Fed Policy and Inflation Risk by Martin Feldstein

"Fed Policy and Inflation Risk" by Martin Feldstein | Project Syndicate

Navigated from Greg Mankiw's Blog | shared via feedly mobile

  CAMBRIDGE – During the past four years, the United States Federal Reserve has added enormous liquidity to the US commercial banking system, and thus to the American economy. Many observers worry that this liquidity will lead in the future to a rapid increase in the volume of bank credit, causing a brisk rise in the money supply – and of the subsequent rate of inflation.

That risk is real, but it is not inevitable, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be. The explosion of reserves has not fueled inflation yet, and the large volume of reserves could in principle be reversed later. But reversing that liquidity may be politically difficult, as well as technically challenging.

Anyone concerned about inflation has to focus on the volume of reserves being created by the Fed. Traditionally, the volume of bank deposits that constitute the broad money supply has increased in proportion to the amount of reserves that the commercial banks had available. Increases in the stock of money have generally led, over multiyear periods, to increases in the price level. Therefore, faster growth of reserves led to faster growth of the money supply – and on to a higher rate of inflation. The Fed in effect controlled – or sometimes failed to control – inflation by limiting the rate of growth of reserves.

The Fed began an aggressive policy of quantitative easing in the summer of 2008 at the height of the economic and financial crisis. The total volume of reserves had remained virtually unchanged during the previous decade, varying between $40 billion and $50 billion. It then doubled between August and September of 2008, and exploded to more than $800 billion a year later. By June of 2011, the volume of reserves stood at $1.6 trillion, and has since remained at that level.

But this rise in reserves did not translate into rapid growth of deposits at commercial banks, because the Fed began in October 2008 to pay interest on those reserves. Commercial banks could place their excess funds in riskless deposits at the Fed, rather than lending them to private borrowers. As a result, the money supply has grown by only 25% since 2008, despite the 40-fold increase in reserves since that time.

During the past year, the Fed has further increased the liquidity of the banking system – and of the American economy – by a strategy called Operation Twist, buying $400 billion of long-term securities in exchange for short-term Treasury bills. The banks that hold these Treasury bills can sell them at any time, using the proceeds to fund commercial lending.

The massive substitution of reserves for longer-term securities during the period of "quantitative easing," and of Treasury bills for long-term securities in Operation Twist, has succeeded in reducing long-term interest rates. The combination of low interest rates at every maturity and the substitution of short-term securities for longer-term assets has also succeeded in raising share prices.  

But it is not clear that the lower interest rates and higher share prices have had any significant effect on real economic activity. Corporations have a great deal of liquidity, and do not depend on borrowing to invest more in plant and equipment. Housing construction has not revived, because house prices are falling. Consumers temporarily increased their spending in response to the increase in the stock market at the end of 2010, but that spending has recently been much more sluggish.

The risk is that the commercial banks could always decide to start using those excess reserves, forgoing the low rate of interest paid on deposits by the Fed (only 0.25%) and lending those funds to firms and households. Those loans would add to deposits and cause the money supply to grow. They would also increase spending by the borrowers, adding directly to inflationary pressures.

When the economy begins to recover and companies have the ability to raise prices, the commercial banks will want to increase their lending. This will be welcome, as long as it is not too much or too fast. The Fed will appropriately want to limit the expansion of bank lending. This is what the Fed used to talk about as its "exit strategy." Essentially, it would mean raising interest rates on the deposits at the Fed and allowing interest rates more generally to rise. If this is done in a timely way and on an adequate scale, the Fed will succeed in preventing the current vast liquidity from generating higher inflation.

Here is what worries me: the structure of US unemployment is very different in the current downturn than it was in the past. Nearly half of the unemployed have been out of work for six months or longer. In the past, the corresponding unemployment duration was only 10 weeks. So there is a danger that the long-term unemployed will be re-employed much more slowly than in previous recoveries.

If the unemployment rate is still very high when product markets begin to tighten, the US Congress will want the Fed to allow more rapid growth in order to bring it down, despite the resulting risk to inflation. The Fed is technically accountable to Congress, which could apply pressure on the Fed by threatening to reduce its independence.

So inflation is a risk, even if it is not inevitable. The large volume of reserves, together with the liquidity created by quantitative easing and Operation Twist, makes that risk greater. It will take skill – as well as political courage – for the Fed to avoid the rise in inflation that the existing liquidity has created.

