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Economy

The power of recall

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The other day, I heard the Stranglers’ Strange Little Girl for the first time in ages, prompting me to recall having an Indian takeaway in a friend’s Morris Oxford somewhere off the Clarendon Road on a sunny evening in 1982. I wonder: does this help explain why older people are more hostile to the Labour party than younger ones?

My response to that particular song was of course idiosyncratic. But it is nevertheless typical. All of us have Proustian madeleines – cues that prompt us to recall some memories. We all, I suspect, have songs which we associate with specific people and places. This is why “trigger warnings” are sometimes necessary: traumatic memories can indeed be triggered. As Daniel Levitin writes:

The brain is not like a warehouse; rather, memories are encoded in groups of neurons that, when set to proper values and configured in a particular way, will cause a memory to be retrieved and replayed in the theatre of our minds. The barrier to being able to recall everything, we might want to is not that it wasn’t ”stored” in memory, then; rather, the problem is finding the right cue to access the memory (This Is Your Brain on Music, p165)

In a new paper Jessica Wachter shows that this process colours our financial decision-making. Take for example the finding of Erin McGuire and Stefan Nagel and Ulrike Malmendier (pdf), that economic conditions in our formative years influence how much we invest in equities even decades later. From one point of view, this seems absurd: expected returns are the same for all of us. So, how can it happen? Simple. The questions “should I buy shares?” or “What is the economic outlook?” trigger particular memories. For some, these are memories of the bear market of the 70s. For slightly younger people they are memories of the 80s bull market. And these generations invest accordingly.

A similar thing, says Professor Wachter, explains why shares fell so far – in hindsight by too much – when Lehmans collapsed. This triggered memories of (reading about) the Great Depression and hence alarm.  (Luckily, though, it also reminded the Fed of the Great Depression, so it knew what not to do).

I suspect a similar process contributes to older people’s greater opposition to Labour. Remember that it is not inevitable that young people should be predominantly left-wing: in 1987, for example, more of them supported the Tories than Labour. So why are things different today?  

One reason, of course, is that older people own houses and younger ones don’t.

But it could be that different memories are involved. If you are in your mid-50s or older, talk of a left-wing Labour party cues memories of the Soviet Union and of the 1970s – and of the more salient aspects of the 70s such as strikes rather than less salient ones such as the fact that most workers got better real-terms pay rises than they’ve had recently.

Young people, however, have none of these memories. For them, talk of nationalizing the railways trigger not memories of British Rail sandwiches but of pleasant train journeys in Europe.

Of course, the 1970s were the 1970s whether you experienced them or not. But as David Hume said, actual experiences – impressions – are stronger than mere ideas.   

In one sense, all of this might be trivially obvious. In another, though, it’s not. Even though the truth should in theory be the same for all of us – in the way that future share price moves will be – we perceive it differently. This is not (just) because we are stupid or dishonest. It’s because of how memory works.  



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Economy

The Deficit Myth: a review

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One common objection to neoclassical economics is that it underweights the importance of history and class. It is therefore paradoxical that Stephanie Kelton's The Deficit Myth, which claims to challenge orthodox economics, should be guilty of just these vices.

Let's start by saying that I wholly agree with the main claims she makes – that a government which enjoys monetary sovereignty can always finance its borrowing. Asking how we will pay for public spending is therefore daft. Instead, the question, as Dr Kelton says, is: can the extra spending be resourced? The constraint on raising health spending for example – if there is one – is a lack of doctors and nurses, not a lack of finance. Where there are resources lying idle, governments should raise spending to employ them. Dr Kelton explain these ideas wonderfully clearly, so I recommend this book to all non-economists interested in government finances.

For this economist, though, it poses a problem. I remember writing a research note for Nomura back in the early 90s arguing that increased government borrowing would not increase gilt yields because the same increased private saving that was the counterpart of government borrowing would easily finance that borrowing. Nominal gilt yields, I said, were determined much more by inflation than by government borrowing. But nobody accused me of originality. And rightly so. I was simply channelling Kalecki, Beveridge, Lerner and Keynes, who famously said back in 1933:

Look after the unemployment, and the Budget will look after itself.

For me, Kelton is – albeit very lucidly – reinventing the wheel. Reading her, I felt like Mr Jourdain in Moliere's The Bourgeois Gentleman, who was surprised to discover that he had been speaking prose all his life.

Here, Dr Kelton is more ambiguous than I would like. At one stage she claims that MMT "didn't exist" before the late 90s. But whilst the phrase did not exist, the ideas certainly did. Randall Wray is right to say (pdf) that "the main principles of functional finance were relatively widely held in the immediate postwar period."

