And Now, Deflation

The one-year implied breakeven on Treasury Inflation Protected Securities has fallen below zero, to -0.17 percent, signaling that the market expects headline CPI deflation over the coming year.

Looking at the data, which has turned sharply since this winter, it's easy to understand why. The CPI fell an annualized 3.4 percent in May, the steepest monthly drop since the crisis in 2008. On a year-over-year basis, headline inflation is plummeting, as every marginal month of deflation or extraordinarily low inflation pulls down the average, which was elevated because of price increases in the fall of 2011.The deflation is largely driven by falling fuel prices; that is, core inflation has stopped rising, but has not slowed. Given that the fuel component of CPI lags the price of Brent crude through retail gasoline prices, it is highly probable that CPI will continue to fall on the basis of catch-up fuel deflation alone -- that is, before even considering the significant likelihood that Brent crude continues to fall as global economic growth slows.A slowdown in food-price inflation in the, another component of headline CPI but not the core, also explains the deflation and is likely to continue, due to falling commodity prices and slowing global growth.

Here is the market forecast for CPI inflation for the coming five years. More than mere deflation, it is highly suggestive of a recession in 2013.
Incidentally, Intrade ascribes a 30 percent probability of recession in 2013.

How the Court Will Say It

My prediction of how the Court will rule is on the record already.

But, given the intense interest that the Court's ruling tomorrow on the mandate case, I thought I would share a little bit more where I can be of assistance.

I have a reasonably close observer's understanding of the precedent cases. Below I are the "money quotes" which I am reasonably certain the anti-mandate side, or maybe even both sides, will cite.

In other words, here are the words the Court will use in their decision, the precedent cases to which the opinions will refer and in which they will drape their arguments.

U.S. Const. art. I, § 8, cl. 3, the Interstate Commerce Clause:
“The Congress shall have the Power [t]o regulate Commerce among the several States.”

Gibbons v. Ogden, 22 U.S. 1 (1824):
To “regulate Commerce” is “to prescribe the rule by which commerce is to be governed. This power, like all others vested in Congress, is complete in itself, may be exercised to its utmost extent, and acknowledges no limitations, other than are prescribed in the Constitution."

The "genius and character" of the Constitution is federalism.

“[T]he enumeration of…power[s]…to be extended would not have been made had the intention been to extend the power to every description. The enumeration presupposes something not enumerated.” (Cited in U.S. v. Morrison and U.S. v. Lopez.)

NLRB v. Jones & Laughlin Steel Co., 301 U.S. 1 (1937):
Congress may regulate "activities with a close and substantial relation to interstate commerce.”

“The commerce power may not be extended to embrace [everything]…thereby creating a completely centralized government. The question is necessarily one of degree.”

United States v. Lopez, 514 U.S. 549 (1995):
“For nearly a century thereafter, the Court's Commerce Clause decisions dealt but rarely with the extent of Congress' power, and almost entirely with the Commerce Clause as a limit on state legislation that discriminated against interstate commerce.”

Congress may not regulate commerce in “a manner that would bid fair to convert congressional Commerce Clause authority to a general police power of the sort held only by the States. Admittedly, some of our prior cases have taken long steps down that road, giving great deference to congressional action. The broad language in these opinions has suggested the possibility of additional expansion, but we decline here to proceed any further. To do so would require us to conclude that the Constitution's enumeration of powers does not presuppose something not enumerated…This we are unwilling to do.”

“[E]ven these modern-era precedents which have expanded congressional power under the
Commerce Clause confirm that this power is subject to outer limits.”

License Cases, 46 U.S. 504 (1847):

"But what are the police powers of a state? They are nothing more or less than the powers of government inherent in every sovereignty to the extent of its dominions. And whether a state passes a quarantine law, or a law to punish offenses, or to establish courts of justice, or requiring certain instruments to be recorded, or to regulate commerce within its own limits, in every case it exercises the same powers -- that is to say, the power of sovereignty, the power to govern men and things within the limits of its dominion.the authority to pass it cannot be made to depend upon the motives that may be supposed to have influenced the legislature, nor can the court inquire whether it was intended to guard the citizens of the state from pestilence and disease or to make regulations of commerce for the interests and convenience of trade."

Concurrence of Justice Frank Murphy in Hirabayashi v. United States, 320 U.S. 81 (1943):
“While this Court sits, it has the inescapable duty of seeing that the mandates of the Constitution are obeyed…[I]n its performance we must not forget that few indeed have been the invasions upon essential liberties which have not been accompanied by pleas of urgent necessity advanced in good faith by responsible men.” [Personal comment: I doubt they will cite this, actually, but I hope they do, because it is one of my favorite opinions.]

Supreme Court briefs and oral argument for this case:
The government “concede[s]…the lack of any doctrinal limiting principles.” Govt.’s Br. 51.

“Congress has the authority under the commerce power and the necessary and proper power to ensure that people have insurance in advance of the point of sale because of the unique nature of this market.” U.S. Dept. of H.H.S v. Florida, Supreme Court case 11-398, petitioner’s oral argument, transcript page 12, lines 10-13.

“[O]ur position is that Congress can regulate the method of payment by imposing an insurance requirement in advance of the time in which the -- the service is consumed when the class to which that requirement applies either is or virtually most certain to be in that market when the timing of one's entry into that market and what you will need when you enter that market is uncertain and…when you will get the care in that market, whether you can afford to pay for it or not and shift costs to other market participants.” U.S. Dept. of H.H.S v. Florida, Supreme Court case 11-398, petitioner’s oral argument, transcript pages 44-45, lines 19-25 and 1-4.

United States v. Comstock, 551 F. 3d 274 (2010):
The “powers reserved to the States…[are] the whole, undefined residuum of power remaining after taking account of powers granted to the National Government.”

“[T]he precepts of federalism embodied in the Constitution inform which powers are properly exercised by the National Government in the first place.”

US v. Morrison, 529 U.S. 598 (2000):
"[W]e always have rejected readings of the Commerce Clause and the scope of federal power that
would permit Congress to exercise a police power…as unworkable if we are to maintain the Constitution's enumeration of powers.”

Marbury v. Madison, 5 U.S. 137 (1803):
"The powers of the Legislature are defined and limited; and that those limits may not be mistaken or forgotten, the Constitution is written. To what purpose are powers limited, and to what purpose is that limitation committed to writing, if these limits may at any time be passed by those intended to be restrained? The distinction between a government with limited and unlimited powers is abolished if those limits do not confine the persons on whom they are imposed, and if acts prohibited and acts allowed are of equal obligation."

McCulloch v. Maryland, 17 U.S. 316 (1819):
“This Government is acknowledged by all to be one of enumerated powers. The principle that it can exercise only the powers granted to it would seem too apparent to have required to be enforced by all those arguments which its enlightened friends, while it was depending before the people, found it necessary to urge; that principle is now universally admitted. But the question respecting the extent of the powers actually granted is perpetually arising, and will probably continue to arise so long as our system shall exist.” 

