Learning From China About Savings And Investment

ThinkProgress:

Michael Pettis’ take on the Chinese economic picture is always worth keeping tabs on, but his latest dose of pessimism about the sustainability of Chinese growth seems to me interesting for its broader implications about how we think of savings and investment policy. He writes that Chinese growth is based on unsustainable over-investment as illustrated by the fact that “Chinese households consume only about 35% of gross domestic product (GDP), far less than any other country.”
How does that happen?
Well according to Pettis, China’s “growth model transfers income from households to the corporate sector, mainly in the form of artificially low interest rates” whereby “[l]ow yields on deposits force them to sacrifice consumption, to save more.” So now forget about China for a moment and think about the United States. Here in the USA people often feel that over the long run, we have unsustainably low rate of household savings, and that investment-boosting measures would improve our long-term growth rate. But if somebody proposed that we step up government regulation to reduce the returns to household saving, the conventional political pushback would be to say that this will push the savings rate down. If you want to boost savings and investment, what you do is take steps to increase the returns to investment. Hence the popularity of lower taxes on capital gains and the like.
What’s interesting is that as best I can tell widespread acceptance of this model — more incentives to save will lead to higher savings — coexists with fairly widespread mainstream acceptance of the Pettis Model of the Chinese economy. And yet the Pettis model is exactly the reverse of this. He says that households target an acceptable threshold level of saving, and that therefore if you reduce the returns to saving households need to save more in order to meet the target. Hence, according to Pettis, China is able to create an investment oriented economy precisely by depriving households of lucrative savings vehicles and investment opportunities. This is the precise opposite of the policy trajectory that US policymakers have been following for the past thirty years.

One piece of evidence for the Pettis view is that, current recession aside, the era of policymaker obsession with increasing incentives to save has in practice been associated with steadily falling savings rates. This has long struck me as an under-discussed problem for the conventional wisdom and the Pettis Model of Chinese growth perhaps gives us a concrete example of how a different paradigm might operate. 

Infrastructure, Long-Run Growth, and Recessions

ThinkProgress:

Matthew Slaughter was on the George W Bush Council of Economic Advisors so he’s probably only saying this because he’s a socialist:

Over much of the 20th century, America’s strong infrastructure investment was a major factor attracting global corporations headquartered in other countries to invest and create jobs here. Rising U.S. standards of living were fueled by a strong infrastructure system that facilitated the growth of companies in America, both global and domestic alike: transportation systems to move people and products, electrical systems to power plants and offices, communications backbones to drive computers and creativity. By 2008, the U.S. subsidiaries of foreign companies employed over 5.6 million Americans — nearly 2 million in manufacturing — and exported $232.4 billion in goods. That’s 18.1% of America’s total.

Today is very different. America’s decaying infrastructure costs the typical American worker hundreds of hours in lost productivity. It also costs companies time and efficiency in moving their products around — and also out of — the country. This decay is particularly stark for global companies, whose executives are witness to the dynamism of emerging economies like China and India that present them with ever-widening choices for where to grow jobs and investments around the world.

Aging Public Infrastructure | ThinkProgress: 

I frequently see letter grades from the American Society of Civil Engineers cited as evidence that we need to invest more in infrastructure, which always seems a bit unpersuasive to me. Civil engineers want more infrastructure spending, admirals want more aircraft carriers, prison guards want more jails, etc. This chart Kevin Drum offered on Friday seems like the more persuasive way to make the point.

Once upon a time, the public sector refreshed its capital stock at a rate similar to that used by private businesses. Over time, our level of investment hasn’t kept pace with the growth of the economy and the age of public sector capital has steadily increased. That’s not a knock-down argument. You could make the case that we had this wrong in the 1960s and it makes sense to maintain public infrastructure that’s distinctly shabbier than private capital goods. That doesn’t seem plausible to me, but you can make the case if you like. Either way, what we have here is a pretty precise take on the existence and scope of the change over time. I’d say it’s been change for the worse.

A big burst of spending on this stuff is genuinely not my first-choice for a “jobs” program since well-designed infrastructure projects don’t necessarily target the segments of the labor market that are most in need of help (not a lot of women, for example, work in these fields) but it’s needed one way or the other.

