## Sunday, December 08, 2013

### The Great Labor Dump

One of my favorite teachers at Michigan was a self-effacing but brilliant labor economist named Mike Elsby. Mike has sadly decamped for Scotland, but he continues to turn out excellent papers. One of his latest, a Brookings conference paper, takes on a hugely important question that has been on everyone's minds of late: Why has labor's share of income declined in advanced countries?

There are basically three competing stories. These are:

1. Robots. Technology has made it cheap to replace humans with automation, driving profits up and wages down.

2. Unions. The relentless decline of organized labor in rich countries has robbed workers of their bargaining power, causing owners to scoop up the surpluses.

3. China/India. The end of the Cold War caused a huge, relatively well-educated labor force to be suddenly dumped onto world markets. A glut of labor on the market means the return to labor goes down and the return to capital goes up.

Mike Elsby and his coauthors find support mostly for story #3. In their own words:
U.S. data provide limited support for...explanations based on the substitution of capital for (unskilled) labor to exploit technical change embodied in new capital goods...[I]nstitutional explanations based on the decline in unionization also receive weak support...[W]e provide evidence that highlights the offshoring of the labor intensive component of the U.S. supply chain as a leading potential explanation of the decline in the U.S. labor share over the past 25 years. (emphasis mine)
This finding disagrees with some other recent papers, such as Karabarbounis and Neiman (2013), who support the "robots" story. Read Elsby et al. to see the particulars of the argument.

Anyway, this is an important piece of research that everyone should know about. Stories about the Rise of the Robots are scary and seductive, but if Elsby is right, then this is more of a concern for the future than the past. And the decline of unions is sad in many ways, but it seems to be a symptom of labor's decline rather than a cause.

So what do we do to bring back labor's share of income? We wait. The Great Labor Dump can only happen once. When it's over - when insanely huge amounts of investment in China have saturated that country with capital, for example - labor's share will bounce back.

...unless, of course, by that time we really are facing the Rise of the Robots.

## Saturday, December 07, 2013

### Wage subsidies

There has been a lot of talk about raising the minimum wage lately. Minimum wage is one of those things where the public strongly disagrees with economists - Americans are very strongly in favor of minimum wage hikes, but most economists think it's a bad idea. Economists generally prefer the EITC, also called a "negative income tax". Minimum wages can cause higher unemployment, and often just give money to high school kids who don't need it; EITC suffers these problems much less.

Why do Americans like minimum wage hikes and ignore the EITC? Two reasons, I'm guessing. The first reason is that people like feeling like they are being rewarded for work. Wages are money that people feel like they have "earned", even if the government has mandated above-market wage levels. Second, EITC is  just clunky to use - you have to file for it through the clunky tax system, you have to know about it in order to claim it, and the acronym "EITC" itself has no meaning for the vast majority of poor Americans. A bunch of eligible Americans don't even claim their EITC. Minimum wages, on the other hand, are easy to use, because the company does all work of administering it.

So is there a policy that would combine the economic efficiency of the EITC with the popularity of the minimum wage? I believe that there is. It's called a wage subsidy. This means paying companies to offer their employees higher wages. Jim Pethokoukis of the AEI has recently endorsed this idea (I think I managed to convince him in our recent podcast interview, if he wasn't convinced already). It's a good one.

Wage Subsidies vs. EITC

Wage subsidies are better than EITC, for several reasons. For one, they are automatic - poor people don't have to take the time and initiative and mental energy to go claim them. Second, they will probably make people feel more valuable, since people tend to view wages as money they "earn". From the worker's perspective, it will just look like wages went up. In fact, a better name for wage subsidies might be "wage matching".

Wage subsidies would replace the EITC, but in order to do this, we would have to supplement wage subsidies with some other form of welfare (such as a basic minimum income), since we don't want unemployed people to starve.

Wage Subsidies vs. Minimum Wage

Wage subsidies are better than the minimum wage. For one thing, minimum wage doesn't necessarily raise wages for people who are slightly higher up the wage distribution but still poor. Wage subsidies can push up wages for all of the working poor.

Also, wage subsidies encourage higher employment, while minimum wage encourages higher unemployment. This is always an important difference, but much more so right now, for two reasons. First, we are in the middle of a long economic stagnation - a large number of Americans are languishing in long-term unemployment, causing their job skills and work ethic to decay. Second, we may soon face increased downward pressure on wages from increased automation - the so-called "rise of the robots" - and wage subsidies would be a way of placing our thumb on the scale for the human beings.

Problems with Wage Subsidies?

Kevin Drum highlights some potential problems with wage subsidies. This one actually isn't a problem at all:
How do you prevent employers from gaming the system and reducing wages because they know the wage subsidy will make up the difference?
This might be a problem higher up the wage distribution, because at some point you have to phase out the wage subsidy or your program ends up getting really expensive (supplementing every American worker's wages with a flat $3 subsidy would cost upwards of$1T). But if you phase it out slowly enough, this won't be much of a problem.

On Twitter, Brad DeLong noted that while minimum wages are a mandate, wage subsidies would require govt. bureaucracy to administer. True. But this bureaucracy is actually already fully in place - it's called Social Security. You see, a payroll tax cut is a kind of wage subsidy.

The final problem with wage subsidies is that they might be politically infeasible. For one thing, they would be paid for with higher taxes on the wealthy, which Kevin Drum points out is certainly going to make Republicans balk at the idea. Second, as Paul Krugman notes, the minimum wage is well-known and already has wide support.