Hamilton v. Kentucky Distilleries Co., 254 U.S. 146 (1919):
"That the United States lacks the police power, and that this was reserved to the States by the Tenth Amendment, is true."

Brown v. Maryland, 25 U.S. 419 (1827):
“The power to direct the removal of gunpowder [for the purpose of public health] is a branch of the police power, which unquestionably remains and ought to remain with the states.”

United States v. Carolene Products, 304 U.S. 144 (1938):
“[T]he existence of facts supporting the legislative judgment is to be presumed, for regulatory legislation affecting ordinary commercial transactions is not to be pronounced unconstitutional unless in the light of the facts made known or generally assumed it is of such a character as to preclude the assumption that it rests upon some rational basis within the knowledge and experience of the legislators…There may be narrower scope for operation of the presumption of constitutionality when  legislation appears on its face to be within a specific prohibition of the Constitution.”

Federalist No. 45:
“The powers delegated by the proposed Constitution to the federal government, are few and defined. Those which are to remain in the State governments are numerous and indefinite. The former will be exercised principally on external objects, as war, peace, negotiation, and foreign commerce; with which last the power of taxation will, for the most part, be connected. The powers reserved to the several States will extend to all the objects which, in the ordinary course of affairs, concern the lives, liberties, and properties of the people, and the internal order, improvement, and prosperity of the State.” [Note: James Madison wrote this one.]

Uncertain on Policy Uncertainty

Does policy uncertainty meaningfully reduce economic growth?

Paul Krugman, Brad deLong and Dean Baker, three left-leaning economists, have argued that it doesn't and that policy uncertainty isn't a compelling explanation of the anemic recovery in the United States. Krugman has argued again and again -- here's one example -- that policy uncertainty is basically irrelevant. DeLong put a big, fat "no" to answer this question on his blog. Baker referred to a "regulation monster," a fictional creature akin to the "confidence fairy" speciously invoked by the political and economic Right.

On the Right, economists such as Edward Lazear, Robert Barro, and John Taylor have argued that policy uncertainty really does matter, both in general and as an explanation of current economic conditions. Lazear, in a recent op-ed in the Wall Street Journal, writes that "[i]t would be difficult to argue that government polices over the past three years have enhanced confidence in the U.S. business environment. Threats of higher taxes, the constantly increasing regulatory burden...and the enormous increase in government spending all are growth impediments." Barro blames the lack of "clarity about future policies." And Taylor? "In my view, unpredictable economic policy...is the main cause of persistent high unemployment and our feeble recovery from the recession."

There is also a recent study by three economists which creates a "policy uncertainty index" which is then used to explain changes in investment, industrial production, and unemployment during the most recent recession. The authors of this study even wrote a recent piece for VoxEU arguing that the rise-and-fall behavior of the recovery corresponded with movement in their measure of policy uncertainty.

Now it's my turn: I have found everyone's arguments unconvincing, as well as correct and incorrect in varying respects.

On the Left, the rejection of policy uncertainty as a meaningful explanation seems to me partisan and made out-of-hand without any serious consideration of the evidence -- or, given the shortage of formal evidence, an examination of what they see as the strongest arguments against their position.

For example: I think all three economists would agree that future government policy can be more or less certain; that is, there exists a "policy uncertainty" variable. And I think all three economists would agree that marginal increases in this variable would, in almost any economic model, correspond to marginal decreases in investment and other real variables. (You can insert any "story" of causes here: loss-averse behavioral responses by firms to policy uncertainty strikes me as particularly compelling.) And I think all three economists would agree that there have been marginal increases in policy uncertainty -- more tax provisions expiring, the debt ceiling debacle, etc. Therefore it follows that all three economists must think that policy uncertainty can reduce economic growth and is, on the margin, doing so today.

I agree with them, of course, that a lack of nominal spending or aggregate demand remains the largest factor in explaining the recession and the weakness of the recovery. But I don't think that their mockery of policy uncertainty -- or, as I have argued in the past, confidence -- reflects well on them as thinkers.

For that matter, I think that the Right is too quick to embrace the narrative which blames policy uncertainty. There is almost no formal evidence behind the contention -- it isn't cited, and it doesn't exist.

And the one major study which merely begins to make the academic argument is not that strong. The authors argue that the measured increase in policy uncertainty causes economic contraction. But the authors' methodology is not particularly rigorous. They cannot eliminate the most obvious alternative story of causation: (1) there is an economic shock, (2) the shock induces or even necessitates a policy response, (3) that policy response is discussed beforehand, during, and after in the media, which shows up as an increase in measured uncertainty.

The study does not show that policy uncertainty causes economic contraction. Instead, the study shows merely that policy uncertainty and economic contraction happen at the same time. There is a relationship, though the direction of causation is unclear. It could run in the direction they hypothesize, the opposite direction, or even both. The authors, to be fair, seem to concede as much at one point in their study -- though not, pointedly, in any of their media discussions of the study. There is also, I imagine, a strong relationship between uncertain policy and bad policy -- that is, policy changes which receive a lot of discussion in media also tend to be policies with potentially large impacts on economic growth.

I think their method of research -- aggregate counts of news stories -- may be a dead end. To better examine the effects of policy uncertainty, I would try a method used in work which is similar but on different topics: looking at lagged changes in employment, output, and other variables among counties which straddle state borders in the United States, or regions within member nations of the EU, when policies are under uncertainty in one state but not the other.

No Post Today, Probably

An early-morning thunderstorm in New Jersey took out my power and broadband Internet service; no post today until I get back online. I used a hand-crank radio to hear the Supreme Court decisions this morning. (This is from my phone.)

Update: I am back online as of 5 p.m. Wednesday evening. A post is in the works for tonight.

Poor and Getting Poorer

I was stunned by yesterday's loudly supportive response to my post on extreme poverty, so I've decided to stick with these issues for a little while. I think they merit more attention.

Finding #2: The mean real income of Americans below the federal poverty threshold is at a historical low, $5957 in 2010, after stagnating since the 1980s.

It is important to explain here that the Census determines the threshold by calculating the minimum income needed for a minimally adequate standard of living, not in comparison to the income distribution -- poverty here is absolute, not relative -- and so the drop in incomes of the poor means that they can provide a lesser and lesser fraction of the goods and services seen as necessary for themselves and/or their families.The current level represents a 4.1 percent drop since 2000. More disturbingly, the mean individual below the federal poverty threshold makes 13.3 percent less in real terms than what he or she did in 1976.

The poor haven't felt any sort of rising tide lifting all boats, so to speak. Instead, they are the worst off they've been in decades.

The Census' data set doesn't go back any further back. I arrived at this result using trapezoidal Riemann sums and the data which shows what percentage of Americans fall into several intervals defined relative to the federal poverty threshold, then multiplying by the actual threshold and dividing by the CPI.

The Recession and Extreme Poverty

The 2008 recession has caused massive increases in extreme poverty.