And indeed Kelton does occasionally see this. There is passing reference to Lerner and to Keynes' How to Pay for the War, though not to Kalecki. And she cites JFK agreeing with James Tobin saying that "the only limit [on government borrowing] really is inflation."

Which is why I say she underplays history. I agree with Gavin Jackson that MMT is not new, and with Hans Despain that she neglects the ontology of MMT. We must ask, as she doesn't: why did these old truths get forgotten*?

I'm not sure about Wray's explanation, that it was because of the inflation of the 1970s. In principle, we might have interpreted that as consistent with functional finance, except that the inflation constraint on borrowing had tightened since the 50s.

Instead, I suspect the answer lies in Kalecki's great paper (pdf), "Political Aspects of Full Employment", written in 1942. He starts by saying "we are all 'MMTers' now":

A solid majority of economists is now of the opinion that, even in a capitalist system, full employment may be secured by a Government spending programme, provided there is in existence adequate plant to employ all existing labour power, and provided adequate supplies of necessary foreign raw materials may be obtained in exchange for exports.

What's not to like, he asks? His answer lay in something else Kelton neglects: class.

Capitalists, he wrote, disliked what we now call MMT because it weakened their power. If governments can use fiscal policy to maintain full employment, they don't need to maintain business confidence and so "this powerful controlling device loses its effectiveness":

The social function of the doctrine of "sound finance" is to make the level of employment dependent on the "state of confidence…[Capitalists'] class instinct tells them that lasting full employment is unsound from their point of view and that unemployment is an integral part of the " normal " capitalist system.

It is surely no accident that the backlash against functional finance came at a time when capitalists re-asserted their power over governments. Nor is it an accident that it's happened when capitalism has shifted away from mass-market Fordism to extractive finance capital: the former requires full employment and a mass market, the latter requires cheap money instead.

The analogy between government and household finances is of course a fiction – as we've known for almost a century – but it is a useful fiction for maintaining capitalists power.

Which is a big gap in Kelton's analysis. In treating public finances as merely a technocratic matter, she is ignoring the fact that capitalist power sometimes precludes good policy. She is making the error Kalecki warned us against:

The assumption that a government will maintain full employment in a capitalist economy if it only knows how to do it is fallacious.

Kelton is right. To implement her ideas (and those of Kalecki, Keynes, Lerner, Beveridge and Minskly!) however requires more than an intellectual (counter-)revolution. It requires a dismantling of capitalist power. And that's a tougher job.

* She neglects another historical question: if monetary sovereignty is as good as she claims, why were European nations (with the support of both public and economists) so keen to abandon it in the 1990s? One answer, I suspect, is that countries lacking the US's "exorbitant privilege" had less effective sovereignty. Whereas demand for Treasuries and dollars is so great as to give the US room to borrow, demand for drachmas, escudos and lira was not so great – and the dumping of such currencies meant their governments faced a tighter inflation constraint than the US.



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Economy

The Surplus Process

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How should we model surpluses and deficits? In finishing up a recent articleand chapter 5 and 6 of a Fiscal Theory of the Price Level update, a bunch of observations coalesced that are worth passing on in blog post form.

Background: The real value of nominal government debt equals the present value of real primary surpluses, [ frac{B_{t-1}}{P_{t}}=b_{t}=E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}. ] I ‘m going to use one-period nominal debt and a constant discount rate for simplicity. In the fiscal theory of the price level, the (B) and (s) decisions cause inflation (P). In other theories, the Fed is in charge of (P), and (s) adjusts passively. This distinction does not matter for this discussion. This equation and all the issues in this blog post hold in both fiscal and standard theories.

The question is, what is a reasonable time-series process for (left{s_{t}right} ) consistent with the debt valuation formula? Here are surpluses

The blue line is the NIPA surplus/GDP ratio. The red line is my preferred measure of primary surplus/GDP, and the green line is the NIPA primary surplus/GDP.

The surplus process is persistent and strongly procyclical, strongly correlated with the unemployment rate.  (The picture is debt to GDP and surplus to GDP ratios, but the same present value identity holds with small modifications so for a blog post I won’t add extra notation.)

Something like an AR(1) quickly springs to mind, [ s_{t+1}=rho_{s}s_{t}+varepsilon_{t+1}. ] The main point of this blog post is that this is a terrible, though common, specification.

