|0:33||Intro. [Recording date: September 24, 2012.] Russ: Debt. In a recent post on EconLog you referenced a rather remarkable paper written in 1933 by Irving Fisher. The title of that paper is "The Debt-Deflation Theory of Great Depressions." It was published in Econometrica, a very respected economics journal. In that paper, Fisher speculated that large contractions in the economy--Great Depressions, of which he was in the middle of one in 1933, when it was published, and certainly in the middle of one when he wrote the paper, a little before--he argued that those contractions in the economy were caused by the interaction of debt and deflation. Explain his argument. Guest: Well, Fisher took for granted the idea that in a normal economy, if the money supply falls, prices will fall; wages will fall. He knew that a lot of his fellow economists took this idea as the standard. The way that this was known was the classical theory of the macro-economy. Wages and prices will adjust to a fall in the money supply. So, to people who believe in that, great depressions were a huge puzzle. If the banking system collapses and it seems as though people can't get their hands on money, why don't wages and prices just fall, and to the point that all the products get sold and all the workers are cheap enough to hire? And Fisher thought he had an explanation for all this. He took the classical ideas at face value. He said: Okay, I'm going to agree with you on the classicals. Of which Fisher was an important one himself, right? I'm going to agree with you classicals that wages and prices are quite flexible and that they adjust when money supply falls. But look: there is one really important contract that doesn't automatically adjust when the money supply falls. And that's debt contracts. So, if you've signed a mortgage that says you owe $100,000 and you have to repay it over 30 years, your bank doesn't come to you and say: Oh, hey, we know things got worse, so now you only owe us $80,000. The same with big corporations who come out and borrow money. If they borrow $10 million and the price level falls in the whole economy, they still owe the same $10 million. And it's much harder to get their hands on that money. And Fisher followed that thought through to its natural consequences. And what he thought would happen is that homeowners, households, and businesses would all be in a scramble to get their hands on cash. And they would try to sell whatever assets they could. And they would create fire sales. There would be a lot of bad macroeconomic consequences from trying to raise the cash so quickly to be able to repay debts that were made back when price levels were higher. Russ: So, this is, if we go to the standard language of Keynesian and modern economics, what's often described as a stickiness. So he was disputing--or maybe not disputing--he wasn't discussing the possibility as many modern economists are that wages and prices are sticky. Meaning slow to adjust to changes in either the money supply situation, the overall price level, whatever it is, changes in supply and demand. All those in microeconomics, you say that: Prices adjust to "clear" the market so there aren't large gluts or large shortages. And so to try to get a handle on what Fisher was arguing: He was arguing that those things, those prices and wages still move around, right? Guest: So, he was willing to concede the point that wages and prices were pretty flexible. And he said: Even if I believe you classicals on that issue, there's an incredibly important contract, an incredibly important price that is still rigid. And it's rigid by law. It's rigid by contract. And these are these debts. That all of us have contracted. Some of us owe money. Some of us are owed. And as Fisher and others since then have put it, the way that one can solve, the way one can fix and economy when there is a debt deflation, is through universal bankruptcy. We all admit we can't repay this: Let's all go to the bankruptcy court and admit that, maybe it's not really our fault because we didn't expect the price level to fall. But let's all contract new debts. Let's all take a zero off of the debts we owe, for instance; and let's go back to trying to repay things with new, lower debt levels. Russ: Well, there's a big difference between--when you say universal bankruptcy, you mean repudiation of existing debt or the writing down of debt? Guest: Well, it could be either way. I mean, I tend to think of it as writing down of debt. That's often what happens in real world bankruptcies. So, corporate bankruptcies, individual bankruptcies often involve a writing down of debt or a rescheduling of a lot of old debts. Russ: So, if I owe you--let's walk through an example of this; and then I want to turn to a little more detail about why this is so problematic. So, let's take one of your examples. Let's say I borrow $100,000 to buy a house. I owe the bank $100,000. And I borrow that money based on my income level today. The bank understands there's a risk I may lose my job. Guest: Sure. Russ: But if that doesn't happen--they will only lend me the money if I'm able to carry the debt and the principal and the interest to repay it. Now all of a sudden, let's say, there's fierce deflation. Fierce. So, all wages and prices fall by 50%. So, my salary, which used to be whatever it was, is now half of what it was. And that $100,000 debt, to meet the payments on it, the monthly payments, is now very, very difficult. Guest: A person would ordinarily have to earn twice as much to pull that off in real terms. So your debt just grew twice as much in real terms. Russ: In real terms. And my ability to repay it, the cash I have on hand from my income, is not going to be adequate. I am suddenly--we're not talking about issues like being underwater, which is a whole separate matter, not unrelated. But right now, I'm physically challenged to pay off my debt. So, either I have to get a second job. I either have to sell some things to finance--sell my car, which let's say I own outright, so I can cover. I don't want to go bankrupt. Now, you are suggesting that one way to solve--first of all, why is that a problem? Explain why. So, I'm in trouble. I'm going to lose my house as a result, probably, in that story. Why is that so bad? I mean it's bad; it's sad. But what's the problem? Guest: In the simplest world, if this person just decided they were going to keep their promises no matter what, then it's a huge windfall for the bank and the owners of the bank, who have a lot more buying power. And a huge loss for the person who borrowed the money. So, it would just be a transfer, if everybody kept their promises here. Russ: Right. Guest: But economists, we try not to moralize too much about transfers. Although-- Russ: But we can't help ourselves sometimes. Guest: But what Fisher pointed out is that what will happen when people try to keep their old promises, is there will be a lot of changes in the economy. Nowadays, we think of these as at the very least supply-side changes. Right? So, the neighborhoods where bankers live will have a lot more buying power. The neighborhoods where bank borrowers live will have a lot less buying power. So, we would expect shops to move from one side of town to the other side of town. That's a supply side change. Russ: Can't happen overnight, though. Guest: Can't happen overnight. Russ: Transition might be challenging. And if it's not across town, it might be across regions.