Drum and Krugman are probably right; the minimum wage is a lot more feasible than wage subsidies, at the present moment. But if conservatives like Pethokoukis start campaigning for it at the elite level, then I think there's some chance Republicans could eventually come to see it as a more palatable alternative to the minimum wage. And if Republicans campaigned on a platform of "raise wages for working Americans", it seems to me there's a good chance they'd smash the Democrats. Supporting wage subsidies would be a way for the GOP to move from being the party of rich people (a small constituency by nature) to the party of business.

As for us technocratic-minded liberals, of course we should not let the better be the enemy of the good - we should still keep campaigning for a minimum wage hike, if for no other reason than to force Republicans to offer wage subsidies as an alternative. But if Republicans ever do get behind wage subsidies, we should join them, instead of sticking to the minimum wage out of pure traditionalism.

So I think that wage subsidies - or "wage matching", if you prefer - are a great idea, even if we can't manage to implement them right away.

Update: Via Carola Binder, I see that I am very, very, very late to the wage subsidy party. Here is a letter sent by a whole bunch of prominent economists in 2010:
Dear Speaker Pelosi, and Messrs. Boehner, Reid, and McConnell:
A great number of different policy actions--including the American Recovery and Reinvestment Act, the financial rescue, and the extraordinary monetary policy measures taken by the Federal Reserve--have in their sum played an important role in changing the trajectory of the economy from one of terrible decline to one of growth.  But with the latest unemployment rate at 9.7 percent, it is clear that additional emergency policy measures to jump-start job creation are still warranted.
A well-designed temporary and incremental hiring tax credit is a cost-effective way to create jobs, and could work well in the current environment.  At a time when GDP is beginning to rise and demand is starting to return, private firms are likely to respond to such a tax incentive by hiring sooner and more aggressively than they otherwise would have done. Such a credit could thus help put Americans back to work more quickly than otherwise. And by targeting firms that are growing, such a tax credit supports the businesses most likely to lead the recovery of employment.
There are many ways to design an effective hiring tax credit, but in general the beneficial effects will be greater the stronger the hiring incentives and the lower the administrative burdens placed on firms.  It is critical that such a tax credit be put into place quickly and that it is publicized widely.  Firms will begin to accelerate hiring only when know they can count on such tax relief.
We judge that a well-designed hiring tax credit is a well-targeted and economically sound strategy for aiding job creation at this phase of the recovery, and so we support a well-designed hiring tax credit.

In our personal capacities, we are sincerely yours,
Mark Zandi
Justin Wolfers
Laura Tyson
Mark Thoma
Peter Temin
Joseph Stiglitz
Betsey Stevenson
Isabel Sawhill
Dani Rodrik
Robert Reich
Richard Portes
Larry Katz
Barry Eichengreen
Peter Diamond
David Cutler
Robert Cumby
Tyler Cowen
Menzie Chinn
Alan Blinder
George Akerlof
Now, they were talking about it as a temporary measure to deal with the recession, but I think it works as a long-term distribution and incentive program as well.

## Wednesday, December 04, 2013

Mike Konczal caused a splash when he suggested the other day that we're teaching econ backwards:
Today, first-year undergraduate students typically start with microeconomics, or the study of individuals and individual markets. This begins with the study of abstract, decontextualized, markets, where supply and demand work perfectly, individuals exist in isolation, and they effortlessly trade with others in isolation of society, the law, and politics...
In their second class, students begin to learn macroeconomics, or what happens when you add up all those markets...
What if macroeconomics came first, before the study of individual markets? If were to reverse the typical curriculum, the first thing undergraduates would encounter wouldn’t be abstract theories about people optimizing, but instead the idea of involuntary unemployment and the idea that the economy could operate below its potential...
[I]t turns out that things like institutions, regulations, income distribution, the way markets are introduced into formerly Soviet countries, and the viciousness of the business cycle and mass unemployment all actually matter.
Paul Krugman endorsed the idea.

I pretty strongly disagree with this suggestion. I think that if business cycle theory were the main purpose of economics, then it might have merit, but this is not the case.

Macroeconomics, and particularly business cycle theory (the theory of why we have recessions), is econ's glamour league. Macro is so important that we elevate it to an equal plane with micro in graduate programs - there's an "introductory micro sequence" and an equally sized "introductory macro sequence". Out there in the real world, everyone and their dog wants to know why recessions happen and how we can prevent or escape them.

But despite its glamour, macro is really only one small part of economics. In addition to the causes of recessions, economics investigates the following:

* how tax policy influences business conditions and human welfare (tax econmics)

* why workers get and lose jobs and are paid the wages they are paid (labor economics)

* why we see the patterns of international trade and capital flows that we see (international econ)

* why people make the consumption, saving, investing, and other economic decisions that they make on a day-to-day basis (decision theory, behavioral economics, experimental economics)

* how auctions work (auction theory)

* how people can optimally play various games and other competitive endeavors (game theory)

* how companies compete and get profit (industrial organization)

* why financial asset prices move the way they do, and how investors should and do behave (financial economics)

* how government should provide public goods (public finance)

* why cities and industrial clusters form and grow and decline (urban economics)

* why some poor countries get rich (development economics)

* why some rich countries experience bursts of productivity growth (growth economics)

* how to use statistics to measure all this stuff (econometrics)

...and more!

So you see, there is a LOT more to econ than business cycle theory. Sure, business cycles interact with most of these things, but the things all interact with each other. Business cycle theory has assumed a special place among the constellation of econ fields, but only because A) people get really upset about recessions, and B) business cycle theory is very contentious and controversial.

