Random Observations for Students of Economics
This graph from David Leonhardt's column is illuminating. Now I understand why those of us who are fiscally conservative and socially liberal have trouble finding political candidates to fully represent our views. There are too few of us!
Isn't it a bit odd to base your candidacy on the sunk cost fallacy?
I was recently chatting with someone who teaches introductory macroeconomics (not using my favorite textbook). He does not teach the students about money creation under fractional reserve banking, which he considers an unnecessary technicality, but he does teach them the following two statements about inflation.
I agree with both of these statements, and I consider them critical for students to understand. But consider: How does one explain the transition from the short run to the long run?
The only way I know to answer this question is that a lower interest rate on reserves increases bank lending and expands the money supply by increasing the money multiplier. But if students don’t know about how banks create money under fractional reserve banking, they are not equipped to understand this logic.
The bottom line: The traditional pedagogy about how banks influence the money supply remains important if students are to understand the economics of inflation.
Update: This post generated more than the usual amount of confusion and misdirection on Twitter. So let me explain my logic more slowly:
1. The collapse of Silicon Valley Bank seems closely related to the fact that we recently experienced the largest drawdown in bonds in history. That is, the bank made an imprudent bet on interest rates and was very, very unlucky.
2. Contrary to the claims of some talking heads, the relaxation of Dodd-Frank in 2018 appears not to be a big part of the story. The "severely adverse scenario" in the regulators' stress test did not include a major bond drawdown. Instead, it described a recession accompanied by falling interest rates. That is, the regulators would not likely have caught the imprudent bet the bank was making.
3. I am not particularly concerned about the moral hazard associated with insuring all bank deposits (though the expansion of deposit insurance should be done explicitly, rather than through the implicit and ad hoc process now occurring). It is not realistic to expect bank depositors to monitor the health of their banks. A sophisticated depositor with a large balance would instead spread his holdings in $250,000 chunks among many banks. Those left with large holdings in a single bank are, by revealed preference, unsophisticated.
4. People say we need better regulation. Of course, but that is easier said than done. Don't expect supervision to get much better, though we should try.
5. The simplest way to avoid these problems is to push banks toward higher levels of capital. Maybe that can be accomplished by making deposit insurance fees depend more strongly on the bank's capital/asset ratio. Or something along those lines.
A wise economist of the center left recently suggested to me that the Biden administration faces a trilemma: They would like to (1) increase spending on programs they consider important, (2) not raise taxes on those making less than $400,000 a year, and (3) put fiscal policy on a sustainable path. But the stark reality is that they can have only 2 out of the 3.
The President's just released budget chooses to forgo fiscal sustainability. As the Committee for a Responsible Federal Budget notes, even under the unlikely scenario that the President gets everything he wants through Congress and his economic projection turns out to be correct, "debt would hit a new record by 2027, rising from 98 percent of GDP at the end of 2023 to 106 percent by 2027 and 110 percent by 2033."
Cengage, the publisher of my Principles text, is sponsoring an online economics teaching conference on March 10. You can find information about the agenda and registration at this link.
My colleague Eric Maskin points me to this opportunity for graduate students.
Recently, I had the opportunity to speak with Boston University economist Larry Kotlikoff and some BU students and faculty. You can listen to the conversation here at his podcast. You can also subscribe to Larry's substack here.
I am not attending the ASSA meeting in person this year, but I will participate via zoom in a session on Efficient and Effective Course Preparation. It is today from 2:30 to 4:30 CST at the Hilton Riverside, Grand Salon A Sec 3 & 6. The panel is also being streamed live. Click here for more information.
My recent paper for Brookings is now published. You can access the final version by clicking here.
Last week, Eric Budish of the University of Chicago gave a great lecture on cryptocurrencies at Harvard. You can watch it by clicking here.
I thought I might explain my fear that the Fed is in the process of tightening too much. Let me begin, however, with two points of agreement with the monetary hawks.
First, I agree that monetary and fiscal policymakers are partly to blame for the recent inflation surge. In fact, I warned about overheating in a February 2021 column in the New York Times.
Second, I agree that some significant amount of monetary tightening is in order. That is especially true because fiscal policymakers are doing little to help contract aggregate demand. Instead, actions like student loan forgiveness are doing the opposite. The so-called Inflation Reduction Act is a feckless political smokescreen.
The question is, how much monetary tightening is in order? This question is hard, and anyone who claims to know the answer for sure is not being honest either with you or with themselves. The reason it is hard is that monetary policy works with a substantial lag. It is no surprise that the recent Fed tightening hasn't had much impact on inflation yet. That is no reason to think the Fed needs to tighten a lot more. The Fed made the mistake of waiting for inflation to appear before starting to tighten. It would be a similar mistake to wait for inflation to return to target before stopping the tightening cycle.
The Taylor rule suggests one way to calibrate the problem. This rule of thumb says that the real interest rate needs to rise by 0.5 percentage points for each percentage point increase in inflation. The yield on the 5-year TIPs, which incorporates recent and near-term expected changes in monetary policy, has risen by 330 basis points over the past year. According to the Taylor rule, that would be appropriate if inflation had risen by 6.6 percentage points. Has it?
The answer depends on what measure of inflation one looks at. If you look at the CPI, then yes, the inflation surge could justify such a large tightening. But some of that inflation surge was due to temporary supply-side events. (Team Transitory was wrong, but not entirely wrong.) Wage inflation has increased only about 3 percentage points. By this metric, which can be viewed as a gauge of ongoing inflation pressures, a smaller monetary tightening would be appropriate.
A related issue is whether the normal real interest rate, sometimes called r*, is higher than the Fed previously thought. It might be. But I am inclined to think that there are long-run structural changes that explain the decline in real interest rates, as I explained in a recent Brookings paper. Those forces are likely to keep r* low in the years to come.
Another data series that I keep an eye on--though it is out of fashion these days--is the money supply. M2 surged before the large increase in inflation. Economists who watch the money supply, like Jeremy Siegel, were among the first to call the inflation surge. Yet over the past year, M2 has grown a mere 3.1 percent.
Finally, another factor is that the monetary tightening is occurring worldwide. Standard monetary rules like the Taylor rule do not explicitly incorporate the international linkages. But perhaps they should. Some of upcoming contraction of the U.S. economy will be attributable to the policies of foreign central banks. It is hard to say how much.
So, if I were one of the Fed governors, I would recommend slowly easing their foot off the brake. That means when the next decision comes and they debate an increase of, say, 50 or 75 basis points, choose the smaller number.
At this point, a recession seems a near certainty due, in part, to the Fed's previous miscalculations that led monetary policy to be too easy for too long. There is nothing to be gained from making the recession deeper than necessary. The second mistake would compound, not cancel, the first one.
I am the Robert M. Beren Professor of Economics at Harvard University. I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.