|8:32||Guest: So, that by itself is a real supply side shock that has to happen. It's just a transition. It might take awhile. But Fisher was more concerned about the fire sales that would happen. And he was concerned about this partly more again for supply-side reasons. He thought that if people were selling their assets, corporations selling off portions of their companies, subdivisions, on the open market in what we call a fire sale, selling as many assets as possible at the lowest price, he was afraid that these assets would wind up in the wrong hands. Not in any moral sense, but just in less productive hands. When you are in a rush to sell, a product is probably going to wind up in the hands of the person who probably can't do the best job with it. Russ: But it's also true that the price of those assets is going to be lower than it might have been a few periods before. Is that problematic? That's usually what people worry about in a fire sale situation. That there's going to be this cascade. That as everyone tried to sell the asset, we're going to get very little for it, and it's not necessarily going to fix the problem, even. Guest: You're right. That's an issue that Fisher was concerned with as well. Because everyone is trying to do it at the same time. That means that it's much harder to solve the problem. And we found some evidence for that in the most recent financial crisis. There were some kinds of insurance companies that were in a big rush to sell their mortgage-backed securities because of the counter-requirements, and there were others that weren't. There was a recent NBER paper that looked at this. And the insurance companies that were in a huge hurry to sell their mortgage-backed securities, for accounting reasons, sold them at much lower prices. Even when you looked at the underlying quality of the asset. So, the fire sale was for real, and these companies didn't raise as much as if they'd been able to have, you know, a couple of weeks, a couple of months to sell these securities. Russ: But as you point out, the other issue, of course, is that not everybody is going to be able to or want to honor their promises. And now we come into this issue of being under water. Defaulting on debt, "voluntarily." After a bad change of circumstances. I say "voluntarily"--I mean choosing not to honor your promises, because it's extremely difficult or very costly or it's in your own self-interest, so you have to weigh any moral issues versus the self-interest issues. So, the issue here would be: I owe $100,000 to the bank. Even if I sell everything I have and take a second job, I'm in trouble. The bank's not going to get the flow of interest it anticipated. So, isn't there an additional issue that the bank itself has made promises to folks that it's not going to be able to keep? Guest: Yes. We're all tied together. Interconnectedness is a real part of modern capitalism. On the financial side and on the real side. So, one bank gets into trouble, and then the people that they owe money to find it tougher. The bank itself might have a tougher time making loans to people. This is something that's been tested a fair amount over the last few financial crises around the world. And when multinational banks have problems in their home country, they start having problems and they are less excited about lending in their branches that are overseas.
|11:41||Russ: So, isn't the solution for this--you talked about universal bankruptcy. And we are talking about the stickiness of these promises that are made in nominal terms. So, one can imagine two ways to fix this. One would be to have contracts written with adjustments written for price indices--inflation, deflation, etc.--so the amount I would have to pay back would adjust with inflation, deflation. But the second is a little more straightforward, and that's called: You write the debt down. What we started talking about a minute ago. So, I can't pay $100,000. I go to the bank and say: Look, when you made the loan to me, I had a salary of such and such. I can't earn that any more because of deflation. I also might be unemployed. But let's just say I have a job still; my salary has just gone down. And that presumes that wages are flexible. And I go to the bank and I say: I need you to take less, and you should be happy with that; because you are going to get in real terms what I promised I'd pay you before. Guest: Now, over the last few years of the financial crisis, a fair number of banks have done this. These are known as short sales. Where the bank just looks around at the real world and says: Yeah, it looks like you paying us whatever you can on the house, you selling the house and giving us 15% less than what you originally owed, we'll take that; and this won't be a big hit to your credit rating. It took banks a little while to come around to that point of view. But these things known as short sales are much more common than I think a lot of us would have expected a few years ago. So, banks are, in a sense, allowing a voluntary bankruptcy. They are allowing voluntary write-downs of a lot of debt over the last couple of years. Russ: Of course, that's very time-consuming. You have a lot of them all at once. When one person has bad luck, a bad set of circumstances--obviously everybody you've lent money to wants to do that. You've got a major issue of negotiation, transactions costs, etc. Although they could just write them off. You could just say: Everybody gets a 10%, or 20%, or 40%, cut. Guest: Yes, and presumably I'm no expert on this, but I'm guessing that banks would have neighborhood-by-neighborhood rules of thumb that they use. This neighborhood, we know it's happened and we'll easily take a 10% write-down; this neighborhood over here, not so much. Russ: So then the puzzle is: Why--? It's an interesting observation. I mean, it's fact. Unexpected deflation. I emphasize unexpected. Unexpected deflation is tough on people who made contracts in nominal terms. The lender might not get the money back. If the lender does, it's a windfall. The borrower might not be able to repay. If the borrower keeps the promise that was made, it's a loss, a transfer, as you said earlier. Why does that cause a depression? What's Fisher's argument for why this chain of events, this fire sale--so what? It's just part of the noise and chaos of an economy that things change and shift. Sometimes your wages go up; sometimes they go down; sometimes your debt gets more expensive, sometimes cheaper. Why does it cause a great depression? Guest: His story was that the mass bankruptcy would have a lot of supply side disruptions that could last for quite a long time. And in