Maturity Diversification

In an earlier post I linked to a provocative proposal by Andy Harless in which he argues that the Treasury should be shortening the maturity structure of government debt. His reasoning is roughly as follows:

1. At current interest rates, money and bills are virtually identical assets: holders of bills are requiring no compensation for the additional liquidity or safety that money would provide. This makes conventional monetary policy (exchanging cash for bills) ineffective. On the other hand, an increase in the issue of bills can have expansionary effects, putting the Treasury effectively in charge of monetary policy.
2. In addition to its expansionary effects, a shift to shorter maturities on government debt should lower the expected value of the costs of debt service, since there is a liquidity premium to be paid on longer term bonds. However, it would also increase the vulnerability of the Treasury to unexpected increases in short term rates (expected increases are already implicit in the yield curve). 
3. Maintaining long maturities to insure against this risk would be hedging against good news, assuming that an unexpected increase in short term rates would signal a more rapid recovery than is currently forecast. In this case (unexpectedly) higher rates would be accompanied by (unexpectedly) greater federal revenues and lower benefit payments, so the financial position of the Treasury need not be worsened despite the greater costs of debt service.
   

That's his argument, if I understand it correctly.  The proposal is similar in some respects to one made recently by Joe Gagnon, in which he argues that the Fed should be buying substantial amounts of long term debt. Both proposals would result in roughly the same mix of short and long term securities in the hands of the public, and would lower long term interest rates. But there are two important differences. First, as Gagnon notes, "it would be better for the Fed to do it because they have the staff and expertise for gauging how much to do and when to stop." Second, there would be greater maturity diversification in Treasury issues, raising the expected value of debt service costs but reducing the vulnerability to unexpected fluctuations in interest rates.

How important is the issue of maturity diversification? A commenter (identified only as JKH) on Harless' blog thinks that it would be irresponsible to ignore it:

As far as the Treasury is concerned, it’s just acting according to prudent interest rate risk management considerations in locking in some interest cost on such a massive prospective debt load. It’s just a matter of judgement on how to diversify maturities, given the “risk” that the Fed may want to start tightening some time. Ignoring the issue of maturity mix is irresponsible. From there it’s judgement on the right mix.

This is fair enough as far as it goes, but what are the principles on the basis of which such judgment ought to be exercised? The trade-off here is between the expected costs of debt service and the risk of facing a situation in which costs are much greater than forecast. The basic problem was expressed very succinctly by Richard Roll (1971) as follows:

For example, consider a government agency borrowing for a specific long term project at currently high rate levels. It might be able to reduce the total expected interest payments (and expected taxes) by financing the project partly with short-term bonds rather than entirely with bonds whose term-to-maturity matches the project's life. On the other hand, even though the agency expects lower rates in the future, it would not feel secure in funding the entire project with short-term bonds that would require a later refinancing. It would prefer to pay the higher expected rate on a portfolio of long- and short-term bonds rather than accept the risk that rates will go higher contrary to expectations.

Given some specification of Treasury preferences and expectations about the future course of interest rates, this is a fairly standard optimization problem. But it is not obvious (at least to me) how the desired maturity structure should vary with changes in uncertainty about future rates. Other things equal, greater uncertainty should lengthen maturities. However, greater uncertainty will also steepen the yield curve and raise the expected costs of long-term (relative to short-term) financing, and this effect should reduce desired maturities. In any case, these effects should be possible to identify, given some specification of Treasury objectives.

Much more difficult is the question of what those objectives ought to be. How much weight should by placed on risk as opposed to the expected costs of debt service? And should the desired maturity structure of government debt be sensitive to macroeconomic conditions?

I don't have answers to these questions but (as I said in a comment on Mark Thoma's page) it is important to resist the temptation to view the problem solely from a corporate finance perspective. There will be a significant shortfall in government revenues over outlays for many years to come, so short-term Treasury issues will have to be rolled over repeatedly for an indefinite period, or converted to long-term debt at some point. If this were a corporation, such financial practices would be madness (for the company as well as its creditors). The company would be engaged in massive maturity transformation, and be highly vulnerable to changes in short term interest rates and credit availability. It would be unable to meet even interest obligations without borrowing - which is Hyman Minsky's definition of Ponzi finance.  

But the Treasury is not a private corporation, and it faces very different constraints and objectives. Matching maturities to expected net revenues is simply not an option, nor should it necessarily be a goal. This much is straightforward. Much less clear is the set of principles that ought to guide the decisions that ultimately determine the maturity structure of government debt.

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Update (12/28). In an email to me (posted with permission), Joe Gagnon adds:

Since the government includes the Treasury and the central bank, we could have one objective function and find the optimal policy from first principles. But I suspect the same result would obtain if the Treasury acted as first mover and followed a reasonable, modestly risk-averse, cost-minimizing strategy for maturity of issuance given the Congressionally set taxes and spending. Then the central bank would take Treasury behavior as given when it decides on the optimal maturity structure from the overall social welfare viewpoint, taking into consideration unemployment and inflation as well as risks to government finance and likely future behavior of Congress.

My own sense (buttressed by Table 6 in my paper) is that the risks to government finance from shifting into short maturities is very small compared to the benefits, and much less costly than outright fiscal-spending stimulus.

Also:

The point about the table is that even in the inflation scare scenario, when future short rates rise quite high for a while, the debt burden is lower with monetary stimulus (via maturity transformation) than without it. Of course, one can construct even more extreme scenarios in which that is not true (or in which the debt burden is reduced by high inflation) but I would argue those scenarios are highly unlikely given the state of the economy and the current membership of the Fed’s policy committee.

Some Further Comments on Maturity Choice

In an earlier post, I discussed the issue of maturity choice for new Treasury issues, arguing that it affects not only the cost of financing the debt but also the shape of the yield curve, the extent of private sector maturity transformation, and the value of the currency (for instance if foreign lenders have different preferences over maturities relative to domestic lenders.) In many respects, therefore, the Treasury performs actions that are normally considered to be within the purview of the Federal Reserve. But while Fed policy is subject to extensive debate, as is the size of the deficit, there seems to be very little discussion of the manner in which the debt is financed by the Treasury.

Andy Harless (via Mark Thoma) has recently written a long and thoughtful post that deals with related issues. The post is worth reading in full, but here's the gist of his argument:

The inflation rate is now lower than most economists prefer, and the economy remains extremely weak despite the recent upturn in the business cycle. The burning issue is how to find the most cost-effective and politically feasible way to stimulate the US economy, and conventional monetary policy is not an option.