For the purpose of our analysis here, an individual as "extremely poor" if he or she resides in a family unit whose income is less than half of the federal poverty threshold. To give you a sense of what that means, the awful extremity of extreme poverty: a single person under 65 must have made less than $5,851, and a family of four must have made less than $11,509. (In my opinion, it is likely that for the majority of the extreme poor, taxable income is zero.)

Recessions, in fact, appear to affect disproportionately the extreme poor, rather than those closer to the federal poverty threshold or the "near poor," those whose income is less than twice the federal poverty threshold.

Consider this: in 2010, 6.7 percent of Americans were among the extreme poor, as compared to 5.2 percent in 2007 and 4.5 percent in 2000. That's a 50 percent increase in the fraction of extremely poor individuals -- the greatest increase, by far, of any income group relative to the poverty threshold.The unambiguous statistical trend since 2000 has been large increases in the fraction of Americans at the extreme end of poverty, with little to no change in the fraction of Americans considered "near poor." The poor, in other words, are getting poorer -- or more precisely, poverty in America is becoming an increasingly extreme and unequal phenomenon.Observe, for example, that since 2008, the percentages of individuals making between one-half and three-fourths of the poverty threshold, and between three-fourths and up to the threshold, have seen the second and third largest growth since 2000 -- 27 percent and 21 percent respectively. The former has increased from 3 percent of Americans to 3.8 percent, the latter from 3.8 percent to 4.6 percent. Meanwhile, the fraction of near-poor individuals has remained roughly stable in the 18 percent range since 2000.

If you're an economist, you might notice that the statistical behavior of the two most extreme poor groups in the first graph -- less than half of the threshold, and between half and three-fourths of it -- is dramatically different from the other income brackets. They appear highly sensitive to recession, rising as sharply as a fraction of the population during the recessions of 1981, 1990, 2000, and 2008. All other poverty-threshold groups show little to no cyclical behavior.

The Money Is Too Damn Tight!

During the elections of 2008 and 2012, the rise of libertarian Ron Paul on the American Right introduced the Republican Party to his strain of Austrian economics. And while the GOP did not endorse it wholesale, the presence of Paul has influenced to some degree the "party line" perspective -- making more visceral its opposition to government, lessening the emphasis on promoting business as the end of tax and regulatory policy change.

Looking broadly through the postwar era, this is an anomaly. During the Eisenhower, Nixon, and Ford administrations, Republicans maintained down-the-line Keynesian economic policies. During the Reagan and Bush administrations, Republican economics revealed a mix of influences: Keynesian on government spending, supply-side on taxes and regulation, monetarism at the Federal Reserve.

Most noticeable, in fact, has been the change of perspective on monetary policy. Where Republicans once lauded the conduct of Fed Chairmen Paul Volcker -- a Democrat, incidentally -- and Alan Greenspan, they have forsaken their legacy amid the recent shift to the right.

I am reminded in particular by Rick Perry's comment about Chairman Ben Bernanke, who George Bush appointed in 2006:

If this guy [Bernanke] prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous, or treasonous in my opinion.

Paul notwithstanding, Republican views accord much more with Perry than they ever did. Milton Friedman rolls over in his grave whenever he hears Romney disparage current monetary policy as accommodative or as a spent force.

All of this is to say that I was pleasantly surprised by Steve Chapman's recent article, which ran in the conservative Chicago Tribune and on the libertarian Reason magazine's website:

Remember the guy who ran for governor of New York as the candidate of the Rent Is Too Damn High Party? We need a new one, called the Money Is Too Damn Tight Party. It would get my vote...[I]nflation-phobes resemble someone stranded in the desert without water who spends his time frantically searching for a life preserver. Plenty of people, including several Republicans who ran for president, think money is too loose. But what would the world look like if the opposite were true?...Commodity prices would fall. Unemployment would be painfully high. People would be reluctant to buy houses for fear they would lose value. Economic growth would stall. Sound familiar? Those signs are a tipoff to our real economic problem: too few dollars in circulation...Could inflation make a comeback? Sure. So could the Soviet Union. But until it does, we should deal with dangers that are not imaginary.

It's a worthwhile read, for sure. A few friendly comments for Chapman:

1. Gold is not only (or maybe not really) a hedge against inflation; it tends to rise in times of financial instability, which increase the premium for real "safe haven" assets. Gold demand has risen in the past few years due to increasing wealth in emerging markets.

2. When you are trying to explain the behavior of commodity prices and interest rates, the stronger relationship tends to be with nominal income, rather than inflation or the price level.

3. It may be helpful to consider a distinction between supply- and demand-side inflation, although I imagine you didn't want to get too technical in your op-ed, in regards to the inflation of the 70s. When Americans think of inflation, they think of the 70s -- and although there was demand-side inflation then which I wouldn't defend, there was also, to a meaningful extent, supply-side inflation generated by oil prices. Demand-side inflation tends to increase both nominal and real income in the short run, whereas supply-side inflation tends to increase nominal income, but decrease real income, in the short run. So the 70s, and thereby all inflation, gets linked to the diminution of real incomes. That's not an association you want, so it tends to be easier (and more theoretically sound) to talk about nominal income. (See here too.)

Two Types of Tech?

"Does Technology Drive the Growth of Government?" Tyler Cowen asked in a 2009 study. Improvements in technology tend to increase the capacity of governments to control social and economic activity, Cowen posited.

Technology tends to be "collectivizing," in other words. But what if the next generation of technology is of a different type -- "individualizing" -- that is, tending to decrease the ability of governments to control social and economic activity?

In his study, Cowen drew an insightful connection between how technology enabled the rise of "Big Business" to its enabling of "Big Government," using the preceding increases in the size of businesses from small enterprises to industrial conglomerates.

Now, however, the United States is seeing the reverse phenomena: technology is enabling firms to be smaller yet still produce at-scale. According to a report by economist John Robertson of the Atlanta Fed, the average new establishment employed roughly 7.5 people in 1994; after a protracted decline, the average new establishment employs less than 5 people as of 2010. Nor do the smaller new establishments grow later on to the size of their forerunners -- they stay small, according to another study published by the Kauffman Foundation.

The window of time is highly suggestive of "individualizing technology," too. The personal computer and the Internet tend to decentralize cultural activities, as compared to how the radio and television created national cultures. The days of everyone knowing the "Top 40" songs, or watching the same TV shows, are dead or dying; Cowen's thesis raises the possibility that government will find collective action ever harder to organize.

We may be standing at the edge of a historic reversal in the growth of government.

No Price Like Home

The Federal Reserve, along with most other central banks, including the Bank of England and the European Central Bank, have been mis-measuring inflation for years. And there's a compelling case that their mis-measurement led, albeit indirectly, to the housing boom and bust, and therefore to the 2008 recession.

I say mis-measured, but in reality, economists have only a vague idea of what they're talking about when they talk about the "price level" is and how it has changed -- price inflation. In fact, how to measure prices has for much of the modern history of economics been a prime subject of debate.