that kind of a world, people are reluctant to trust each other. This is something I would say is much clearer in later research--Ben Bernanke's work on net worth and business fluctuations is I think probably the best follow-on to Irving Fisher's idea, which is that when people are underwater in their homes, when companies are essentially underwater on their own balance sheets, when their debts are high relative to the present value of their future cash flows, these companies can't go out there and borrow readily. They can't put skin in the game when they have a promising project. Entrepreneurial people over the last few years find it much harder and much more expensive to get a home equity line of credit for their homes. And entrepreneurs start new businesses with home equity lines of credit. Those of us who want to start businesses, who have promising ideas for new businesses--if you've got home equity you can be borrowing at 4% or 5% right now to start that new business. A person who doesn't have home equity is going to be borrowing on their credit cards--18, 20, 25%. And so that adds a real barrier to starting off new businesses. Russ: So, the argument there is that we get over-extended--for reasons we'll get to in a minute, because Fisher has a speculation as to how we get into this over-indebtedness. It's not just that there's debt in the economy. He argues we get over-indebted, and that then limits our ability to climb out of the whole. If I understand what you are saying. Is that a good summary? Guest: Yes. That when people are underwater in their homes and when companies are essentially underwater in their own firms, it makes it a lot harder to climb out. This is often called the debt-overhang hypothesis. So, Japan, some people think has been suffering from debt overhang for well over decade, going on two decades now. Russ: And so, underwater, just to clarify: underwater means? Guest: It's when you owe more than your asset is worth. So, if I have a $100,000 mortgage and Zillow tells me my home is worth $75,000, I'm under water in my home. No bank will give me a home equity line of credit because I have no home equity. Russ: You have negative equity. And so to keep making that payment is not so attractive. You might do it again out of obligation or worries about your future ability to get credit, but it's a very bad deal. Guest: It's a very bad deal from the bank's point of view. Russ: No, from the borrower's point of view, right? You are repaying an amount that isn't very attractive relative to the asset's value. You are buying something at a price that's higher than it's worth. Guest: Yes. This is something that a lot of families in Arizona and places like Florida are worried about over the last couple of years. Why am I paying a mortgage on a home that I'm never going to own? Russ: Or that if I own, I'll have overpaid for it. Guest: Why not just hit the reset button and move to a new neighborhood. Russ: And the answer would be: It's bad for your credit; you might not feel good about it, morally. Etc. Now, let's put this a little bit--we're going to come back and talk more about Fisher's theory, but I want to put it in historical context. So, he's writing this in 1933. What I find striking about it is that I often hear that John Maynard Keynes was the first economist to address the business cycle. Now, we've talked on this program before that he wasn't. Economists kind of were aware that economies went through slumps. Mises obviously had written a book on it in 1920. There were others. But here's Irving Fisher and this article was an attempt to summarize a book he had written called-- Guest: Booms and Depressions. Russ: And one of the things I find charming about the article--I've seen a link to it; I hope it's property-right legal, but if not you can Google it and find it, I suspect; and it's certainly on Jstor. What's charming about it--there are many things that are charming about the article--one of the things that's charming about it is that he worries that he may have missed some past literature on this topic that he just wasn't aware of. So, he doesn't claim it's novel or unique; but he says: When I wrote the book, I must have been anticipated by other people. And he's assured by other scholars and looking that he can't find anything. Guest: He has a humility about his writing. Which of course is well-suited to him, especially because he's so well known in economic circles for being the person who, in 1929 said that the stock market had reached a permanently high plateau. Russ: Yes. Guest: And he wasn't just talking cheap like a lot of us economists do, speculating on things that we have no financial interest in. He actually had his entire net worth tied up in the stock market. He, as some people know, invented the precursor of the Rolodex; became a very wealthy man from that. And invested this all in the stock market; and lost it all, and became not quite penniless; but Yale University allowed him to live in a home and never charged him rent for it, for the rest of his life. Russ: Do you know when he died? Roughly? Guest: I actually do not know. I recommend looking up the Wikipedia article on him, if only because his photograph is so stately. So, would that all economists today, would that I myself, could pull off that kind of appearance in public.
|20:25||Russ: So, I want to turn to the cure for this debt and deflation crisis, which again is rather striking in historical context. I'm going to read a paragraph or so from the paper, where he makes the following claim; and then I'd like you to react to it. Here's the quote. He's going to talk about reflation, meaning what we would call inflation, or returning the price level back to its original, pre-deflation level. He says: |
If reflation can now so easily and quickly reverse the deadly
down-swing of deflation after nearly four years, when it was gathering
increased momentum, it would have been still easier, and at any time,
to have stopped it earlier. In fact, under President Hoover, recovery
was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September
1932. The efforts were not kept up and recovery was stopped by various