And today Treasury bills are not just more like money than like other assets; from a portfolio point of view, on the margin of new issuance, Treasury bills are exactly like money. Holders of short-term Treasury bills are willing to hold them without receiving interest. Anyone who is willing to hold them is placing no value whatsoever on any liquidity or safety advantage that might be had from holding those assets in the form of money.

Issuing more short-term Treasury bills will have exactly the same effect as issuing more money, since people are indifferent between the two. For practical purposes, as long as their interest rate remains at zero, short-term Treasury bills are part of the money stock. A Treasury bill is a million-dollar bill in the same sense that a Federal Reserve note with Abraham Lincoln on it is a five-dollar bill. Conventional monetary policy, which exchanges money for Treasury bills, is ineffective because it is no policy at all: it simply exchanges one form of money for another.

To put it another way, since the Treasury can issue bills that are exactly like money, it is now the Treasury that is in charge of monetary policy. And whatever one may think of the policy it chooses to follow, we should be holding the Treasury responsible. If you’re worried about “exit strategy” and the possibility of inflation in the near future, then perhaps you should congratulate the Treasury for its policy of financing more of its debt long-term. If you’re worried (as I am) about the persistence of a weak and potentially deflationary economic environment, then you should be critical of the Treasury’s policy. By increasing its maturities the Treasury is essentially following a tight-money policy exactly when a loose-money policy is needed.

The Treasury, of course, has its reasons. Officials expect interest rates to rise over the next several years and would like to lock in today’s low rates, to limit how much it will cost to service the national debt over a longer horizon. I’m skeptical, however, of the assumptions underlying these reasons.

Are interest rates going to rise over the next several years? Perhaps, but if so, then why are people being foolish enough to hold longer-term Treasury securities when they could be holding bills and waiting for a better deal? If it’s just a matter of the future course of interest rates, then it’s a zero-sum game. If the Treasury wins, bondholders lose – and bondholders usually make a point of trying not to lose. Are Treasury officials so much smarter than bondholders?

You might argue that it’s a matter of risk. When the Treasury locks in today’s low interest rates, it may not end up paying less (since it gives up even lower short-term rates), but it makes the payments more predictable. Even if the Treasury is likely to end up paying more, the hedge is worth the price, because the Treasury receives some insurance for the worst case, where rates rise more than expected.

But are rising interest rates really the worst case? Interest rates will rise when and if the economic recovery gains enough speed and traction to give the Fed and bond markets reasonable confidence in its eventual convergence toward our potential growth path. As an ordinary citizen, that’s not an outcome against which I would feel a need to hedge. I don’t want to buy insurance against good news. I’d rather hedge against the opposite outcome, where the recovery peters out and interest rates fall.

I urge you to read the whole thing. Regardless of whether or not you accept his prescriptions, the question of maturity choice deserves an airing.

Harless attributes some of his ideas to Benjamin Friedman, with whom he once studied. This reminded me of a paper that Friedman wrote with (a very young) David Laibson, published in a 1989 issue of the Brookings Papers on Economic Activity. This issue also contains an extended commentary by Hyman Minsky, whose work I have discussed previously. Both the paper and Minsky's comments on it are well worth reading, and I hope to post my thoughts on them in due course.

On Mattresses, Ideologues, and Cheerleaders

I suppose one ought to be grateful for small mercies; Bryan Caplan has learned how to spell mattress.  Here he is on December 16:

unless employers are unusually likely to put cash under their matresses...

And here again three days later:

the net effect on AD depends on the marginal propensity to stuff income under one's mattress.

Now it would a a major step forward if he were to discover the existence of bills, bonds, equities, mutual funds of various stripes, and rare stamps and coins, all of which can serve as channels for savings, and none of which automatically create a demand for current production in equal measure to the cost of acquiring them. But, as Winterspeak notes, that would be too much to ask:

Glibertarian Bryan Caplan reveals why microeconomics is just useless at analyzing the economy at a macro scale. If you cannot understand that spending equals income at an economy wide level, you'll spout a lot of two sentence nonsense.

I don't think that microeconomics is at fault. The blame lies with a particularly crude and naive textbook version of microeconomics and its uncritical application by ideologues and their cheerleaders.

Some Progress in the Minimum Wage Debate?

On the blog he shares with Tyler Cowan, Alex Tabarrok writes:

A fall in wages increases the incentive to hire (call this the substitution effect) but it decreases the income of people who already have jobs and this in turn decreases their spending and other people’s income (call this the macro income effect).  In essence, Krugman and others are arguing that the macro income effect can dominate under certain situations.

Yes, but one needs to go a bit further than this. If the macro income effect dominates, then there will be layoffs in other sectors, most immediately in those producing outputs that low wage workers purchase. And these layoffs will not be confined to low wage workers. This means that even if the employment of low wage workers rises, there will be a decline in employment across other segments of the skill distribution. Concede this point and we're done.

Tabarrok doubts the empirical relevance of the macro effect, based as far as I can tell on the perusal of a before-and-after table by Scott Sumner. I will leave the empirical question to the empiricists, except to say that the magnitudes of the various effects will obviously depend on the initial level of the minimum wage and on prevailing economic conditions.

Finally, let me repeat that I agree with Winterspeak, Tyler Cowan, and The Economist that the effects on aggregate demand of changes in the mimimum wage, regardless of their sign, are likely to be small. But it's important to get the reasoning right, because the same methods apply to discussions of flexible wages and prices more generally.

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Update (12/18). As I said in my earlier post on the topic, the aggregate demand consequences of a fall in wages also depend on financial market effects. If the the unspent portion of the rise in employer incomes makes it into the bond market, lower long-term rates could stimulate investment. If it goes into stocks, the resulting asset price appreciation could also conceivably raise investment. Neither of these effects seems likely under current conditions. This is why I have argued that Greg Mankiw's proposal of an investment tax credit is deserving of serious attention.