Daron Acemoglu on Inequality [via TheBrowser]

Daron Acemoglu on Inequality
http://thebrowser.com/interviews/daron-acemoglu-on-inequality

The US, the UK and many other countries have become far less equal over the past 30 years. The MIT economics professor says it's important we understand how and why this happened, and what it means for our societies

Hoping you enjoy this FiveBooks interview from http://thebrowser.com
For more like it, explore the archive at http://thebrowser.com/fivebooks/archive

Monetary policy: Understanding NGDP targeting | The Economist

http://www.economist.com/blogs/freeexchange/2011/10/monetary-policy-3?fsrc=rss

Understanding NGDP targeting

NOMINAL GDP targeting is not a new idea. It has an intellectual pedigree that goes back well before the crisis, but even if we just focus on the recent debate over changing Fed policy to targeting growth in the level of nominal output, we're talking about nearly 3 years' worth of public discussion. Scott Sumner started his blog in early 2009, was linked by Tyler Cowen just a few weeks later, and had the economics blogsphere debating intensely by the end of that year. It has taken a while for non-economist elites to notice, but the debate has been bubbling for a while. Neither has the American debate proceeded in isolation. Central banks pay varying amounts of attention to the path of nominal output, and some—among them the Bank of England—put quite a lot of weight on NGDP. But Kevin Drum writes that it's important to get the NGDP debate out in the open. I suppose that's right; I just figured that's what we'd all been doing for the past 30 months.

The trigger for Mr Drum's post was a recent Wall Street Journal op-ed which purported to call into question claims made on an NGDP target's behalf. What it mainly demonstrated was that quite a lot of journalists haven't paid attention to the debate over NGDP targeting. I supose that's to be expected. Those who have simply must do a better job explaining the contours of that debate to others. 

Now is as good a time as any for me to do a little of that explaining. Mr Drum writes:

Matt [Yglesias] is right that one of the theoretical virtues of NGDP targeting is that it combines both employment and inflation into a single metric, which would make this question moot for policymakers, but it unquestionably does imply that during recessions the Fed would tolerate higher inflation. I think that's a good thing (as does Matt); [WSJ writer Evans doesn't]. But it's certainly a key issue that deserves plenty of public discussion.

Let's slow down here. Does an NGDP target imply greater inflation in recessions? Were the Fed to adopt an NGDP level target right now, most supporters of the policy would recommend that the Fed allow for a period of "catch-up", during which the economy would expand at an above-trend rate in order to make up some of the ground lost during the recession. This isn't a feature unique to NGDP targeting; advocates of price-level targeting would call for something similar. During a period of catch-up, inflation would probably run above the desired rate, as would real output growth. This actually isn't even inconsistent with an inflation-rate target. A central bank actually targeting an inflation rate should react to deviations above and below target similarly, suggesting that the Fed should be no more aggressive in fighting above-normal inflation than it was in fighting below-normal inflation; 2% on average is good enough. A period of catch-up NGDP growth and inflation is really only inconsistent with a policy of steady opportunistic disinflation or, to the extent that the two are different, of central bank incompetence. One way of understanding the push for an NGDP target, I think, is as a means to get the central bank to take its mandate more seriously.

Of course, it's worth asking why there is so much ground to be made up in the first place. One of the strongest points in favour of NGDP targeting, in my view, is that it implied a need for far more action from the Fed far earlier in this business cycle. People remember how aggressively the Fed intervened to prop up the financial system in the fall of 2008, but they forget how slow the central bank was to react to what was obviously a precipitous decline in the macroeconomy. The fed funds rate stayed at 2% from April until October of 2008. The Fed didn't ramp up its initial asset purchase programme above $1 trillion until March of 2009, at which point the economy had already lost some 6m jobs. Why the delay? One data point worth noting: the monthly core inflation rate was positive throughout 2008 and 2009. NGDP growth, by contrast, was already negative in the third quarter of 2008, and was sharply negative in the fourth quarter of that year, when total spending in the economy shrank at an 8.4% annual pace. A central bank with an explicit NGDP level target would have faced (appropriately) intense pressure to do much more much sooner than one with the Fed's present, vague focus on an inflation target as a means to broader macroeconomic stability.

Now, in a situation in which a central bank has credibly established an NGDP target, recessions would by definition be due to real shocks. In those cases, maintaining the target would mean higher inflation to go with lower real growth. So if the American economy is hit by a real shock, an NGDP target might mean inflation at 5% and zero real growth, rather than what we might observe today—inflation around 3% and a drop in real growth of perhaps 2%. I'm happy to have a debate about which Americans are likely to prefer, provided that we stipulate that in the meantime, the NGDP target is also preventing major episodes of cyclical unemployment. It's worth mentioning that given a positive productivity shock, an NGDP target would imply real growth above normal levels and inflation below normal levels. An inflation-targeting central bank, by contrast, might respond by adding more stimulus to an economy, potentially inflating bubbles.

