New knzn Stabilization Policy

knzn has a rebuttal to my comments on his post:

More about knzn fiscal policy, by knzn: Thanks to Mark Thoma for picking up my last post. I think I could fill my blog for a month with daily posts responding to Mark’s comment, the comments on my blog, and the comments on Mark's blog. For today, anyhow, I’m just going to address one issue. As Mark notes:

…there are two separate issues here, one is stabilization policy and for that part of fiscal policy I have no problem with requiring that the budget be balanced over the business cycle. The other is investments in, say, human and physical capital…

I’ll certainly agree there are (at least) two issues, and maybe in the future I will comment on how the two interact. For now, I want to address the first issue.

From a pure stabilization point of view, I don’t think that balancing the budget over the business cycle is a good idea, in part for reasons already discussed in my previous post, and in part because I’m not even sure I believe in the whole concept of a “business cycle” per se. Business, and the macroeconomy, unquestionably has its ups and downs, but so does, for example, the stock market. We don’t normally speak of a “stock market cycle” (although some people do). There are recessions, and there are depressions, and there are inflationary booms, and there are non-inflationary booms. Recessions are limited by definition, but depressions can persist for many years. Inflationary booms are self-limiting, but the jury is still out on non-inflationary booms. Even if recessions and inflationary booms were the only phenomena, they can’t necessarily be expected to alternate: you could have 3 recessions in a row, separated by incomplete recoveries, and followed by 2 inflationary booms in a row, separated by a “soft landing.” The word “cycle” suggests a symmetry which is not, in general, present.

On the purely semantic point, I can accept the use of the word “cycle” for want of a better term, but the argument to balance the budget over the business cycle seems to rest on a substantive presumption of symmetry. It presumes that the stimulus needed during times of economic weakness will be exactly compensated by the excess revenue available during times of economic strength.

You might argue this symmetry must apply in the very long run, because the government has to satisfy an intertemporal budget constraint. Even that point is debatable: in the very long run, the government’s budget constraint applies only if the interest rate is at least as high as the growth rate. Otherwise, if you look out far enough into the future, there will always eventually be enough revenue to pay off any debt the government might accumulate over any finite stretch of time. Some have argued that, empirically, the government typically has faced an interest rate that is less than the growth rate.

But that’s not really my point. I’m cognizant of Keynes’ famous warning about excessive concern with the long run. And a single “business cycle” isn’t much of a long run, anyhow. Conventional business cycle theory might argue for a certain symmetry based on the characteristics of the Phllips curve, under the assumptions that the curve is linear in the short run and vertical in the long run. Under those assumptions, deviations from the NAIRU in one direction are always compensated – let’s say in the medium run – by deviations in the other direction. For the sake of argument I’m willing to accept the vertical long-run Phillips curve, but the linear short-run curve seems to me to be more an econometric convenience than a credible assertion about reality. Back when people believed in static Phillips curves, they used to plot the curves. I’ve seen reproductions of such plots, I can’t remember ever seeing one that looked like a straight line.

Even if (counterfactually) the business cycle is symmetric, it isn’t well-defined, at least not until after the fact. The NBER can’t make the government retroactively balance the budget once it decides what the business cycle dates were. Even if our goal is to balance the budget over one “cycle,” there is no obvious policy that would result in such a balance. The closest we could come is perhaps to require the budget be balanced over, say, 5 calendar years, but that strikes me as a very bad policy: during the first 3 years, we won’t know in advance whether the next 2 are going to be stronger or weaker economically, so we won’t know whether to run a deficit or a surplus. Knowing Congress, I expect the tendency would be to declare the first 3 years a recession and run deficits, which would then require surpluses during the last 2 years and result in an actual recession.

So here’s my alternative proposal: pick a set of interest rates and make fiscal rules contingent on those interest rates. For example, when the 10-year Treasury yield rises above 4%, a deficit ceiling goes into effect; when it rises above 5%, pay-go rules go into effect; when it rises above 6%, a surtax and specific spending restraints go into effect; and so on. We can quibble about the details, and in any case they can be adjusted later if necessary. But this policy makes a lot more sense to me than some attempt to handicap a vague business cycle (or for that matter a vague “trend” in the debt-to-GDP ratio, which can also be hard to identify without benefit of hindsight).