But here's the thing: Business cycle theory is contentious and controversial precisely because it doesn't work very well. Cursed with uninformative data, macroeconomists have so far failed to definitively answer the following Big Questions:

1. What causes recessions?

2. Can recessions be forecast in advance?

3. Can recessions be prevented by government policy, and if so, how?

4. Why do inflations happen?

5. Why do hyperinflations happen?

6. Why do "jobless recoveries" happen, and can they be prevented?

This doesn't mean macroeconmists have done nothing. They have catalogued a vast array of business cycle facts and features. They have identified a few policies whose effect can be predicted fairly reliably (e.g., if the Fed raises interest rates it will cause a sharp recession in the short term). They have debunked a lot of old, dangerous ideas about what the central bank should do.

But if we teach kids macro first, we will be deliberately starting them off on the stuff that doesn't really work. Notice that no other science does this. Take an intro physics class, and it starts with Newton's Laws, projectile motion, classical electrodynamics, and optics - not the deepest stuff, not the cutting edge, but the stuff that has worked really, really well for hundreds of years. The successes. Only five or six years later do you get to the string theory and the cosmology and the speculative, cutting-edge stuff.

Similarly, I think we should start kids off with the econ theories that work. What are the econ theories that work? Well, there are a lot, but here are a few:

* Supply and demand work for many, many things. If a storm destroys your orange crop, the price of oranges will go up. The invention of a popular new orange juice will cause the price of oranges to go up. And so on. Many of these are so obvious that we take them for granted - they don't use fancy math, and the fate of nations doesn't hang in the balance. But these are real successes for economics.

* Game theory works very well in some situations, such as auctions, where everyone knows the payoffs and the rules.

* Tax economics works very well when predicting the impact of certain kinds of taxes (less well for others).

* Financial economics gets a great many things right. When interest rates go up, bond prices go down. Diversification of stocks can reduce risk without reducing expected return. Etc.

* Public finance theory works when explaining many externalities. By modeling pollution as a negative externality, economists managed to create some very effective "cap and trade" systems.

* Econometrics has had a lot of successes in predicting stuff, and it's never too early to start learning the baby versions.

Actually, there are a lot more. This was just a quick short list off the top of my head.

These things are often simple. They are often un-glamorous. People don't argue about them a lot. But they have led to real improvements in humanity's ability to control our world. In other words, they are scientific successes. I think we should teach these things before we start teaching about problems that economists have been butting their heads against, like business cycles or development econ.

(And actually, we mostly do teach these things first, at least at the undergrad level. So would I keep Econ 101 the same? No, I'd emphasize empirical evidence more than we do. Just like intro physics classes make you do labs and verify the equations of projectile motion, I'd have undergrads take a look at data and do some regressions to at least get an idea of how well some of these theories match reality.)

Addendum: I also think that undergrad macro, when we do teach it, should be taught from the standpoint of "Why we don't get what's going on." Teach the Loanable Funds model, but then show how poorly it's performed. Etc.

### Noahpinion is back!

The Not Quite Noahpinion experiment is complete, and I'm back from blogging hiatus. Thanks so much to Carola, John, Yichuan, Josiah, Guan, Peter, and Jeremie for subbing for me. All of y'all out there in the blogosphere, remember to follow those guys.

And here are their blogs:
Quantitative Ease, by Carola Binder
EconoSpeak, with Peter Dorman
Azizonomics, by John Aziz
Bruegel, with Jeremie Cohen-Setton
Synthenomics, by Yichuan Wang
The TPPF blog, with Josiah Neeley

And here are their mainstream media ventures:
John Aziz writes for The Week
Josiah Neeley writes for The Daily Caller

And here are the top 5 most viewed posts from Not Quite Noahpinion:

Now back to your regularly scheduled programming...

## Tuesday, December 03, 2013

### Interview with Jim Pethokoukis on robots and jobs

I was recently interviewed by Jim Pethokoukis of the American Enterprise Institute for his Ricochet podcast. The subject was the "rise of the robots" - i.e., what happens if and when technology starts replacing human labor entirely. A transcript, and the podcast itself (if you like hearing my voice), can be found here. The upshot of what I said:

* Technology wasn't as big a cause of declining labor share during the past couple decades as people think Globalization was a bigger culprit. But technology is a much bigger worry going forward.

* Teaching people to be entrepreneurs is one way to stop the rise of the robots from causing horrendous inequality; each person or small team of people can command their own little "army of robots", in the form of a company that they own.

* We will also probably need to resort to some mass redistribution of income. The best way to do this is to have the government subsidize wages, i.e. to pay companies to hire humans and pay the humans more. This is like putting our thumb on the scale against the robots.

Anyway, read or listen to the whole thing here!

### Why the Fed Should Do More - A Look at Monetary Offset

I have a new article published on Quartz titled on how recent fiscal events have shown the Fed plays still a powerful role in maintaining growth. Thus the interesting question isn't whether the Fed should do more, but rather to ask why the Fed hasn't.

An excerpt:
In its recent minutes, it appears that the US Federal Reserve has been preparing to taper. Yet given the outsize role the Fed has played in supporting the recovery, that would almost certainly be a mistake. Unemployment has been ticking down, yet long-term unemployment is still very high and labor force participation is still low. While the recovery has made progress, it is still not guaranteed, and the Fed’s accommodation will be critical if the economy is to secure the gains it has made.
The key to understanding the argument is to understand a concept central to economic analysis: the counterfactual. Counterfactuals are alternative histories of what could have been. In military history they are the answers to questions like “What would have happened if Napoleon had won the battle of Waterloo?” In this case, the key counterfactual is “What would have happened to the economy if the Fed hadn’t done quantitative easing?” Throughout this recovery, the federal government has been tightening its belt. Indeed, as MKM Partners chief economist Michael Darda has repeatedly noted, net government outlays have fallen for two consecutive quarters during this recovery, making the recent bout of austerity the biggest since the Korean War demobilization. Had the Fed not offset such a large contraction in spending, the US almost certainly would have been sent into another recession.
This will be my last post here, and I will be continuing to blog back at my home blog, Synthenomics, once the semester is over and things become more settled.