Mr Drum continues:

Evans's other two points are worth thinking about too. It's true that the Fed has to pick a target no matter what it's doing, but NGDP is a new one with no track record. That makes it trickier to get a consensus about what the right figure should be, and consensus is important since the whole point of NGDP targeting is that everyone has to believe the Fed is really, truly committed to its target.

NGDP is not a new one with no track record. Countries have been keeping track of nominal output for ages, and most central banks, including the Fed keep a close eye on the path of NGDP either explicitly or implicitly, by putting weight on both inflation and real output in making policy decisions. This isn't some crazy new variable that's been dreamt up. Consensus and commitment to an NGDP target are no more or less important than they are for an inflation or price-level target.

And the question of whether the Fed can hit an arbitrary NGDP target is critical. Central banks have pretty time-tested mechanisms for hitting inflation targets, but growth targets are something different. There are plenty of economists who are skeptical that monetary policy alone can accomplish this.

Luckily for us all, the mechanisms available to hit an NGDP target are exactly the same ones used to hit an inflation target. The Fed will communicate its policy goals, then use the levers at its disposal to move NGDP to the desired level. When the fed funds rate isn't stuck near zero, that means the standard change in the fed funds target rate and corresponding open-market operations. If NGDP is expected to be too high, rates go up; too low, and rates go down. At the zero bound, the tools are the same ones the Fed has been using or saying it could use for the past three years. If you think the Fed can affect inflation, you think the Fed can affect NGDP; that's all there is to it. Now, you might argue that the Fed can't affect inflation, but that's an extremely difficult position to reconcile against recent data.

Mr Drum closes:

Finding some kind of mechanical monetary rule that automatically produces stable growth is sort of the Holy Grail of monetary economics, and we should subject any new proposed rule to plenty of tough questioning.

Perhaps there are people making extraordinary claims for NGDP targeting. In general, I think that most of its supporters consider it to be part of the evolution of monetary economics toward a greater understanding of how the central bank can best achieve macroeconomic stability. I don't consider NGDP targeting to be a panacea or a holy grail. I simply think it's likely to perform better as a policy goal than inflation over the long run, and much better in the rare but very costly economic disaster. And I tend to believe that the idea has grown in popularity not because of unreasonable claims made on its behalf, but because of the strength of the arguments in favour of it.

NYTimes.com: Four Nations, Four Lessons

BUSINESS DAY   | October 23, 2011 Economic View:  Four Nations, Four Lessons By N. GREGORY MANKIW Recent financial mistakes in France, Greece, Japan and Zimbabwe could presage a sad future for the United States economy - if we're not careful.

The Case for more quantitative easing

No Extra Credit

By JOE NOCERA

What if everything that is happening in Washington right now is just meaningless noise?

What if the Obama jobs plan, the coming deliberations of the supercommittee, the debate over taxing millionaires — what if none of it is likely to make a whit of positive difference for the economy? What if the only thing that matters is something Congress and the president rarely mention, and can do nothing about?

I’ve come to believe this is the case. What is killing the economy is lack of credit. In the aftermath of an asset bubble, invariably the result of too-loose credit, banks don’t just tighten their standards; they practically shut down.

This was true during the Great Depression, and it’s been true during the Great Recession. And until normal credit standards return, economic growth will continue to be stunted. “Overreaction to the credit bubble is now the knee on the throat of the economy,” says my friend Lou Barnes, a mortgage banker at Premier Mortgage Group in Colorado.

Not long ago, Lou sent me a powerful new piece of evidence, a presentation put together by Paul Kasriel, chief economist for Northern Trust. Titled “If Some Dare Call It Treason, Was Milton Friedman a Traitor?” (the title will become clear shortly), it has the force of revelation.

The first part of the paper is spent “dispelling the nonsense” (Kasriel’s words) that factors besides credit are the root of the problem. He persuasively mocks the idea that “uncertainty” is holding back companies from borrowing. (“Uncertainty,” Kasriel told me, “is the last refuge of economists who can’t explain what is going on.”) Ditto for onerous taxes, record budget deficits and lack of demand.

He then documents “a post-WW II record” credit contraction, before moving on to a surprising solution: more quantitative easing from the Federal Reserve, which is essentially the buying of bonds from investors by the Fed, using money it prints, as Kasriel freely admits, “out of thin air.”