Briefly, with asymmetries, the budget will need to be balanced on average over all cycles rather than cycle by cycle, but so long as as a central trend can be defined (and this can be debated), But I believe it is still possible and desirable to balance the portion of the budget devoted to stabilization policy. [Investment in the future is another matter.]

Gabriel takes a predictable "freshwater" stance - there are no business cycles - events like the Great Depression are just big swings in trend GDP.

Comments

[Gabriel M.]

>> "events like the Great Depression are just big swings in trend GDP"

Technically, I agree. They are swings in trend. I have a problem with the "just", though. -- That particular swing in trend was extremely important (and we have reasons to believe that it was caused by monetary mismanagement, for example). So, it's definitively a big deal.

That the G.D. could be seen as coming from extremely louse realizations of the stochastic term in the autonomous equation for productivity--in a baseline RBC model--doesn't tell us anything interesting. It basically says that a neoclassical, "general equilibrium"-ish economy could take that path (but, of course, it can take pretty much any path).

The point was that there's no *cyclicity* -- recurrence at intervals. So we can't average over that interval; and probably (co/auto)variance data isn't enough to give you a meaningful, "expected" interval because of huge variance.

This is how I've read Knzn's remark about no *cycles* and I still think this is what he meant.

[knzn]

I think Gabriel’s interpretation of my views is fairly accurate – a spin, but not a distortion. Obviously I’m more of a saltwater guy, but I object to the conventional, stylized version of the saltwater view.

[bakho]

The part of the debt that is money loaned to the general fund by pension surplusses. That is internal accounting.

However, borrowing money from the wealthy and paying them dividends out of taxes collected from others is a redistribution of money from less wealthy taxpayers to wealthy bond holders. Why not just tax the wealthy to get more revenue and dispense with the redistribution?

If the bond holders are foreign then bonds are a way to use foreign capital for domestic infrastructure.

Overall, I fail to see the advantage to selling bonds over collecting taxes if the economy can take it.

[Gabriel M.]

Financial instruments are used to move sums across time and states of nature ("the dark forces of time and ignorance" and so on). -- You can use them to get a smoother profile; and a smoother profile is a Good Thing (tm) I think.

Besides, higher deficits signal higher future taxes (including the inflation tax).

What I don't fully understand is how limited participation in the bonds market impacts efficiency, distribution and so on. Clearly, it does. So maybe it should be an issue when designing fiscal policy...

[paine]

a sublime discussion

what pip squeaks we all are

to think this junior high bull session
amounts to policy science

exhibit A:
"That the G.D. could be seen as coming from extremely louse realizations of the stochastic term in the autonomous equation for productivity--in a baseline RBC model--doesn't tell us anything interesting. It basically says that a neoclassical, "general equilibrium"-ish economy could take that path ..."

GLIB BUT FRUITLESS
AS IN

"... of course, it can take pretty much any path.."

[Bruce Wilder]

paine: "a sublime discussion"

heh, indeed

[Winslow R.]

GM wrote: "What I don't fully understand is how limited participation in the bonds market impacts efficiency, distribution and so on. Clearly, it does. So maybe it should be an issue when designing fiscal policy..."

Start with understanding that purchasing Tsy Secs is fairly open now that tsy direct is in operation.

http://www.treasurydirect.gov/indiv/products/prod_auctions_glance.htm

Next realize these auctions are oversubscribed.

Here is an example:
http://www.publicdebt.treas.gov/of/releases/2007/ofm0612071.pdf

Next realize how easy access to the fed funds required to purchase tsy secs can be accessed by only a select few.

http://en.wikipedia.org/wiki/Primary_dealers

Why have open public access at the Treasury yet only restricted private access at the Fed?

Everyone here understands the power of leverage. Everyone here can understand that with public citizen access at the Fed, leverge of tsy secs would be distributed across the entire citizenship.

