Low Interest Rates, Overheating, and Household Indebtedness

In previous posts, I wrote about the opinions of a few Fed officials regarding the role of monetary policy
in causing and managing bubbles. In particular, Governor Jeremy Stein expressed a desire for the Fed to use monetary policy to address "overheating." In a recent speech at NYU, James Bullard commented that Jeremy Stein "pushed back against the Bernanke doctrine."

"The Bernanke doctrine has been that we’re going to use monetary policy to deal with normal macroeconomic concerns, and then we’ll use regulatory policies to try to contain financial excess. And Jeremy Stein’s speech said, in effect, I’m not sure we’re always going to be able to take care of financial excess with the regulatory policy. And in a key line he said, raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see, or you might not be able to attack with the regulatory approach. So I thought this was interesting. And I would certainly think that everybody should take heed of this. This is an argument that, maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years.”

Now, Scandinavian central bankers are chiming in. Danish central bank Governor Lars Rohde echoes the concern of Bullard and Stein. The role of monetary policy in Denmark is to maintain the fixed exchange rate. Thus, low interest rates in the world's largest economies have required correspondingly low rates in Denmark. The Danish deposit rate has been zero since July, and Rohde worries that this could fuel asset bubbles. In other words, he says that Fed-induced "overheating" is affecting smaller countries like Denmark.

Concern with the effects of monetary policy on financial stability are prevalent elsewhere in Scandinavia. The February minutes of the Swedish Riksbank, for example, also make frequent reference to financial stability concerns. For instance:

In Ms af Jochnick's opinion, developments in recent years have shown that central banks should have an overall perspective with regard to both monetary policy and financial stability, as financial stability is a necessary condition for monetary policy to function efficiently. This is also documented in research and analysis. What this means is the focus is on the inflation target and our independence, but that we thus cannot disregard the slightly longer run effects with regard to financial imbalances building up, for instance... Monetary policy is a blunt instrument when it comes to counteracting the build-up of financial bubbles, but financial imbalances can lead to major problems for companies and households and ultimately cause lower growth and higher unemployment. Just the fact that the Riksbank has talked about the risks entailed in the high level of household debt has contributed to stabilising the household debt ratio, albeit at a high level, according to Ms af Jochnick.

As those comments make clear, one concern in particular is that low interest rates are contributing to a higher household debt ratio. This struck me as somewhat strange because household debt to GDP in the United States has been falling steadily despite our low interest rates (see FRED graph at bottom.) I wonder if she is correct that the Riksbank has actually managed to stabilize the household debt ratio just by talking about the risks of high levels of household debt! An article in Reuters says:

Swedish Riksbank Governor Stefan Ingves, who is also the head of the Basel Committee on Banking Supervision, has warned low rates are adding to the risk of driving up household debt. 

In minutes of the bank’s Feb. 12 meeting, Ingves said, “With the current low interest rates, one must be aware of the link between household debt and monetary policy.”

The article neglects to mention some extremely important follow-up discussion by Deputy Governor Lars Svensson. In response to Ingves' concern that low interest rates could be driving up household debt, the minutes report that Deputy Governor Lars Svensson noted:

There seems to be a misunderstanding about what monetary policy can  achieve with regard to household indebtedness. Extensive research and inquiries, as well as practical experience, have led to the conclusion that monetary policy has very little impact on household indebtedness in the short term and - with low and stable inflation -no effect in the long term. According to this research and the Riksbank's own inquiries, a policy rate that is raised by 1.5 percentage points in one step, is held at this higher level for a year and then gradually returns to its original level leads to a household debt ratio that is approximately 1.5 percentage points lower a couple of years ahead than would otherwise be the case. That is, a debt ratio of 175 per cent of disposable income would fall to just over 172 per cent. 

Mr Svensson asked whether anyone believed that this would reduce the potential risks of household indebtedness and be worth more than the costs in the form of the lower rate of inflation and the higher rate of unemployment. Moreover, the thinking in Mr Ingves' article is based on the assumption that monetary policy can reduce indebtedness in the long term. But monetary policy has no long-term impact on indebtedness according to established research and science.

Svensson's conclusion was that "The potential risks of household indebtedness have to be managed by
other means, means that have a significant effect. We should not use monetary policy to limit household indebtedness. This will only serve to run the economy into the ground." His opinion seems to have held sway,  as the Executive Board decided to maintain the repo rate at one percent.