Write a general MA process, [ s_{t}=a(L)varepsilon_{t}. ] The question is, what’s a reasonable (a(L)?) To that end, look at the innovation version of the present value equation, [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =Delta E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}=sum_{j=0}^{infty}beta ^{j}a_{j}varepsilon_{t}=a(beta)varepsilon_{t}% ] where [ Delta E_{t}=E_{t}-E_{t-1}. ] The weighted some of moving average coefficients (a(beta)) controls the relationship between unexpected inflation and surplus shocks. If (a(beta)) is large, then small surplus shocks correspond to a lot of inflation and vice versa. For the AR(1), (a(beta)=1/(1-rho_{s}beta)approx 2.) Unexpected inflation is twice as volatile as unexpected surplus/deficits.

(a(beta)) captures how much of a deficit is repaid. Consider (a(beta)=0). Since (a_{0}=1), this means that the moving average is s-shaped. For any (a(beta)lt 1), the moving average coefficients must eventually change sign. (a(beta)=0) is the case that all debts are repaid. If (varepsilon_{t}=-1), then eventually surpluses rise to pay off the initial debt, and there is no change to the discounted sum of surpluses. Your debt obeys (a(beta)=0) if you do not default. If you borrow money to buy a house, you have deficits today, but then a string of positive surpluses which pay off the debt with interest.

The MA(1) is a good simple example, [ s_{t}=varepsilon_{t}+thetavarepsilon_{t-1}% ] Here (a(beta)=1+thetabeta). For (a(beta)=0), you need (theta=-beta ^{-1}=-R). The debt -(varepsilon_{t}) is repaid with interest (R).

Let’s look at an estimate. I ran a VAR of surplus and value of debt (v), and I also ran an AR(1).

Here are the response functions to a deficit shock:

The blue solid line with (s=-0.31) comes from a larger VAR, not shown here. The dashed line comes from the two variable VAR, and the line with triangles comes from the AR(1).

The VAR (dashed line) shows a slight s shape. The moving average coefficients gently turn positive. But when you add it up, those overshootings bring us back to (a(beta)=0.26) despite 5 years of negative responses. (I use (beta=1)). The AR(1) version without debt has (a(beta)=2.21), a factor of 10 larger!

Clearly, whether you include debt in a VAR and find a slightly overshooting moving average, or leave debt out of the VAR and find something like an AR(1) makes a major difference. Which is right? Just as obviously, looking at (R^2)   and t-statistics of the one-step ahead regressions is not going to sort this out.

I now get to the point.

Here are 7 related observations that I think collectively push us to the view that (a(beta)) should be a quite small number. The observations use this very simple model with one period debt and a constant discount rate, but the size and magnitude of the puzzles are so strong that even I don’t think time-varying discount rates can overturn them. If so, well, all the more power to the time-varying discount rate! Again, these observations hold equally for active or passive fiscal policy. This is not about FTPL, at least directly.

1) The correlation of deficits and inflation. Reminder, [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =a(beta)varepsilon_{t}. ] If we have an AR(1), (a(beta)=1/(1-rho_{s}beta)approx2), and with (sigma(varepsilon)approx5%) in my little VAR, the AR(1) produces 10% inflation in response to a 1 standard deviation deficit shock. We should see 10% unanticipated inflation in recessions! We see if anything slightly less inflation in recessions, and little correlation of inflation with deficits overall. (a(beta)) near zero solves that puzzle.

2) Inflation volatility. The AR(1) likewise predicts that unexpected inflation has about 10% volatility. Unexpected inflation has about 1% volatility. This observation on its own suggests (a(beta)) no larger than 0.2.

3) Bond return volatility and cyclical correlation. The one-year treasury bill is (so far) completely safe in nominal terms. Thus the volatility and cyclical correlation of unexpected inflation is also the volatility and cyclical correlation of real treasury bill returns. The AR(1) predicts that one-year bonds have a standard deviation of returns around 10%, and they lose in recessions, when the AR(1) predicts a big inflation. In fact one-year treasury bills have no more than 1% standard deviation, and do better in recessions.

4) Mean bond returns. In the AR(1) model, bonds have a stock-like volatility and move procyclically. They should have a stock-like mean return and risk premium. In fact, bonds have low volatility and have if anything a negative cyclical beta so yield if anything less than the risk free rate. A small  (a(beta)) generates low bond mean returns as well.