Yglesias on Frum’s Infrastructure Bank:

David Frum’s proposed State of the Union speech contains both a lot to like and some to dislike, along with this wonky proposal:
I propose that all revenues from gasoline taxes, aviation fees, and other similar sources be placed in a fund directed by an independent infrastructure bank. The bank would be permitted to issue bonds up to a certain level, too. Instead of Congress writing a highway bill every five years, the bank would develop a list of priorities — no politics allowed. I’d suggest we have seven directors of the bank. Three would be nominated by the president and confirmed by the Senate. Two would be nominated by a conference of the Republican state governors, two more by a conference of the Democratic state governors. The directors would serve fixed and overlapping terms. When we’re balancing the budget, we can move slowly through the list of bank infrastructure priorities. In a year like 2011, when it’s cheap to borrow and workers need jobs, we can bring projects forward faster. Congress would always have the last word, in an up-or-down vote. And Congress would decide whether to increase or reduce the flow of future tax revenues into the infrastructure bank.
Every American will have the reassurance that these new infrastructure projects are not pork barrel. They were not chosen to reach some political deal. The money you pay at the pump or at the airport or in future taxes on carbon dioxide and other pollutants will be reinvested toward faster travel, more advanced telecommunications, and cleaner water.

I like the spirit of this suggestion, but worry about the details. Slightly more than fifty percent of the American people live in California, Texas, New York, Florida, Illinois, Pennsylvania, Ohio,  Michigan, and Georgia and slightly less than 50 percent of the population lives in the other 41 states. Wouldn’t the practical impact of board dominated by gubernatorial appointments be to even further exaggerate the American political system’s over-weighting of the interests of low-population states? Crowded airports in New York, Dallas, Los Angeles, Chicago, Houston, Miami, and Atlanta would be taxed to finance upgrades in Cheyenne and Albuquerque. Instead of a rail tunnel under the Hudson, we’d get a bridge to nowhere . . . exactly the problem this proposal was supposed to solve. 

Private infrastructure is also aging.  The privately-owned car fleet is older than ever and residential housing has been underbuilt since at least 2007.  

Good Examples of Monetary Policy

Switzerland, Sweden, Austrialia, & Israel. These countries also have the advantage of being small and having independent currencies that can fall in value, thus boosting exports.  Australia (like Norway and Canada) also has the advantage of being a natural resource exporter at a time when developing nations like China are buying unprecedented quantities.  The developing world is not in a recession which shows that it is not really global nor inevitable.  If poor countries like China can achieve modestly raised inflation, cheap currency, and full employment, why not the US?

Big Macro Stories of 2007

Four years ago I put in my Macro class notes a preliminary list of the biggest macro stories of the previous decade.  The great moderation and the housing bubble have changed and today the biggest macro stories are completely different although some of these are still important.  Here they are in no particular order:
1. income inequality
2. the US absorbed 70 per cent of the rest of the world’s surplus capital, but consumption has accounted for 91 per cent of the increase in gross domestic product in this decade. savings-glut vs. “money-glut” hypothesis. If we live in the savings-glut world, the US current account deficit is protecting the world from deep recession. If we live in the money-glut world, that very same deficit is threatening the world with a dollar collapse and, ultimately, even a return of worldwide inflation.
3. "great moderation" - increase in stability
4. rise of trade
5. growth of China (and other parts of Asia)
6. housing bubble? - related to cheap money.

Debt Reduction By Doing Nothing

ThinkProgress:

Given the amount of griping about debt reduction in Washington, it’s remarkable how little attention is paid to the fact that doing nothing solves the medium-term problem:

When we argue about the long-term deficit, we’re arguing about health care costs. But when we argue about the medium-term deficit, we’re primarily arguing about how to keep the deficit manageable consistent with extending a bunch of tax cuts. Politicians who are genuinely obsessed with the deficit as such should simply be saying, “I won’t vote for any tax cuts or spending increases that aren’t offset.”

Liquidity Traps, Money, Inflation, and Bond Yields

Stephen Williamson:

What is a liquidity trap? This is really two questions: (i) What is the "liquidity" that is getting trapped and (ii) What is the "trap" all about? In Old Keynesian economics and Old Monetarism, we think of the financial world in terms of two assets: interest-bearing assets and money. Money is the stuff that is used in transactions - liquidity - and private sector economic agents are willing to substitute money for interest-bearing assets in response to changes in the nominal interest rate. The nominal interest rate is essentially a measure of the scarcity of money as a medium of exchange. Monetary policy is about swaps by the central bank of money for interest bearing assets, or the reverse, and the attendant effects of those actions. One of those effects is a short-run liquidity effect. A central bank swap of money for interest bearing assets tends to make money less scarce as a medium of exchange in the short run, and the nominal interest rate falls.

But what if the nominal interest rate were zero? In that case, money is not scarce as a medium of exchange, so that money and "interest-bearing" assets are essentially identical, in which case central bank swaps of money for other assets are irrelevant. That's Grandma's liquidity trap. ...

