Dear Paul

My Harvard colleagues Carmen Reinhart and Ken Rogoff have written an open letter to Paul Krugman. (pdf version)

Weitzman on Climate Change

Wisdom from my Harvard colleague Marty Weitzman.

On Stock Investing

Click here to read my column in Sunday's NY Times.

Christy Romer on Japan

Last month, I had the pleasure of hearing Christy Romer give a great talk about Japanese monetary policy at the NBER Macro Annual conference.  You can now read it here.

The ZLB in My Favorite Textbook

In a recent blog post, Paul Krugman writes:

As far as I know, among basic textbooks only Krugman/Wells even talks about the liquidity trap.

This is probably a true statement.  It is not that other books don't cover the topic, however.  It is just that Paul Krugman doesn't know it.

FYI, here is what the leading introductory text says about the topic:

The Zero Lower Bound

 

As we have just seen, monetary policy works through interest rates. This conclusion raises a question: What if the Fed’s target interest rate has fallen as far as it can? In the recession of 2008 and 2009, the federal funds rate fell to about zero. What, if anything, can monetary policy do then to stimulate the economy?

 

Some economists describe this situation as a liquidity trap. According to the theory of liquidity preference, expansionary monetary policy works by reducing interest rates and stimulating investment spending. But if interest rates have already fallen almost to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: Rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public’s asset portfolio more liquid, but because interest rates can't fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be "trapped" at low levels.

Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending. 

A second possibility is that the central bank could conduct expansionary open-market operations with a larger variety of financial instruments than it normally uses. For example, it could buy mortgages and corporate debt and thereby lower the interest rates on these kinds of loans. The Federal Reserve actively pursued this last option during the downturn of 2008 and 2009.

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 4 percent, then the central bank can easily push the real interest rate to negative 4 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policymakers more room to stimulate the economy when needed, reducing the risk of hitting up against the zero lower bound and having the economy fall into a liquidity trap.

Stocks are cheap

...say two NY Fed economists. 

 

Larry Summers on Reinhart and Rogoff

Here.

Fiscal consolidation: At what speed?

From Olivier Blanchard and Daniel Leigh.

Preventing the Next Catastrophe

Wisdom from David Romer.

Stevenson-Wolfers on Reinhart-Rogoff

They write:

In the end, all the corrections advocated by the critics shift the average GDP growth for very-high-debt nations to 2.2 percent, from a negative 0.1 percent in Reinhart and Rogoff’s original work. The finding remains that economic growth is lower in very-high-debt countries (see chart). It has been disappointing to watch those on the left seize on the embarrassing Excel errors but ignore this bigger picture.

Click on graphic to enlarge. 

Snapshots from the Performance

 Photo credit:  JACOB BELCHER/HARVARD OFA

The President as Financial Planner

He and Michelle seem inattentive to their own finances:

The Obamas paid $45,046 in mortgage interest in 2012, which appears from the disclosure statement to be at a 5.625% interest rate with Northern Trust. That suggests an outstanding principal balance of about $800,000. 

On the other hand, the bulk of their investments are in Treasury notes. Based on the disclosures, I estimate they hold about $3 million in Treasury notes (also held by Northern Trust), yielding 0.71% if averaging a five-year maturity. 

By selling some of those Treasuries and paying off the mortgage, they would effectively be getting five more percentage points on the amount; they would also be about $40,000 better off each year before taxes, not to mention being less exposed to notes that could take a hit from possible rising rates. 

The Obamas would pay more in taxes but make much more after taxes -- especially since they aren’t getting the full deduction anyway, due to the AMT. That's more money going to the U.S. Treasury and more money for them; Northern Trust would be the loser.

Mistakes

Several people have asked me to comment on the coding error found in one of the Reinhart-Rogoff papers. I have avoided the topic, since I don't think I have a lot to add to the discussion.  But because so many people have asked, here are a few observations:

1. Everybody makes mistakes. I once made an analytic error in one of my published papers and, after it was pointed out to me, subsequently wrote a correction (published version).  Finding and correcting errors is a part of the research process.  Sure, errors are embarrassing, but there is nothing dishonorable about making them.

2.  Policy should not be based on the results of a single study.  And my experience is that it never is.

3. I believe that high levels of debt and deficits are a negative for the economy in the long run.  My views on this issue have not changed substantially since I wrote about it with Larry Ball almost twenty years ago.

4. I never thought there was a magic threshold for the debt-to-GDP ratio above which all hell breaks loose.  The world is more continuous than that.

5. The coding error in Reinhart and Rogoff has gotten a lot more media attention than it deserves.  Some people on the opposite side of the policy debate have taken advantage of this opportunity to pound the drum for their views.  But just because someone in Team A makes an inadvertent excel error does not mean that everything Team B believes is true.  To suggest otherwise would be a truly egregious mistake.

A Reading for the Pigou Club

Europe's Cap-and-Trade Scheme Failing Spectacularly

More Endorsements

From Megan Amram, Tommy Amaker, and Larry Summers. More to come at this link in the coming days.

Help a Student!

A student I know (specifically, my older son) is trying to collect some survey data.  Click here if you are willing to participate.  The survey will take about 15 minutes.

Update: No more data is needed.  Thanks to the more than 1000 of you who participated.

A Message from Jason Alexander

A Message from John Lithgow

Beethoven's Fifth

A performance not to be missed.

Rethinking Macro

The IMF is holding a conference "Rethinking Macro" on April 16-17.  You can watch a live webcast.  Click here for information.

Congratulations, Raj

My Harvard colleague Raj Chetty has won the John Bates Clark Medal.

Economics Teaching Conference

For information about submitting papers or registering, click here.

Solow on Bernanke

In The New Republic, with thoughtful and thought-provoking commentary on the financial system.

The President's Latest Bad Idea

Apparently, President Obama's budget is going to include some kind of penalty for people who have accumulated more than $3 million in retirement accounts.  The details are not yet known, but I think we know enough to say that this is a terrible idea.

A sizable body of work in public finance suggests that consumption taxes are preferable to income taxes.  Completely replacing our tax system with a better one is, however, hard.  Retirement accounts, such as IRAs and 401k plans, are one way our tax code has gradually evolved from an income tax toward a consumption tax.  The use of these accounts should be encouraged, not discouraged.

By the way, exceeding $3 million in such accounts is not very difficult for an individual who is financially successful and frugal.  Under current law, a self-employed person can put about $50,000 a year in a SEP-IRA.  If he does that every year for 40 years, and his savings earn a return of 5 percent per year, he will retire with about $6 million.

So, yes, President Obama's $3 million constraint would be a significant disincentive for saving.  It would move the tax code in the wrong direction.

A Hyperinflation Vacation

From The Atlantic.