circumstances, including the political "campaign of fear." So, that's a rather remarkable passage in light, I would say, of Friedman and Schwartz's Monetary History of the United States, which makes a very similar claim in I think 1961; and our modern era. So, react to that. Guest: Sure. His statement about the "campaign of fear" is interesting because it's reasonably contemporaneous. He seems to be implying that something about the Presidential campaign, presumably the Democratic campaign for the Presidency, created an environment of fear, an environment that made people afraid of investing, made banks afraid to lend money, and so held back the money supply. He doesn't elaborate, but that seems like the proper reading. I would like to note that I believe--I don't have a copy in front of me but I believe one will find that Friedman and Schwartz actually refer to this piece in Econometrica in one of the footnotes. So, they knew that Fisher knew about this. So, the idea that Benjamin Strong had the right idea and that the death of Benjamin Strong, who was head of the Federal Reserve Bank of New York, was a key reason why the Great Depression occurred. Strong was a big fan of what we would now call "leaning against the wind." Russ: Explain. Guest: Leaning against the wind is the idea that--another way this is explained is it's the Federal Reserve's job to take away the punch bowl just as the party is getting fun. But on the flip side it means that when the economy is in a downturn, the Federal Reserve's job-- Russ: Break out the punch. Guest: Break out the punch. But with the specific target here of the price level. Not of let's maximize employment, let's try to control GDP; but at least keep the price level from plummeting 10, 20, 30%. Russ: So, many contemporary observers, Scott Sumner being one who has been a guest on this program, have argued that the Federal Reserve's biggest mistake in this current crisis was a failure to expand the money supply; that monetary policy was too tight in 2007 and 2008, and that precipitated the crisis. What's the evidence for that, if any, in light of the Fisher theory? Would Fisher blame Bernanke for letting the price level--it didn't fall very much. It's not like it plummeted, like it did in the Great Depression times. There was some debate over whether we had some deflation, whether we just had 0 inflation. Does Fisher's perspective tell us anything about what's happened in this crisis? Guest: I suspect that Fisher is in the same camp as Friedman and Schwartz here. And Friedman and Schwartz in their discussion of the Great Depression, they took it for granted that when spending by itself, when the velocity of money fell, that would be fairly hard for a central bank to counteract quickly. So, sometimes the private sector just gets worried and wants to hold onto their money for a while. And that's a decline in the velocity of money. Russ: It doesn't turn over as many times per time period. Guest: And so over time a central bank can decide whether to react to that, but it's something that people in the monetarist tradition generally thought that that was a little bit on the dangerous side. The government might not be smart enough or wise enough to know when to counteract a decline in the velocity of money. And a decline in the velocity of money is emphatically what we saw in the Fall of 2008. So, when we say: Why did total spending fall? Why did what we call nominal GDP fall? It was mostly because of a decline in the velocity of money. And Milton Friedman over the course of his career wondered whether a better monetary policy could counteract a decline to velocity. He sort of hinted at it in his famous Presidential Address. But at that time he thought it was beyond the scope of good monetary policy to react to that. Sumner is in the camp of thinking that it is within the power of good central bankers to react to changes to nominal spending. I think that changes in macroeconomics made it a little easier to talk about that then back in Friedman's day. And Friedman himself had some sympathies toward targeting total spending later in life. Russ: But what about this argument that Fisher is making. Fisher is saying that great depressions--he is suggesting that large contractions of the economy--1873, 1907, 1920, 1929, you could argue 1981, what we are in now--these larger, unusually large contractions, that they are due to a boom that ends up having lots of debt. And he ends up in the paper we are talking about that the debt comes about because all of a sudden people have this chance to make money, and they figure what I have isn't enough and I'll borrow some. And people say: Well, it's okay to lend it because things are going so well. So the boom sows the seeds for the bust. When the bust comes, because people have all this debt, there's this large, co-occurring contraction in the money supply, a change in nominal values; and that debt then punishes the economy much more than it would if the debt weren't there. And the Fed can counteract that by expanding the money supply. Could the Fed have done that in 2007, 2008 and avoided unemployment over 10%? I'm asking Garett Jones; I'm also asking you to put on your Irving Fisher hat. It would be a wizard's hat, I think not a basketball team's hat. I'm talking about the kind of pointed, stars and crescent moons on it, maybe. Guest: Always happy to wear a wizard hat for Russ Roberts. Um, well I think Fisher would have seen this as a chance to follow an aggressive monetary policy. I think Fisher, when he saw a big asset bubble bursting, the first thing he would think is: Wow, a whole lot of people are going to be going to try to get their hands on a lot of money really quickly. We would now call that a decline in the velocity of money. Yeah, he'd be pretty sympathetic to the idea of boosting the money supply, although in good monetarist tradition, he would be aware of the long and variable lags that occur when the Fed does something. There's a lag between when the Federal Reserve increases the money supply in New York and it percolates out to the rest of the economy. So, because monetarists were traditionally worried about that, they might take baby steps toward reversing big declines. So, something a little more tepid than what some of the market monetarists of today would be in favor of.
It would have been still easier to have prevented the depression almost
altogether. In fact, in my opinion, this would have been done
had Governor Strong of the Federal Reserve Bank of New York lived,
or had his policies been embraced by other banks and the Federal Reserve
Board and pursued consistently after his death. In that case,
there would have been nothing worse than the first crash. We would
have had the debt disease, but not the dollar disease--the bad cold
but not the pneumonia.
If the debt-deflation theory of great depressions is essentially correct, the question of controlling the price level assumes a new importance; and those in the drivers' seats--the Federal Reserve Board and the Secretary of the Treasury, or, let us hope, a special stabilization commission--will in future be held to a new accountability.