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Update (12/19). It's worth thinking a bit more closely about what Alex calls the substitution effect. This is presumably what Tyler had in mind when he urged me to shift marginal cost curves down and watch what happens. He was arguing that the firm will lower price and use the additional hires to step up production to meet the increased demand. Now obviously this will not increase market share if one's competitors are doing the same thing, but it could increase the overall consumption of goods and services produced with low wage labor. Even disregarding the macro income effect, this implies a decline in demand for goods and services produced with skilled, high wage labor. In other words, there will be a "substitution effect" in unemployment patterns, more unskilled jobs and less skilled jobs. Add the macro income effect to the analysis and matters become worse. The only way that lower wages can increase aggregate demand is by stimulating private investment through changes in asset prices and interest rates. This is just not going to happen under current conditions (hence my support for this proposal). In any case, a partial equilibrium analysis is totally inadequate for thinking through these questions.

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Update (12/19). Nick Rowe (via Mark Thoma) addresses the "microeconomic miscreants" from a macroeconomic perspective. I personally feel a bit uneasy using models with such high levels of aggregation because they leave out too many things (for instance, the effects of changes in the minimum wage on the skill distribution among the unemployed). But he makes some useful points. 

On the Distribution of Gains from Government Action

Greg Mankiw has written a thoughtful post making the case for an investment tax credit. I was struck in particular by the following passage:

The cash-for-clunkers program is thought by many to have promoted, or at least accelerated, car purchases.  An ITC would be similar, but it would apply to business investment rather than personal cars.  Instead of targeting a very narrow, politically favored industry, it encourages investment broadly.  It should have positive effects on aggregate demand in the short run and positive effects on aggregate supply in the medium and longer run.

The cash-for-clunkers program bothered me not only because it targeted a specific industry but also because it distributed gains among consumers on the basis of criteria that were very arbitrary. For instance, the requirement that eligible trade-in vehicles had to have a combined city/highway fuel economy of at most 18 miles per gallon excluded from participation those who had purchased fuel efficient vehicles in the past. This does not conform to any intuitive notion of fairness.

The biggest recent example of such distributional effects is of course the bailout of AIG counterparties by the Federal Reserve. Earlier this month I attended a speech by Bill Dudley at Columbia University in which he explicitly recognized the anger that such actions can fuel:

The actions taken by the Federal Reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. Many of those financial institutions are now prospering, and many of their employees will be highly compensated. This situation is unfair on its face. But it is even more galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet.

Later in the speech he returns to the issue:

... it is deeply offensive to Americans, including me, and runs counter to basic notions of justice and fairness, that some of the very same individuals and financial firms that precipitated this crisis have also benefited so directly from the response to the crisis. This has occurred at the same time that many Americans have lost their jobs and hard-earned savings. The public outrage this situation has produced is understandable. In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefitted from our intervention. In a perfect world we would be able to prevent those individuals and institutions from benefitting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.

The issue came up again in the question and answer session (which is not transcribed in the published version of the speech).

I don't know whether there were options available at the time that would have secured the goal of maintaining financial stability without such a large redistribution of wealth in favor of those who stood to lose from an AIG bankruptcy. But it seems to me that such fairness concerns are not given enough early attention in the design of government policies.

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Update (12/18). I find Greg Mankiw's case for an investment tax credit quite convincing. He advocated the same policy a few days ago in a New York Times piece, but the substance of the argument there was lost amid the partisan jabs, on which Nate Silver pounced. I discussed the longstanding Mankiw-Silver feud here, concluding that "couching an economic argument in overtly moralistic or political terms can considerably diminish its impact." This is certainly a case in point.

On Partial Equilibrium Models of Demand and Supply

My last post on the aggregate demand effects of changes in nominal wages has attracted some attention, so I'd like to clarify a couple of things.

It was not the point of the post to claim that declines in nominal wages would lower or increase aggregate demand. The point was to argue that the simple partial equilibrium models of demand and supply that were being used by some to address the question were simply not up to the task of answering it. It was a reaction against the view -- expressed by Bryan Caplan and endorsed by Tyler Cowen -- that such effects could easily be deduced from textbook microeconomic theory. And it was a plea to move beyond partial equilibrium analysis in addressing such questions.

Tyler Cowan responded to this with yet another partial equilibrium model of supply and demand:

Graph a monopolist and shift the marginal cost curve down. Watch what happens. The first main paragraph of Sethi simply doesn't consider this mechanism but rather it assumes that changes at the margin don't matter.

That was in the comments section of Mark Thoma's blog. A similar claim now appears on his own page:

There is a simple story here.  Lower the minimum wage and firms with market power will in general hire more labor.  (Sethi's critique refuses to consider that mechanism but simply shift the MC curve and watch it happen.)

By all means, shift the MC curve and watch what happens. But please keep in mind not a single firm but a population of firms, some of which do not pay minimum wage at all. And be sure to shift the demand functions for all firms producing goods and services that minimum wage workers currently purchase. And now tell me whether it is self-evident that aggregate demand will rise in response to a decline in nominal wages.

It is not self-evident. In order to address the question it is necessary at a minimum to work with a model with multiple firms, in which the expenditure patterns from wage and capital income are properly specified, and some alternatives to immediate consumption (such as financial assets) exist. Simulate this model on a computer if you like, and watch what happens. I would be interested to know. But please don't make definitive claims about aggregate demand effects of changes in nominal wages based on an introductory textbook model that is simply incapable of carrying the weight.

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Update (12/17). Andrew Gelman is (understandably) puzzled by the fact that there is a debate going on about a policy that has no chance of being implemented. Mark Thoma provides some explanation, and I hope to post my own thoughts on this soon. Paul Krugman has more. 

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Update (12/19). Some possible signs of progress in this debate.

Some Further Comments on Nominal Wage Flexibility

Tyler Cowan thinks that we should cut the minimum wage, and links to Bryan Caplan for an explanation. And Caplan thinks that it's all quite elementary:

Cutting wages increases the quantity of labor demanded.  If labor demand is elastic, total labor income rises as a result of wage cuts.

Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income.  So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.

Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income.

Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.

Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized.

Mark Thoma has more on this, as does Paul Krugman. I discussed the opposing views of Becker and Tobin in an earlier post. What I cannot understand is why people of considerable intelligence persist in conducting a partial equilibrium Walrasian analysis of the labor market, as if we were dealing with the market for oranges. Please stop it.

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Update (12/16). Thanks to Mark for reposting this, and to Paul Krugman for following up. Tyler responds as follows on Mark's page:

Graph a monopolist and shift the marginal cost curve down. Watch what happens. The first main paragraph of Sethi simply doesn't consider this mechanism but rather it assumes that changes at the margin don't matter.