## Monday, December 02, 2013

### Data Visualization -- China Plotting

I spent a good deal of time over the course of the past semester working on topics about Chinese development. A lot of it started from my work at MKM Partners over the summer in which I worked on topics of regional Chinese growth. This eventually turned into a sequence of Quartz articles: one on the growth potential of the inland provinces, another on the overall success of the high speed rail program (which was actually backed up by a later NYT article), and a third on boosting Chinese consumption through a social service led urbanization (which ended up being an important part of the 3rd plenum). I found it an engaging topic to research, and I will have an article in the next edition of the Milken Institute Review on these topics. If you have any thoughts about those articles, please share in the comments below and I'll try to get back to you.

In this process of working with Chinese data, I was faced with the task of analyzing a lot of spatial data about Chinese provinces, and in this process I had to write a lot of R code. After a while, I got annoyed by how long the process would take, and as a result I took the liberty of designing an R Shiny application to help do some of the heavy lifting. Fortunately, these applications are all hosted on the cloud, and you can find the China Mapping Application here:

To give you an idea of how it works, after you upload the csv file you will see a screen like this showing you the data:

You can go directly from there to see the map. This was done using the GADM databases for the shapefiles and then the spplot package to render the drawing. Spatial rendering is expensive, so this should take around 60 seconds to do:

And finally, you can go to the interactive bar chart and observe the distribution of your data. This was done using the rCharts package, which creates javascript visualizations using just R code.

If you want some data to play around with, you can take a look at the two dropbox links on China on my data page.

Anyways, I hope my fellow China researchers can enjoy the tool, and if anybody has any suggestions feel free to tweet me at @yichuanw or leave a comment below.

Edit: For those of you interested, the source code can be found here.

## Sunday, December 01, 2013

### Does QE cause deflation?

Oh my gosh. I am really excited. For years, I've been waiting for a chance to disagree with Brad DeLong about something econ-related, and the day has finally come!! It's enough to make me break my blogging hiatus a few days early.

Remember back in 2011 when Narayana Kocherlakota theorized that low interest rates cause deflation? Well, on Wednesday, Steve Williamson made a similar claim, writing that in a liquidity trap, QE will cause long-term deflation. Williamson based his post on this paper.

In a testy response, Nick Rowe called Williamson's post "horribly wrong," lamenting: "What the hell has gone wrong with some of the best and brightest in economics?" Brad DeLong then jumped in, accusing Williamson of mistaking an unstable equilibrium for a stable one. Paul Krugman echoed that accusation.

But David Andolfatto, in this excellent post, showed that DeLong and Krugman's criticisms are misplaced. In a typical New Keynesian model - the kind that now mostly dominates business-cycle theory, and the kind preferred by Rowe and Krugman - it's true that Williamson would be picking an unstable equilibrium. But Williamson is not using a New Keynesian model! Williamson's model is actually quite different. And as Andolfatto points out, there are macro models out there that are very similar to New Keynesian models, but have one small twist that makes the "QE-causes-deflation" equilibrium the stable one!

So DeLong and Krugman have gone too far. They are arguing from their preferred model, and that's fine. But to say - as Brad does - that Williamson doesn't deserve a "union card as an economist" is wrong. And to say - as Krugman does - that Williamson has made a simple "misconception" by forgetting about stability is wrong. Williamson is simply using a different model than the standard model, and DeLong and Krugman have not yet examined that model carefully.

What's more, Andolfatto points out that Williamson's critics should be more empirical and less theoretical in their arguments:
The fact that Japan has spent decades [with deflation despite zero nominal interest rates and periodic bursts of QE] suggests that [such an equilibrium] may in fact be stable...
It seems to me that the critics should have instead attacked his results and interpretations with empirical facts (or am I too old-fashioned in this regard?). After all, Williamson at least motivated his post with some data (the diagram at the top of this post). And he makes what is potentially a testable prediction (notice the if-then structure of the statement):
In general, if we think that inflation is being driven by the liquidity premium on government debt at the zero lower bound, then if the Fed keeps the interest rate on reserves where it is for an extended period of time, we should expect less inflation rather than more.
Yes. Although macro data is not generally very conclusive, it's important to look at it anyway. Williamson's model, if I'm not mistaken, predicts that QE will cause a short burst of slightly higher inflation, followed by a long period of lower inflation disinflation in the long-term. That seems consistent with what happened after Japan's QE during the Koizumi years. It also seems consistent with what the U.S. is experiencing now. (As for Japan's new Abenomics QE, it is too early to tell.)

Of course, Krugman, DeLong et al. have their own explanation for Japan' s ongoing deflation (and the U.S.' ongoing inflation) - the "secular stagnation" hypothesis. And that's fine. To determine whether QE's failure to cause inflation is caused by a Williamson model, secular stagnation, or some third phenomenon is far beyond the scope of this blog post.

My point is to say that neither theory nor data tell us that Williamson's model is obviously wrong.

(Well, OK, actually, that's not quite true. As Nick Rowe points out, Williamson's model implies that QE will cause a never-ending deflationary spiral. Obviously that's not realistic. But that kind of infinite spiral exists in most New Keynesian models too, if a central bank keeps interest rates too high. Generally, none of these models makes any sense in extreme cases.)