The economics field has produced more measures of macroeconomic price inflation, as a result, than I know or will count here. Just for starters, you've got the Consumer Price Index (headline and core), the Personal Consumption Expenditures price index (headline, core, trim-mean), the GDP deflator, etc. They all appear in different areas: CPI is often used for adjusting wages for cost-of-living, the Fed targets the headline PCE price index at 2.0 percent year-over-year, the GDP deflator is used in national accounts calculations.

Most of them, however, do a frankly poor job of measuring a very important component of prices: housing. You might say, in fact, that there's "no price like home" if you want to understand how monetary policy got it so wrong in the 2008 recession.

With the exception of the GDP deflator, the CPI and the PCE all use a measure of housing prices called "owners' equivalent rent," or OER. What OER basically entails is the Bureau of Labor Statistics (BLS) asks homeowners for their own assessment as to the potential rental price of their own home -- and as a result, what OER has failed to count has been the asset-price inflation of housing.

Housing asset-price inflation had been included in the CPI until 1983, in fact, when the BLS introduced OER because asset prices "can lead to inappropriate results for goods that are purchased largely for investment reasons." The reason to count housing prices via assets and not via OER, however, is pretty straightforward: houses are not just a financial investment, they are also a consumer cost. Analogously,  the CPI counts cars by their asset prices if they are new or used, and by the costs of leasing when they are leased. Today, I find it fair to flip the Fed's 1983 statement on its head, and say that OER "can lead to inappropriate results for goods that are purchased partially as a consumer durable good." (Mike Shedlock, a.k.a. Mish, agrees with me.)

Replacing OER with a measure of housing asset prices, the Case-Shiller 10-City Home Price Index, in the headline and core CPIs, we get the following data:Let's call this measurement CPI-H, for "housing." I've made my datasets available here (headline CPI-H) and here (core CPI-H) on FRED, and they will forever update themselves, so bookmark this page or something.

You'll notice that CPI-H is substantially different from the regular CPI numbers, with inflation running higher in the 2000s, a sharper deflation in the 2008 recession, and weaker inflation since then. The contrast emerges because OER was such a large component of the headline and core CPI numbers: as of the December 2010 weighting, it was 24.9 percent of headline, 32.3 percent of core.

I bring this up, in part, because there's been movement by the Office for National Statistics in the UK to replace their CPI and RPI, or Retail Prices Index, with a CPIH, which would include some OER and some mortgage payment costs. (The mortgage payment component is a proxy for asset prices.) At the same time, Eurostat, which compiles the HICP inflation numbers for the Eurozone, is considering a new approach to owner-occupied housing.

Both the Bank of England and the European Central Bank have figured out that they are mis-measuring housing; it's time for the Fed and the Bureau of Labor Statistics to introduce a CPI-H. In the meantime, you're free to use mine.

The Math Behind The Culture

From John Milton's Paradise Lost to YouTube, there is beautiful math behind cultural phenomena.

Consider the long s, that archaic letter which looked like an f or integral sign. It once appeared in words where an s fell at the beginning or middle of a word.

Using Google's N-gram tool, we can pinpoint the moment that the long s fell out of style: 1800. It was then when "ſaid" became "said," when "Paradise Loſt" became Paradise Lost -- and when, more broadly, modern English as we mostly know it today came into form.

What is so striking, even beautiful, about the demise of the long s is that, as seen the time series documenting the disappearance of "loſt" and its replacement by "lost" look exactly like a pair of logistic functions.

Here is a graph of the time series from 1750 to 1850, with a "smoothing" of 3:


The results repeat themselves for most other examples.

Compare that to an example of modern culture -- the YouTube video of President Obama speaking at this year's White House Correspondents' Dinner:

Again, if you look at the statistics for many other YouTube videos, the logistic function appears again and again, after any major link-to a video received.

The Destabilizing of Inflation

"Longer-term inflation expectations have remained stable" is a favorite platitude of many central banks. It is more or less the equivalent of affirming that "we the central bank are doing our job."

The Fed said as much in its statement today. What people don't realize is that it is not true any more. Longer-term inflation expectations have been dramatically destabilized since 2008. It is the Fed's fault.

First, a note about short-term inflation expectations. After the Fed's statement, the market expectation of one-year inflation in the U.S. this year fell 40 percent. That's not a typo. At yesterday's close, it was 0.2433 percent, and today it is 0.1475 percent. These numbers come from the yield curve of Treasury Inflation Protected Securities, also known as TIPS, and its spread against Treasuries of the same maturity. The market, in other words, is betting that next year will be ever closer to deflationary, as measured by the Consumer Price Index. This appears to contradict the Fed, who projected PCE inflation between 1.2 and 1.7 percent for the coming year. Given that today's meeting revised down this  projection by almost a full percentage point -- the Fed had projected PCE inflation between 1.9 and 2.0 percent in its April meeting -- I think I will continue to trust the market projection.

But the scarier news about inflation, something that I think the monetary policy discussion has ignored, perhaps for fear of its implications, is that long-run expectations have been meaningfully dis-anchored.Before the crisis, the market knew what to expect: inflation between 2 and 2.5 percent for the foreseeable future. Now, not so much. The acute phase of the crisis disrupted inflation expectations, sending the market's expectation for five-year inflation briefly negative, and the 10- and 20-year to near-zero. Since then, they have bounced around the 2 percent level.

And it is the bouncing which is problematic. When the Fed eases, you might expect short-term inflation expectations to rise; long-run expectations should only move to the extent that the long run includes that short run and that the short-run accommodation will not be later cancelled out by a contraction.

What we've seen instead, however, is that the volatility in short-run inflation has extended to a remarkable extent into longer-run inflation. The market seems to be saying that what the Fed does now, in the short-run of the present, has extraordinary, even unprecedented, leverage over inflation in the future.

A QE program, or lack thereof, appears to alter inflation expectations by up to 1 percentage point for every year for 5, 10, or even 20 years.

We can see this more rigorously by looking at the standard deviation of 5-, 10- and 20-year inflation expectations -- and what we see is that inflation expectations have been indeed more volatile post-crisis than they have were pre-crisis. (Note: I date the start of the crisis as the first week of October 2008, and my post-crisis data sample begins in February 2010, when the 30-year Treasury bonds were reintroduced. The finding, also, is generally robust to any reasonable selection of pre- and post-crisis data.)This graph should be deeply disturbing to any economist. The 20-year outlook is now as uncertain as the 5-year outlook in terms of inflation. Long-run inflation has been dis-anchored downward.

When I first noticed this destabilization in January, I thought this was the liquidity trap at work:

I see this as the clearest evidence I've ever seen of market concern that without continued accommodative monetary policy, we could be heading for a liquidity trap scenario of protracted periods of low growth, low inflation, and high output gaps. The only reason long-run inflation expectations would respond in this way, we can see, is that if the market expected Fed actions now would be highly determinative of the long-run. This is what an economy making an unsure exit from a liquidity trap looks like. It is highly suggestive that the Fed, moreover, remains disturbingly close to deflationary pressures and has significantly more leeway than I would have thought previously for expansions of QE before it has any negative [i.e. accelerative] impact on inflation expectations.