That this solution is controversial is not lost on Kasriel; his title is an obvious play on Rick Perry’s comment that continued quantitative easing by the Fed chairman, Ben Bernanke, would amount to borderline treason. But that’s where his reference to Friedman comes in. Kasriel is absolutely convinced that if the great conservative economist were alive today, he would be leading the charge for quantitative easing. It’s all we’ve got left.

In the 1930s, the Fed’s tight money policy compounded the lack of credit and sent the country into the Depression. Decades later, Milton Friedman was the economist who most persuasively proved that point. Bernanke, a student of the Depression, took that lesson to heart; his willingness to flood the system with liquidity during the financial crisis prevented a repeat.

It is also what led Bernanke to try the first two rounds of quantitative easing. “Banking under normal circumstances is a transmission mechanism from the Fed to the economy,” Kasriel told me. “That transmission mechanism is broken.” Quantitative easing is not nearly as efficient at expanding credit as having the banks involved, but it does work. During the decade of stagnation in Japan, Kasriel points out, Friedman urged its central bank to expand the money supply and buy bonds — exactly what Bernanke has been doing.

The main argument against the printing of money is that it raises the odds of inflation; even the esteemed Paul Volcker is worried about it, as he wrote in Monday’s Times. But Kasriel is convinced that the bigger fear right now is deflation, and that the expansion of credit by the Fed should be seen in combination with the contraction by the banks. In that larger context, the Fed’s move no longer looks inflationary. It looks instead like the only means we’ve got right now to create badly needed credit.

There is much resistance to another round of quantitative easing, not just from G.O.P. presidential hopefuls, but from many in the political establishment. Yet it’s worth noting that the reason Volcker is esteemed today is because, 30 years ago, as Fed chairman, he stuck by a monetary policy — a severe tightening, in his case — that he believed in despite fierce denunciations. His willingness to chart an unpopular course led directly to the economic revival of the 1980s.

Today, Ben Bernanke is every bit as vilified as Volcker was back then. Yet the Fed remains politically independent, and like Volcker, he has the right to chart the course he believes best, without political interference. The course he has charted is quantitative easing. Kasriel is utterly convincing that this is the right course. Bernanke should make the Fed’s independence matter.

Source: New York Times

The Economist | The proper diagnosis: Profligacy is not the problem

The proper diagnosis

Profligacy is not the problem

Solving the euro-zone mess means understanding the nature of its ills. And by insisting it is just about budget deficits, too many Europeans show they don't

MISDIAGNOSIS is not, in itself, malpractice. Everyone, be they doctors or central bankers or politicians, makes mistakes. But when the misdiagnosis involves ignoring some symptoms and persisting in treatments that aren't working, it is not so easily excused. And that is what is going on with the euro, where a stress on demanding austerity has eclipsed the need to boost confidence.

See full article

Working harder and hardly hiri... (economist.com)

Working harder and hardly hiring
http://www.economist.com/blogs/freeexchange/2011/09/growth-and-jobs?fsrc=scn%2Ftw%2Fte%2Fbl%2Fworkingharderandhardlyhiring

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How Big? A Caption Contest

President Obama with Treasury Secretary Geithner, while NEC Director Gene Sperling looks on. 

Check out this caption contest from Freakonomics' Blog:

How Big? A Caption Contest

Selection effect

Marginal revolution:

I love this example of the importance of selection effects:

During WWII, statistician Abraham Wald was asked to help the British decide where to add armor to their bombers. After analyzing the records, he recommended adding more armor to the places where there was no damage!

The RAF was initially confused. Can you explain?

You can find the answer in the extension or at the link.

Wald had data only on the planes that returned to Britain so the bullet holes that Wald saw were all in places where a plane could be hit and still survive. The planes that were shot down were probably hit in different places than those that returned so Wald recommended adding armor to the places where the surviving planes were lucky enough not to have been hit.

The illustrated guide to a Ph.D.

What does a PhD do?
http://matt.might.net/articles/phd-school-in-pictures/

How To Get More Free Dropbox Storage With Your School Email Address [News]

  

How To Get More Free Dropbox Storage With Your School Email Address [News]

via MakeUseOf by Bakari Chavanu on 7/28/11

Millions of us use the free in-the-cloud, file sharing and syncing service Dropbox who allow you to increase your free storage by using their referral system. When you get someone else to sign up for a Dropbox account, you get an extra 250MB of additional space.
But now if you're a student or educator with a .edu email address, you can get double the credits for referrals. That's 500MB per friend you invite. With enough Dropbox space, you can nearly replace the local documents folder on your computer with your Dropbox account, which means accessing your content from any online computer.
Dropbox is a great tool for students who work between two or more computers. Plus, the file sharing features of Dropbox are useful for group projects in school.