Now, on plausibility grounds, Williamson's model is suspect - he assumes that Congress follows a certain policy rule, and in fact his results depend on Congress acting in that one simple predictable way. That's almost certainly not very realistic. So don't read this post as me endorsing the Williamson model! Then again, New Keynesian models - and indeed, all of modern macro models - contain huge lists of equally unrealistic (and empirically falsifiable) assumptions about the behavior of economic agents. So don't get me started down that road...

But anyway, I completely disagree with DeLong's and Krugman's criticisms of Williamson. They shouldn't have pounced on the stability thing. And as for Nick Rowe, as nearly as I can tell, he's just angry that anyone in the world could have anything other than a monetarist/New Keynesian view of how the economy works. And instead of getting mad, I think he should be engaging with alternative models. (Update: Rowe has a response.)

OK, so now let me move on (as Andolfatto also does) to giving Steve Williamson a hard time.

In his new 2013 paper, Williamson says that:

1. QE causes low interest rates and deflation,

2. That's a good thing, because deflation is good, and

3. Fiscal stimulus (i.e. having the Treasury issue more debt) would be effective in getting us out of a depression.

Fine. Good. These things flow right out of Williamson's model. Paul Krugman would actually seem to have a lot to agree with in #3!

BUT, a year and a half ago, Williamson wrote this:
I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise.
His prediction was based on this 2012 paper.

These two predictions are exactly opposite!!!

(Oh, and to round out the set of predictions, here Williamson argued that because of Wallace Neutrality, QE can't affect inflation one way or the other!)

Maybe Williamson changed his mind about how the world works between 2012 and 2013. Great! Fine! He should write a post about what made him change his mind.

BUT, what Steve and I usually argue about is the general state of macro - he says macro is in fine shape, I say it hasn't discovered much. I think this reversal supports my thesis. If a top-flight macroeconomist, who knows the whole literature backwards and forwards, can so easily change his workhorse model in one year, and reverse all of his main predictions and policy prescriptions, then good for him, but it means that macroeconomics isn't producing a lot of reliable results.

Sure, I know that Williamson (2012) and Williamson (2013) have different sets of assumptions, and that's why their conclusions are so opposite. But how does Williamson expect us to tell which set of assumptions corresponds to the real world, and which is just fantasy-fun-land? The papers, of course, offer no guidance, which is utterly normal for macroeconomics. A million thought experiments, and no way to tell which one to use. Is this science, or is this math-assisted daydreaming?

Anyway, to sum up, the only person I really agree with in this whole debate is Andolfatto. Which is totally unrelated to him buying me a beer at the St. Louis Fed conference earlier this year.

Brad DeLong responds to me in the comments. Steve Williamson joins in. I'm relieved to find I still disagree with Brad!

Steve Williamson responds to DeLong/Krugman/Rowe on his blog.

Steve Williamson responds to me on his blog. Key quote:
Back in days of yore, my concern was that we could indeed get higher inflation. How? I had thought that the Fed had the ability to control inflation, but when push came to shove, they wouldn't do it. Once people caught on to that idea, we could get on a high-inflation path that was self-sustaining. Of course, since I said that, I've continued to work on these problems, and stuff has been happening. In particular, we're not seeing that high-inflation path.
So a year of low inflation made Steve go looking for an alternative model to explain the fact that QE wasn't causing inflation. And the feature of the model that Steve changed was his assumption about the behavior of policymakers. That clears things up a bit. And Krugman will be happy to know that Williamson updated his priors. But I think my criticism stands. If one year of data and one change in assumptions can utterly reverse both the prediction ("QE causes inflation" --> "QE causes deflation") and the policy recommendation ("less QE" --> "more QE, and maybe more fiscal stimulus"), I still think this is a teachable moment about the limitations of modern macro. If we have to change our working model of the macroeconomy to fit the most recent macroeconomic event, that demonstrates how silly the whole endeavor is, right?

Scott Sumner chimes in, agreeing with Nick Rowe. So does David Beckworth, who does some quick-and-dirty data analysis. Beckworth and Williamson argue in the comment section.

Tyler Cowen chimes in, agreeing with me.

Krugman has a response. He says that the basic problem with Williamson's model is that there's no explanation for why firms have an incentive to change their prices in response to QE - and hence, no micro-level explanation for why QE causes deflation. That's a legit question, of course. I think that in Williamson's model, QE just lowers aggregate demand by depriving banks of usable collateral (long-maturity govt. bonds), so that they need to hold more cash. That's like a liquidity preference shock, which causes cash hoarding and lowers AD, causing firms to lower their prices. I'm not 100% sure, and it doesn't seem particularly realistic, but that's how I think the model works. It turns out that in Williamson's model, things that increase output decrease inflation. So there is sort of a reverse Phillips Curve, at least when the interest rate is at the ZLB.

Scott Sumner gets increasingly annoyed at Williamson.

Brad DeLong responds on his blog. Key excerpt:
[One story of how QE causes deflation] is: (i) people think “there is going to be a deflation; I need to hold more currency”; (ii) people sell their assets to the Federal Reserve, and so the Federal Reserve injects more currency into the economy; (iii) people notice that they have more currency, and think “it would not be rational for me to hold this much currency unless there were a deflation going on”; (iv) people think “if there is a deflation going on, I need to cut my prices in order not to lose my customers”; (v) people start cutting their prices, and the deflation begins.
This is also a fine story. But it is not a story of the Federal Reserve undertaking Quantitative Easing. It is a story of a self-fulfilling deflationary-expectations panic.
This is true, but I'm not sure that this is what is going on in Williamson's model; in his model, I think the QE (and the weird fiscal policy response that it induces) actually starves banks of collateral, which reduces aggregate demand and causes deflation that way. It all hinges on the way Williamson models the behavior of banks. I'd definitely like to see Williamson explain this part better, but I have kind of run out of time to pay attention to this issue at the moment...

