Inflation or Deflation?

April 14th, 2014 by under Faculty Commentary. No Comments.

Longbrake3by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the April 2014 Longbrake Letter. To read the letter in its entirety, click here.

Now that economic expansion in the U.S. finally appears to be gaining traction and the Federal Reserve has begun the process of normalizing monetary policy by slowly reducing the quantity of large scale asset purchases, attention has turned toward whether renewed inflationary pressures might be just around the corner. But, some warn that the pending threat is not one of inflation but rather one of deflation.

With the exception of Japan, courtesy of Abenomics, global inflation rates are either stable at very low levels or are still declining. In the U.S., core PCE inflation has been stable between 1.1 percent and 1.2 percent for the last eleven months, while total PCE inflation has fallen to 0.9 percent. In Europe, total inflation continues to fall steadily and was 0.5 percent in March. Europe’s core inflation rate in March was 0.8 percent. Global inflation was relatively stable at a low 2.0 percent rate in February, reflecting modest downward pressure from some developed economies and an absence of upward pressures from emerging economies.

Conventional wisdom assumes that global growth will improve during 2014 and 2015 and that as that occurs output gaps will narrow and upward pressures on inflation will naturally emerge. But, the question is whether the conventional wisdom is right or whether other forces are at work which threaten deflation, notwithstanding improvements in global growth.

Capitalism is inherently deflationary. That tendency is not fully appreciated because we have lived in an era marked by persistent inflation. The name of the game in capitalism is to produce more with less and to maximize profits, which creates unrelenting pressure to cut costs and to use inputs more efficiently. One need only study the causes of persistent deflation in the U.S. between the Civil War and World War I to understand how market-driven capitalism results in deflation.

Everyone is taught that inflation occurs when demand exceeds supply. But, in a market-based economic system relatively free of government and regulatory interference, supply tends to lead demand. So what is it that leads to self-sustaining inflation?

There are two sets of conditions that result in persistent inflation. The first set involves macroeconomic policies, both monetary and fiscal, driven by government and central banks. The second set involves how participants in an economy adjust behaviors to inflationary expectations. If one expects prices to rise tomorrow, then it is best to purchase goods and services today at lower prices. But, the very act of accelerating purchases increases demand relative to supply and the increase in prices becomes self-fulfilling. Of course, expectations can also reinforce deflation – postpone purchases today because prices will be lower tomorrow. Japan’s lost two decades of persistent deflation leave no doubt that expectations are a powerful reinforcer of trends in prices and can work in either the inflationary or deflationary direction.

Monetary policy’s impact on inflation is well understood. If there is too much money chasing too few goods and services, prices will rise. Of course, the opposite is also true. Part of the deflation problem of the late 19th century was that the money supply was tied to the stock of gold and the stock of gold did not grow sufficiently rapidly to facilitate the more rapid growth in economic activity.

In recent times global central banks have become generally paranoid about their role is fostering a self-sustaining inflationary process. For that reason, most have adopted specific inflation targets with 2 percent being the favorite target level. However, 2 percent is generally viewed as a ceiling, not as an average level to hit over the economic cycle. Some, such as Paul Krugman, question whether a 2 percent target, especially since policy treats it as a ceiling, provides a sufficient buffer to prevent unintended embedding of deflation.

When central banks are behaving and limiting inflationary pressures through monetary policy, inflationary pressures can still emerge through fiscal policy. Government policies intended to stimulate economic activity, particularly if they result in substantial debt creation, will stoke inflationary pressures. Debt creation can occur directly in the public sector but it can also occur in the private sector, as the recent U.S. housing bubble amply demonstrated, by virtue of specific government legislative and regulatory policies.

It is understood that debt creation can accelerate economic growth by boosting demand. That is what the Chinese miracle is all about. But, as Hyman Minsky pointed out, if debt growth is excessive it will result in nonproductive speculative activity, and in the extreme Ponzi financial activity, which, if left unchecked, will result in financial instability and an eventual painful correction.

There is a natural rate of growth in debt that is neither inflationary nor deflationary. This natural rate is a function of the natural rate of interest as the famous economist Knut Wicksell theorized. The natural rate of interest is that rate of interest at which intended investment and intended saving balance. The equilibrium natural rate of interest occurs at the rate that induces enough savings – supply of funds – to fund investments – demand for funds – whose expected returns exceed the equilibrium rate of interest. Since the natural rate of interest is not observable, actual decisions are based upon the market rate of interest. But, if the market rate of interest is different from the natural rate, some decisions will be “incorrect”. This initiates policy risk and its magnitude will depend on the size, direction, and persistence of the divergence between the natural and market rates of interest.

Debt will grow too rapidly if the market rate of interest is persistently less than the natural rate of interest. This will foster speculative activity rather than productive investments. Usually, this is thought to be a monetary phenomenon, not a fiscal policy driven one. However, fiscal policy can affect the natural rate of interest by increasing or decreasing investment activity. When there is a great deal of slack in an economy, governments can create investment initiatives with good rates of return that the private sector is unwilling to undertake. All else equal, this would soak up excess saving and lower the natural rate of interest. But not all government spending has equal value in terms of investment. If increased government spending goes into transfer payments, it boosts demand, not supply and contributes to inflationary pressures.

Governments can also create an inflationary bias by constraining competition. For example, rules intended to protect industries or workers or policies that subsidize demand for certain products can limit price competition and depress productivity. Implementation of economic reforms, whether it be Japan’s Abenomics third-arrow, China’s Third Plenum reforms, or Europe’s requirements for Greece, Spain, and Portugal, are intended to increase economic efficiency and boost productivity.

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China – Will Commitment to 7.5 Percent Real GDP Growth Lead to Financial Instability?

March 19th, 2014 by under Faculty Commentary. No Comments.

Longbrake3by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the March 2014 Longbrake Letter. To read the letter in its entirety, click here.

In recent days, Chinese data reports for industrial output, investment, and retail sales have systematically fallen short of investor expectations. Although this follows a pattern that has occurred at the beginning of the calendar year in each of the last three years, it is receiving more concern this year because of concern about tight credit and potential financial stress. This growing concern is reflected in the poor performance of the China Shanghai Composite stock index, which has fallen over 35 percent over the last three years.