To get more storage, you simply need to verify your .edu email address. Once your address is verified, your current Dropbox account storage will be doubled; for example, from 2GB of existing Dropbox space to 4GB after your .edu account is verified.
When you refer a friend and he or she actually signs up for a Dropbox account, your storage space will be doubled again. You can get up to 8GB of free space using the referral process.

If you don't already have a Dropbox account, go here to get started. After you're signed up, log into your account and link into the referral process to invite your friends, using their email, and/or your Twitter and Facebook accounts.
Source: How-To Geek

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100 Best Blogs for Econ Students

100 Best Blogs for Econ Students

Delicious hotlist

6 Blogs That Will Help You Understand Economics

6 Blogs That Will Help You Understand Economics

MakeUseOf.com

One of the most common questions of the last few years has been "how did we get into this mess?" Understanding why the global economic problems occurred, and what issues are currently relevant, isn't easy. TV pundits and politicians have their opinions, but they're often contradictory, resulting in further confusion.
But worry not, layman economists! Although economics is complex, it doesn't necessarily need to be out of your grasp. There are numerous blogs across the Internet that provide interesting, timely information and argument about the economy of both today and tomorrow. More importantly, the econ blogs out there are written in a language you can actually understand.

Calculated Risk

If you're looking for the latest information about current economic conditions in the United States and, to a lesser extent, the world, Calculated Risk is the place to be. This blog can be a little bit daunting at first because of the volume of information that it delivers and the initially obscure nature of the graphs and post titles.
Dive into the posts themselves, however, and you'll find that Calculated Risk does a pretty good job of summarizing what's important and leaving out what isn't. The blog also does regular round-ups that point out the most important news of the last week and the most important upcoming announcements.
Calculated Risk doesn't delve much into economic history or theory, but it's an amazing blog for people who want to learn about what's happening right now. They also have really awesome graphs!

Carpe Diem

Staffed by Mark Perry, a professor of economics at the University of Michigan, Carpe Diem is a centrist current economics blog that tends to skew towards covering "weird" or "unique" topics – one series of posts argues that increasing voter turnout would not have any major effect on the outcomes of elections, for example. Whatever the topic, however, Mark does a good job of providing clear posts that don't fall into using too much economic mumble-jumbo.
Carpe Diem is also one of the few blogs that has been posting positive economic news on a fairly regular basis. If you're a glass-half-full kind of person you'll probably enjoy this blog.

China Financial Markets

There is no question that China is an important part of the global economy, but the economics of the country in which a sixth of the world's population resides isn't usually explored by western media outlets. China Financial Markets fills that gap.
While published in a blog format, China Financial Markets is more like a single-article online magazine. New posts occur only about once a week, but they're incredibly long and very detailed – I'd say the average post is between 1,000 and 2,000 words. This is probably the hardest blog listed here to understand, and at least part of that difficulty is due to the fact that the posts may touch on people, objects and locations you've never heard of before. It's an incredibly insightful blog, however, and well worth your time.

Freakonomics

This pop-econ blog is, like the book of the same name, focused on strange and unusual economic outcomes that occur throughout the world. The blog features posts from the authors of Freaknomics, but includes occasional posts from other contributors as well.
You won't find much serious economic talk on this blog, but what you will find are engaging posts about economics that are easy to read and easy to understand. If you're very new to reading about economics, and you're not ready to jump into the heavier stuff just yet, reading Freakonomics for awhile can get you into the right state of mind – and the fact that this blog isn't serious business doesn't mean you won't learn anything.

The Big Picture

If you take Calculated Risk's tendency to post cool graphs, add a dash of political opinion, and smother the whole thing with some in-depth economic analysis, what do you get? The Big Picture.
Created by Barry Ritholz (the author of Bailout Nation), a financial journalist and money manager, The Big Picture provides timely posts about current economic events and laces them with engaging, well written commentary. Although the author of this blog has Wall Street ties, this is not a blog built to sell the author's services or trumpet Wall Street's successes while neglecting its failures. Instead, The Big Picture acts as a watchdog – many of the blog's posts are about how poor behavior on the part of Wall Street is having negative economic consequences.