Steve Williamson responds to Krugman. This response is pretty interesting, as you can really see the differences in philosophies of how macro itself should be done.

Karl Smith comes out of blogging retirement to enter the debate on the DeLong side.

Williamson writes a second, longer response to Krugman, trying to explain his intuition. He says that his results come from financial markets, not from goods markets. What's kind of interesting here is that Krugman/DeLong are basically saying that Williamson's model isn't microfounded enough, or at least the microfoundations of firm behavior aren't made explicit enough. Usually, Williamson would tend to be the guy saying "But how does it work?" while Krugman would be the guy saying "IS-LM works, just use it."

And here is the second part of Williamson's explanation of his intuition.

Bob Murphy chimes in, on the side of DeLong and Rowe. It's kind of neat how this debate has totally shuffled the usual "opinion coalitions".

Nick Rowe has one more response to Williamson, and still thinks Williamson is nuts. Key line: "[Williamson's model] explains why Zimbabwe had hyperdeflation." *ZING*

Yichuan Wang, Scott Sumner, and Tyler Cowen have more. The econ-blogger field continues to be mostly anti-Williamson.

Iza Kaminska jumps into the debate, endorsing Williamson's ideas and providing her own intuition for why QE is deflationary.

Ryan Avent enters the debate, taking a rather nuanced position. He presents some quick-and-dirty evidence in favor of Williamson's assertion.

Tony Yates says who cares if QE is deflationary or not, the point is that it didn't do what we wanted it to do.

Nick Rowe continues to say not-very-nice-things about the "QE causes deflation" supporters.

Tyler Cowen has a great roundup of evidence that QE is, in fact, inflationary. The evidence is not conclusive - evidence in macro almost never is - but it definitely puts Steve Williamson's story on the back foot.

## Tuesday, November 26, 2013

### A History Lesson for Scotland

In Guan's recent post on this blog, "Scotland, sterling and the debt," he notes that Scotland will hold a referendum on independence from the United Kingdom in September 2014. The Scottish Government suggests that an independent Scotland should be in a currency union with the UK. Guan writes:
"There are probably some sound arguments for that: it could take years to join the euro, and much of Scotland’s trade is with rest-of-UK, and vice versa.
On the other hand, events of recent years have kind of cooled the enthusiasm for currency unions in Europe. It’s not at all clear that it would be a good idea for Scotland to adopt sterling. The UK Government’s position is, sensibly enough, that a currency union would be unworkable without a fiscal and political union, which is kind of absurd when the goal is Scottish independence."
For historical perspective on a potential Sterling Area, we should look back to the Austria-Hungary monetary union of 1867-1918. The monetary union began following the Habsburgs' defeat by Prussia. In "The Logic of Compromise," Marc Flandreau explains that:
"The Austro-Hungarian monetary union was not the result of a monetary marriage but the by-product of a fiscal divorce. Austria and Hungary became in 1867 two sovereign budgetary entities. In the process, they retained a common bank of issue and thus formed a defacto monetary union that would operate until its post-World War I collapse."
A Sterling Area currency union with an independent Scotland would likewise be a product of divorce, not of marriage. An annex to the Scottish Fiscal Commission Working Group's First Report assessing possible currency options for an independent Scotland notes that there are two ways to retain Sterling: through a formal monetary union or through an informal arrangement ("Sterlingisation.") The Scottish Parliament is in favor of the formal monetary union, in which the Bank of England would make monetary policy decisions in consideration of conditions in both Scotland and the rest of the UK.

Scotland's proposed formal monetary union would resemble the set-up in the Austria-Hungary monetary union. At the start of the Compromise, the Austrian National Bank was the sole bank of issue for Austria and Hungary. As Flandreau details, Hungary gained increasing control over the central bank over the years. In 1878 the Bank became the Austro-Hungarian Bank. The Austro-Hungarian Bank inherited its predecessor's balance sheet and became a federal institution, with Managements in both Vienna and Budapest. At least two of the twelve Councillors had to be Hungarian. Over the pre-WWI years, there was "a definite trend in Hungary's formal influence within the common Bank. This trend was also reflected in substantive policies of the Bank...The Austro-Hungarian National Bank transformed itself from being a predominantly Austrian institution in 1867 into being a truly binational institution."

Flandreau explains the political economy behind the transformation at the Austro-Hungarian National Bank:
"Consider a monetary union comprising two parts, a 'large' (Austria) and a 'small' (Hungary) country. The common central bank delivers a range of services that are valuable to both parts, but not equally... If power is proportional to size, the small country has very little control over common decisions. It is bound by the discipline of the union without being able to influence decision-making in a way that would address its own specific interests. Co-operation (that is, participation in the union) is sub-optimal and the small country prefers to quit. Sustained co-operation requires that the large country accepts a decision-making process in which the small country receives a greater voting share than size alone would predict...
However, it is not clear why the large country should accept this dilution of power. The normal outcome should therefore be secession...[Casella (1992)] shows that if co-operation delivers a number of public goods that are useful to all parts, then the large country may nonetheless accept a reduction of its relative ability to set decisions, since the additional output may compensate for the initial loss."
Flandreau's logic is relevant for a possible Sterling Area. The Fiscal Commission notes that "Over the medium term it may well be in Scotland’s interests to move to an alternative arrangement, should either the performance of the Scottish economy change or the preferences of the people of Scotland change." A "Sterling Area Bank" would have to be acceptable enough to both parts of the Sterling Area to be maintained. In the Austria-Hungary arrangement, Austria had to provide Hungary with considerable incentives to stay on board. Austria was willing to make the necessary concessions because the benefits to Austria of keeping Hungary in the union were sufficiently great. These benefits may have included dynastic and imperial considerations, maintenance of the crown as an international currency, and maintenance of bilateral trade.