To which I have replied as follows:

Tyler, a fall in wages won't just shift the marginal cost curve down, it will also shift down the demand curve and hence marginal revenue. This will happen for all firms who produce stuff that minimum wage workers consume, regardless of whether or not they themselves pay minimum wage. Now we may disagree about what the eventual outcome will be (I think there will be debt deflation, as described in Fisher 1933, and so admirably summarized recently on your blog). You may disagree. But we can't settle this with partial equilibrium models of monopolists and their cost curves.

I'm sure that this debate will continue. My only hope is the we get beyond partial equilibrium models from introductory microeconomics in discussing these terribly important questions.  

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Update (12/17). The Economist points out (quite sensibly) that even demand constrained firms may increase hiring with lower wages in order to improve product quality: "If a firm can produce a particular number of burgers with either 5 workers earning $7 an hour or 6 workers earning $6 an hour it won't necessarily prefer the 5 worker set-up." True enough, but this is not the appropriate comparison: if the wage drops, employment will rise only if 6 workers earning $6 an hour are preferred to 5 workers earning $6 (not $7) an hour. In other words, the choice is between improving quality or pocketing the difference in wages.

I do not doubt, by the way, that a lower minimum wage could raise employment in some firms. But unless the aggregate wage bill rises, some other firms will experience declining demand, and may respond by laying off workers across a much broader range of skills. My point is simply that in order to capture these effects, it is essential that one move beyond the partial equilibrium framework. More here.

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Update (12/18). Winterspeak adds:

Any discussion of the minimum wage turns into a Rorschach test for the ideology of the commenter.

This is unfortunately true, and ideology does seem to be clouding judgment and analytical clarity on the issue. My focus has remained on the methods one uses to reason about the effects of changes in the minimum wage, rather than on the magnitude or sign of these changes. I agree with Winterspeak, Tyler Cowan, and The Economist that the effects of such changes on aggregate demand, regardless of their sign, will likely be small. But it's important to get the reasoning right, because the same methods apply to discussions of flexible wages and prices more generally. To answer Andrew Gelman, this is why I think the debate is important. Hence the title of this post, and the content of the earlier post to which it refers.

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Update (12/19). Perhaps some signs of progress in this debate. Alex Tabarrok writes:

A fall in wages increases the incentive to hire (call this the substitution effect) but it decreases the income of people who already have jobs and this in turn decreases their spending and other people’s income (call this the macro income effect).  In essence, Krugman and others are arguing that the macro income effect can dominate under certain situations.

My response:

Yes, but one needs to go a bit further than this. If the macro income effect dominates, then there will be layoffs in other sectors, most immediately in those producing outputs that low wage workers purchase. And these layoffs will not be confined to low wage workers. This means that even if the employment of low wage workers rises, there will be a decline in employment across other segments of the skill distribution. Concede this point and we're done. 

Furthermore:

It's worth thinking a bit more closely about what Alex calls the substitution effect. This is presumably what Tyler had in mind when he urged me to shift marginal cost curves down and watch what happens. He was arguing that the firm will lower price and use the additional hires to step up production to meet the increased demand. Now obviously this will not increase market share if one's competitors are doing the same thing, but it could increase the overall consumption of goods and services produced with low wage labor. Even disregarding the macro income effect, this implies a decline in demand for goods and services produced with skilled, high wage labor. In other words, there will be a "substitution effect" in unemployment patterns, more unskilled jobs and less skilled jobs. Add the macro income effect to the analysis and matters become worse. The only way that lower wages can increase aggregate demand is by stimulating private investment through changes in asset prices and interest rates. This is just not going to happen under current conditions (hence my support for this proposal). In any case, a partial equilibrium analysis is totally inadequate for thinking through these questions.

Is Nate Silver the World's 22nd Best Economist?

Nate Silver likes to refer to Greg Mankiw as "the world's 23rd best economist." He also seems to relish every opportunity to take him on.

About six months ago, Mankiw made a somewhat disparaging comment about Sonia Sotomayor on his blog:

I once wrote a short paper... based on the premise that there are two types of people: Some save and intertemporally optimize their consumption plans, while others live paycheck to paycheck, spending their entire income as soon as it's received. Sometimes readers of the paper think of the two groups as rich and poor, but that interpretation is wrong. Some people with low incomes manage to scrimp and save (I always think of my grandmother), and some people with high incomes spend most everything they earn.

Apparently, the new Supreme Court nominee Sonia Sotomayor is an example of the latter...

My grandmother would have been shocked and appalled to see someone who makes so much save so little.

Here Mankiw is assigning Sotomayor to the group of individuals who do not "intertemporally optimize" based simply on evidence that her accumulated savings are small relative to her income. Using impeccable economic reasoning, Nate Silver countered as follows:

What are a person's incentives to save, rather than spend, money? The four basic ones are usually these:

1. To protect against downside in one's income, particularly the risk of being fired.
2. To save for retirement.
3. To save for one's family and children.
4. To save for an expensive purchase, such as a home or a nice car. 

Nos. 1-3 don't really apply to Sotomayor. With the possible exception of being a tenured professor at Harvard, few positions offer more job and income security than that of a justice on the Federal Circuit Court; Sotomayor would have to be impeached by the House and found guilty by the Senate to lose her job, something which has happened only a handful of times in American History. Sotomayor's federal pension is undoubtedly very generous, rendering #2 somewhat moot, particularly as she could also stand to make a significant "post-retirement" income in private practice or on the lecture circuit. And she does not have a children or a husband to support. It would be quite irrational if she had half a million dollars collecting dust and 0.01% interest in her Chase checking account.

Perhaps Mankiw's grandmother would find her more virtuous if she were saving up for a Lexus or a summer home in the Hamptons, but that doesn't seem to be her cup of tea. Her one real indulgence is the apartment she keeps in the West Village. Although virtually anywhere that would be a reasonable commute from her courtroom in Lower Manhattan would be relatively expensive, she could save a bit by living in the Financial District or perhaps in Brooklyn. But Mankiw, who lives in a zip code where the median price of a house is 1.65 million dollars, should not exactly be throwing stones from his undoubtedly very charming, New England Colonial home.

In other words, given her circumstances and preferences, it appears that Sonia Sotomayor is intertemporally optimizing perfectly well.