For a variety of reasons, a financial crisis is not imminent in China. But serious imbalances in the Chinese economy have been building for years and, if the policies that have been responsible are not adjusted, the imbalances will continue to build and could lead eventually to a severe financial crisis. That is because resources are being allocated increasingly to investment activities that have low or negative rates of return. The investments are being financed by credit that ultimately cannot be repaid in full because the investments are not earning sufficient returns to service both interest costs and repay principal. Put differently, the rate of return on investment is less than the cost of capital. This state of affairs can be sustained for a while through refinancing loans and capitalizing interest expenses, but eventually losses will have to be realized and bankruptcies will occur. Thus, sometime in China’s future a financial cataclysm – a Minsky moment – lurks unless policies are pursued that reverse the persistent misallocation of resources in non-economic activities.

As a reminder, Minsky moments occur when markets realize that significant amounts of credit cannot be repaid through cash flows naturally flowing from the business activities they finance. Credit extension increasing covers losses in addition to new investment initiatives. This is a pattern consistent with financial speculative bubbles. When markets realize that loans will never be repaid in full, credit access is abruptly withdrawn and the Minsky moment is underway. Governments then are forced to intervene and absorb the losses to prevent economic collapse. This is what happened in the U.S., Europe, and elsewhere in the world during the financial panic of 2007-08. But, while governments can stop panic, the harm done to economies is severe and, as we have seen, recoveries are slow and extended. And, there is also a limit to how much bad debt a government can absorb before it has its own Minsky moment. Greece is a recent case in point but there are many other examples throughout history.

There are two data points that underline the evolving credit speculative bubble. The first has to do with deteriorating return on assets (ROA) and return on equity (ROE) in state-owned enterprises (SOEs). According to data from the Ministry of Finance, ROA for nonfinancial SOEs declined from a peak of 5.0 percent in 2007 to 3.25 percent in 2011. The decline was broad-based across a variety of industries. Other data indicate that the ROA for non-state companies was approximately 8.0 percent in 2007 and 9.0 percent recently.¹

The second set of data has to do with the rate of growth in credit compared to the rate of growth in nominal GDP. When credit grows faster than GDP, which is what has been happening in China, this indicates that a portion of credit is going to support price increases in existing assets, to refinance existing debt and capitalize interest, or to finance unproductive investments. This is reflective of speculation or, in Minsky terminology, Ponzi finance. But the situation is deteriorating because the gap between the rates at which credit and nominal GDP have been growing has been widening. This means that an increasing portion of credit growth is going in speculative ventures and nonproductive investments. These are the indicia of inflating bubbles.

There is hope that China’s new leadership and the reforms announced at the culmination of the Third Plenum last November will diminish the extent of existing imbalances and set China on a course of sustainable growth. However, to date many of the reforms are couched as goals and have yet to be articulated through specific implementation plans. The absence of specifics for dealing with misallocation of resources and underperformance of SOEs is especially troublesome. Also, the leadership is clinging to a real GDP growth goal of 7.5 percent for the next several years, which can only be met in the short run by continuing to pursue the policies that are contributing to growing, but ultimately unsustainable, imbalances.

To avoid a potentially painful and stressful future, China needs to implement reforms with teeth and accept the reality that a healthy and stable economy will be one that grows more slowly than 7.5 percent.

¹Data provided by Gavekal Dragonomics.

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Another Way to Do the Math for Social Security Reform

March 7th, 2014 by under Faculty Commentary. No Comments.

Swagel-Phillip-HRby Phillip Swagel, Professor in International Economic Policy, Maryland School of Public Policy and Academic Fellow, Center for Financial Policy

This post was originally published in The New York Times’ Economix Blog. To view the original post, click here.

Social Security is a hot button political issue, but there is actually more agreement on the matter than might meet the eye. Consider a potential Social Security reform that increases benefits for low income retirees and raises taxes on workers with relatively high incomes. This sounds a lot like what Democratic members of Congress might favor.

Now compare this to an alternative that maintains current taxes on the rich but lowers their benefits, while again raising benefits for those with low incomes. In broad strokes, this is the Republican proposal. It turns out that those are the same, once assessed from a perspective that looks at the net of lifetime contributions and benefits. Too bad, though, that President Obama, who once upon a time spoke about making tough decisions to ensure the sustainability of vital entitlement programs such as Social Security, is stepping back from the issue.

The Obama budget released on Tuesday leaves out the President’s previous proposal to modify the formula by which Social Security benefits are adjusted for inflation, a change meant to improve the financial condition of the retirement program. This is even though last year’s budget documents noted that “most economists agree that the chained CPI provides a more accurate measure of the average change in the cost of living than the standard CPI.”

News reports indicated that Mr. Obama is still actually open to the idea in principle. But proposals favored by the president are put in the budget, even if like his various suggestions for higher taxes and more spending, they stand little chance of enactment.

The omission, which was explained to the press, is not surprising. Neither side in Congress seems eager to address Social Security’s financing gap, whether through higher revenues or slow benefit growth. Even putting forward the proposal last year caused problems for Mr. Obama within his party. Doing so again would make it awkward for Democratic candidates in this fall’s Congressional election to accuse their opponents of wanting to hurt seniors.

While understandable, the budget change is disappointing because it steps away from a proposal that would begin to address the gap between the future revenues available to Social Security and the promised benefits that cannot be sustained under current law. Consider, for example, a potential Social Security reform that makes no changes to payroll taxes but increases benefits for retirees with low lifetime incomes and reduces benefits for retirees with high lifetime incomes.

Projections from the Social Security Administration’s actuary indicate that the disability system faces a financing crunch in 2016, while the old age retirement program will be able to pay promised retirement benefits until 2035. If retirement and disability funds are considered together, system reserves will be depleted in 2033, with revenues in that year sufficient to pay 77 percent of scheduled benefits, a figure that declines to 72 percent of scheduled benefits in 2078. With no change in the law, then, changes to Social Security will still take place, with current projections indicating that this would involve a reduction in benefits of 23 percent and rising for all retirees, both high- and low-earners.

The arithmetic of these projections is straightforward, but my sense is that discussion of the available policy options is often confused in the public debate. The adjustment to Social Security will eventually come through either revenues or benefits, or some combination of the two. With this in mind, a useful way to analyze the burden of adjustment is to consider the net impact of changes to revenues and benefits over workers’ lifetimes.