The Great Recession and Preferences for Redistribution

Differences in attitudes towards welfare and redistribution are an important source of political tension, especially during recessions. What factors shape people's attitudes towards welfare and redistribution? There are two main strands of thought on this question in the literature. One strand emphasizes economic self-interest as a key determinant of attitudes toward welfare and distribution. According to this view, people’s position in the labor market, exposure to layoff risk, and financial status are the main factors determining their attitudes. Another strand emphasizes different ideological dispositions on issues such as fairness, equality, and the role of government.

It is empirically difficult to distinguish between the two strands, since material circumstances and ideology may influence each other. Two recent papers take advantage of the Great Recession in their empirical design to study social preference formation. First is a paper by Yotam Margalit titled "Explaining Social Policy Preferences: Evidence from the Great Recession":

I use an original panel study that consists of four waves of surveys in which the same national sample of respondents was contacted for repeat interviews between July 2007 and March 2011. In these repeat interviews, detailed information was collected not only on respondents’ changing labor market circumstances but also on their political attitudes. Utilizing this rich longitudinal data, covering periods both before and after the eruption of the financial crisis, I estimate how individuals’ preferences on welfare policy shift in response to the personal experience of three types of economic shocks: a substantial drop in household income, a subjective decrease in perceived employment security, and the actual loss of a job. 

The central finding of the analysis is that voters’ preferences regarding welfare policy are strongly affected by changes in their own economic circumstances. In particular, the loss of employment is found to have a major effect, increasing the average probability of support for greater welfare spending by between 22-25 percentage points.

An interesting secondary finding is the following:

The analysis also reveals that the experience of the economic shock does indeed lead to a convergence in the welfare preferences of harmed individuals who prior to the shock held distinct political views. In particular, I find that in response to a personal economic shock such as layoff, Republicans and Independents grew significantly more supportive of welfare assistance, while among Democrats the effect was much smaller.

The effect may not be permanent:

I find that with the passing of time, as job losers regain employment, their support for the expansion of welfare spending decreases significantly. This shift in attitude among the re-employed is more frequent among voters on the right. 

The other paper is a working paper by Raymond Fisman, Pamela Jakiela, and Shachar Kariv called "How did the Great Recession Impact Social Preferences?" This paper focuses on the formation of ideological dispositions toward equity and redistribution. This is an experimental paper utilizing the Xlab at UC Berkeley. Subjects were drawn from the UC Berkeley student body, the socioeconomic composition of which is held fairly constant by the admissions office. The same experiments were conducted both before and during the Great Recession. Subjects played different variations of the "dictator game," in which one player decides how much money (or tokens) to allocate to herself and to other players. The game is an experimental test of people's self-interestedness. Variations of the game, discussed in the paper, allow researchers to disentangle selfishness from the willingness to tradeoff efficiency and equity.

Our main fi nding is that the Great Recession had a dramatic eff ect on individual social preferences: subjects who participated in laboratory dictator games prior to the economic downturn are signi ficantly more altruistic than those who took part in identical experiments after the onset of the recession. Our experimental design--employing graphical representations of modified dictator games that vary the price of redistribution--enables us to distinguish indexical selfi shness from the willingness to tradeoff equality and e fficiency. Moreover, our experimental method generates many observations per subject, and we can therefore analyze both types of social preferences at the individual level. We fi nd that subjects exposed to the economic downturn place greater emphasis on effi ciency and display greater levels of indexical sel fishness.

Chronicles of a Reverse Helicopter Drop

Ben Bernanke's nickname, "Helicopter Ben," refers to a famous "thought experiment" in economics. What would happen if the government were to rain money down upon us from a helicopter? Milton Friedman pondered this question in "The Optimum Quantity of Money" in 1969. The helicopter drop thought experiment is increasingly mentioned in discussions of unconventional monetary policy possibilities for the Fed, Bank of England, and ECB. Helicopter money was the subject of a speech given by David Miles, External Member of the Monetary Policy Committee of the Bank of England. Forbes calls QE4 "Another Step Towards Helicopter Money."