That exchange was back in May, and there the matter rested until Mankiw published a piece in the New York Times this week arguing for a change of course in fiscal policy:

Congress passed a sizable fiscal stimulus. Yet things turned out worse than the White House expected. The unemployment rate is now 10 percent — a full percentage point above what the administration economists said would occur without any stimulus.

To be sure, there are some positive signs, like reduced credit spreads, gross domestic product growth and diminishing job losses. But the recovery is not yet as robust as the president and his economic team had originally hoped.

So what to do now? The administration seems most intent on staying the course, although in a speech Tuesday, the president showed interest in upping the dosage. The better path, however, might be to rethink the remedy.

When devising its fiscal package, the Obama administration relied on conventional economic models based in part on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy.

But various recent studies suggest that conventional wisdom is backward...

These studies point toward tax policy as the best fiscal tool to combat recession, particularly tax changes that influence incentives to invest, like an investment tax credit. Sending out lump-sum rebates, as was done in spring 2008, makes less sense, as it provides little impetus for spending or production.

This was too much for Nate to resist. In his response he notes first that tax cuts were indeed a large component of the original stimulus package.

First, let's take a look at what the stimulus package was actually designed to consist of... Some $288 billion -- 37 percent -- consisted unambiguously of tax cuts that were labeled as such. Meanwhile, $274 billion -- 35 percent -- consisted of traditional, Keynesian-type investments in infrastructure and related areas. These types of spending are easy to characterize...
 
Indeed, it's probably fair to think of the stimulus as consisting of about half tax cuts. About 37 percent of the stimulus consisted of tax cuts which were labeled as such. But also, some fraction of the 10 percent labeled as transfer payments functioned like tax cuts, and some fraction of the 18 percent allocated to state and local governments had the effect of offsetting tax increases (or perhaps financing a tax cut proper in a few cases).

Does this mean that tax cuts are ineffective in stimulating production? Not really:

In other words, the stimulus -- in terms of its potential impact on the economy thus far -- looks at least as much like Mankiw's alternative as the "conventional economic models" that he trashes.

All of which might indict Mankiw's thesis -- except that he also may be wrong about his other conclusion: that the stimulus is not working. Mankiw cites studies describing the impact of various types of stimulus on GDP -- not unemployment -- and as we pointed out yesterday by GDP standards the stimulus has done quite well, with 3Q growth coming in at 2.9 percent versus a consensus forecast of 0.7 percent and 4Q GDP poised to print at about 4.0 percent versus a forecast of 1.9 percent...

So, to summarize: Mankiw is wrong that the stimulus consists mostly of Keynesian-type investments. So far, it has been closer to the tax cut end of the spectrum. But he's also wrong that the stimulus is not working. By the benchmark that he implicitly endorses -- GDP -- it's done very well. Mankiw is so wrong, in other words, that he may actually be right: the stimulus looks a lot like one he might have designed, and it's helping the economy.

As Nate concedes, the substance of Mankiw's argument (that tax cuts are more effective than spending increases in stimulating production) may well be correct. The empirical studies cited by Mankiw do seem to support his position, and do indeed run counter to the conventional Keynesian view. This is an important debate to have, both for immediate policy purposes and for our theoretical understanding of the manner in which fiscal policy operates. But there seems to be no reason to make it a partisan exercise.

What can one learn from all this? First, that couching an economic argument in overtly moralistic or political terms can considerably diminish its impact. And second, Nate Silver may well be the 22nd best economist in the world.

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Update (12/16): There's yet another noteworthy exchange between our two protagonists, dating all the way back to January 2009. It started with an article by Mankiw arguing (just as he did in his more recent piece) that the government spending multiplier was much smaller than conventional wisdom would have us believe, while the tax multiplier was significantly larger. Silver responded by claiming that the empirical findings on which Mankiw's argument was based could not be generalized to the current economic environment because they referred to the effects of exogenous changes in  taxes and expenditure. Mankiw replied that without focusing on exogenous changes one could not possibly hope to identify causal effects of any kind. In this case both were making valid points: Mankiw about identifiability and Silver about external validity, as Andrew Gelman helpfully pointed out.

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Update (12/18):  Mankiw makes a much more effective (and considerably less partisan) case for an investment tax credit on his blog.

Paul A. Samuelson, 1915-2009

"Gentlemen, did we pass?"

That's what Joseph Schumpeter is reported to have asked the other members of Paul Samuelson's dissertation committee at the end of his doctoral defense. Many a true word is spoken in jest.

Over the next few days there will be a lot of testimonials to Samuelson's brilliance and professional accomplishments, but the two passages I found most poignant in the New York Times obituary concern his character. First, his unwillingness to accept a political appointment:

Though Professor Samuelson was President Kennedy’s first choice to become chairman of the Council of Economic Advisers, he refused, on principle, to take any government office because, he said, he did not want to put himself in a position in which he could not say and write what he believed.

And second, his opinion of himself and his profession:

Despite his celebrated accomplishments, Mr. Samuelson preached and practiced humility. The M.I.T. economics department became famous for collegiality, in no small part because no one else could play prima donna if Mr. Samuelson refused the role, and, of course, he did. Economists, he told his students, as Churchill said of political colleagues, “have much to be humble about.”

Indeed.

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Update (12/14): William Barnett's version of the Schumpeter anecdote differs slightly from that of Wolfgang Stolper (as reported by Arnold Heertje), and neither is confirmed. Apocryphal or not, the plausibility of the story itself says a lot about Samuelson.

On the Choice of Maturities for New Treasury Issues

Every week the Treasury issues new securities with maturities ranging from a few days to several years. In the first ten days of December, for instance, bills and bonds with aggregate face value in excess of 220 billion dollars were auctioned; these had maturities ranging from four days to thirty years and annualized interest rates ranging from practically zero to 4.4%. About two-thirds of the total was short term borrowing due for repayment within the next six months, and the remainder was raised by issuing three and ten year notes, and thirty year bonds. Since there is no prospect of a budget surplus at any time over the next few years, incoming tax revenues will be fully absorbed by projected spending and the short-term debt will have to be rolled over on an ongoing basis (or converted at some point to long-term debt).

Clearly, the Treasury has a fair amount of discretion regarding the manner in which the deficit is financed. How ought this discretion to be exercised? And how is it exercised in practice? Theories of corporate maturity choice (such as Diamond, 1991) are not terribly useful in answering these questions because the goals and constraints are so different. The Treasury does not have to worry about liquidation by its creditors, for example, and corporations are not generally concerned with the effects of their actions on the term structure of interest rates or the value of the currency.