Now I think it is just an uncertain Fed unable to manage the expectational channel.

Doing Its Level Best?

The Fed targets inflation, aiming for a 2 percent year-over-year change in the Personal Consumption Expenditures (PCE) price index, to be precise. It is intended as a "flexible" inflation target -- that is, one which helps accommodate swings in real variables, especially real output and employment -- although in current practice the flexibility is rather lacking.

Yet, for several reasons, the Fed's statement of its legally-prescribed dual mandate does not make a lot of sense.

First, it is inconsistent with its definition in the Humphrey-Hawkins Act of 1977:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.

Humphrey-Hawkins, which establishes the mandate, speaks about levels. Not rates, as is inflation. But levels.

"Stable prices" means, most literally, the price level. One has to take some liberties with the Act to arrive at the conclusion that rate targeting, rather than level targeting, is in the Fed's mandate. Notice that "maximum employment" is also a level; the equivalent rate would be the annual change in nonfarm payroll employment, or something to that effect.

Second, the Fed is trying to combine a rate target of one variable, PCE inflation, with a level target of another, the unemployment rate. The combination introduces a significant lack of clarity, not only in the long- and short-term relationships established in the Phillips Curve, but also because the level variable is dependent upon history (unemployment) and the rate variable (inflation) is not. Consider this problem in the form of the Mankiw indicator, which combines the two variables to the end of deriving a Taylor-type rule for an interest-rate monetary policy. What does the difference of a rate and a level even mean?

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.

Fourth, the academic literature views price level targeting as better than inflation targeting. (See here, for one example.) In most respects, a price level target would be the same as an inflation target; the two differ in respect to history. If inflation was higher than the target for a year, the rate-targeting central bank would "forget" it; the level-targeting central bank would have to compensate by undershooting in terms of inflation for the next year. The rate-targeting central bank thus suffers from "base drift," which is economically inefficient in a model economy with contracts spaced out over different lengths of time, because it is the price level, not year-to-year inflation, which determines the purchasing power of nominal wage contracts or the amount repaid on a nominal interest rate loan. Economic calculation is less uncertain when all agents operate without concern as to "base drift" and can expect a stable price level path.

Steven Solomon's 'Water'

The sea erodes the land to match the flow of tides and currents. Rivers form deltas, marshes, and arable land in their passage. Shoreline provides harbors, fisheries, and straits. In all respects, water is omnipresent, omnipotent. So goes the thesis of Stephen Solomon's "Water," an ambitious chronicle of the role water has played in civilization and its history.

Suffice it to say that I was deeply disappointed by the book. "Water" could have been another "Big History" masterpiece akin to Jared Diamond's "Guns, Germs, and Steel." Instead, I found it tiresomely detailed in some respects, woefully insufficient in others, and on the whole unconvincing and unoriginal.

First, tiresome. In his narrative of world history, Solomon fails to exercise proper editorial judgment of what details do or do not pertain to water. The book consequently entertains a lengthy and frequently overgeneralizing summary of the history of civilization from prehistory to the present.

Second, insufficient. When Solomon's narrative does dip into water, it almost always fails to engage the topic in appropriate depth. The book's examination of technology as it pertains to water, for instance, is strikingly unserious -- it appears that Solomon does not know enough about engineering, or has failed to sufficiently consult experts who do, to tell the reader anything a reasonably well-informed layperson would not already know about canals, aqueducts, shipbuilding, sewage or irrigation systems, or the like.

Third, unconvincing. Solomon has a penchant for sweeping statements and faulty deductive reasoning. For example, he claims at one point -- I have lost the page -- that cities have been always a productive and advancing force. This would be true but for the long history of extractive regimes which transferred wealth from agricultural areas into cities, in fact the normal arrangement until the Industrial Revolution. After only a few of the 86 times Solomon uses the word every, the 34 he uses always, or the 23 he uses everywhere, the reader knows to wince.

Fourth, unoriginal. A reporter and as such not a water expert, Solomon has little to offer us in the way of new information or insight. When he quotes his sources directly -- such as Alfred Thayer Mahan's The Influence of Sea Power upon History,  Karl Wittfogel's Oriental Despotism, or Frederick Jackson Turner's "The Significance of the Frontier in American History" -- the reader ends up taking note as to what he should have read. Furthermore, in his discussion of current challenges with water, Solomon does little but digest the "limits-to-growth" environmentalist position. He does not discuss with any substance either the validity of that view relative to Julian Simon's "ultimate resource" thesis, nor the appropriate policies and technologies to resolve what Solomon sees as a looming environmental crisis.

I elect not to close this review with a bad invocation of a watery idiom. Other reviews of this book can be found here; I agree in particular with the comments by The Economist.

That's the Spirit!

One of the things I hate most about airline travel -- and there's a lot to dislike, for sure -- is how non-business passengers grossly abuse the carry-on baggage system, lugging massive suitcases into the cabin that should be checked.

I forgive the frequent flyers who, usually for business, carry their (usually quite light) bags on. But for the recreational travelers, who do this merely to avoid paying for checked bags, I feel nothing but frustration and contempt.

The time they waste runs in the tens of man-hours, cumulatively for all passengers and crew, in loading and unloading their usually massive bags from the overhead compartments.

This is a problem created by incentives. Passengers used to check their luggage, but when airlines added fees, passengers responded. They quickly figured out that they could circumvent the fees by carrying the bags on -- or when the overhead compartments filled, brimming with suitcases, they could check them at the gate for no cost.

Some airlines then tried to attach fees to this practice, but Senator Charles Schumer extracted promises from five major carriers against charging for carry-on luggage too large to fit beneath the seat, according to John Cochrane, who shared my frustration in a recent blog post.

But some smaller carriers ignored Schumer and charged fees. And, reporting firsthand from my flight yesterday on Spirit Airlines, I can report to you that "people [do indeed] respond to incentives."

Spirit charges $30 for the first carry-on bag on domestic flights, not including something that can go under the seat, when a standard passenger reserves that right online during booking. But, in what constitutes a $2 incentive, they charge $28 for the first checked bag when booking online.

And the incentives keep coming: if you wait until you show up at the airport counter to decide that you need to carry on or check a bag, it costs $40 and $38 respectively. That means there is a $12 incentive to decide during online booking you will check a bag than deciding at the counter to carry the bag on. Again, a $2 incentive exists at that moment to check rather than to carry-on.

If you wait until the gate, instead of getting a freebie, you get punished with a $45 per-bag charge for carry-ons. The cumulative incentive against doing what everybody does on every other airline is $17 per bag.

Spirit Airlines has the incentives aligned correctly. They want people to pack light, or failing that, to check their bags and check them early, rather than waiting until the last minute to drop them off at the gate.

The incentives work wonders. Instead of completely-filled overhead compartments, I estimate there were fewer than ten suitcases stored. The total difference time to board and disembark the aircraft, again estimating, was roughly a half-hour. Multiplied for a cabin of roughly 180 passengers, total time saved is 90 man-hours.