Jiang, Lustig, Van Nieuwerburgh and Xiaolan recently raised this puzzle, using a VAR estimate of the surplus process that generates a high (a(beta)). Looking at the valuation formula [ frac{B_{t-1}}{P_{t}}=E_{t}sum_{j=0}^{infty}beta^{j}s_{t+j}, ] since surpluses are procyclical, volatile, and serially correlated like dividends, shouldn’t surpluses generate a stock-like mean return? But surpluses are crucially different from dividends because debt is not equity. A low surplus (s_{t}) raises  our estimate of subsequent surpluses (s_{t+j}). If we separate out
 [b_{t}=s_{t}+E_{t}sum_{j=1}^{infty}beta^{j}s_{t+j}=s_{t}+beta E_{t}b_{t+1}  ] a decline in the “cashflow” (s_{t}) raises the “price” term (b_{t+1}), so the overall return is risk free. Bad cashflow news lowers stock pries, so both cashflow and price terms move in the same direction. In sum a small (a(beta)lt 1) resolves the Jiang et. al. puzzle. (Disclosure, I wrote them about this months ago, so this view is not a surprise. They disagree.)

5) Surpluses and debt. Looking at that last equation, with a positively correlated surplus process (a(beta)>1), as in the AR(1), a surplus today leads to  larger value of the debt tomorrow. A deficit today leads to lower value of the debt tomorrow. The data scream the opposite pattern. Higher deficits raise the value of debt, higher surpluses pay down that debt. Cumby_Canzoneri_Diba (AER 2001) pointed this out 20 years ago and how it indicates an s-shaped surplus process.  An (a(beta)lt 1) solves their puzzle as well. (They viewed (a(beta)lt 1) as inconsistent with fiscal theory which is not the case.)

6) Financing deficits. With (a(beta)geq1), the government finances all of each deficit by inflating away outstanding debt, and more. With (a(beta)=0), the government finances deficits by selling debt. This statement just adds up what’s missing from the last one. If a deficit leads to lower value of the subsequent debt, how did the government finance the deficit? It has to be by inflating away outstanding debt. To see this, look again at inflation, which I write [ frac{B_{t-1}}{P_{t-1}}Delta E_{t}left( frac{P_{t-1}}{P_{t}}right) =Delta E_{t}s_{t}+Delta E_{t}sum_{j=1}^{infty}beta^{j}s_{t+j}=Delta E_{t}s_{t}+Delta E_{t}beta b_{t+1}=1+left[ a(beta)-1right] varepsilon_{t}. ] If (Delta E_{t}s_{t}=varepsilon_{t}) is negative — a deficit — where does that come from? With (a(beta)>1), the second term is also negative. So the deficit, and more, comes from a big inflation on the left hand side, inflating away outstanding debt. If (a(beta)=0), there is no inflation, and the second term on the right side is positive — the deficit is financed by selling additional debt. The data scream this pattern as well.

7) And, perhaps most of all, when the government sells debt, it raises revenue by so doing. How is that possible? Only if investors think that higher surpluses will eventually pay off that debt. Investors think the surplus process is s-shaped.

All of these phenomena are tied together.  You can’t fix one without the others. If you want to fix the mean government bond return by, say, alluding to a liquidity premium for government bonds, you still have a model that predicts tremendously volatile and procyclical bond returns, volatile and countercyclical inflation, deficits financed by inflating away debt, and deficits that lead to lower values of subsequent debt.

So, I think the VAR gives the right sort of estimate. You can quibble with any estimate, but the overall view of the world required for any estimate that produces a large (a(beta)) seems so thoroughly counterfactual it’s beyond rescue. The US has persuaded investors, so far, that when it issues debt it will mostly repay that debt and not inflate it all away.

Yes, a moving average that overshoots is a little unusual. But that’s what we should expect from debt. Borrow today, pay back tomorrow. Finding the opposite, something like the AR(1), would be truly amazing. And in retrospect, amazing that so many papers (including my own) write this down. Well, clarity only comes in hindsight after a lot of hard work and puzzles.

In more general settings (a(beta)) above zero gives a little bit of inflation from fiscal shocks, but there are also time-varying discount rates and long term debt in the present value formula. I leave all that to the book and papers.

(Jiang et al say they tried it with debt in the VAR and claim it doesn’t make much difference.  But their response functions with debt in the VAR, at left,  show even more overshooting than in my example, so I don’t see how they avoid all the predictions of a small (a(beta)), including a low bond premium.)

A lot of literature on fiscal theory and fiscal sustainability, including my own past papers, used AR(1) or similar surplus processes that don’t allow (a(beta)) near zero. I think a lot of the puzzles that literature encountered comes out of this auxiliary specification. Nothing in fiscal theory prohibits a surplus process with (a(beta)=0) and certainly not (0 lt a(beta)lt 1).

