetime. That preference ordering is fixed at birth and swings into action at the age of consent, at which time each of us exercises our endowed ability to choose among competing alternatives to maximize our happiness. 

That, of course, is poppycock. The view of homo-economicus as a utility seeking machine is not to be found in Smith, who had a much richer view of human nature as evidenced by his “other book” on The Theory of Moral Sentiments. Nor is it to be found in John Stuart Mill’s eloquent defense of free speech in his essay On Liberty. Both of those eminent social scientists would, I am certain, have been open to the idea that our opinions are formed through rational argument with other human beings. Our preference orderings do determine our actions; but they are not preordained. Nature and nurture are equally important determinants of human action.

Financial Policy

John Cochrane supports the case (forcefully made by Anat Admati) for higher capital requirements, citing excellent pieces by Pat Regnier at Time and Peter Coy at Business Week who explain exactly what this does and does not,  mean. I agree: we need banks to hold more capital.  But is that enough?

The following passages are extracts from my recent paper in the Manchester School on the role of the Financial Policy Committee as a guardian of financial stability.  I make the case that financial markets are inefficient because we cannot trade in markets that open before we are born. That fact is an important source of market incompleteness that I call the "absence of prenatal financial markets".

We all agree that financial crises occur. We disagree as to their cause. Some economists argue that markets are not only informationally efficient; they are also Pareto efficient. The boom and the bust are a consequence of the natural flow of knowledge acquisition in a capitalist economy. They are the price of progress. I disagree.

How to Estimate Models with Indeterminacy

My coauthors, Vadim Khramov, Giovanni Nicolo and I, have recently completed a revision of our working paper, "Solving and Estimating Indeterminate DSGE Models".

Dynamic Stochastic General Equilibrium Models (DSGE) often have many equilibria. I have long argued that we should exploit that idea to explain real world phenomena. For example, multiple equilibrium models can help to explain why "animal spirits" drive real world markets (see my survey here).

In 2004, Thomas Lubik and Frank Schorfheide published an influential paper which applied that idea to US monetary policy.  A number of authors have taken up their method, but the technique they used is not very easy to apply in practice. Our paper shows how to solve and estimate models with indeterminate equilibria using readily available software packages such as Chris Sim's code Gensys, or the widely used Matlab based package Dynare.

Thought for the Day

The hardest part of doing research is escaping from prejudices.

TheTreasury and the Fed are at Loggerheads over QE

In my last post on QE, I quoted a paper by James Hamilton and Cynthia Wu that provides some empirical evidence for the importance of the asset composition of the Fed's balance sheet and its effect on the term structure of interest rates. They have posted their data online and it makes for interesting bedtime reading. 

Hamilton and Wu combined their data with evidence from the yield curve. They found that qualitative easing can be effective at the lower bound and that

... buying $400 billion in long-term maturities outright with newly created reserves, ... could reduce the 10-year rate by 13 basis points without raising short-term yields.

To construct these estimates, they used a theoretical model developed by Vayanos and Vila which assumes that there are investors who have a 'preferred habitat'.

The Hamilton Wu results are important. I ran some regressions of term premiums on bond supply by maturity, using their data, and I found the same orders of magnitude in the response of interest rates that they found. But there is an interesting sub-text to their analysis discussed in Section 8 of their paper. The Fed and the Treasury have been following conflicting policies. David Beckworth on his blog in 2012 makes the same point.

Quantitative Easing took place in three phases. QE1 from 11/08 to 03/10, QE2 from 11/10 to 06/11 and QE3 which is ongoing. Along with monetary expansion, the Fed attempted to refinance its portfolio by selling at the short end and buying at the long end of the yield curve. But at the same time, the Treasury was refinancing its own portfolio. The end result was that the Treasury restructuring completely swamped any effect of Fed operations at the long end of the yield curve.  

Figure 1

In Figure 1 I have broken down the System Open Market Account (SOMA) of Fed holdings of Treasuries by maturity as a percentage of all outstanding Treasuries, using the Hamilton Wu data set. The two vertical red lines are the beginning and end of the last recession and the vertical black line marks the collapse of Lehman Brothers.

The Greenspan Put and the Yellen Call

In today's Guardian, I make the case for a more aggressive financial stabilization policy,  "No more boom and bust? The financial policy committee has time on its side". I argue that the Bank of England's FPC should buy shares in the stock market when the PE ratio is low, and sell them when it is high.

Kimdriver makes the following comment.

The Greenspan put with real teeth ?

My worry is that, while CAPE has historically been a good predictor of future returns, the level that the FPC should be ready to intervene would have to be set so low that it might be fairly useless. Otherwise the safety net would just encourage increased irrational exuberance.

My response ...

I am not arguing just for a Greenspan Put: but also for a Yellen Call. It is just as dangerous to allow market bubbles as it is to allow them to crash.

Read more here...

Why Death Matters for Central Bank Policy

Noah Smith raises the question: can the Fed influence the interest rate? Although the answer may seem obvious, the question itself reflects a conundrum for neoclassical theory. It is representative of a related but more comprehensive question: does the asset composition of the central bank balance sheet matter?

Let me set aside, for now, the deep question: what is money? I will take for granted the fact that the liabilities of the central bank are special. Perhaps this is due to legal restrictions, as Neil Wallace has suggested, or perhaps it is a matter of social convention. My focus here is not on central bank liabilities; but on their assets.