The Conscience of a Liberal

There are few economists who are controversial as Paul Krugman, the Noble Prize winning professor who, as the title of his blog suggests, stands defiantly on the political left. What really makes Krugman's blog stand out from the crowd, however, is the ease with which he makes his economic arguments accessible. Although he occasionally falls into deeply academic talk, his posts are for the most part laid out in layman's terms. They address specific points, as well, which makes it easier for economic newbies to follow what's being discussed.
The Conscience of a Liberal is a bit of a pessimistic blog (at least at the moment) so be warned that you may come away deeply afraid that you and everyone you know will lose their jobs and never be able to find another one, ever. There is a reason why the New Yorker once ran a comic depicting Krugman as a street preacher foretelling the end of days.

Conclusion

Reading these blogs won't necessarily turn you into an economics professor overnight. These blogs will, however, give you a much better perspective on current events. So what are you waiting for? Start learning, real good!

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Burton Malkiel on Investing | FiveBooks | The Browser

Five good books on investment.
http://thebrowser.com/interviews/burton-malkiel-on-investing

200 Countries and 200 Years in 4 Minutes

200 Countries and 200 Years in 4 Minutes

Greg Mankiw's Blog

ONE: The app every American should own

ONE: The app every American should own

TUAW

My brother and I frequently discuss the fact that, though many Americans are passionate about a wide variety of issues affecting our country, few seem to actually take the time to do anything about it. And who can blame them? Many Americans are so overworked, underpaid, and in fear of how they'll make their mortgage payment or health insurance premium next month that they may not have time to attend a political rally or contact their representative on a certain issue? Well, now there's an app that makes it easier for the average Joe to take political action and promote change -- all from his iPhone.
ONE Campaign is essentially a call-to-action app. It lists a number of political issues or advocacy movements and gives you instant access to proven projects that are working to combat the issues (like vaccines for children, for example). You can then enlist your Twitter or Facebook friends to help spread the word and join movements that are important to you. But the best thing about the app is that it gives you instant tools so you can actually take political action. With a few taps you can call your Congressman or sign a petition to support your cause. The app knows who your Congressional leaders are based on the zip code you enter. So many political action apps are solely news-focused. They tell us the bad things that are happening and leave us angry or distressed. The ONE app allows us to take productive action on an issue as easily as we download a song. ONE Campaign is a free download.

ONE: The app every American should own originally appeared on TUAW - The Unofficial Apple Weblog on Sat, 04 Jun 2011 08:00:00 EST. Please see our terms for use of feeds.

Source | Permalink | Email this | Comments

Strong Dollar = Strong Economy ?

Strong Dollar = Strong Economy ?

Greg Mankiw's Blog

An excellent column from Christy Romer.

Google Plays the Yield Curve

Google Plays the Yield Curve

Greg Mankiw's Blog

Click on graphic to enlarge.

I was fascinated a story in today's Wall Street Journal.  Apparently, Google is sitting on $37 billion in cash, but nonetheless decided to sell $3 billion worth of bonds.  Why?  To take advantage of low interest rates.

It is like reverse maturity transformation.  The banking system borrows short and lends long.  Google is borrowing long and lending short.  (Or maybe I should call it reverse quantitative easing, as Google is also doing exactly the opposite of what the Fed has been doing.)

Does this make sense for Google?  I have no idea, and I am ready to concede that those guys are a lot smarter (and financially successful) than I am.  But there is reason to be skeptical. 

The chart above shows the spread between the ten-year Treasury bond and the three-month Treasury bill.  The yield spread is now high by historical standards.  The empirical literature on the expectations theory of the term structure (in which I have sometimes played) suggests that this is a good time to borrow short and lend long--the opposite of what Google is doing.

Maybe this time is different, and past empirical regularities will not hold going forward.  But ponder this question: If you had a friend with a paid-up house, would you suggest that he now take out a long-term mortgage in order to deposit the proceeds in a money-market fund?  If not, does it make sense for Google to be doing much the same thing?

Updates:

1. A smart reader sends in the following plausible explanation:

While it's true that Google has $37 billion in cash and equivalents, almost all of that $37 billion is in non-U.S. accounts (an artifact of funneling most of their profits through low-tax Ireland). They cannot spend that $37 billion in the U.S. without incurring a tax rate of 35 percent; thus, the borrowing is to finance spending in the U.S. (as opposed to abroad). All the big tech companies do the same thing (Microsoft was in the news for the same thing some 6 months ago).  Thus, Google is not trying to play the yield curve so much as intertemporally arbitrage the U.S. tax code. By not repatriating the $37 billion now, they are betting that the U.S. corporate tax rate on repatriated foreign profits will be appreciably lower in the future than it is now.