Assuming that people value their time at $8 per hour, and that 80 percent of passengers would have otherwise carried large bags on, the per-bag benefit of the incentive structure is $5. Remember, Spirit Airlines effectively pays its passengers $2 to check their bags.

If you consider the $5 per bag as an externality -- the cost imposed by the bag-wielding passenger on the rest of the passengers -- then Spirit's incentives are in effect a side payment which generates a Pareto-efficient outcome. Vive le Coase theorem!

(Add onto that your own estimate of the opportunity cost to Spirit Airlines of keeping the plane running with crew for the additional half hour, and moreover the fuel costs for the total difference in baggage weight.)

I never thought I would use this blog to publicly praise an airline -- heck, I never thought I would praise an airline, period -- but Spirit Airlines' bag-fee incentives serve as a remarkable example of the power of economic incentives, as well as a practical application of  side payments to resolve an externality problem.

The Instability of Monetary Union

Fiscal and political union is necessary to the survival of monetary union, assuming that the united economies display heterogenous responses to real and nominal shocks.

Assuming a basic model of monetary policy in which the central bank can target a nominal aggregate across the monetary union, it follows that for the non-targeted nations or those "lost in the mix," there will be some nations for which monetary policy is overly accommodative or overly contractionary.

As the overly-accommodated nations experience inflationary demand growth, and the overly-contracted nations experience nominal recessions, the monetary policy has "passively loosened" or "passively tightened" relative to the monetary policy's goals, implied by the aggregate target. Therefore the countries individual nominal economies "veer off" in different directions as passive monetary policy exacerbates their heterogenous conditions.

The only way to stop this process is fiscal transfers or monetary breakup. If the overly-accommodated nations transfered some of their nominal income to the overly-contracted nations, that would close the gap and eliminate the passive tightening or loosening problem.

This is fundamentally what is happening in the Eurozone -- it explains the cause of the "fraying," or increasing variance, I observed in another post among individual European nations from mean Eurozone real output growth.

Update: Timothy Lee observed that labor mobility could help resolve the real dislocations; however, other factors of production, particularly fixed investment, are not mobile. This implies that monetary unions will still face the magnifying problem of passive loosening or tightening, given that long-run potential output cannot fully adjust to aggregate demand. Consider the example of German reunification: East Germany, even if the East Germans could have all taken up jobs in West German firms and left their communities, would have been left with even more unused capacity and would have become increasingly depressed without extensive fiscal transfers from the German state.

How Greece Exits

Today's elections in Greece could very well force the nation's exit from the Eurozone. Yet amid the worry, there has been strikingly little discussion of how, exactly, drachmaization would be achieved. This post thinks out loud the actual means which I see as necessary. (Let's save for another post the policies which the rest of the Eurozone countries will need to make it through.)

Drachmaization is a logistical nightmare, raising a variety of pressing economic, political, and technical questions:

First and foremost, how so you convert a nation of 11.3 million people and an economy of 55.5 billion euro to a different currency?

How do you do this given national unrest? Without causing bank runs? Given the obvious necessity of huge devaluation? In the context of hyperinflation?

How do you balance the objectives of public finance and economic stabilization?

Here are my tentative answers to these questions. Please leave a comment, or write your own blog post, if you see better alternatives.

When Greece joined the Eurozone, the entry process involved a conversion period in which savings deposits were available in both euros and drachma, when cash was distributed to businesses and banks, when drachma could be returned to banks in exchange for euros but not the other way, until full euroization was achieved. But Greece will not have the luxury of time needed for such a gradual, orderly process.

The Greek government should first establish capital controls to prevent a massive capital outflow, which would destroy its banking system. The Wall Street Journal suspects border controls may also be necessary. The harder part, though, is replacing the entire physical currency stock within the country immediately after the Greek government declares the establishment of a new drachma.

The government would need to print and distribute the new drachmas to banks as quickly as possible. During a hasty transitional period, the government could temporarily allow the legal use of euro by establishing an official exchange rate and forcibly converting all foreign and domestic deposit accounts into new drachma. The problem with this is that a period of two currencies cause hoarding of the euro, per Gresham's Law, as the "bad money" drives out the "good."

To prevent bank runs, some sort of "bank holiday" program will be likely necessary, minimizing the euro withdrawals to what is absolutely necessary for economic activity. Furthermore, the government should let banks restrict payments voluntarily beyond what the government requires. As the new drachma becomes available, government could reduce the legal availability of euro currency until all withdrawals had to be made in new drachma. The government should also pledge publicly to all depositors that their savings are safe even if the bank temporarily runs out of physical currency. The temporary lack of reserves should not spell bank failure.

To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive  -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma.

Devaluing the new drachma, after deposits have been converted over, is also certain -- The New York Times reports a consensus estimate of 50 to 70 percent. The objective is not temporary stimulus, but rather to reduce real wages and restore competitiveness, given that downward rigidity in nominal wages has obstructed the internal devaluation process of prices adjusting to clear markets.

Amid drachmaization, the relationship between the Greek government and its central bank will be precarious. Indeed, central bank independence will be severely compromised, if not eliminated. I could easily imagine a period of total subordination of the Bank of Greece to the fiscal needs of the Greek state -- the central bank would fully monetize the budget deficit and inflate away.

On the other hand is the competing objective of economic re-stabilization and regaining competitiveness. As I've discussed before on this blog, Greece faces a 22.6 percent nominal GDP gap, as well as a 21 percent unemployment rate. It is most certainly in the country's long-term interest to keep the Bank of Greece, to the greatest extent possible, independent. Perhaps some compromise can be arranged in which the Bank of Greece will purchase government debt and devalue the currency in foreign exchange markets until unemployment returns to some tolerable threshold and NGDP returns to its level path, at which point the Bank of Greece expects the economy to have improved sufficiently for tax revenues to be up and for the government to have cut spending, such that the fiscal position is sufficiently improved.

The Greek government may still need financial repression for quite some time to finance its debts. Once  the new drachma is established and Greece returns to economic stability -- that is, if history is any indication, several years off -- the capital controls and financial repression program could be dismantled,  the Bank of Greece could return to full independence, and Greece would be back to square one.

Demand (and) Better Policy

Today I want to focus on the fundamentals and offer a perspective on, though hardly a complete answer to, a question of great importance: What caused the recession of 2008?

This question means a lot to me, and (I think) in a unique sort of way.  I became interested in economics during, even because of, the 2008 recession. It has shaped how I think about economics, as I imagine it has for much of my generation, in a way for which the only historical precedent seems to be the wave of Keynesian economists forged by the Great Depression who swept academic and policy circles in the 1940s, 50s, and 60s.

So what caused the recession of 2008? A drop in aggregate demand which was caused by, or not counteracted by, monetary policy. Full stop.

That's what the chart above should show you. What I've done is create a simple graph of real GDP and the PCE price index in P-Y space. And what you see is that, starting in the southwest corner of the graph, real GDP (Y) had grown steadily, and the price level (P) had risen, from 2005 until the first quarter of 2008, when a supply shock increased inflation. (That's why the graph appears to draw two parallel lines of positive slope.) Notice that real GDP remains roughly constant during this time; the real shock is not what caused the recession.