If there are many policies that support a zero nominal interest rate forever, that's also saying that there is a subset of monetary policies, among which the choice is irrelevant, i.e. if the central bank conducts certain kinds of asset swaps, then nothing changes, i.e. there is a liquidity trap.

Why am I calling this Grandma's liquidity trap? During the National Banking era, there were recurrent banking panic episodes, and it is most useful to think of these as currency shortages, i.e. "liquidity" shortages. The way to correct a currency shortage is through conventional central bank actions - open market purchases of interest-bearing assets and discount window lending. This is just the logical extension of standard day-to-day central banking practice: Target a "degree of liquidity scarcity," i.e. a nominal interest rate, and then accommodate shocks to the private sector's demand for liquidity. This view of the world is consistent with how Friedman and Schwartz thought about the Great Depression. Basically, in Grandma's world, the idea is that the central bank does not need to be worried about the sources of fluctuations in the demand for currency. All that matters is that these fluctuations be accommodated appropriately with the standard tools available to central bankers.

I am convinced that this is not the way we want to think about the recent financial crisis, or about how monetary policy should be conducted given current circumstances. We are not in Grandma's liquidity trap.

Here's a better way to think about it. Think of the world as having two kinds of liquidity: currency and other liquid assets. The other liquid assets include bank reserves, Treasury bills, long maturity government debt, asset-backed securities, bank loans, etc. - all the assets that are somehow useful in some form of exchange (retail, wholesale, financial) either directly, or because they can be transformed by financial intermediaries into some asset that can be used in exchange. The "other liquid assets" of course have different characteristics, and are used in different ways in exchange. Risk, including maturity risk, is important in determining the prices of these assets (relative to each other), and different liquid assets will have different liquidity properties, reflected in how they are used in exchange. An important concept here is the "liquidity premium" which we can measure as the difference between an asset's market price, and its "fundamental," i.e. the price it would trade at, based on the stream of future payoffs the asset is a claim to, if the asset were not useful in exchange.

Bank reserves - the accounts of financial institutions with the Fed - are a key liquid asset, as reserves are used daily in the clearing and settlement of a very large volume of transactions. However, it takes a very small quantity of reserves to support this extremely large volume of financial trade - the velocity of circulation of reserves within a day (pre-financial crisis) is typically humongous. Currently, the financial system is awash with reserves, to the point where the marginal value of reserves in financial transactions is essentially zero. The interest rate on reserves (IROR), which is currently 0.25%, is higher than the interest rate on 3-month T-bills, which is currently 0%. Thus, T-bills command a higher liquidity premium than do reserves, as they are actually more useful in financial exchange (inside and outside the US).

The key liquidity trap - the contemporary liquidity trap - the Fed is faced with currently is that all of the other liquid assets are now essentially identical, from the point of view of Fed asset swaps. The Fed cannot make reserves more or less scarce as a liquid asset through swaps of reserves for other assets, and therefore has no hope of moving asset prices. The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

An important point to note is that the contemporary liquidity trap, in contrast to Grandma's liquidity trap, has nothing to do with the zero lower bound on the nominal interest rate. Remember that the short-term safe nominal interest rate tells you how scarce currency is relative to other liquid assets. The IROR could be 2%, 5%, or 8%, so that currency is scarce, but there would still be a contemporary liquidity trap if reserves were not scarce relative to other liquid assets.

As I have discussed in earlier posts, the only relevant policy instrument the Fed has, so long as the stock of excess reserves is positive, is the IROR. Thus, the only lever the Fed has is the ability to make currency more or less scarce relative to other liquid assets, and that is the avenue by which the Fed can control the prices of goods and services. Here is where the zero lower bound on the IROR comes in of course. At the zero lower bound, the Fed cannot achieve a higher price level, except through talk about the future.

Now, to put this in context, let's look at some traditional monetary measures.The first chart shows the stock of currency over the last five years. You can see that the currency supply grew significantly during the financial crisis; this is likely driven by overseas demand, but it is hard to know - we don't know exactly where US currency resides or what it is doing. Over the last two years, and particularly this year, currency has been growing at a reasonably brisk pace (more on growth rates later).

The key thing to note here is that, under the current regime (positive stock of excess reserves), the currency stock is not directly under the Fed's control. The Fed determines the total stock of outside money (currency + reserves) and financial institutions, firms, and consumers determine how that is split between currency and reserves. The stock of currency could be rising because the demand for it is rising, or because reserves are looking less desirable for financial institutions. This of course matters - in the latter case this would be inflationary, in the former case not.