According to Flandreau, then, monetary compromises are determined by bargaining power.  It is not clear to me whether the bargaining power dynamics between Scotland and the rest of the UK would be suitable for sustained cooperation. As commenter Absalon says in response to Guan's post, "Scotland would not need the permission of England to continue to use sterling any more than Panama and Ecuador need American permission to use the dollar. Of course, Panama and Ecuador have no say in setting the policies of the Fed." If an independent Scotland wanted some amount of power in a supranational or joint shareholder central bank, it would need enough bargaining power. Bilateral trade is one consideration. Guan describes another attempt to assert bargaining power:
"The argument of the Scottish National Party-led government is that the British pound and the Bank of England (name notwithstanding) are “assets” of the United Kingdom. Assets and liabilities of the United Kingdom should be split up among the constituent countries, and if rest-of-UK refuses to divide the sterling 'asset', then Scotland would refuse to assume its share of the liabilities—the UK national debt."
In Austria-Hungary, Austria was directly responsible for the pre-1867 common debt. Hungary paid an annuity corresponding to a one-third share. (Unlike in the Eurozone, no "stability pact" was signed.) But it took more than just the desire for Hungary to pay its share of the common debt to hold the currency union together. Times were very different during the Austria-Hungary currency union, so there are limits to the lessons that can be drawn. But the union did manage to exist without a formal fiscal union. In many ways, it was beneficial for Hungary. Scotland would like to enjoy similar benefits, but it may not have the necessary bargaining power that Hungary had.

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This is my last post on Not Quite Noahpinion before it reverts to Noahpinion. I really appreciate the opportunity to post here for the past few months and thank you all for reading and commenting. I'll be working on my dissertation and (at least occasionally) posting on my own blog. Keep in touch.
Happy Thanksgiving!

### Scotland, sterling and the debt

 Does your separatist movement have an infographic?

Scotland will hold a referendum on independence from the United Kingdom in September 2014, and the Scottish Government has just released a 670 page white paper on Scottish independence (conveniently available in both Kindle and ePub formats for nice bedtime reading). The white paper presents the government’s case that Scotland can and should be in a currency union with the rest of the UK.

There are probably some sound arguments for that: it could take years to join the euro, and much of Scotland’s trade is with rest-of-UK, and vice versa.

On the other hand, events of recent years have kind of cooled the enthusiasm for currency unions in Europe. It’s not at all clear that it would be a good idea for Scotland to adopt sterling. The UK Government’s position is, sensibly enough, that a currency union would be unworkable without a fiscal and political union, which is kind of absurd when the goal is Scottish independence.

But let’s read between the lines. The argument of the Scottish National Party-led government is that the British pound and the Bank of England (name notwithstanding) are “assets” of the United Kingdom. Assets and liabilities of the United Kingdom should be split up among the constituent countries, and if rest-of-UK refuses to divide the sterling “asset”, then Scotland would refuse to assume its share of the liabilities—the UK national debt.

(By the way, did you notice the reference to “the most optimistic scenario … by the Institute for Fiscal Studies, would be to cut public spending by £3bn more than the UK government plans by 2021”? Emphasis added, of course.)

This is a brilliant strategy and a win-win for the pro-independence campaign, given Scots’ apparent sentimental attachment to a currency issued by a bank that is named for their erstwhile enemy. They either get to keep sterling, or they get a huge chunk of debt relief. Given the quality of economic decision-making in London, it’s seems likely that rest-of-UK will go for the latter.

I think this is the endgame, assuming the referendum passes (which doesn’t seem so likely right now): an independent Scotland with its own currency, a geographic share of hydrocarbon reserves and no debt. Great way to start a country.

## Monday, November 25, 2013

### New Quartz article: A battle for the soul of macroeconomics

Miles and I have a new article in Quartz, about the shakeup at the Minneapolis Fed, the ongoing battle between Freshwater and Saltwater macro (which Saltwater appears to be winning), and the history of modern (read: DSGE) macro.

It was very tricky to write this column, since A) we really don't know if the Minneapolis thing is part of the Saltwater/Freshwater battle, or whether it was just a personality conflict, and B) we wanted to take sides in the Saltwater/Freshwater battle without either endorsing or criticizing Kocherlakota's personnel decision. That is a tricky tightrope to walk, but I think we did a decent job.