The issue is really quite important. A couple of weeks ago, Paul Krugman suggested that the Treasury should shift towards shorter-term maturities to finance the deficit if long term interest rates were to start rising. Two days later New York Times reported that the Treasury was in fact doing just the opposite, "exchanging short-term borrowings for long-term bonds." Without a theory (either positive or normative) of maturity choices for new issues, such proposals and actions are hard to evaluate. Furthermore, the costs of making poor judgments can be very high, both in terms of the interest burden on taxpayers, and the effects on private sector choices of changes in the yield curve.

If the future path of interest rates could be anticipated with perfect precision, then the yield curve at any point in time would be fully determined by no-arbitrage conditions. In this case the cost of borrowing would be essentially independent of maturity choice. But there is always uncertainty about future rates, so rates on short term debt, which is a preferred habitat of lenders, typically tend to be lower than long term rates.  In this case the cost of debt service will be smaller if the deficit is financed with short rather than long term obligations.

Aside from the cost of financing the deficit, maturity choices by the Treasury affect the shape of the yield curve and the extent to which private sector institutions engage in maturity transformation. This has implications for the stability of the system and its vulnerability to liquidity crises, as Bill Dudley has recently observed. In light of these considerations, I find it a bit surprising that while the size of the deficit is a topic of endless controversy, there is such little debate about the manner in which the deficit is financed.

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Update (12/17): In an interesting post, Andy Harless discusses related issues.

On the Consequences of Nominal Wage Flexibility

With the unemployment rate hovering above 10% and likely to stay in this range for some time, there has been a lot of discussion about what (if anything) the government should do to stimulate job creation. Following a link on Greg Mankiw's blog, I came across Gary Becker's view of the matter:

Keynes and many earlier economists emphasized that unemployment rises during recessions because nominal wage rates tend to be inflexible in the downward direction. The natural way that markets usually eliminate insufficient demand for a good or service, such as labor, is for the price of this good or service to fall. A fall in price stimulates demand and reduces supply until they are brought back to rough equality. Downward inflexible wages prevents that from happening quickly when there is insufficient demand for workers.

As one might expect given his diagnosis of the problem, Becker goes on to "fully endorse" a cut in the minimum wage, but does not see this as being politically feasible at present.

I found this post striking for three reasons. First, it expresses a view that is actually quite widely held among economists today, namely that if nominal wages were flexible in the downward direction, involuntary unemployment could not persist for very long. This view is held even by many who would strenuously object on fairness grounds to a cut in the minimum wage. Second, Becker attributes to Keynes an opinion that is precisely the opposite of that expressed in the General Theory.  And third, there has been very little serious analysis of the consequences of nominal wage flexibility in an economy with involuntary unemployment. A notable exception is a 1975 paper by James Tobin that has been largely (and unjustly) forgotten. For reasons discussed below, Tobin's analysis does not support Becker's position.

Keynes did indeed assume for the most part that nominal wages were inflexible, but also maintained that wage flexibility would make matters worse rather than better: "it would be much better that wages should be rigidly fixed and deemed incapable of of material changes, than that depressions should be accompanied by a gradual downward tendency of money wages" (p. 265). This is the starting point for Tobin's analysis:

Keynes tried to make a double argument about wage reduction and employment. One was that wage rates were very slow to decline in the face of excess supply. The other was that, even if they declined faster, employment would not - in depression circumstances - increase. As to the second point, he was well aware of the dynamic argument that declining money wage rates are unfavorable to aggregate demand. But perhaps he did not insist upon it strongly enough, for the subsequent theoretical argument focused on the statics of alternative stable wage levels.

To drive this point home, Tobin builds a simple model with three dynamic equations: output adjusts in response to excess demand in the goods market, inflation (relative to expectations) adjusts in response to deviations of output from its full employment level, and expectations of inflation adjust adaptively in response to the difference between actual and expected inflation. So prices (and nominal wages) are fully flexible and there is no limit to how low these can fall if output remains persistently below its full employment level.

An equilibrium of this model is characterized by full employment, steady inflation, and correct expectations. But Tobin is less interested in the equilibrium behavior of the economy than in the dynamic adjustment process from an initial state of disequilibrium. He establishes that even if the equilibrium is locally stable, it need not be globally stable: if, for whatever reason, output drops far enough below its full employment level, then (as in Axel Leijonhufvud's corridor hypothesis) cumulative declines in employment and prices can result.  Instead of improving matters, the downward flexibility of money wages can prolong and deepen an economic contraction.

Tobin's analysis here is methodologically old-fashioned in the sense that no attempt is made to provide microfoundations for the postulated adjustment processes.  But the logic is compelling, and I am certain that with sufficient ingenuity, the argument could be expressed in more modern terms. In any case, it is no less convincing than the partial equilibrium Walrasian analysis of the labor market that has led some to prescribe lower nominal wages as a solution to our current woes.

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Update (12/9): Thanks to Mark Thoma for reposting this, to Paul Krugman for his comments and references, and The Economist for linking. I should note that aside from Keynes and Tobin, Fisher (1933) and DeLong and Summers (1986) have also explored mechanisms that can cause price flexibility to be destabilizing.

On Animal Spirits and Knee-Jerk Reactions

A couple of weeks ago Robert Shiller published a piece in the New York Times in which he explored the role of mass psychology in generating business cycles, and argued that "the economic recovery that appears under way may be based on little more than self-fulfilling prophecy." This led Mark Thoma to respond as follows:

I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.

But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.

This captures my sentiments almost exactly. I'm trying. I too have the greatest respect for Shiller and consider his 1981 paper on stock price (relative to dividend) volatility to be an absolute classic. But I can't help thinking that too much is being asked of behavioral economics at this time, much more than it has the capacity to deliver. In an earlier post on Elinor Ostrom I expressed this view as follows:

Behavioral economics... has been very successful in identifying the value of commitment devices in household savings decisions, and accounting for certain anomalies in asset price behavior. But regularities identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.

If one is to look beyond economics for metaphors and models, why stop at psychology? For financial market behavior, a more appropriate discipline might be evolutionary ecology. This is not a new idea. Consider, for instance, this recent article in Nature. Or take a look at the chapter on "The Ecology of Markets" in Victor Niederhoffer's extraordinary memoir. Or study Hyman Minsky's financial instability hypothesis (discussed at some length in an earlier post), which depends explicitly on the assumption that aggressive financial practices are rapidly replicated during periods of stable growth, eventually becoming so widespread that systemic stability is put at risk. To my mind this reflects an ecological rather than psychological understanding of financial market behavior.