|29:07||Russ: But the Fed responded quite aggressively, you could argue. And nothing happened. As far as I can tell. People could argue that there was a counterfactual; it would have been much worse. Others will argue that no, no, no, they didn't do enough. Monetary policy on the surface looks pretty impotent. The money is sitting in the banks. It's on their balance sheets. They have excess reserves. I blame that partly on the Fed's paying interest on the reserves, which mystifies me. I don't understand that, because it seems to counter what they are trying to accomplish. But is Fisher right? Is Friedman right? Can we really reflate the economy like they claimed? We have had an incredibly aggressive monetary policy and not much reflation. Guest: That's true. We have had an extremely aggressive monetary policy. I'm certainly in the camp of those who think that if we hadn't taken some dramatic steps to keep lending flowing, we would have had something much worse happen. So, it's not hard to get me to imagine really bad things happening after a financial crisis. We have the story of the Asian financial crisis, which occurred while I was earning my Ph.D. So, for me that was and informative experience, watching what happened in East Asia. And we managed to avoid that kind of complete collapse. And I think part of it--not the only reason--was that we had a central bank that responded really aggressively and made it clear to people that even if the stock market was tanking, they were not going to allow the money supply to collapse. I do think they made mistakes. I think interest on reserves was a calculated risk, and one that I think in retrospect we'll look back on as a mistake. It does seem a little bit wrong to legally require banks to hold assets that don't pay any interest. Right? Why can't they earn the interest that they would have received on these otherwise, had they been making normal, private-sector investments. So, just as a question of fairness, there's an argument for paying interest on reserves. Russ: I think it's a really bad argument because I don't know what amount you would possibly decide was fair. Since the Fed is simultaneously manipulating the rate and promising to pay some amount. One thing that's striking about it--when Fisher wrote these words, the Federal Reserve was 20 years old. Not very old. And he's suggesting this golden era of discretionary monetary policy. And I find it fascinating that people like Friedman, who were basically--not basically--strongly in favor of limited government, found themselves in a position where they were arguing in favor of--and this continues to today--government manipulating the money supply to try to keep the economy on track. Obviously Friedman understood the dangers of the discretionary part of that; flirted with various monetary rules. John Taylor, who is a modern, I would say disciple of Friedman-- Guest: I would, too-- Russ: invokes the Taylor Rule as a way to avoid the discretionary risk. But Fisher here, it feels like he's discovered this magic potion--going back to our wizard idea--of reflation, so that we'll never have another downturn again. And some would argue that we didn't for a long, long time. We had at least 50 years of good times, 40 years of good times, after this, before there was a serious recession in 1981, which of course was partly a result of bad monetary policy in the 1970s. Then we had the Great Moderation, supposedly the result of wise monetary policy. What do you think? I'm not sure what the question is. I'm just talking. Guest: Sure, sure. Well, let me point to--we don't have to say that Fisher was looking back on 20 or so years of good Federal Reserve policy. He could look back at the classical gold standard, which was a time of enormous long-run price stability combined with, I want to emphasize, really high, really volatile short-run prices. So, short run inflation was incredibly volatile during the classical gold standard for the United States. Boom times in the United States were times of rising prices and wages. Recessions were times of collapsing prices and wages. They had a kind of flexibility that we don't see at all today. But notice what that means is that under the classical gold standard, if there was a 5 or 7 or 8% decline in overall prices and wages, everyone knew that prices were going to go back up, because the gold standard pinned down the long run price level. And that meant that if somebody looks around and says: Wow, it looks like I can't afford my mortgage today because my wages are low; well, in a year or two you are probably going to be able to. Because we know what happens under the classic gold standard: wages and prices go back up. So, any kind of deviation would just be a temporary issue. So, those who look to the gold standard as a model because they think it will dampen inflation volatility are quite wrong. That's not one of the strengths of the gold standard. The gold standard pins down long run prices. It does not pin down short run prices. Russ: But you get this other benefit that you are saying-- Guest: That when prices fall, you know they are going to go back up. So, you don't have debt deflation. Russ: Yeah. Guest: So, Fisher looked at that. And he has charts in the paper showing the long run price stability under the gold standard era. And that must have been one of the things he saw as something the Fed should be trying to replicate: how to get the good benefits of the gold standard era while avoiding something like the Panic of 1907, which was the Federal Reserve's creation. Russ: At least, that's the official story. Guest: That's the official story. Russ: I'm not so sure that's true. I think it was equally possibly a political maneuvering by small banks versus large banks, and or large banks versus small banks. I'm sympathetic to a public choice explanation. Guest: I'm always sympathetic to a public choice explanation. Russ: Because there have been a lot of other crises; why this one precipitated this big change, I don't know. It's hard to know.
|35:30||Russ: Now you've also written--this is related, and you can tell me how it's related--that private debt and public debt are not so distinct. Does that have any significance for our conversation? It's an interesting observation. You can talk about what you mean by that. What's its relevance for this recovery or the mess? Guest: Part of what we found out during this financial crisis is that a lot of debts that were private sector on paper were public sector de facto. Right? So, economists knew this was true for, say, Fannie and Freddie debt. The debts they issued were officially not guaranteed by the government. But economists all suspected, most of us at least, that the government would back that up. And sure enough, that's what happened. Russ: So did markets. If you look at Treasuries, the premium that they had to pay over Treasuries was quite small. Guest: Just a few basis points. Russ: Suggesting that investors presumed they would be backed by the government. Guest: And they were right. Market prices gave the right message there. But also what we found out in this crisis was something fewer people expected, which was that debts of all the biggest banks--all of the biggest banks--were backed by the government. So, every time in the mid-2000s, when Citibank was going out into financial markets and ostensibly borrowing, you know, $10 million here, $100 million there, every time any of the big top-ten banks, certainly the top-ten banks in the country, were borrowing private money, what they were really doing was borrowing money that was insured by the government. We just didn't know it yet. And so, this is one reason for us to be a little bit cautious about encouraging high levels of indebtedness. High levels of private sector indebtedness. Russ: An argument: Well, it's private, and people think they are taking their chances. But it's not their chances. It's my chances. Guest: It's the government's chances; and it's the taxpayer's chances. For big players, and for homeowners, the line between public and private debt is quite blurry. Russ: Why is that important? Other than the moral hazard. Is that the importance of it? Guest: I think the moral hazard is important because it means we've invested in the wrong things. Russ: We are less careful. Guest: We are a lot less careful. And after a crisis hits, it just changes the kind of government we have. We now have a government whose job it is to repay this enormous amount of debts. Of explicit and implicit liabilities. That is now what our government is for. So the federal government in the United States has these explicit liabilities to repay Treasury bondholders. We have implicit liabilities to repay, or fairly explicit liabilities to repay Social Security, Medicare, Federal employees' retirement benefits, veterans' health care benefits. And now the debts of the biggest banks. Russ: The strangest part of that, of course, is that in our earlier conversation we talked about the potential for write-downs or forgiveness or bankruptcy. When the government is holding the debt it's a little weird, right? Their willingness to negotiate is no longer just a matter of rationality or prudence. It becomes a political issue. And we see this with General Motors (GM) right now. Supposedly GM wants the government to sell its shares of GM so it can be fully private. And the government is not interested in doing that, because they've realized a $15 billion dollar loss, which would be politically embarrassing to the Obama Administration, I assume. Guest: Let's wait until mid-November before we do that. Russ: Yeah.