Update

Jiang et al. also claim that it is impossible for any government with a unit root in GDP to issue risk free debt. The hidden assumption is easy to root out. Consider the permanent income model, [ c_t = rk_t + r beta sum beta^j y_{t+j}] Consumption is cointegrated with income and the value of debt. Similarly, we would normally write the surplus process [ s_t = alpha b_t + gamma y_t. ] responding to both debt and GDP. If surplus is only cointegrated with GDP, one imposes ( alpha = 0), which amounts to assuming that governments do not repay debts. The surplus should be cointegrated with GDP and with the value of debt.  Governments with unit roots in GDP can indeed promise to repay their debts.



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Economy

Campos: The Trump Delusion—Noted

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Paul Campos: The Trump Delusion https://www.lawyersgunsmoneyblog.com/2020/06/the-trump-delusion: ‘How is it that, despite everything, 40% of America continues to support Donald Trump? I’ve suggested that Trump’s supporters can be sorted into a few broad categories, with many of those supporters belonging to more than one of these groups: White nationalists…. Alienated burn it all down anti-establishment types…. Upper class Republicans who want big tax cut…. Religious conservatives, overwhelmingly white evangelicals…. Low information voters who always vote Republican out of tribal habit. These people have the most fantastical ideas about Trump, such as for example that he’s a “successful businessman,” rather than a “politician,” which is why he manages to “get things done.” This last group in particular includes a lot of overlap with the more cultish strain of religious conservatives…. Relatively few people are capable of maintaining a genuine lesser of two evils attitude toward the leader of an essentially charismatic—to use Weber’s typology—political movement. Almost everyone in the movement must eventually embrace the delusion that the leader is actually a good person, despite all evidence to the contrary. For example, the following message has gone viral on social media over the last few days. The text is headed by the photo at the top of this post:

Anonymous: 'Let’s look at this man for one damn second!!!! A 74-year-old man is coming back home from work at 2 AM while most men his age are retired in their vacation homes. He comes back after a long day that probably started before the sun rose and gets back home exhausted with his tie open and hat in his hand, feeling that an accomplished day is finally over…

…This amazing man is in the age range of many people’s grandfathers, great grandfathers, or my grandfather when he passed away, but this man just came back home from work, for me, for you. This man left his massive gold-covered mansion where he could retire happily and play golf all day long. But this man put his wealth aside and went to work for free, for $1 a year, for me, for you, for us, for AMERICA.

While other presidents became rich from the presidency, this man LOST over 2 billion dollars of his wealth during this short 4 years of his life. He put aside his amazing retirement lifestyle for getting ambushed every single day by the media and the Radical Left Democrats that trash this man who works for them until 1 AM for free!

No, he doesn’t do it for money or power, he already had it. He is doing it so their houses will be safe, so their schools will get better, so they will be able to find jobs or start a new business easier, so they will be able to keep few dollars in their pockets at the end of the month.

Look at this picture again, that man is at the age of your fathers, grandfathers or maybe YOU! Where is your respect? Honor? Appreciation? Are you THAT BLIND? THAT BLIND to not see a thing this man is doing for you and for your family? THAT BLIND that after all his work for minority groups in America you keep calling him a racist? I am the son of an Auschwitz Survivor and someone who lost 99% of my family to the camps and ovens of Nazi Germany. And I’m no fool! DONALD TRUMP IS NO RACIST OR ANTI-SEMITE!

Are you THAT BLIND to not see how much this country developed in last 4 years? President Donald J. Trump, I want to thank you with all my heart. I am so sorry for blind hatred you have been made to endure. You are a good and generous man. I KNOW THIS.

What I don’t know and think about often is what kind of people is it who can be so hateful in their hearts to spew such hate and evilness, not just at you but at your family too? Or people mocking and making jokes of you because you’re not a professional politician groomed in speech making and straight faced lying. Or how about them attacking your wife and young son? How awful that must make you feel.

People are sure they have not been manipulated. People believe their hatred is their own. But for why, they can’t articulate. What kind of people are these? WHAT KIND OF PEOPLE ARE THESE?? People not realizing they have been manipulated and brainwashed by such a deep-rooted EVILNESS MOTIVATED BY AN EVIL MEDIA AND DEMOCRAT PARTY. The American People are in a bad place right now….in their hearts and souls. God help us…Trump is not the problem.

This level of frankly delusional thinking is, I believe, far more common than either an enthusiastic embrace of anyone resembling the actual Donald Trump, or the sort of arms-length transactional support of people who recognize him for what he is, but have concluded that Paris is worth a mass.

Which is a fancy way of saying that a lot of his supporters are, at this point, basically insane.

…Meanwhile:

Aaron Rupar: 'This morning, Trump retweeted a QAnon account, thanked supporters of his who were filmed yelling “white power,” and issued a misleading non-denial of a story about him turning a blind eye while Russia offered bounties for US troops. All before 9 am…

.#noted #2020-07-10



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