This is just the tip of a 4000 year old iceberg. My hat's off to the citizens of the first country to melt this iceberg.

[Winslow R.]

Just to show Delong should not be your 'go to' guy when it comes to understanding banking.

Delong wrote:

Banks can't lend money unless someone has deposited money in the bank: loans plus reserves equals deposits--and those deposits are somebody's savings. Investment does need savings to finance it.
http://www.j-bradforddelong.net/movable_type/2003_archives/001773.html

Bernanke wrote:

"Recently, researchers have pursued a number of approaches in search of evidence of a distinct banking channel. For example, some researchers have focused on smaller banks, which may have fewer funding alternatives to deposits and whose customer base may consist disproportionately of bank-dependent borrowers (Kashyap and Stein, 2000). Of course, these days, even the smallest of banks has ready access to sources of funds other than retail deposits. Thus, even for the smallest banks, the source of any bank-lending channel remains the existence of a finance premium on marginal sources of (uninsured) nondeposit funding, rather than an absolute constraint on the quantity of available funding.

http://www.federalreserve.gov/boarddocs/speeches/2007/20070615/default.htm#fn3

[paine]

winslow
you are knocking out the wall of private capital here

we need no private capital really

in fact as u well show
the credit system can provide
all the funds investors need

the flow into "real " social productivity enhancing projects like R&D
or say into a more fully automated factory
requires zero private "savings "

this is trivial
if we're talking borrowed funds

but even the necessary
ratio of private equity is a variable

firm level
leverage optima changes dramatically
if the total economic system
has an overtly " shared bottom "

ie
fully interconnected
"ownership"
of
fully socialized funds

the risk to the equity crowd
depends on their individual
port folio diversity
and this on average
reflects
relative intertemporal demand stablity
ie
somethin' macro management can effect
... obviously

[paine]

see the series of early 90's papers
by
Arnott and Stiglitz

OH BY THE WAY in a pure work income economy

the rate and level
of
payroll taxes
and household credit
provide
the necessary demand control

in job-topia

no one saves a penny

why bother ???

[Outside the Box]

There are lots of good policies possible, the trick is to find one that politicians can carry out without distorting the policy too badly. The Fed has shown that it has the discipline to carry out its portion of the plan, but Congress has shown no ability to consistently carry out counter cyclical spending increases/decreases. History has shown that once Congress starts spending on a program, they rarely cut back again when the policy calls for it. A stabilization plan that requires Congress to cut spending at certain well defined times has little chance of being carried out consistently.

[2slugbaits]

Talking about GDP trends just sort of skates over 25 years of debate as to whether things like the Great Depression or the 1973 and 1979 oil shocks were transitory or stochastic shocks.

I think the intuitive notion of smoothing over the business cycle is really more like keeping government spending on track with potential GDP. If actual GDP falls below potential, then it's okay to run a defict. If actual GDP rises above potential GDP, then we should run a surplus.

I understand KNZN's point about the government being able to perpetually roll over debt as long as the growth rate exceeds the interest rate, but this raises more questions than it answers. For one thing, we really do not know what the interest rate will be 10 years from now. Yes, we have bond prices that represent today's best guess, but those guesses are conditional and bondholders have been known to guess wrong. So what happens if we think the long run interest rate will be 5% so we borrow up to the hilt. Then interest rates spike to 10% just when we planned on rolling over the debt. Sort of like the homeowner who gets an adjustable rate with a low initial rate and then whamo.

Finally, do we really want to take growth above the interest rate and bleed that off to fund current government consumption? If the government borrowed the money to invest in infrastructure or public goods with a long horizon (e.g., fighting global warming), then that would be fine. But do we really trust George Bush or Hillary Clinton to act responsibly?

[paine]

2slug
the secular trend
in the real rate of interest
is the key not nominal
one presumes if nominal rates rise they will rise in tandem
unless one has a trend change
in the real growth real interest rate ratio
embedded
in your forecasting model

but i agree ten year out trends
of productivity are hardly predictable

then again the secular mean deficit rate
can be trimmed when the slow down
in trend growth arrives ...right ??