Then, in the fourth quarter of 2008, suddenly both P and Y collapse, as represented by the sudden jump  in the southwesterly direction. Notice that there are only three data points along the downward leg, testifying to the sudden collapse of aggregate demand during this time.

A real shock cannot explain the sharp decline in both the price level and real output, nor can it the fact that, as the economy recovered, it almost returned to the same price/output combination as existed before the recession, almost sealing up the lacuna in our graph.

The 2008 recession was almost entirely about a sudden collapse in aggregate demand, engineered by a fall in nominal spending or NGDP.

For more on the 2008 recession, here is a post I wrote about the primacy of investment in all of this, another about why the housing bubble is a frankly lousy explanation, and yet another about the concept of the "balance-sheet recession."

On Land Taxes

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas...It is ideas, not vested interests, which are dangerous for good or evil. - John Maynard Keynes, The General Theory, revisited by "Fear the Boom and Bust"

Matt Yglesias has a thought-provoking post up about land taxes. What he didn't really mention, now giving me an excuse to blog about it, is the fascinating intellectual history of land taxes. I don't really get to do a lot of economics history on this blog -- busy with the present -- but the argument that we really should be taxing land, and not property or other capital, goes back to Henry George and the 19th century. It's why I put the famous Keynes quote at the top of the post; George is very much the archetype of "some defunct economist." (Incidentally, Yglesias is far from oblivious of his intellectual influences.)

What I find so fascinating about Henry George, who proposed that the state's primary source of tax revenue should come from a flat tax on the value of unimproved land, is that the economics behind his idea are, in my opinion, sound and offer still a strong argument on its behalf. It represents a "road-not-taken" in our modern history, inviting us to peer down. (Remember that before this century, the U.S. federal government, among others, funded itself primarily through excise taxes and tariffs. The emphasis on individual and corporate income and payroll as the main source of revenue has not always been the case.)

The first argument in favor is that, in theory, a land tax will not create a deadweight loss. The supply of land is inelastic -- nobody (except the Dutch) can change, i.e. create or destroy, the quantity of land. Without a change in quantity supplied, there will be no loss in social welfare -- only a change between consumer surplus, producer surplus, and government revenue. (See graph to right.)

Second, shifting the burden of property taxes to unimproved land makes sense because, as Matt wrote, the incentives property taxes create are awful. Moreover, taxing unimproved land reverses the incentive problem entirely, encouraging land-use efficiency.

Third, it's well recognized that it's inefficient to tax capital income, which is a fundamental problem with the property tax.

If only because I want an excuse to read Progress and Poverty, can we make the idea of land taxes the next big thing in the economics blogosphere?

Inflation, Forever and Always?

Anyone who thinks that Greece et al. only need a one-off fix in the form of debt rescheduling or monetization from the European Central Bank is probably kidding themselves. The truth is that the European periphery needs inflation not only to stimulate growth and to pay down their debts in this instance, but also as a sustained, routine means of financing their government.

For decades before the Eurozone came into place, countries like Greece ran expansive government budget deficits through expansionary monetary policy and exchange rate devaluation. They elected to pay for the post-war European model of the welfare state not through concomitant direct taxation, but through inflation. For all intents and purposes, inflation represented perhaps the only effective, broad-based tax which existed in these countries.

No normative judgments here. Big government and high inflation present, certainly, their own inefficiencies and downsides -- but accepting them as the effective choice by democratic consensus in these countries, it should be strikingly obvious that this mode of governance is irreconcilable with what Germany wants.

To remain in the Eurozone, for Greece, is ultimately not a question of whether to accept austerity now in exchange for emergency debt relief. It is a question which asks Greeks to decide whether they are willing to forever pay more of their taxes and cut down the costs of their government, or whether they prefer the inflate-it-away method of financing government.

Let's look at the numbers. Since the 1970s, when Greece transitioned back to democracy, the average government budget deficit has been on the order of 8 percent of GDP, which is probably a good estimate of the Greek structural budget deficit. As of October 2011, it was 15.1 percent of GDP, and even in the best of times, the Greeks never got the budget deficit into the +/- 3 percent of GDP range which is required under the treaties governing Eurozone membership.

What this is about is a combination of high expenditure, even by European standards -- up to 52.9 percent of GDP before the cutbacks in 2010 -- and a consistent inability of the government to raise the appropriate revenue -- roughly 40 percent of GDP over the last decade, as compared to an EU average of 45 percent of GDP.

As a result, inflation was the de facto primary means of taxation. Between the time that Greece joined the European Union in 1981 and the Eurozone in 2001, the inflation rate varied between 25 percent and 10 percent annually. Only towards the end of the 1990s did it come under control, below 10 percent, and that does not appear to be related to any true improvements in Greece's structural budget deficit.Simultaneously, to maintain competitiveness, Greece devalued or depreciated the drachma extensively. A drachma in 1982 was worth five and a half times what a drachma was worth in 2000 in dollar terms.More disturbingly, Greece isn't the only periphery country which employed this strategy. Italy, Spain, and Portugal are also on the list.

This all leads me to a different, darker interpretation of what's happening in Europe, perhaps fittingly right before the Greek elections this weekend. I've already said in another post that I don't think it's primarily about debt, and that a massive derailment from these nations' growth paths of nominal GDP has a lot to do with it. That explains why we're having this crisis now, as opposed to five years earlier or five years later.

But ultimately what I am forced to conclude by virtue of the facts and the data is that the Greeks, and the rest of the EU periphery running such an "inflation tax" policy of financing government, were on a collision course with the more conservative predilections of the Germans running the European Central Bank. There is no way their government's fiscal-monetary policy strategies could ever be compatible in a currency union.

Swiss Watching

Roughly two weeks ago, I wrote two posts on Switzerland which used their currency peg of 1.20 against the Euro to argue the power of credible monetary promises. (See here and here.)

I've written before that I have no problem admitting I'm wrong. This blog is a learning exercise for me. And while some of what I argued remains true, in other respects some of what I argued I no longer stand by.

The Swiss central bank's latest balance sheet has me going back to re-evaluate where I went right and where I went wrong. The big news was that, amid Europe's  "bank jog" (the slow version of a bank run) and correspondingly large capital flows, the SNB's holdings of foreign currencies expanded to 303 billion CHF in May from 238 billion in April.

I had implied in both posts that the floor was so credible that it did not require an active defense. Indeed, for several months after its establishment, the SNB did not have to conduct any trades. That is no longer true; I realize now that the correct conclusion to make was not that the Swiss currency floor would not require any currency purchases. Rather, the floor's credibility eliminates the need for foreign currency purchases to the extent that those seeking to buy Swiss francs are speculating on exchange rates. To the extent, however, that Swiss franc buyers are seeking to park money in Swiss assets or deposit accounts, the SNB will have to purchase foreign currency to maintain the floor.