The Economics of Hyman Minsky

There has been a resurgence of interest in the economic writings of Hyman Minsky over the past few years, and for good reason. I find this immensely gratifying. I first came across his work as a graduate student, and remember being struck by the manner in which he was able to weave together sweeping macroeconomic hypotheses with rich institutional and historical detail. In a 2002 review of a collected volume in his honor, I summarized the broad outlines of his argument as follows:

Minsky's theoretical framework combines a cash-flow approach to investment with a theory of financial instability. Investment is motivated by the expectation that it will yield a stream of cash flows sufficient to cover contractual debt obligations as they come due, while allowing for adequate margins of safety. During stable expansions, profits accrue disproportionately to firms with the most aggressive financial practices, resulting in an erosion of margins of safety. This raises the probability that a major default will trigger a widespread crisis. When a crisis does eventually occur, its most devastating impact is on the highly indebted firms that prospered during the expansion. Balance sheets are purged of debt, margins of safety rise, and the stage is set for the process to begin anew. From this perspective, expectations of financial tranquility are self-falsifying. Stability, as Minsky liked to put it, is itself destabilizing. The real effects of a crisis depend on the size of government and the role of the central bank. Large countercyclical budget deficits can sustain profit flows even when investment collapses, preventing a crisis from resulting in a debt-deflation. Similarly, lender-of-last-resort interventions can keep a crisis from spreading beyond its point of origin.

Ten years earlier I had grappled with the question of whether or not Minsky's financial instability hypothesis requires substantial departures from economic rationality at the level of individuals and firms. I tried to argue in a 1992 paper that it did not, because even sophisticated models of learning at the individual level need not result in convergence to rational expectations equilibrium paths. The formal analysis in that paper is largely forgettable, but it does have the merit of containing the following reasonably faithful overview of Minsky's conceptual framework:

An essential feature of Minsky's financial instability hypothesis is that a long period of sustained stability gives rise to changes in financial practices which are not conducive to the persistence of stable growth:

"The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy." (Minsky, 1982, pp. 65 f.)

In particular, there is an increase in the degree to which investment is debt financed, and in the ratio of "speculative" to "hedge" financing. Speculative financing differs from hedge financing in that the expected cash receipts fall short of the debt-repayment commitments in some periods, particularly in periods which are in the immediate future with respect to the date at which the investment is undertaken. Hence there arises a need to roll-over debt during initial periods after the investment. Since the present value of all expected future cash flows exceeds the present value of debt repayments by an amount which includes acceptable margins of safety, firms do not generally foresee problems with regard to raising funds for purposes of rolling-over debt during the initial periods. Nevertheless, the possibility of present value reversals in the face of sharp rises in interest rates cannot be ruled out entirely, and this is what makes speculative financing riskier from the point of view of economy-wide-stability. On the other hand, if firms were able to borrow an amount which was strictly constrained by their expected receipts in every period, the potential for expansion would be severely curtailed and several reasonable profit opportunities would have to be foregone. The degree to which bankers are willing to engage in speculative finance clearly depends on their state of confidence with regard to general economic conditions in the future, as well as the merits of the specific projects at hand. The willingness to refinance positions as debt repayments become due is likewise influenced by their expectations, as well as the liquidity constraints they face.

Hence hedge financing is conducive to stability while speculative financing is conducive to faster expansion. A sustained period of stability gives rise to optimistic expectations and a rise in speculative financing. As long as the investments undertaken during this period are effective in raising productivity and engender a steady expansion of output, the optimism can be sustained. However, if a large number of investments which are prompted by the availability of speculative finance are found to be inept, so that immediate cash flows are significantly lower than expected, then the need for short-term refinancing becomes acute while at the same time banks are less willing to roll over existing debt. A sharp rise in short-term interest rates occurs which can lead to present value reversals, a rush towards liquidity, a plunge in the prices of illiquid assets, both real and financial, and a corresponding drop in new investments. Such an event, depending on its severity, is generally described as a credit crunch, a state of financial distress, or a financial crisis.

The severity of the recession that follows on the heels of a financial crisis depends on the size of the government relative to the private sector and the degree to which the drop in investment is compensated for by a rise in the government deficit. A sufficient rise in the deficit can help maintain the gross profits of business and hence validate the existing liability structure. This is achieved, however, at the cost of sustaining an inefficient industrial structure and inevitably leads to accelerating inflation. In the case of small government or a government that is determined to maintain a balanced budget, the financial crisis is likely to be much more severe, and the collapse of gross profits, by further curtailing investment, may be expected to give rise to a protracted depression. Lender-of-last-resort action by the monetary authorities can help offset the liquidity squeeze, preventing an extreme escalation of short-term interest rates and allowing the refinancing of positions which have been created through speculative financing. The fall in asset prices which is engendered by the rush towards liquid assets can thereby be contained, so that the financial crisis is less acute. There is a serious long-run cost to indiscriminate lender-of-last-resort action, however, in that the expectation of such action on the part of banks and firms, once it has become established, leads to the general (and correct) perception that the risks associated with speculative financing are not too severe. Imprudent financing may thereby be encouraged.

To summarize, there are inherent tendencies in advanced capitalist economies with sophisticated financial structures which give rise to instability in financial markets. The severity of the financial crises that occur, and the subsequent losses in output and employment depend on the size and actions of the government. Instability is generated endogenously, in the sense that a period of sustained stability encourages an increase in speculative financing which renders the financial structure fragile. Instability on the other hand encourages financial prudence, and thereby creates the conditions for a period of sustained growth. It is within the context of such dynamic interactions that Minsky is able to speak of the "destabilizing effects of stability."