The assertion that increased benefits for retirees with low lifetime incomes and reduced benefits for retirees with high lifetime incomes are similar on net leaves aside the vagaries of individual mortality. This is an important topic but considering it does not reverse the points made here, since the proposed reform is to increase benefits for those with low earnings who tend to have shorter life spans than high earners.

For a given improvement in the system’s financial condition, then, the two alternatives are to maintain current benefits and have higher taxes or to keep taxes the same but slow benefit growth from what is now promised, but not payable.

Either way, the net impact is the same, with the burden of the adjustment falling on high earners in both instances. The plan with higher revenues does provide greater assurance to one group: people who made lots of money while working and then spent it all.

But it seems hard to imagine that protecting this group with higher benefits would be a strong reason to prefer for a plan that raises taxes on people with relatively high earnings and thus runs more money into the government merely in order to pay out higher benefits to the people with relatively high earnings. And again, under both reform proposals, people with low lifetime earnings would have higher benefits and not higher taxes than in the current system.

The idea that people at the bottom should do better on net while the burden of adjustment falls on those with high lifetime incomes is common to Social Security reform proposals, including those previously put forward by Congressman Paul Ryan, the Republican from Wisconsin, and President George W. Bush. Senator Tom Harkin, an Iowa Democrat, and Senator Elizabeth Warren, the Democrat from Massachusetts, among others, have proposed expanding Social Security benefits.

Implicit in the Harkin-Warren proposal to avoid benefit reductions is to eventually increase system revenues, (since otherwise benefits would be cut once system funding is inadequate.) And presumably Senators Harkin and Warren would do this in a progressive fashion by having the burden of higher taxes fall on people with relatively high lifetime incomes. This means that on net their proposal is broadly similar to that from the other side, with an improved outcome for low-income retirees and the net burden of adjustment falling on those with greater lifetime earnings. This is clear with a lifetime perspective.

I realize that it is uncommon to see this group of policymakers as sharing common ground on Social Security reform, but that is the implication of viewing changes to the system through the lens of the net burden of adjustment.

President Obama could have adopted the idea of Senators Harkin and Warren to increase benefits for retirees with low lifetime incomes, which would have left the impact of slower benefit growth focused on those with higher lifetime earnings. Mr. Obama had already proposed safeguards to protect vulnerable retirees who most depend on Social Security and others who depend on government assistance programs such as food stamps. Higher benefits for low earners would have been a natural expansion of his proposal, rather than simply striking it from the budget.

Other changes to Social Security would be desirable, such as to improve incentives for people to work; the former deputy commissioner of the Social Security Administration, Andrew Biggs, provides a useful discussion. It should be expected that there will be different views between the two parties on many aspects of reform. The point here is that on the burden of adjustment there is broad consensus.

The timing of reform matters. If progressive changes to revenues or benefits are made in 2033 rather than sooner, up to twenty years’ worth of rich people get both higher benefits and lower taxes and thus do not share in the burden of adjustment (and again, in all cases, people with low lifetime incomes would have higher benefits and not higher taxes). This means that a larger adjustment will be borne by others, including in future generations.

Social Security reform is off the political discussion table for now, but the eventual burden of adjustment will fall on someone–this is the implication of the actuarial figures listed above.

A few days before releasing his first budget in 2009, President Obama hosted a fiscal responsibility summit at the White House at which he noted that “tough choices” would be needed to address the long-term fiscal challenge facing the United States, including to ensure the solvency of Social Security. The necessary adjustment should take place slowly and take hold after the economic recovery is further along. But developing a societal consensus around reform will take time and require political leadership. In this regard, President Obama’s budget is a step in the opposite direction.

Postscript: More information on a range of topics relating to Social Security reform can be found a set of background papers on the issue written while I was Assistant Secretary for Economic Policy at the Treasury Department, which can be found here. These papers do not represent the view of the Obama administration (though I suspect that their economists would agree with much of the contents–the reports were drafted by the talented career economists at the Treasury). I am glad, however, that the Treasury under Secretary Geithner and Secretary Lew has continued the tradition of ensuring that such reports are available on the Treasury website, just as the reports written and speeches given in the Clinton administration and before remained online during the Bush administration.

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The Bank Rescue, Five Years Later

February 19th, 2014 by under Faculty Commentary. No Comments.

Swagel-Phillip-HRby Phillip Swagel, Professor in International Economic Policy, Maryland School of Public Policy and Academic Fellow, Center for Financial Policy

This post was originally published in The New York Times’ Economix Blog. To view the original post, click here.

Sometimes government programs that seem flawed at their launch turn out to succeed against all expectations. No, this is not a post about the Affordable Care Act — I still think that will prove to be an unsustainable fiscal train wreck. I have in mind the Obama administration’s Financial Stability Plan to continue the bank rescue, kicked off in a speech by Timothy F. Geithner as Treasury secretary just over five years ago, on Feb. 10, 2009.

Mr. Geithner sought to explain how the new administration would carry on with the job of stabilizing still-fragile financial markets. The Bush Treasury, at which I was a senior official, had intervened to support money market funds, banks, General Motors and Chrysler, and the American International Group insurance company (for which TARP money was used to restructure the Federal Reserve’s loan). The Federal Reserve and Federal Deposit Insurance Corporation had taken a range of vital and innovative actions to stanch the crisis, and staff members from the Treasury and Fed were developing a program to address credit market strains that were hindering business and consumer lending.

Even though Mr. Geithner had made key contributions to the financial rescue programs while in charge of the Federal Reserve Bank of New York, it was natural to expect the recently inaugurated President Obama to put his own stamp on the program, especially when many Americans were understandably discomfited at the idea of the bank rescue in the first place. Indeed, the president himself had built up expectations just a few days earlier that his Treasury chief would provide “a new strategy to get credit moving again.”

The Geithner plan aimed to assure investors of bank stability, to cleanse bank balance sheets of remaining illiquid assets such as subprime mortgage-backed securities, and to encourage new lending to businesses and consumers. In broad strokes, this had the makings of an appropriate response to the problems facing the financial system, in large part by continuing and building on the efforts already under way that had succeeded in arresting the panic of September 2008.