An earlier version of the helicopter drop thought experiment did not involve helicopters, because they were not invented yet. David Hume, in 1752, asks us to "suppose that,by miracle, every man in Britain shou’d have five pounds slipt into his pocket in one night." (Robert Lucas later criticizes the "magical" quality of this scenario.) Hume reasons that it should have no effect:

Where coin is in greater plenty; as a greater quantity of it is then requir’d to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself: no more than it wou’d make any alteration on a merchant’s books, if instead of the Arabian method of notation, which requires few characters, he shou’d make use of the Roman, which requires a great many.

Yet, Hume notices that in practice, his conclusion doesn't seem to hold. “Tho’ the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease, but some time is requir’d before the money circulate thro’ the whole state, and make its effects be felt on all ranks of people." His observation is based on the experience of France in the 1720s, an experience almost as magical as the five pound miracle.

In a paper with one of my all-time favorite titles, "Chronicles of a Deflation Unforetold," Francois Velde describes and analyzes the French monetary experiment of the 1720s. French currency at the time was gold and silver coins with nominal value set by government decree. The monarch could raise the legal tender value of the coins (augmentation) or lower their value (diminution). Over a seven-month period in 1724, the nominal value of the coins was reduced by 50% through a sequence of diminutions. On one instance, coins lost 20% of their nominal value overnight. This episode served as an experiment testing the neutrality of money. Here is Velde's abstract:

Suppose the nominal money supply could be cut literally overnight by, say, 20%. What would happen to prices, wages, output? The answer can be found in 1720s France, where just such an experiment was carried out, repeatedly. Prices adjusted instantaneously and fully on one market only, that for foreign exchange. Prices on other markets (such as commodities) as well as prices of manufactured goods and industrial wages fell slowly, over many months, and not by the full amount of the nominal reduction. Coincidentally or not, the industrial sector (as represented by manufacturing of woolen cloths) experienced a contraction of 30%. When the government changed course and increased the nominal money supply overnight by 20%, prices responded much more, and the woolen industry rebounded.

By the spring of 1724, the diminutions had cumulatively reduced the value of coins by one third, but without a matching reduction in prices. In other words, money was non-neutral. This of course caused economic troubles including industrial contraction. Policymakers clearly recognized that public expectations were a cause of monetary non-neutrality and a channel of monetary transmission. Following a diminution on April 4, 1724, the finance minister Dodun wrote a letter to be made public (cited in Velde).

The minister explained that the cumulative reduction in coin value had by now reached a third, and the public ought to see the benefit of this reduction in lower prices. This had not yet happened “because merchants and workers, foreseeing that other reductions might happen, used this pretext to increase prices rather than reduce them.” But coins were now at a rate destined to remain “for a long time if not forever, the public has no reason to fear further reductions for now.”

Dodun's letter served as an attempt of "forward guidance," but was not credible; another diminution ocurred on September 22. Today, monetary policymakers still attempt to make use of the power of public expectations. Forward guidance has been especially emphasized since 2011.

On another occasion, Dodun remarked that

...experience has shown us that the prices of commodities and goods is influenced less by the value of coins than by the fear of an impending reduction on coins and uncertainty over their future value, and this same fear and uncertainty would persist and prevent the previous reductions from having their effect...

Dodun's remark sounds familiar. The choice criticism of Fed policy even now is the accusation that it causes uncertainty. John Taylor, for example, argues that the Fed's quantitative easing announcements amplify uncertainty. In a speech I discussed in a previous post, Cleveland Fed President Sandra Pianalto lists "managing uncertainty" as a primary responsibility of the Fed. The American Enterprise Institute cautions that "Economic policymakers must focus not on experimental policy responses, but rather on reducing the high level of economic policy uncertainty by simplifying the tax system and avoiding new initiatives like the Federal Reserve’s QE3."

Dodun mentions not only uncertainty, but also fear. It is the combination of fear and uncertainty that he finds disruptive. Fear, I would argue, has the potential to do more harm than uncertainty, but the two tend to be confused. Unconventional monetary policy, to the extent that it is poorly understood and sometimes unprecedented, may cause uncertainty but it need not cause fear. The Fed can take some steps to address uncertainty through communication, provided they don't toss credibility out the window like Dodun. In a crisis, doing nothing would cause more fear than trying something new. "Avoiding new initiatives" is not the way to reduce fear and uncertainty.