|39:10||Russ: Now, when you posted on this Fisher article, you said you found it much more convincing than Keynes's General Theory, which was published three years later. What's the evidence for that claim? Is it just a matter of your tastes? Why do you say that? Guest: I don't think it's just--it may partly be a matter of my tastes. I'll concede that. But what Fisher does, is, even though it's a short paper, it is a complete equilibrium story. He tells you a story of a whole economy. The reason he can do it in just a few pages is because he basically imports the whole classical structure. He says: Okay, you know, labor supply, labor demand, prices adjust; okay, I'm importing all of that, and I'm just adding this one thing. So, mentally a reader who is kind of familiar with classical macro, wage and price flexibility--it's easy for us to see this as a complete model of the economy. Keynes instead starts off his book saying: I'm doing something completely different; I'm throwing out everything from the old days. And once he's done that, we have to start anew. Mentally it's very hard. I think a lot of us read the first few chapters, where Keynes claims he is laying out his complete model of the economy, his complete general theory, and I came away with the experience thinking he didn't actually build a model here. He talked about a couple of channels. But he didn't close it out. So, Fisher feels like an economics model. So, in a sense we can say that John Hicks and maybe to some extent Paul Samuelson and later folks tried to close Keynes's story and make it feel more like a normal model, make it feel more like economics, where we can tell: Who are the people making choices? What are their incentives? How are they interacting with each other? So, there's a lot fewer can-openers, I think, sitting in Fisher's story. Russ: What role do bubbles play in Fisher's story? If at all? Guest: He certainly thinks there is some kind of bubble going on during the boom. Right? And the bubble leads to the debt. And to him the debt is the problem. So, some other macro theorists look at the boom and see supply side imbalances occurring. We're building the wrong machines during the boom. Russ: That would be the Austrians. Guest: Yes, I think most associated with Austrians. During the boom, people build a lot of capital projects, take on a lot of projects that turn out to not work in the bust. So, that's a supply side channel. Fisher and I would guess we could say Hyman Minsky as a later person in that same vein, both thought that what happens during the boom that is the biggest problem is that we write the wrong contracts. People signed--voluntarily--the wrong contracts, during the boom. And that's what has to be unwound during the bust. Russ: And it won't be sustained. It can't be sustained once the deflation comes. Guest: Once the deflation comes, those contracts start looking like a lot of macroeconomic trouble. It creates a windfall for a few, but it creates real supply-side disruptions for the many. Russ: To close out this discussion about Fisher's model and Keynes's alternative view: Keynes generated a lot of interest in this idea that the labor market doesn't clear. Not because of what we were talking about earlier, which was transactions costs, reallocation costs, things can't happy quickly. But because prices of labor don't adjust; that wages are "sticky." Or inflexible. Now, obviously some wages are literally inflexible in the same way debt could be inflexible. I could have a long-term contract for my wage rate. But it's a bit of a puzzle, why, or whether even, wages adjust downward. You are suggesting that in the classical gold standard period, wages were flexible downward, and that unemployment problems were very short-term. And disappeared fairly quickly. Is that accurate to capture what you are saying? Guest: Um, well, I'll say that I don't know the data from the classical gold standard on employment rates as well as a lot of people. But recessions, rapid recoveries, were quite common during the gold standard period, right? So, that was a benefit of that time. And the fact that there was such flexibility back then would suggest to us: Maybe there could be that kind of flexibility again. Maybe the rigidities we see are partly built around the fact, based around the fact, that we've created a lot of macroeconomic stability, so people can--again, one can argue that the welfare state, that social insurance programs help make people more reluctant to take big wage cuts. But then again, prosperity itself might make people more stubborn about taking wage cuts. Pride. Pride is a luxury good, and people in the rich countries might be able to afford their pride. Russ: Yeah, or they want to afford. I've thought about it a lot, and I've used this example on the program before: If you are a carpenter in Nevada--excuse me, I mean Nevada [repronounced with first "a" as in "advertisement" rather than as in "want," per recent news flurries over the pronunciation--Econlib Ed.] for those Nevadans listening--and you are making a certain amount of money and now there is no chance of making that salary because nobody is building a house in Nevada for a long time now and won't be for a while, because there are too many of them, how easy would it be for you to take a 20% pay cut? And what would be the implications of that, not just for your pride, but for your next job after that? If you say: I'm going to do this for a while. Is it only a pride issue, that you have publicly stamped on your forehead what your productivity is? Or is there some signaling issue here? Guest: That's exactly right. Signaling is very important, as a [?] that might explain this. You take a big wage cut and future employers can kind of sense it. Maybe they can tell formally, or informally. But they'll get a sense of what kind of person you are. And the wages you earn stamp you. So, my colleague Bryan Caplan correctly makes a big deal about how a lot of education is signaling. That you get a degree and that degree sticks with you for the rest of your life. It says, it tells somebody about your brand. And that seems to predict your wages for quite a long time. The wages of your last job have to be doing something similar. Russ: Yeah. Perhaps. It's an interesting puzzle to think about what current levels of unemployment are, their persistence. Why they are persistent. Guest: I would like to say though that there is evidence that a lot of the rigidity seems to be happening inside of firms. So, there is an excellent book by Truman Bewley called Why Wages Don't Fall During a Recession, a Yale labor theorist, who had written a lot of abstract models and then finally decided to do something that few economists do, which is actually go talk to people about how they set wages rather than just theorizing about it. And what he learned was that, the word that came back again and again when he talked to top business executives, to labor union leaders, to human resource professionals, as to why companies didn't just cut wages when a recession hit--in order to avoid layoffs and hire cheap people--was the word "morale." Russ: Yeah. Guest: That word came back again and again. Morale. They were afraid that it would hurt their own firm if word got out that they were cutting wages or if they told everybody that they are taking a 10% across-the-board cut. That would