The next two charts show M1 and M2, again for the last 5 years.These charts are very interesting. Both M1 and M2 show recent large spikes. Further, if we look at year-over-year growth rates in currency, M1, and M2, these are all getting large, as we see in the next chart. The twelve-month growth rate in M1 now exceeds 20%, and growth rates in M2 and currency are at or close to 10%. Allan Meltzer should be having a cow.

Of course, this is where Grandma's liquidity trap comes in. Monetary aggregates are constructed to include private and public liabilities that are widely used in exchange by firms and consumers, under "normal" circumstances. But circumstances are not normal - a checking account is now a convenient short-term store of value with no associated opportunity cost. Thus, these spikes in M1 and M2 need not be associated with more inflation. However, I don't think we know enough to tell.

But why the spikes in M1 and M2 in the last weeks? That may have something to do with what you see in the last chart. This one shows, again for the last five years, nominal and real (i.e. TIPS) yields on 10-year Treasuries. These yields have also fallen significantly in the last weeks. This reflects a scarcity of other liquid assets, presumably because of a general "flight to quality" in world asset markets.

Now, if other liquid assets are becoming more scarce, it would make sense that we should see growth in financial intermediation, reflected in growth in M1 and M2, as the private sector creates more assets in the "other liquid assets" category. However, it could also be that there has been a decrease in financial intermediation not reflected in M1 and M2. For example, there could have been a shift out of "shadow banking" into conventional commercial banking, but unfortunately we do not measure shadow banking activity.

The scarcity we are observing is not a traditional currency scarcity. As such, we can't correct the scarcity by using conventional central banking tools - open market operations in short-term government debt and discount window lending. Neither can we correct it through "quantitative easing." We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma's liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma's liquidity trap, the LM curve is flat, monetary policy doesn't work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

What's the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.

Can the Fed increase inflation?

The Washington Post:

The key to all these proposals is that the Fed’s statements and actions can affect inflation expectations, and thus inflation. By spurring a bit more inflation, it can then drive up growth and speed the recovery along. But though the people proposing this know whereof they speak — Woodford is arguably the most respected monetary theorist alive today — there are a number of economists who dispute the idea that the Fed, at the moment, can do much to drive up inflation. Peter Diamond, the Nobel laureate and failed Fed nominee, told Ryan Avent in an interview that although the Fed can set a level of inflation that it’s willing to tolerate, it can’t itself spur inflation. Donald Kohn, who served as vice chairman of the Fed from 2006 to 2010, told me he also doubts the Fed can do much to spur inflation at the moment. The Fed can create inflation, he explained, either by spurring demand so high that there’s upward pressure on prices (obviously, not a problem right now) or by creating credible inflation expectations. “At this point with the economy operating so far below potential and monetary policy having trouble pushing it higher one might wonder whether either of these would be operative right now,” he said in an e-mail. With demand as low as it is now, convincing the markets that inflation is going up might be impossible, so it could be that the Fed just can’t affect inflation expectations for now.  ...
Obviously, it would be great if the Fed had the power to spur growth through higher inflation, and there are a lot of economists who think it does. But it’s not a settled matter by any means.

This is insane! Inflation is a reduction in the price of money. Suppose you became a magical alchemist who could turn worthless dirt into gold at zero cost in any amount. Could you lower the price of gold?  Is this any different from the price of money?  Why? 


Here is Steven Williamson saying that the Fed cannot raise inflation (reduce the price of money).  

While one could find sound reasons why [the inflation] target could be higher [than the Fed's target of 2%], there is nothing the Fed could be doing that it has not already done that could actually increase the inflation rate in the United States.

Bizarre. Numerous third world countries have accomplished inflation.  Germany was able to do it despite its economy being devestated by World War I.  What stops the US from being able to do it if there are 'sound reasons' to do it?  Recently Switzerland devalued their currency which is done just like inflation is accomplished.  Yglesias:

Earlier today the central bank of Switzerland showed that there’s a lot that can be done through the communications channel of monetary policy by simply stating that they will not allow the Swiss franc’s price in Euros to rise above a certain level, and promised to engage in “unlimited” printing of money and purchasing of foreign currency to hit the exchange rate peg. Naturally, this immediately moved currency markets because when someone with the ability to create arbitrary quantities of Swiss francs at zero cost speaks of his determination to reduce the price of Swiss francs, you listen closely.
I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can—but only if we agree to talk about exchange rates rather than “aggregate demand.”