As the integrity of the European financial system is ever more in doubt, more of the currency purchases will reflect non-speculative capital inflow.

Quotes from this Reuters article -- which, it's worth noting, discusses the probability that the floor won't be maintained -- reflects the fact that non-speculative capital inflows will indeed compel SNB forex purchases:

"Don't be surprised if the Swiss franc catches fire as a safe haven even with the 1.20 cap set by the SNB."
...
"But, investors still want to hold Swiss francs, even if they cannot expect gains," he said. "In relative terms, it is better to have a zero return than a negative return."

Nevertheless, the case for a currency floor -- or any species of monetary policy commitment -- is stronger than ever. Swiss real GDP growth for the first quarter of 2012 hit 2.8 percent annualized, rising from 1.2 percent in September when the floor was established. The SNB has also revised upwards its expectations for real growth. Amid a sea of double-digit unemployment rates across Europe, Swiss unemployment ticked up to 3.2 percent from 3.1 percent, seasonally adjusted.

I can't imagine what Switzerland's neighbors would trade for those stats. (Perhaps, and we'll see over the next few days, weeks, and months, their Eurozone membership.)

So Much for Irrelevance

Today's economic news should put to rest any notion that monetary policy is irrelevant or otherwise ineffective in this environment, i.e. at the zero lower bound. It should exhaust the idea that central banks' stimulus "ammunition" has been exhausted; perhaps, even, the notion that such ammunition is exhaustible. It should slay the defeatism.

Reports of the death of monetary policy have been greatly exaggerated.

The Bank of England announced a pair of new liquidity programs, coordinating with the British government. A top finance minister in Japan said that his country may seek to devalue the yen. And analysts began to pencil in action from the Federal Reserve, and maybe even from the European Central Bank.

The result was swift. Stock markets in the United States rose sharply in the closing hours, up 1 percent. More importantly, the market's one-year inflation expectations lept up 14 percent, moving from 0.28 percent over the next year to 0.32 percent, marking a full week of stability after a total collapse of inflation expectations I have documented here and here on this blog.

Today's market reaction was in spite of pretty awful economic fundamental news, including a rise in weekly jobless claims.  Disinflation continues -- we saw both headline CPI deflation of 0.2 percent on the month, mainly due to fuel and food costs falling. Core CPI growth seems to have stabilized in the neighborhood of 2 percent year-over-year. By another measure, trim mean PCE, annualized inflation in April was 1.5 percent, down from 2.0 percent last month.

Tell me: if markets in the US have one hour to react to news of a possible monetary policy change, is this what that reaction should look like if monetary policy was irrelevant?

What it looks like, rather, is that markets are market monetarists.

Rewiring

If you've visited the site in the last hour or so, pardon the ugliness. I have just finished reprogramming the site to work with the newer version of Blogger. Incidentally, the comments should now work better. Enjoy. I will be fixing bugs and reintroducing features over the next few days.

A Dimon for Your Thoughts

I've been watching bits of JPMorgan CEO Jamie Dimon's testimony before the Senate Banking Committee on his firm's trading loss of $2 billion.

Perhaps my favorite moment was Senator Bob Corker's line of questioning, in which he asked Dimon if the Dodd-Frank law has made the American financial system significantly safer. Despite a few attempts at evasion from Dimon, Corker persisted until he got Dimon to admit "I don't know." (In the WSJ's feed, the conversation is noted at 11 a.m.) Roughly a half hour later, to Senator Mike Johanns, Dimon said that Dodd-Frank was costing JP Morgan $1 billion a year in compliance, and he said at another point that Dodd-Frank's costs were even higher to smaller community banks as a percentage of total operation costs.

I don't always establish comprehensive regulatory schemes whose costs run in the billions of dollars, but when I do, I make sure that there are net benefits. (This is a pop culture reference.)

I've written only a little bit about Dodd-Frank on this blog, mainly because financial regulation is not a field in which I consider myself all that knowledgeable. In the past, I wrote that the evisceration of the spirit of Dodd-Frank was predictable, given the concentrated power of the financial industry, and I also wrote in defense of "bright-line" regulations in response to Arnold Kling's call for "principles-based regulation."

But watching Dimon testify, I'm beginning to think that the very premise that the United States can, through appropriate regulations, eliminate or contain systemic risk is flawed. You don't need to be a regulatory wizard to be able to see that what is broken is not our regulations, but the idea of regulations as panacea.

I think the only way to really understand systemic risk, and why it is a problem requiring collective action at all, is to see it as a negative externality. Too often, conversations about systemic risk abstract it into some sort of mystery force we don't know how to deal with except through command-and-control regulation and supervision. But we know that regulation is not the only way to internalize externalities -- Pigouvian taxes work too. (There's one mention of "public goods" in this speech by St. Louis Federal Reserve Bank president James Bullard...and then it turns directly to regulation.)

Yet systemic risk is, in some very important ways, as simple a negative externality as air pollution. When banks make loans, or nonbank financial companies engage in securities trading, buying or selling insurance, underwriting, investing, etc., all of those activities create a private expected benefit and a private expected cost. But they also create a positive social expected cost, mainly in the form of counterparty risk.

Like air pollutants, which have a per-unit social cost, systemic risk too can be looked at in this way. Without the need of a regulator to compute assessments of systemic risk for each individual firm, we should be able to determine the social expected cost of systemic risk by looking at firm size, firm revenue, various measures of portfolio risk, etc. Developing equations to quantify the level and cost of systemic risk may not be easy, but it certainly is going to be easier, more successful, and more efficient than individual-firm systemic risk assessment.

More importantly, such practices would avoid the games of hide-and-seek with regulators and the dubious practices, as with JP's C.I.O. office.

With our social cost function, we can then consider the ways in which a Pigouvian tax is best applied. I would not go as far as recommending a tax on its face, as is done in this VoxEU article -- it will never happen in the US, and there are other levers. Instead, what make more sense is something like this proposal from Cato's Mark Calabria to limit the extent of deposit insurance available at systemically-risky financial institutions. (As a matter of fact, Matt Yglesias has said some positive things about Calabria's idea too.)

What Calabria ultimately is proposing is a backdoor Pigouvian tax. I would modify his proposal slightly, saying that the level of deposit insurance should fall as our social cost function measuring systemic risk rises. At a small bank, or a bank which has a very conservative loan portfolio, or whatever else, the individual depositor would be eligible for more FDIC backing than would a depositor at a large or risky bank. That would create an incentive for individuals to be conscious of deposit risk, and for banks to manage their size and risk appropriately and, most importantly, efficiently. (There is an efficient nonzero level of systemic risk.)

Where deposit insurance isn't relevant, there are other levers, such as reserve requirements, other liquidity requirements, the discount rate, etc., through which a per-unit cost can be passed back through onto the social-cost creators (the systemically-risky banks).

I really think that economists need to push harder for less intrusive ways of resolving systemic risk as a negative-externality problem than command-and-control regulation. As the conversation on financial system reform returns, let's look for more market-oriented, Pigouvian solutions.