hurt productivity inside the firm. So, it's a reminder that entrepreneurs--people who own businesses--often think of themselves, to exaggerate a little bit: They are hostage to their own employees. They need to keep these people happy in order to keep the brand value of the firm. Russ: Well, I think there's some truth to that. I think if you told your employees you are cutting their salaries 20%, they'd get real mad. They wouldn't say: Oh, that's great, because now I won't be unemployed. They're going to say: What are you doing? What are you talking about? And I think it comes back to your earlier point. If you've got a Federal Reserve whose goal is to avoid deflation at any price, and you've never experienced deflation at any point in your life--which, most of us have never experienced anything remotely like the 1929 period or what happened at other times, pre-Fed, in the United States, the flexibility in prices you are talking about--then taking a pay cut is brutal. There is no feeling: well, don't worry, prices have come down 20% so your purchasing power won't change; just take this 20% wage cut. In many ways the Fed's putting a floor under the price level has destroyed the opportunity for markets to respond to these kind of situations. Guest: Yeah. This is, you know, um--we economists, especially when we start talking about unemployment, after a while we start sounding like sociologists. And I mean that as a compliment to sociologists, right? Russ: Yah. Guest: That the shared experience of knowing that a lot of people that you know took wage cuts probably makes you a lot more willing to take a wage cut. Russ: Yeah. Guest: So, that social knowledge that I know that everyone else knows that this is normal, to take a wage cut every couple of years--that's an experience that a lot of us have lost. Russ: For sure.
|48:23||Russ: What do you think the central bank should do right now in the United States? If you were in Ben Bernanke's chair--we are recording this at the end of September, 2012, days after Bernanke has announced that we have a new vision for the Fed: We are going to do whatever it takes and do it for as long as it takes until the economy is strong again. I'm thinking--I have a lot of thoughts. But one of them is: Could you have done it before? Do you think everything was fine until now? But putting that to the side, the strategic question: Is he doing the right thing? Would you suggest something different? Guest: Um, I'm quite sympathetic to this new, rule-based Quantitative Easing [QE] approach, which people are calling QE3. The last few waves of Quantitative Easing have been clearly stated as one-off events. Right? This is a rule-based system which is-- Russ: What do you mean, rule-based? Guest: What I mean is they've said: We will do x--in this case, buying up about $40 billion of mortgage assets a month and boosting the narrow money supply by that every month--until the labor market substantially improves. With the caveat, in the context of price stability. Right? So, this will keep going. And it's an outcome-based measure, just a little bit like the Taylor Rule--I think that's worth noting. And it's not a discrete, we are going to do $500 billion, we are going to do $200 billion, we are going to do $150 billion of that. So, the first part--the fact that it's partly based on a quantitative outcome--means that markets have a sense of the duration. So, when shocks hit, if bad news comes along, if there's an earthquake in some important country, if there's a financial crisis in some other country--the financial markets will know: Oh, I guess that means this will be going on a little bit longer. The fact that it says in the context of price stability means that all of us, all economists, all financial analysts have a pass. We have a get-out-of-jail free card that says: We can complain as much as we want to to the Fed if we start seeing market-based indicators of inflation shooting up. Because they promised they will not allow prices to become unstable. And you know, kind of their informal goal is a 2% long-term inflation goal. So-- Russ: And if those goals aren't consistent? Guest: If those goals aren't consistent, my guess is they side with price stability. I could be wrong, but I bet that's at least well over a 50% chance that they are willing to send the economy back into a recession if they start seeing-- Russ: Don't you think Ben Bernanke wants to be reappointed? Guest: I think he wants to be reappointed and he does not want to go down in infamy. So, there's a certain kind of infamy that comes from being a Fed chair during the 1970s. Economists love to attack some of those folks now, and they have a certain kind of infamy. I don't think Ben Bernanke wants that infamy. I suspect that many years from now we'll learn a lot about--well, or we won't learn a lot about--the political battles that took place inside the Fed. We've seen some academic papers, some speeches by people at the Fed, where they were talking about: Hey, if we were going to do Quantitative Easing, shouldn't we have something kind of rule-based? That's so much at the heart of modern macro--it's the little bit of public choice that got imported into modern macro. It solves a lot of problems when people can build expectations about the future, when the Fed it kind of tying its own hands, if only by stating some public goals. The Taylor Rule was a good kind of rule for that reason. We could tell in 2000 when the Fed was way off, when the Taylor Rule was getting off track. This new rule might--we could see Narayana Kocherlakota throwing out a slightly different rule, a slightly more aggressive rule, actually. So, we'll see some of these rules for how QE could work, in the context of price stability, debated. And some of them are going to be wrong. Russ: So, given that QE2 doesn't seem to have injected much liquidity into the economy--it injected a lot of liquidity into the banks' balance sheets--why is this going to be any different? I mean, they are going to buy up a bunch of mortgages that are sitting on the balance sheets of banks, I assume? Right? So banks are going to have larger excess reserves; they are going to collect their interest. Why is this going to make any difference? You know, this is actually an old question in macro and monetary economics: Why does any open market operation do anything? Because these are all voluntary exchanges. Right? Every time the central bank is going out there doing a $2 billion dollar open market operation, it's a voluntary trade of one government asset, called Treasury Bills, for another government asset, called Federal Reserve Deposits. So, it's swapping assets around, right? So, that is a little bit of a puzzle, I have to admit. The usual story is that some assets are more liquid than others. And that liquid assets seem to be especially important in money creation. So, my reading of the data is that there have been a number of studies on this looking at how QE2 and QE1 have affected different inflationary expectations. I think at least on the inflation expectation side, before the time of QE2 there was a more substantial risk of deflation. And then QE2 kind of erased that. I think if you just do a Google search, a Google word search, you will see a lot more references to deflation before QE2 than afterwards. I think that risk was erased. Or substantially reduced.