Americans have long come to expect the Obama administration to overpromise and underdeliver. But the introduction of the financial stability plan took place before this pattern became clear, and market participants were dismayed that the secretary’s speech had little information on how the worthwhile goals it set out would be achieved.

Trust in the stability of banks gradually had been rebuilt after the October 2008 announcement of TARP capital injections. The improvement reversed following the speech, as can be seen in Figure 15 of a report issued by the Treasury in September 2009, which shows an increased cost to buy insurance against bond defaults by major banks. (It is admirable that the Geithner Treasury marked the timing of the secretary’s speech on charts in its report even while knowing that this would highlight the self-inflicted wound.)

I remember the feeling of dismay at the seemingly half-baked plan while watching the speech with others at a New York City asset management firm where I was talking about the economy. The reaction of equity markets mirrored the unhappiness in that room, with stocks down more than 5 percent that day.

It turns out, however, that the program sketched out by Mr. Geithner both came to pass and made a difference. Five years later, the United States financial sector is in much better condition. Banks have absorbed losses from loans made during the bubble and rebuilt their capital, and investor confidence has returned. Mr. Geithner’s proposals did not all work right away or in the scale initially envisioned. In the end, however, Secretary Geithner deserves credit for making good on what he promised.

By far the most important component of Mr. Geithner’s proposal was a stress test to assess whether banks had “sufficient financial strength to absorb losses and to remain strongly capitalized” in the event of another severe downturn. Led by the Federal Reserve, the stress test involved coming up with forecasts of banks’ financial positions in the event of a hypothetical renewed recession and housing price collapse. Banks that could not make it through this very negative economic scenario would be given six months to raise capital from private investors, after which regulators would have pressed them to accept more TARP capital.

It is hard to remember, but back in the spring of 2009 many people believed that the United States government would nationalize large banks, starting with Citigroup and then moving on to Bank of America and perhaps others. Indeed, according to the New Yorker writer Ryan Lizza, this was a well-founded concern in the sense that nationalization was discussed as a policy option by the Obama administration amid a swell of sentiment for this action among economists and columnists.

In reality, nationalization was unlikely from the start for both legal reasons and political ones, the latter including that administration officials did not trust the F.D.I.C. to handle a seized megabank, as would have been required by law. But investors did not realize this, and thought that new equity investments in banks would be at risk of being wiped out by a government takeover.

Concern over the possibility of force majeure was heightened by the Obama administration’s erratic response in March 2009 to the political furor involving bonuses to A.I.G. executives, with President Obama ordering officials to find ways to block the bonuses even after his staff had already declared that this was not possible under the law. Together, these factors led to a halt to capital raising by banks in the first quarter of 2009 (as can be seen in Figure 1 on Page 7 of the September 2009 Treasury report). Just when financial stability and economic recovery depended on a stronger banking system, investor fears — some reflecting the administration’s own missteps — stood in the way.

The stress test results announced in May 2009 dispelled these concerns. Ten of the 19 banks examined were required to raise $75 billion of additional capital between them, but the needed amounts were widely seen as attainable for all but GMAC Bank (since renamed as Ally Bank and still having problems with the Fed’s stress tests). On the whole, the first stress test was seen as a credible indication that major American banks would not fail — and thus were not at risk of being taken over by the government. Citigroup in the end converted government preferred shares from TARP into common stock, substantially diluting the holdings of many pre-crisis investors. But the company remained afloat.

For market participants, the stress test results were the equivalent of an “all clear” flag at the beach after a storm — it was safe to go back into the water of banking industry investments (and they did, as noted a year later by the Fed chairman, Ben S. Bernanke). A straight line can be drawn between the 2009 stress tests and today’s stronger American banking system — not at all what was expected given the initial reaction to Secretary Geithner’s speech.

The initiative to support new consumer and business lending announced by Secretary Geithner was the Term Asset-Backed Securities Lending Facility (TALF) under development since the fall of 2008 — Steven Shafran, the brilliant Treasury official who had come up with the idea, stayed on into the new administration to get the program up and running. The TALF was designed to restore the flow of securitized lending for auto purchases, student loans, business equipment, and other activities in which individual loans were packaged together into securities that were then sold to investors. This lending had fallen off sharply since the crisis manifested in August 2007. TALF was a complement to the Federal Reserve’s quantitative easing program in the sense that the Fed purchases of Treasury bonds and mortgage-backed securities were meant to push down overall long-term interest rates while TALF was aimed at specific market strains.

The program had a clever design: it was attractive to use during times of market stress, when funding to make loans was expensive, but it became relatively costly and thus less desirable once markets returned to normal. New lending was closed in June 2010 with $43 billion in loans outstanding. A full discussion of TALF is a topic for a different post (though still relevant in that there are proposals even within the Fed for what amounts to a permanent TALF). But an evaluation of TALF lending found that the program resulted in lower interest rates for the target activities while not favoring any particular security. In other words, TALF worked effectively to address a problem that hindered particular types of household and business spending.

The last piece of the Geithner plan was for a Public-Private Investment Program (PPIP) in which the Treasury put government money alongside private investors to buy up the so-called legacy bad assets — the illiquid mortgage-backed securities that had figured so prominently in the crisis. It turned out that the additional capital raised after the stress tests was more important for restoring confidence in the financial system than government assistance in cleaning up the old bad assets. In the end, PPIP was a modest program (though with a positive financial return for taxpayers), but the problem at which it was aimed was largely addressed elsewhere.

As Mr. Geithner put it in May 2009 after the release of the stress tests, he was looking for banks “to get back to the business of banking.” This is what has happened. To see the alternative, consider the situation in euro zone countries, where multiple rounds of stress tests have not convinced investors that banks are sound, and weak credit growth remains a problem for economic growth.

Mr. Geithner is writing a book and can eventually give his account of these and other initiatives while he was Treasury secretary, including those on housing, where the results are still widely seen as not living up to the administration’s promises. On the bank rescue, however, the passage of time casts a considerably more favorable light than could possibly have been imagined back when his financial stability plan was announced.

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Income Inequality – Policy Proposals

February 18th, 2014 by under Faculty Commentary. No Comments.

Longbrake3by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the February 2014 Longbrake Letter. To read the letter in its entirety, click here.