2. On the other hand, another loyal reader points me toward this source, which says:

The firm doesn't have the same issue with overseas cash that many of its large-cap technology peers do. Of Google's $37 billion in cash, only about $17 billion is sitting outside the U.S. Microsoft, by contrast, has no net cash remaining in the U.S., while nearly 90% of Cisco's cash is sitting outside of the country.

Sent with Reeder

Answering the bunnies

Answering the bunnies

Econbrowser

A cartoon has been making the rounds (e.g., Forbes, Zero Hedge, and Real Clear Politics) in which cartoon characters (bunnies maybe? or perhaps some other life form) ask questions about quantitative easing. I would have provided slightly different answers than did the didactic character in the cartoon, so I thought it might be fun to interject myself as a third character in the bunnies' conversation.
The cartoon begins with a discussion of quantitative easing.

Bunny: What does that mean?
JDH: It means that the Fed is going to buy some more long-term Treasury securities. The idea is that by buying a large amount, the effect will be to increase the price of those bonds, which would make the interest rates on those and other bonds lower. Lower interest rates might help make more loans available to small businesses and create better opportunities for households to refinance. By depreciating the dollar, the move may also encourage U.S. exports and discourage U.S. imports.
Bunny: Why do they call it the quantitative easing? Why don't they just call it printing money?
JDH: Actually no money is going to be printed. The Fed will pay for these purchases by crediting accounts that banks have with the Fed. Although it is true that banks could ask to withdraw these funds in the form of green currency, they currently are showing no interest in doing so. And before banks did start to want to withdraw these funds as money, the Fed plans to sell the assets off to bring the reserves back in. There is no plan now or in the future to "print a ton of money".

The bunnies then go on to note correctly that one of the goals of quantitative easing is to prevent deflation.

Bunny: Isn't [deflation] good? Doesn't that mean people can buy more of the stuff?
JDH: It would if your nominal income stayed the same. But that's exactly the problem. In episodes of deflation, people's wages go down, and many lose their jobs and can't find new ones. A decrease in the price of what we buy sounds good to us, but a decrease in the price of what we sell (namely, a decrease in our salary) does not. The experience of countries in which wages and prices are falling has been very painful, and the Fed wants to avoid this.
Bunny: But aren't food, gas, health care, and tuition prices higher than a year ago?
JDH: Yes, though items such as clothes and furniture are lower. But if we wait until deflation is established more broadly before acting, measures like the ones the Fed just announced would likely be less effective.
Bunny: Aren't bond prices higher than a year ago?
JDH: Bond prices don't enter into consumer's budgets. In fact, the higher bond prices are one indicator that deflation is a greater risk today than it was a year ago.
Bunny: Has the Fed ever been right about anything?
JDH: A study by Christina and David Romer published in the American Economic Review in 2000 found that Federal Reserve forecasts of inflation were significantly better than those generated by the Blue Chip survey of economic forecasters, the Survey of Professional Forecasters, or Data Resources, Inc. A study by Jon Faust and Jonathan Wright published in the Journal of Business and Economic Statistics in 2009 found the Fed's forecasts of inflation were significantly better than those generated by a battery of state-of-the-art time-series forecasting techniques.

The bunnies then get into a discussion of the mechanics of bond purchases by the Fed.

Bunny: If the Ben Bernank wants to buy the Treasury bonds with the American people's money, he does not buy them from the Treasury, he buys them from the Goldman Sachs?
JDH: Goldman Sachs is one of 16 different dealers from which the Federal Reserve Bank of New York solicits competitive bids. That's the way it's been done for a century, and it would be illegal for the Fed to do as the bunnies propose. From U.S. Monetary Policy and Financial Markets, 1998, Chapter 7:

The Federal Reserve makes all additions to its portfolio through purchases of securities that are already outstanding. The Federal Reserve Act [of 1913] does not give the [Federal Reserve] System the authority to purchase new Treasury issues for cash. Over the years, a variety of provisions had permitted the Treasury to borrow limited amounts directly from the Federal Reserve. Options for such loans existed until 1935. Temporary provisions for direct loans were reintroduced in 1942 and renewed with varying restrictions a number of times thereafter. Authority for any kind of direct loans to the Treasury lapsed in 1981 and has not been renewed.

The reason that the Fed has always been required to buy bonds from private dealers rather than the U.S. Treasury is that the process of money creation needs to be institutionally separated from the process of financing the public debt. In fact, the potential blurring of those boundaries is one of the most important legitimate criticisms of quantitative easing.