|53:51||Russ: Why do you think the Fed is targeting mortgage-backed securities? And what's the implication for the central bank of the United States holding most of the mortgages that exist in our economy? It's kind of a weird, flakey thing, isn't it? Guest: It definitely is. It's a strange part of the market for them to be involved in. My guess is that there's a public choice issue going on inside the Fed, where maybe that's the most you can get out of these folks. It's possible that that's his first choice; maybe he's looking at sort of a--Roger Farmer is it, Ed Leamer?--who wrote that housing is the business cycle. Russ: That was Leamer. Guest: So, Leamer, and other economists note that, you know, housing is a big predictor of recession and recovery. So, part of it could be that, basically this sort of hydraulic macro view: which part went down; let's try to push that part back up. I have my doubts about how important that is. Trying to read their mind, taking the view that I don't know these folks, I don't go drinking with them-- Russ: I don't think they do a lot of drinking. They take away the punch bowl, they put it back, they leave the punch bowl kind of in a sacrosanct kind of area of the Fed. They just kind of leave it there. They don't dabble in their own sampling, I don't think. Guest: My guess is Bernanke only wanted to do this if he could get a supermajority vote, so he found what he could get a supermajority vote for. Russ: Yeah. Guest: The supermajority vote gives credible commitment to this. So, regardless of who is President next year, this thing got through with a near-unanimous vote. So even if a few votes get swapped out, you'll still have a majority. Credibility in monetary policy is probably worth making some sacrifices for. Building--having a Fed that can make and keep commitments is such a good thing to have that it is probably worth getting somewhat worse policy in order to achieve that. Russ: And you are referring to the supermajority--meaning more than just a bare majority vote. Guest: Yes. So, there are many things in democracies, things that just skim through with a slim majority can get overturned next year. Whereas things that have a supermajority, you are pretty sure it's going to be around for a while. Russ: Yeah. It'll be interesting to see. Congress--there's a lot of tension in the air because there is an election looming. Maybe there will be more post-election discussion of how to deal with this new era for the Fed as savior. I find it a little scary, myself, but maybe it will turn out well. Guest: It's a high risk time, certainly, one way or the other.
|56:31||Russ: We focused the whole time on monetary policy. We have a few minutes left. You [?] say: you are sympathetic to this risk. Would you do anything else besides letting the Fed be more aggressive? You have some other plans? Some fiscal policy or other things you think would be a good idea? Guest: I would love to see the United States tackle its long-term entitlement crisis. In some way it makes it clear to people that the Fed government is not on the hook for everybody's health care forever. These incredibly open-ended commitments really have to be--they are going to get curtailed one way or the other. I'm certainly in the camp of thinking that the U.S. government is not going to default, either explicitly or through inflation. But sooner rather than later would be really nice. Russ: Why do you say that, other than it seems like the mature thing to do? Guest: Because--one reason the U.S. government is unlikely to default is because it will want to borrow no matter what. Even if we default on our debts 5 or 10 years from now, it's kind of too early to default. Right? Because we still have all these baby boomers to fund. And we'll need to repay. There will be a strong democratic pressure to repay those folks. Countries that default on their debts tend to default only slightly. Right? They don't default 100 cents on the dollar. And part of the reason is that they love having access to the financial markets. So the incentive to default is kind of weak. Russ: But why do you think it's important that we solve this looming crisis, say? So, I'm in your camp. I call it grown up behavior, adult behavior. I don't think it's adult to make promises that you don't have any idea how you are going to keep. Not that we all haven't done that occasionally. But it's not adult. It's what kids do. Guest: Yup. Russ: Why is it important that we act like grownups, whether the government acts like, politicians act with respect to these promises that have been made? Guest: Well, if we can--I don't want a country where the best and the brightest people are doing one of two things: either trying to lobby Washington to get Medicare to use their health care equipment, or ultimately trying to become medical doctors because of the ever-expanding government subsidized health care field. We may be moving toward a world where the government is basically one massive health-care provider. And that can sap a lot of our human capital, both on the lobbying side as people come to D.C. for favors--I've seen parts of that in some of my work on Capitol Hill--and on the other side--just a lot of people moving into the government-subsidized industry of health care. Russ: That's an interesting point, which I'm sympathetic to. I thought you'd say something about the uncertainty created about the fiscal environment, where we are not sure how that promise is going to be kept--whether we are going to raise taxes, lower benefits--and that that has implications for economic decision making. Do you think that has any relevance there? Guest: I think in the short run this is certainly an issue. Yeah. I think these one-year fiscal fixes are appalling. And I don't just mean that because it's fun to complain about it. But I think it really does hurt the government's planning--makes that inefficient--and I think it hurts the private sector's planning. It makes that inefficient. This is both--whether you are a Keynesian or a supply-sider, you should be appalled by this. And it's only the politicians who need re-election, of both parties, who really don't want to just take a hit and sign something that lasts for 5, 10, 15 years. Russ: More fun to kick the can down the road. Guest: Yes. Somebody else can do this. Maybe this will be the time. Maybe this lame duck will be the time they cut a deal. There are rumors abounding; but maybe the reason the rumors are coming out is because people want--they are stage-managing their positions. They want to people to think: I'm the one acting like a grownup.