President Obama in his 2014 State of the Union address, asked Congress to pass legislation introduced by Sen. Tom Harkin (D) of Iowa and Rep. George Miller (D) of California, which would raise the federal minimum wage from $7.25 per hour, where it has been stuck for years, to $10.10 in three steps over a two-year period and index it to inflation thereafter.

President Obama also announced that he would sign an executive order requiring these increases to be paid by federal contractors. So far in 2014, 13 states have raised the minimum wage.

Broad Public Support Exists for Raising the Minimum Wage

Americans overwhelming support the efficacy of a minimum wage. A recent Gallup poll indicated that 76 percent support raising the minimum wage to $9.00 per hour. This is not just a liberal issue – 57 percent of Republicans are supportive. Historically, surveys have indicated 60 to 70 percent support a minimum wage, but as income inequality has worsened, support has risen.

Congress Has Been Reluctant to Pass Legislation

In spite of broad public support, Congress has not given this issue serious attention. Why is that? Americans have a deep visceral commitment to “fairness” and an aversion to exploitation. Mandating a “living wage” through minimum wage legislation is viewed as a legitimate component of America’s social contract. Based on these values and the broad bi-partisan support, one would think that Congress would have acted long ago.

Lobbyists, such as those representing the restaurant industry, are partially responsible for the lack of action. Politics may be involved as well. Democrats actively advocate raising the minimum wage as evidenced by Sen. Harkin’s and Rep. Miller’s sponsorship of the current legislation. Since this hasn’t been an issue that Republicans have claimed as their own, there is little to nothing for them to gain politically by supporting legislation. Thus, there is little incentive for the Republican-controlled House of Representatives to consider minimum wage legislation.

Economic Arguments Opposing Increasing the Minimum Wage

Economic purists argue that fixing a minimum wage interferes with natural market processes and could lead to fewer jobs. However, most studies of the impact of increases in the minimum wage rate show no significant effect on employment levels. It appears that wage increases typically get passed through to consumers through higher prices. If demand is price inelastic, which means that changes in prices have limited to no impact on demand, then employment would not decline. Other research shows that modest increases in the minimum wage lower turnover and vacancies and this reduces aggregate employment costs and boosts worker productivity, which collectively offset higher direct wage costs.

Even though research shows that increases in the minimum wage rate have little impact on employment, there is some risk that a patchwork approach at the state and local level could have some consequences on a regional basis. This risk can be mitigated through federal legislation. Then, to the extent that higher wages are passed along to consumers through higher prices, this would lift inflation. But, this could be a welcome development at this time because the inflation rate is well below the FOMC’s long-term target level of 2 percent. More importantly, pulling up wages for lower income workers should boost consumption spending and reduce income inequality.

Arguments Favoring Increasing the Minimum Wage

Ron Unz, who is publisher of The American Conservative, is pouring a substantial amount of his personal wealth into a citizen initiative in California which would raise the minimum wage from $9.00 per hour to $10.00 in 2015 and further raise it to $12.00 in 2016. He cites many benefits.¹ For example, he argues that raising the minimum wage would help reduce government spending on social services. It would raise payroll tax revenues, which would improve the long-term solvency of Social Security, Medicare, and other government entitlement programs. It would increase sales tax receipts by enabling higher consumption – the propensity to consume is high for low wage earners and declines as income rises.

Raising the Minimum Wage Rate Is An Inefficient Way to Deal With Income Inequality

Some analysts argue that policy should focus on raising the earned income tax credit (EITC) rather than the minimum wage because the EITC is available only to low-income households and incentivizes employment; whereas, the minimum wage would apply across the board, including benefiting second wage earners in high-income households that do not qualify for the EITC, and, arguably, who are not necessarily victims of income inequality at the household level.One idea is to encourage firms to hire people at low wages, which might breach the minimum wage, and couple that with an expanded EITC for those individuals hired. This is an interesting idea but probably would be very hard to administer.Others argue that the taxpayer funded EITC distorts markets by enabling employers to benefit by paying low wages. An expanded EITC would also result in reduced tax revenues since the EITC works not just as a tax credit but also as a tax rebate for those owing no federal taxes.

Alternatives That Would Be Effective For Job Creation and Improving Income Equality

Ideally, the objective of employment policy should be to increase labor force participation and income equality. The risk of focusing only on income equality is that it will reduce labor force participation especially among those at the bottom end of the income distribution.

One idea is to combine a government-provided wage subsidy with a lower minimum wage requirement that would cover hiring of long-term unemployed workers.

Another idea would be to adopt the German program of job sharing in which rather than laying off workers, all workers in a business work fewer hours and the government makes up the difference in reduced wages. This is an alternative to unemployment insurance and, like unemployment insurance, would be paid for by employers over the business cycle by contributing to an insurance fund. Germany’s program has been highly effective in reducing unemployment volatility. It also weighs against the loss of skills and re-employment stigma that stems from long-term unemployment in the U.S.

Other ideas increasing participation and reducing unemployment faster include providing a cash bonus to people who find jobs and go off of unemployment, providing monthly rather than weekly unemployment benefits which would incent workers to accelerate job searches, and provide relocation subsidies.

While most of these proposals focus on increasing work force participation, a program to guarantee employment at a “decent wage” for anyone willing to work would address both the participation and income equality objectives. A job guarantee program could be run through the government or through non-profit institutions. Government already provides funds to many non-profit social service agencies that are frequently more efficient in delivering social services to the public than is possible through government. An increasing number of non-profit organizations are becoming social enterprises which are run with both a mission and a bottom-line focus.

A job guarantee program would be expensive, perhaps as much as one to two percent of GDP or about $175 to $350 billion annually and would increase federal government outlays by 5 to 10 percent. It would have to be paid for through higher taxes, but a good part of the cost would be covered naturally by higher tax revenues that would flow automatically from increased employment and income levels. A job guaranty program has been much discussed by liberals, but is not a favored approach among conservatives. Nonetheless, it seems an idea worthy of much more serious policy and economic analysis. People forget that the U.S. has engaged de facto in job guaranty programs in times of war. World War II, for example, resulted in full employment and enormous prosperity that was accompanied by rapid increases in the standard of living and a leveling of income inequality.