Fed Officials Want to Tackle "Reaching for Yield"

Cleveland Fed President Sandra Pianalto gave a speech on February 15 called "Providing Balance while Managing Uncertainty." She says that the Federal Reserve "has been aggressive and creative in its response to a very challenging economic environment, and our actions have been beneficial for the economy." Nonetheless, her outlook is not among the most optimistic. She predicts that the unemployment rate will be 7.5% at the end of this year, and around 7% at the end of 2014. According to the Fed's threshold rule, the Fed won't raise the funds rate until unemployment falls below 6.5% or inflation rises above 2.5%. By Pianalto's estimation, that won't be happening until 2015 at the earliest.

Pianalto's counterpart at the St. Louis Fed, James Bullard, expounded upon the threshold rule in a speech the day prior to Pianalto's speech. Both Bullard and Pianalto address the Fed's balance sheet policy, QE3.  While Bullard describes the asset purchase program as "potent," Pianalto fears that it will have both "diminishing benefits" and increasing costs:

Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past. In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them.

The first such risk that she notes is the following:

First, financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment. 

This is reminiscent of John Taylor in an Op-Ed in the Wall Street Journal called "Fed Policy is a Drag on the Economy." Taylor writes that

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

Miles Kimball challenged the logic of this "reaching for yield" concern in two posts. Karl Smith weighed in on Forbes, and I did too on this blog. Kimball argues,

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality...

I have no problem believing that, indeed, investor ignorance and irrationality and schemes that prey on that ignorance and irrationality do indeed cause people to take on more risk as a result of low interest rates than they otherwise would. This is a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment.

Interestingly, Kimball's point about the appropriate domains of financial regulation versus monetary policy brings up yet another February Fed speech, this one by Governor Jeremy Stein of St. Louis. Stein argues that the Fed should take on what has typically been the role of financial regulators in alleviating "overheating" in credit markets. No surprise, he cites as one cause of overheating the fact that "a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to `reach for yield.'"

Stein alludes to the same sort of model that Kimball has in mind. Stein admits both irrationality ("changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational") and fraudulent schemes ("At any point, the agents try to maximize their own compensation, given the rules of the game. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society.")

Their models for the causes of reaching for yield are roughly the same, but their policy prescriptions are polar opposites. Kimball says that tighter monetary policy is the worst solution to reaching for yield, and improved financial regulation is the better option. Stein says that monetary policy has benefits over financial regulation. Pianalto apparently comes down on the side of Stein, tentatively suggesting that tighter monetary policy may be necessary to reduce the threat of financial instability caused in part by reaching for yield. She says that "we could aim for a smaller sized balance sheet than would otherwise occur if we were to maintain the current pace of asset purchases through the end of this year, as some financial market participants are expecting."

The Unwarranted "Unwarranted Pessimistic Signal"

St. Louis Fed President James Bullard gave a speech on February 14 called "U.S. Monetary Policy: Easier Than You Think It Is." He claims that Fed policy is easier now than it was in 2012, mainly due to the implementation of a "threshold rule." The rule is basically a promise that the Fed will not raise policy rates until the economy reaches certain pre-specified thresholds: 6.5% unemployment or 2.5% inflation. The Fed will wait to raise the federal funds rate target until unemployment drops below 6.5% or inflation exceeds 2.5%. Prior to implementing a threshold rule, the Committee offered date-contingent rather than state-contingent forward guidance, stating that the policy rate would likely remain near zero until mid-2015.

The previous announcement that the policy rate would remain near zero until mid-2015 created a "pessimism problem," Bullard explains, because "the date could be interpreted as a statement that the U.S. economy is likely to perform poorly until that time." Bullard views the thresholds as alleviating an "unwarranted pessimistic signal" created by the date-based rule.

The threshold rule is also called the Evans rule, after Chicago Fed President Charlie Evans, who advocated for it and announced it in November 2012. Evans notes that Narayana Kocherlakota, Eric Rosengren and Janet Yellen have all publicly advocated threshold rules. But Bullard's view of how the threshold view is supposed to work seems different than the explanation proffered by Evans, who said:

An important new aspect of current round of purchases was to tie its length to economic outcomes, rather than announcing a fixed amount of purchases over a predetermined period as we have done in the past... Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

Whereas Evans views the threshold as a way to clarify policy goals and assure the market that accommodation will be sufficient to close the resource gap without raising fears of excessive inflation, Bullard focuses instead on the "unwarranted pessimistic signal" issue. The idea that monetary policy can send a "pessimistic signal" is neither new nor unique to eras of unconventional policy. It has long been noticed that announcements of policy rate changes have the opposite effect of what theory would predict on long term interest rates (Cook and Hahn 1989). A proposed explanation for this puzzle is based on asymmetric information between the Fed and the public. Easy monetary policy can have a counterproductive impact if it signals to market participants that future economic conditions are likely to be worse than they thought. But this is only possible if the Fed has some information that the market does not have.