Expectations play a central role in the precipitation of the crisis, as well as in the creation of the conditions which characterize financial fragility. The basic assumption made by Minsky with regard to the formation of expectations is reflected in the following passages:

"Financing is often based on an assumption 'that the existing state of affairs will continue indefinitely' (GT, p. 152), but of course this assumption proves false. During a boom the existing state is the boom with its accompanying capital gains and asset revaluations. During both a debt-deflation and a stagnant recession the same conventional assumption of the present always ruling is made; the guiding wisdom is that debts are to be avoided, for debts lead to disaster." (Minsky, 1975, p. 128)

"A recovery starts with strong memories of the penalty extracted because of exposed liability positions during the debt-deflation and with liability structures that have been purged of debt. However, success breeds daring, and over time the memory of the past disaster is eroded. Stability -- even of an expansion -- is destabilizing in that more adventuresome financing of investment pays off to the leaders, and others follow." (Minsky, 1975, p. 126)

Although fully conscious of operating in a cyclical economy, the individuals described above are prone to making decisions, particularly with regard to liability structures, on the basis of assumptions that are periodically discovered to be false. This exposes Minsky's analysis to the charge that his explanation of financial instability depends on an assumption of irrationality on the part of financiers and entrepreneurs, in the sense that they persist in holding expectations that are systematically wrong.

But is it really true that Minsky's theory depends on an assumption of significant and persistent departures from economic rationality on the part of firms? I tried to argue that this was not necessarily the case:

From a theoretical point of view, it is desirable to determine what manner of departures from rationality, if any, are required for Minsky's central propositions to hold. Bernanke (1983, p. 258) has stated for instance that Minsky and Kindleberger "have in several place argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational behavior." Bernanke does not elaborate on the precise nature of the departures which are a necessary component of the FIH, and his conclusion is somewhat perplexing in the light of Minsky's repeated assertions to the effect that "capitalism abhors unexploited profit opportunities" (1986, p. 219). In fact profit maximizing banks and firms are central actors in the scenario that is depicted, to the extent that financial innovation itself is explained on the basis of self-interested behavior, often in response to policy initiatives. It is possible that Bernanke is referring to irrationality with regard to expectation formation, and if this is the case, then his sentiments are shared by Flemming who believes that "the argument depends on agents failing to distinguish a run of good luck from a favorable structural shift in their environment." It is indeed true that Minsky refers occasionally to "conventional" assumptions which prove to be false, and to psychological phenomena such as "success breeds daring" (1975, p. 128). It is far from clear, however, that such features of the theory are in any way essential to the argument. The possibility that an optimizing approach to expectation formation may not be inconsistent with the theory arises because Minsky is dealing explicitly with what has come to be called a self-referential system (Marcet and Sargent, 1989), in which the actual law of motion describing the evolution of economic magnitudes is not independent of the perceived law of motion which guides the actions of agents. In such environments, the convergence to rational expectations trajectories even of extremely sophisticated learning procedures cannot be taken for granted. It is true that the FIH does not appear to be compatible with the RE hypothesis, in that firms persist in adopting liability structures which give rise to outcomes which violate the assumptions on the basis of which the liability structures were chosen. This occurs both in the case of excessive caution following a period of instability, and excessive boldness following a long expansion. Nevertheless, simply because a Minsky economy is not characterized by a movement along a rational expectations equilibrium trajectory, this does not force one to conclude that the agents described therein are in any meaningful sense irrational; the question must be raised within an explicit model of learning.

In retrospect, my attempt to answer this question fell woefully short. But the question itself seems worth addressing, as part of an attempt to explore the logical consistency of the financial instability hypothesis and clarify the assumptions on which it is based.

Cormac McCarthy's Typewriter

The Santa Fe Institute is a fascinating place, built on an unusual vision of how academic research should be conducted. It has a small core of resident faculty, and a large group of rotating short-term visitors. Interaction continually crosses disciplinary boundaries, with a healthy mix of natural and social scientists (and some non-academics) at each seminar. Offices are shared and doors usually left open. Lunch at noon and tea at three are communal events: there are a few large tables around which everyone gathers. And there is a broad range in ages: undergraduate researchers mingle with post-docs, professors, and the occasional Nobel Laureate. 

A few years ago I had the good fortune to share an office for a few weeks with Cormac McCarthy. I'm not sure which book he was working on at the time (I think it may have been The Road), but I noticed right away that there was no computer at his desk. This is what he was using:

That's right, a manual typewriter. One that he bought for $50 in 1963 and has now put up for auction: 

Lately this dependable machine has been showing irrevocable signs of age. So after his friend and colleague John Miller offered to buy him another, Mr. McCarthy agreed to auction off his Olivetti Lettera 32 and donate the proceeds to the Santa Fe Institute, a nonprofit interdisciplinary scientific research organization with which both men are affiliated.

“He found another one just like this,” a portable Olivetti that looks practically brand new, Mr. McCarthy said from his home in New Mexico. “I think he paid $11, and the shipping was about $19.95.”

In an accompanying letter of authentication, Cormac writes:

"I have typed on this typewriter every book I have written including three not published. Including all drafts and correspondence I would put this at about five million words over a period of 50 years."

I hope that the auction brings in a substantial sum, and that the collector with the winning bid draws some satisfaction from the fact that the proceeds will be funding basic research at the Institute.

Maturity Transformation and Liquidity Crises

William Dudley's keynote address at a recent CEPS symposium on the financial system is worth reading in full. What I found especially interesting were the following remarks on structural sources of instability:

The risks of liquidity crises are also exacerbated by some structural sources of instability in the financial system. Some of these sources are endemic to the nature of the financial intermediation process and banking. Others are more specific to the idiosyncratic features of our particular system. Both types deserve attention because they tend to amplify the pressures that lead to liquidity runs.

Turning first to the more inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation — the maturity of their assets is longer than the maturity of their liabilities. The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation — borrowing shorter-term in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent... But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line... because the liquidation value is lower than the firm’s value as a going concern...

These sources of instability create the risk of a cascade... Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention.

As Dudley notes, maturity transformation is "endemic to the nature of the financial intermediation process and banking." But non-financial firms (and the United States Treasury) can also engage in maturity transformation by borrowing short relative to their expected revenue streams. This is what Hyman Minsky called speculative (as opposed to hedge) financing. One of Minsky's key insights was that over a period of stable growth with relatively tranquil financial markets, there is a progressive shift away from hedge and towards speculative financing:

The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. (Minsky 1982, p.65)

Short-term financing of long-lived capital assets is lucrative as long as debts can be rolled over easily at relatively stable interest rates. But this induces more firms to engage in speculative rather than hedge financing, making the demand for refinancing increasingly inelastic. The eventual result is a crisis of liquidity and a shift back towards hedge financing.

Many economists (myself included) have tried to construct formal models of the process described by Minsky, but with limited success to date. This may be a good time to give it another shot.