Concluding Comment

In summary, while as with most issues there is a plethora of views and opinions about raising the minimum wage rate. Although a higher minimum wage is likely to reduce income inequality to some extent, as explained in the November Longbrake Letter – Special Edition: Income Inequality, the forces driving increasing income inequality are deep and broad and solutions to reverse this trend will need to be equally deep and broad and extend well beyond simply raising the minimum wage.

1 Unz, Ron. “Raising American Wages by … Raising American Wages,” New American Foundation, October 2012. Also, see Medina, Jennifer. “Conservative Leads Effort to Raise Minimum Wage in California,” The New York Times, November 25, 2013.

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Data Science for Finance

February 6th, 2014 by under Faculty Commentary. No Comments.

Louiqa Raschidby Louiqa Raschid, Professor of Information Systems, Smith School of Business; Professor, Institute of Advanced Computer Studies; and Faculty Affiliate, Center for Financial Policy

The transforming potential of data science for finance, and financial BIGDATA and social data, will emerge over the next decade. The promise is the availability of large scale datasets that allow the modeling of complex ecosystems reflecting cyber-human decision making. While complex data-driven models have emerged for climate modeling or systems biology, there has been less activity in macro-modeling with multiple heterogeneous economic or financial datasets.

The financial world is a closely interlinked Web of financial entities and networks, supply chains and financial ecosystems, where multiple financial entities may be counterparties to a complex financial contract. Financial analysts, regulators and academic researchers recognize that they must address the unprecedented and unfamiliar challenges of monitoring, integrating, and analyzing data at scale. This may result in improved tools for regulators to monitor financial systems as well as fundamentally new designs of market mechanisms, new ways to reach consumers, new ways to exploit the wisdom of the crowds to review and rate financial products, to make recommendations, etc.

The 2008 financial crisis raised awareness of the dearth of computational tools and datasets for early warning, monitoring and recovery. The following years saw the emergence of data science as a research paradigm as well as the availability of BIGDATA and social data. Over the last five years, I have been leading an effort to develop the next generation of financial cyberinfrastructure (tools and datasets) and to develop a “data science for finance” agenda for research and education.

These efforts have been supported by National Science Foundation Workshops in 2010 and 2012 , the Computing Research Association and the Smith School of Business.

Over the next few months I will be posting nuggets on upcoming events,research challenges and activities, and I will be interviewing the thought leaders in this exciting “data science for finance” adventure.

Let me sign off by inviting you to submit a paper or an abstract/poster to the first workshop on Data Science for Macro-Modeling with Financial and Economic Datasets DSMM2014 in conjunction with the leading ACM SIGMOD conference on data management.

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Challenges for the Yellen Fed

January 29th, 2014 by under Faculty Commentary. No Comments.

Phillip Swagel

by Phillip Swagel, Professor in International Economic Policy, Maryland School of Public Policy and Academic Fellow, Center for Financial Policy

This post was originally published in The New York Times’ Economix Blog. To view the original post, click here.

The good news for Janet Yellen is that she will take the reins at the Federal Reserve on Saturday with inflationary pressures subdued and the United States economy finally in an upswing (occasional stock market gyrations notwithstanding). Too many Americans remain out of work or have given up looking for a job, but the worst of the financial crisis and recession are past – an accomplishment for which Ben S. Bernanke, the departing chairman, will receive deserved acclaim.

The difficult part for Ms. Yellen is that she faces a new set of challenges involving not just monetary policy but also broader questions regarding the role of the Fed in the nation’s economy and political system.

Most immediately, she will be charged with guiding a monetary tightening — first by completing the Fed’s tapering of purchases of Treasury bonds and mortgage-backed securities, and then by returning to a more usual level of interest rates after five years in which the overnight rate set by the Fed has been virtually zero. Ms. Yellen has associated herself with the view of Mr. Bernanke that the pace of monetary normalization depends on the data, but this still leaves the difficult question of knowing when the labor market is nearing a level of full employment at which inflation would become more of a concern.

If a strong enough economy can bring people off the sidelines and back into the labor force, then there is more slack in the labor market than implied by the recent decline in the unemployment rate. In this case, the Fed could maintain easy monetary conditions in an attempt to drive up wages and the participation rate. The benefits of the third round of quantitative easing, the so-called QE3, have shown up most prominently in driving up asset prices like stock values. While the move is intended to strengthen the broad economy, the immediate gains thus appear to have been skewed toward wealthier households. One could imagine that the new Fed chief, the first Democrat in the position in decades, might view monetary policy as a way to produce higher wages, and thereby direct more of the benefits of Fed actions to a broader group of Americans.

If inflation picks up, however, this would signal that the labor market has reached a new normal in which wage and inflation pressures arise with lower participation and higher unemployment than in the past — a sign that the crisis and recession have brought about a lasting change for the worse. In this case, the Fed would need to tighten sooner and more quickly than is now envisioned.

A misstep in either direction would be costly. An overly rapid monetary tightening might unnecessarily choke off some growth and job creation, while a mistake in the other direction would leave the Fed behind the curve as elevated inflation gets embedded into wage- and price-setting. This would then require a yet more painful monetary contraction to restore price stability and reset the Fed’s credibility. Worries over soaring inflation are distant now, but a strengthening economy and easy lending conditions could combine to change that.

The episode last June in which Mr. Bernanke’s hint of a taper led to a sharp increase in long-term interest rates illustrates that even communication missteps can have significant results. The resulting market whipsaw last summer, for example, led to a spike in mortgage rates until the Fed explained itself better in September.

The Fed has convinced markets that even as it gradually backs away from quantitative easing, interest rates will remain near zero into 2015 and the low-rate environment will continue for a considerable time after that. The communication challenge for Ms. Yellen is to assure market participants that the Fed will stick to this plan even when an improving economy would normally signal the time to tighten under historical relationships between the job market, inflation and monetary policy. And if new data lead the Fed to revise its plan, the yet steeper challenge will be to explain the change. At some point continued declines in the unemployment rate without a pickup in participation will lead Ms. Yellen to try her hand at some new forward guidance.