And here is the original cartoon, in which you'll see that the bunnies' own answers are much funnier than mine.

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Assessing Fantasy Scenarios

Assessing Fantasy Scenarios

Econbrowser

With the EGTRRA/JGTRRA extensions and proposals for tax reform and debt reduction flying left and right, I think it behooves us to review what the theoretical (well, actually undergraduate textbook) literature and the empirical assessments suggest will be the impact of tax rate changes. I want to devote special attention to the hypothesis that there will be large dis-incentive effects on high income households should their tax rates go up, with correspondingly large negative ramifications for overall economic activity.
Tax rate reductions can affect the macroeconomy in many different ways. In what is typically characterized as the Keynesian approach, the tax rate reduction increases disposable income, and hence consumption. In what is typically characterized as the supply side approach, the tax rate reduction induces an increase in labor supply.
The former effect induces an outward shift of the aggregate demand curve, while the latter shifts out the long run aggregate supply curve (since potential output depends upon the labor stock employed).

Figure 1: Shift in aggregate demand curve due to reduced tax rate, or shift in potential GDP.
Now, in typical macroeconomic modeling (in what is sometimes called the Neoclassical synthesis), both effects are included. Which effect dominates? This is an empirical issue (Interestingly, this was the topic of the first economics paper I wrote in college, during the era of Arthur Laffer and Jude Wanniski; I guess economic policy is like fashion -- some things, like platform shoes, keep on coming back).
Theory
To highlight the reason why this is an empirical issue, first consider the impact of a tax reduction on the after tax wage rate, and hence the labor-leisure tradeoff. Let IC₁ be the original indifference curve, X the maximum number of hours of leisure, and Y income.

Figure 2: Impact of (after-tax) wage rate increase. Source http://www.knowledgerush.com/kr/encyclopedia/Labor_market/
The original equilibrium point is A, with X_A hours of leisure, Y_A income. A tax rate decrease raises the after tax wage rate, making the relative price line steeper. The new equilibrium is at B. Now leisure falls to X_B, as income rises to Y_B. Leisure is a normal good in this example. Notice that the income and substitution effects are then offsetting (X_A to X_C is the income effect, X_C to X_B is the substitution effect). Notice that the indifference curves could be drawn so that in fact leisure increased in response to the tax rate decrease. In such instances, the labor supply curve would be backward bending. Only if leisure is an inferior good (i.e., one prefers less leisure as income rises, which seems like an unappealing assumption) can one rule out the backward bending supply curve over the entire range of wage rates. (More undergrad-level notes here, and here).
Empirics
Since theory does not provide guidance on the real-world effect, we have to appeal to data. There are numerous studies addressing this question (see a meta analysis here). I'm going to refer to the numbers the Congressional Budget Office uses in its microsimulation model, here; I show Table 2 from the paper below.

Source: CBO, "The Effect of Tax Changes on Labor Supply in CBO's Microsimulation Tax Model," Background Paper (April 2007).
The table can be read as follows:

Income elasticity measures the percentage change in total hours worked that would result from a 1 percent increase in after-tax income, holding the after-tax wage rate constant. Substitution elasticity measures the percentage change in hours worked from a 1 percent increase in the after-tax wage rate, holding the worker's utility constant. The total wage elasticity is the sum of the two elasticities; it measures the percentage change in hours worked that would result from 1 percent increases in both after-tax income and the after-tax wage rate.

I think it's of interest that if one is worried about the incentive effects on the top four deciles (top two quintiles), these elasticities suggest that the anxiety is misplaced. The elasticity for these two quintiles is 0.028; that is a tax rate increase that decreases after tax wages by 1 percent would decrease labor supply by these individuals by 0.028 percent(!). Notice that the elasticity is much higher for secondary earners.
Overall, the CBO concluded in the 2007 report (Table 3) that only about 4% of the static revenue loss associated with extending the EGTRRA/JGTRRA and implementing an AMT fix would be offset by the increased tax revenue associated with people working longer hours due to supply side effects.
Policy Implications
What this tells me is that in crafting tax increases, one should pay attention to incentives, but one shouldn't overstress the importance of supply side effects. And in particular, those incentive effects seem particularly small for high income earners. There is a separate question of whether a higher tax rate would disproportionately impact the consumption of high income households, which account for a large share of overall US consumption (as opposed to raising taxes on lower-income liquidity constrained households, which arguably have a higher marginal propensity to consume). To me, that makes more sense, from an analytical perspective, than fixating on the supply side effect.
Postscript: These are static effects in the CBO study. For discussion of dynamic effects, see this post.

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