In a 2000 paper, Christina and David Romer compare Federal Reserve and commercial forecasts and determine that the Fed does indeed have information about inflation and output that the markets do not, so the signalling mechanism is plausible. One effect of lowering the policy rate is to reveal some of the Fed's negative information about the future. But this does not entirely justify Bullard's claim that the Fed was sending a pessimistic signal by announcing that the policy rate would remain near zero until mid-2015.
This announcement could have revealed either positive or negative information about the future. Market participants may have actually been more pessimistic than the Fed originally, believing that the economy would stay bad until later than mid-2015, in which case this announcement would provide an "optimistic signal."

There is no reason to assume that the markets were originally more optimistic about when the economy would improve than the Fed. So we do not know whether the announcement about mid-2015 caused people to become more optimistic or more pessimistic. Naming it an "unwarranted pessimistic signal" is, well, unwarranted. Thus we can't say that introducing a threshold rule has made monetary policy easier by removing an unwarranted pessimistic signal. I still think the threshold rule may be a good idea, but the explanation offered by Evans makes more sense.

New Berkeley Working Papers

The Berkeley Economic History Lab (BEHL) has just announced the launch of a new working paper series. BEHL was established in 2011 with funding from the Institute for New Economic Thinking (INET). I have certainly benefited from BEHL, mostly from the weekly seminar series, post-seminar coffee hours, faculty mentoring, and biweekly student seminar lunches. The working papers are contributed by visitors and other affiliates of the BEHL. Since "their circulation is intended to stimulate discussion and comment," I plan to use the blog as a venue to assist with that. I will put up a link and write a paragraph or so about each working paper as they appear, and invite you to read the papers that interest you and leave your comments and questions. I'll send the relevant authors a link to the comment thread. Two working papers are already up.

The first is "State Capacity and Long Run Performance" by Mark Dincecco and Gabriel Katz. State capacity refers to the combined extractive and productive capabilities of the state-- its ability to tax and to provide public goods and services. The concept has come to prominence in the development literature, where it is recognized that lack of state capacity is a limit to development. This is the theme of a 2011 paper by Timothy Besley and Torsten Persson who study current-day "fragile states" that are ineffective at taxing and providing basic services to citizens. Dincecco and Katz' paper studies state capacity from an economic history perspective, using four centuries of European data (1650-1913). They study the impacts of political transformations--particularly fiscal centralization and parliaments-- on extractive and productive capabilities, and in turn on economic growth.

The second is "Financing a Planned Economy: Institutions and Credit Allocation in the French Golden Age of Growth (1954-1974) " by Eric Monnet. The years 1945-1974 are called the "Golden Age of European Growth," yet they witnessed startlingly high levels of financial repression. Monet investigates this seeming discrepancy between high growth and financial distortion. He looks in detail at the planned ("dirigiste") economy of postwar France, where the "nationalization of credit" was a priority. The Planning office, the Bank of France, and semi-public credit institutions played decisive roles in allocating credit in accordance with national economic and social priorities. The state actively supported the development of bank credit. This paper also provides an original database and analyzes it to account for the role of finance in the French Golden Age.

Take a look at these new working papers and stay tuned for more in the BEHL series!

Forecast Errors and Fiscal Multipliers: What am I Missing Here?

Today Mark Thoma's blog has a link to a paper by Olivier Blanchard and Daniel Leigh called "Growth Forecast Errors and Fiscal Multipliers." They find that "fiscal multipliers were substantially
higher than implicitly assumed by forecasters." I hope someone else who has read the paper can help me understand one part of it that is confusing me. This is their primary claim:

Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors (pg. 1).

I wanted to model it to convince myself. Here is my model:

They run the regression with one year of data at a time, not many years of data. Forecasted consolidation can certainly differ from actual consolidation. From (2) then, I am confused about why "the coefficient on the fiscal consolidation forecast should be zero." I think I'm missing something simple. Can someone chime in?