Regardless of whether this more rapid tightening becomes necessary, Ms. Yellen will face the new challenge of adapting her institution to a world in which Fed actions do not just affect other countries (as has always been the case), but the impacts in turn spill back over to have meaningful consequences for the United States. Last week’s market plunge threw into relief the challenge posed by higher United States interest rates for emerging-market countries that have depended on inflows of capital to sustain investment and consumer spending. With higher yields in the offing in the United States, global investors are looking warily at emerging market favorites such Brazil, Russia and India.

The concern is even greater in countries such as Turkey, where domestic political problems threaten to affect political stability and thus the economy. The Fed is well aware of what its decisions mean for other countries, but in the past it has given little weight to this in setting monetary policy since there was scant consequence for the United States. Increased cross-border feedbacks could change this calculus. To be sure, the Fed will not hesitate to adjust rates to counter domestic inflation, but it will think carefully if a rapid monetary tightening creates havoc overseas that seriously affects American markets.

Such market convulsions highlight a conundrum for the Yellen Fed. On the one hand, markets accustomed to easy credit could have problems once it is withdrawn. This possibility is built into the Fed’s calculations and is a reason for its cautious approach to tightening. In the other direction, however, is the concern that easy credit has led investors to take inappropriate risks, meaning that continued monetary ease could give rise to another bubble and the attendant consequences once it deflates. Thus the possibility of problems if credit is tight or too loose.

In an interview at the Brookings Institution on Jan. 16, Mr. Bernanke said that he recognized these concerns over distortions in asset markets, but concluded that the Fed could prevent another bubble with more careful supervision over the financial industry and through policies like requiring banks to fund themselves with more capital and have better access to liquidity. This sounds reassuring, but regulators did not prevent the last crisis despite considerable legal authority.

Moreover, while increased regulatory oversight and heightened capital requirements were surely appropriate in the wake of the crisis, there is a trade-off between measures such as these that can improve the stability of the financial system and the economic activity that financial firms support. The Fed going forward will face a delicate balancing act — not just between inflation and jobs, but also regarding financial market stability. Steps to improve stability, for example, could dampen economic activity, giving rise to calls for additional monetary easing that threaten to pump up yet new bubbles.

Finally, Ms. Yellen must respond to continued demands for greater transparency from the Fed regarding its policy interventions. Mr. Bernanke knew that lending money to investment banks or bailing out the counterparties of the American International Group would be unpopular, but he took these extraordinary steps because he recognized that a failure to act could be catastrophic and he was willing to take the political consequences for the good of the country. The Federal Reserve is independent precisely to allow such decisions, but this status could yet be tested.

While Fed skeptics are clustered to the right of the political spectrum, catcalls will come from the left if Ms. Yellen determines that tighter monetary policy is needed to head off inflation even while the unemployment rate remains high. A natural response will be for the new chief to speak clearly about the rationales behind her policy steps. There will always be critics, but Ms. Yellen can win the respect of fair-minded observers by explaining her view of the economy and connecting these observations to policy steps.

Alan Greenspan was tested by the October 1987 stock plunge just two months after becoming Fed chairman, and the housing bubble began to unwind within months after Mr. Bernanke took over in February 2006. Economic and financial conditions seem more favorable for the start of Ms. Yellen’s term, but she will nonetheless face considerable challenges both in setting monetary policy and in explaining her decisions to an anxious public and political system.

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Shortfall in Business Investment Spending and Low Productivity

January 23rd, 2014 by under Faculty Commentary. No Comments.

Longbrake3by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the January 2014 Longbrake Letter. To read the letter in its entirety, click here.

There is a general belief that large corporations are awash in cash which could at any time be quickly put to work financing new investment initiatives. However, the inflation-adjusted rate of change in capital spending has been declining steadily and is near zero. Cash is being deployed into nonproductive uses such as share buybacks, dividends, and mergers and acquisitions. These activities fall into the category of financial engineering. They can boost share prices, but they do not contribute to expansion of economic activity.

In a world of repressed interest rates, courtesy of FOMC quantitative easing, the risk-adjusted rate of return on capital is simply inadequate to prompt significant investment activity. This is a demand feature. But, it is reinforced on the supply side by tight underwriting standards that are a legacy of the Great Recession, tighter regulatory capital and liquidity requirements for banks, and closer prudential supervision.

In recent remarks to the American Economic Association, Federal Reserve Chairman, Ben Bernanke, noted that productivity recently has been disappointingly weak for reasons that are “not entirely clear.” He mentioned some possible reasons including the impact of the Great Recession on credit availability, slow growth in sales revenues, mis-measurement, or unspecified long-term trends. Notably, he did not mention the possibility that the FOMC’s own policy of depressing long-term interest rates may be contributing to the investment shortfall and miserable productivity gains.

As I have repeatedly pointed out, the potential rate of real GDP growth depends importantly on the level of productivity. And, higher productivity depends on robust investment spending. However, both private and public investment spending remains extremely weak. In the case of private investment spending the depressed risk-adjusted rate of return on capital incents firms to deploy cash in financial engineering, which returns capital to investors, rather than pursue new capital projects. The shortfall of public investment is simply the result of budget deficit anxiety and significant cutbacks in government spending.

It is interesting that economists do not agree on the repressive effects of quantitative easing on capital investment. In fact, it is argued by many, including FOMC participants, that lower interest rates, particularly on safe assets, should induce greater investment spending. The mystery to them, as Chairman Bernanke notes, is finding a reason why this has not happened. What we do know with certainty is that quantitative easing depresses the long-term discount rate on financial assets and in so doing boosts their nominal value. Stock market investors do very well and paper wealth is created. However, this increase in paper wealth is not translating into greater capital investment.

To be fair, part of the rationale for quantitative easing is intentionally to create financial wealth with the expectation that this will increase consumer spending. Then, as consumer spending increases, sales revenues will improve and firms will be less hesitant about investing cash and borrowing funds to finance capital investment projects. In this way, it is argued, quantitative easing helps accelerate economic recovery.

But, as is so often the case in economics, the supply and demand dynamics are complicated and what appear to be simple logical explanations of what should happen overlook or misunderstand the complexity of these dynamics. But with the passage of time we can assess outcomes and look back and better understand consequences of policy actions.

It may turn out that quantitative easing, which is intended to accelerate economic recovery, has contributed in a meaningful way to a sustained lower potential rate of real GDP growth by discouraging investment necessary to boost productivity. So, although FOMC officials may not understand why the long-run potential rate of growth is declining, as can be seen in the table below, they have acknowledged the reality by steadily reducing the median of the central tendency range of long-term real GDP projections from 2.7 percent in January, 2011 to 2.15 percent at the December, 2013 meeting. The current low value is consistent with my own analysis, but unless investment activity increases, even today’s lower expectation could prove to be too optimistic.

Median of FOMC’s Central Tendency Real GDP Growth Projections Compared to Actual Results – 2011 to 2016

Median of FOMC’s Central Tendency Real GDP Growth Projections Compared to Actual Results – 2011 to 2016

(*GS forecast    #Bill’s “Steady Growth” long-run potential = 2.16%; Bill’s “Strong Growth” long-run potential = 2.39% )

Note that Larry Summer’s discussion of secular stagnation (see the December Longbrake Letter) focuses on the long-term consequences of persistent negative real rates of interest. He comes at the issue of a depressed long-term rate of growth by arguing that when the zero bound is binding, monetary policy is unable to lower interest rates enough to achieve positive real rates, which are necessary to induce investment. This is essentially the same logic as summarized above. Summers’ solution is for the government to engage in massive infrastructure investment spending because there is no way that the private sector will engage in significant investment spending as long as the real rate of interest is negative.

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Economic Outlook for 2014 – U.S. Economic Fundamentals Should Improve More Rapidly in 2014, But Return to Full Potential Will Take Much Longer

December 17th, 2013 by under Faculty Commentary. No Comments.

Longbrake3by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the December 2013 Longbrake Letter. To read the letter in its entirety, click here.

It has been four and a half years since the official end of the Great Recession. Following all other recessions since the end of World War II, after four and a half years the economy was operating near or above potential. As we come to the end of 2013, even as there is growing optimism that the U.S. economy will improve more rapidly in 2014, there is still a long ways to go to achieve full potential. This policy objective will not be achieved in 2014 or 2015.

Although U.S. payroll employment rose 2.1 million over the first eleven months of 2013 and is growing at a 1.7 percent annual rate, payroll employment is 1.3 million below and household employment is 2.0 million below the pre-Great Recession peaks reached in January 2008. By comparison, payroll employment four and a half years after the severe 1980-82 double dip recessions was 11 percent above the pre-recession level.

Unemployment during 2013 has fallen from 7.85 percent to 7.02 percent and is closing in on the Congressional Budget Office’s (CBO) full-employment estimate of 5.5 percent. That is the good news. But the official unemployment rate understates the extent of labor market weakness.

For example, the ratio of those employed to those eligible to be employed (employment-to-population ratio) did not improve during 2013. That ratio was .586 at the beginning of the year and remained at .586 in November. What this means is that all the job creation during 2013 has been just sufficient to absorb the natural increase in those eligible for employment. This ratio was .629 at the beginning of the Great Recession. There would be 10.8 million more people employed today, if the employment-to-population ratio had not declined.

What has happened to these 10.8 million people? They fall into four categories: (1) those officially counted as unemployed by the Bureau of labor Statistics (BLS); (2) those who have dropped out of the labor force permanently as a natural result of demographic trends, such as the aging of the baby boom and delayed entry because of pursuit of higher education; (3) those who have exited permanently because their skills no longer meet employer needs (this is referred to as structural unemployment or hysteresis in economist parlance); and (4) discouraged workers, who have employable skills, but simply have given up trying to look for work. Table 1 shows the composition of reduced employment as of November 2013.

According to my statistical analysis, demographic trends are reducing the participation rate by 0.23 percent annually. This is similar to GS’s estimated annual rate of decline of 0.25 percent. This amounts to about 570,000 annually or 3.3 million over the last six years.

What all of this means is that the U.S. economy is simply smaller today than it would have been had the employment-to-population ratio not declined. The issue confronting policymakers is what the employment-to-population ratio would be, if jobs existed for those willing and qualified to work. The number of additional jobs required to return the economy to full employment ranges between 5.22 (4.44 million, if the full employment unemployment rate is 5.5 percent) and 7.44 million, depending upon whether any of the structurally unemployed people could ever expect to become reemployed. The number of jobs needed could be less than 5.22 (or 4.44) million, if some of the discouraged workers actually belong in the structural unemployment category.

Table 1
Composition of Reduced Household Employment in November 2013 Compared to January 2008 When Unemployment Rate Was 5.0%
(In millions)




Increase in Number Unemployed as Reported by BLS


Assumes a 5.0% unemp. rate; 1.98 for 5.5% unemp. rate
Decrease Due to Demographic Trends


Bill’s estimate
Increase in Structural Unemployment


Residual of other estimates
Number of Discouraged Workers


Bill’s estimate


9.99 assuming 5.5% unemp. rate

If the recent rate of growth in employment continues at 1.7 percent, it will take 2.9 years (5.5 percent unemployment rate) to 3.5 years (5.0 percent unemployment rate) to eliminate the employment gap (late-2016 to mid-2017).

Of course, if the pace of employment growth accelerates in 2014 and 2015, the employment gap would close more quickly. There are grounds for optimism that this could occur. Payroll employment has grown at a 1.6 to 1.7 percent rate in each of the last three years in the face of significant negative forces, including housing foreclosures, tax increases, over indebtedness, gyrations in oil prices, and political uncertainty. Most of these factors should be more benign in 2014. In particular, the large tax increases in 2013, which depressed consumer spending, will not be repeated. Stock prices and housing prices are rising. Repair of consumer balance sheets is well advanced. Increasing U.S. energy production and shifting Chinese economic policy carry the promise of stable oil and gas prices. And, perhaps, the unsettling brinksmanship that Congress has engaged in will abate. The recent budget deal is cause for optimism.

We may look back a year from now and see that a virtuous circle finally took hold in 2014. With no further increases in taxes and rising employment, consumer spending should grow faster in 2014. This is the necessary catalyst to inaugurate the virtuous circle. Increased consumer spending will bolster employment growth. Employment growth will lead to even more consumer spending. And, as the employment gap slowly closes, nominal wages should begin to edge up. None of this is likely to occur very quickly but all of these developments should be mutually reinforcing and contribute to steady improvement.

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