Excerpts from the article:
Two of the Minneapolis Fed’s most eminent and long-serving economists, Patrick Kehoe and Ellen McGrattan, have been fired...[A]lthough the Minneapolis Fed shakeup could be due to any number of reasons—a personality conflict, a disagreement over the Fed bank’s mission, etc.–one possibility is that the personnel changes are related to Fed officials’ changing attitude toward business cycles...
Patrick Kehoe, one of the economists dismissed from the Fed, is a key figure in a school of economics called “Freshwater Macroeconomics” (the other, Ellen McGrattan, is his frequent co-author)...If the Fed prints money to try to stimulate demand, [the Freshwater people] say, it will only succeed in creating inflation rather than reviving the economy...
The Freshwater school gained enormous clout in the ‘80s. But in the ‘90s, there was a counterattack from the coast. The Saltwater macroeconomists believed that recessions were economic failures, and that monetary policy was important in fighting them...But one bastion of hard-line freshwater thinking held firm: “Minnesota macro.” The researchers at the University of Minnesota and the Minneapolis Fed have largely hung onto the belief that monetary policy can affect inflation, but can’t fight recessions.
But there is good reason to think that this view is losing credibility at the Fed.
Narayana Kocherlakota is...an important bellwether of Fed thinking. His views have shifted decisively toward believing that monetary policy can stabilize the economy. What changed his mind? The answer is obvious: the Great Recession, and the failure of large purchases of long-term government bonds and mortgage-backed assets—QE—to create inflation. It makes all the difference in the world when the No. 1 event shaping the questions macroeconomists ask is no longer the Great Inflation of the 1970s, but the Great Recession that still casts its shadow over the world.
Nor is Kocherlakota the only Fed official to change his mind. So even if the Minneapolis Fed shakeup wasn’t caused by a clash of ideas, the Fed’s shift toward Saltwater macro is a real phenomenon...
As QE ramped up, disputes broke out among Fed economists. Some, like Philadelphia Fed president Charles Plosser (himself a noted Freshwater researcher) and Minneapolis Fed president Narayana Kocherlakota, argued that QE would put us in danger of inflation. But as the Fed’s printing presses rattled on and inflation failed to materialize, some “hard money” advocates had second thoughts. Last year, Kocherlakota declared that he had changed his mind, and now supported QE...
Kehoe and McGrattan’s dismissal drew loud protests from other members of the Freshwater school...Steve Williamson, a Freshwater economist at Washington University, blogged that Kocherlakota “seems intent on destroying the [Minneapolis Fed] as a research institution.” So whether or not the firings had anything to do with economic theories, Freshwater folks are concerned, and with good reason. A key part of the genesis of Freshwater macro was a desire to say something about monetary policy (i.e., why not to use it). If the Fed refuses to listen to leading Freshwater voices, then a big chunk of the real-world influence of this school of thought will be gone.
There's much more in the article (Miles' first draft was over 3000 words!), so read it all here.

Another difficult thing about writing this column was that it comes off sounding like we're critical of Kehoe's ideas, but I personally really like both of the Kehoe papers I've read! And one of those two papers is the paper where he criticizes New Keynesian (Saltwater) economics! In that paper, Kehoe acts as the "microfoundation police," pulling micro evidence to show that some of the assumptions in the most popular New Keynesian models don't add up. Since bad microfoundations really annoy me, I enjoyed that paper quite a lot, and it's one reason I'm a lot less sanguine about New Keynesian models than Miles!

(FYI, the other Kehoe paper I've read is this excellent paper on herd behavior.)

So the article ended up containing more pro-Saltwater boosterism than I would have included had I written it alone, but that's fine with me, because most of the Freshwater RBC-type models I've seen just assume away any role for monetary policy, so it doesn't make a lot of sense for the Fed to be using these. (Note that the "New Monetarist" models made by people like Steve Williamson don't make this assumption, and they're considered Freshwater too, so there's a distinction between "Minnesota macro" and "St. Louis macro" that was too subtle to put in the column.) Plus Freshwater microfoundations are probably even less realistic than Saltwater ones.

But anyway, I think the article turned out OK. I'd love to hear any feedback that people have.

Mark Thoma thinks the shakeup was probably due to personality conflicts, not differences in economic theory. Brad DeLong also suspects this is the case.

Nick Rowe, on his blog and in the comment section, has some very harsh and disapproving things to say about both Narayana Kocherlakota and his erstwhile advisors. He might want to take this up by Steve Williamson, who has some equally harsh things to say on the opposite side of the issue.

Paul Krugman takes the opportunity to criticize Minnesota macro.

Philly Fed economist Makoto Nakajima tweets (in Japanese!) that Miles and my analysis is "shallow", and suggests we have better ways to spend our time.

A couple people have written to me with thoughts about the Fed firings. One alternative hypothesis I had not considered: It's all about money. Economists who hold university professorships and also do work at the Fed are paid full-time salaries by their universities and full-time salaries by the Fed (I had not known this fact). But working at the Fed probably doesn't make those joint economists put out much more research than they would if they just worked at their university. So the $that the Fed is paying to those economists might be mostly waste, especially if the researchers in question are not doing much in the way of direct advising on policy matters. So it could be all about budget cuts. ## Monday, November 18, 2013 ### New article: BS jobs in BS industries I have a new article out in The Week, discussing the phenomenon of "bullshit jobs", as postulated by David Graeber. Excerpts: Back in August, the anthropologist and anarchist David Graeber wrote an article for Strike!Magazine entitled "Bullshit Jobs." Graeber asked why we were still working so hard, despite being so much richer than in ages past. Where was the utopia of leisure that we were promised?...As you might expect, Graeber's article was thoroughly panned by most of the economists who even paid attention. But Graeber is on to something. Though I heavily doubt that many of our jobs represent a diabolic plot by our overlords to keep us in chains, it seems clear that many Americans no longer understand how their work creates value... According to Econ 101, people are supposed to get paid for the exact value they create....[But w]hat if your employer itself isn't adding value?...I suspect that many Americans these days wonder how much of their paycheck comes from value-added work, and how much comes from "rent."... Finance takes up fully 8 percent of our economy, up from less than 3 percent in 1950. But is our finance industry giving us anything now that it wasn't back then?... If finance is big, health care is gargantuan. The health-care sector takes up nearly one-fifth of our entire economy — far more than in other countries — and this share is climbing fast, as costs continue to rise. But despite this orgy of spending, we have little to show in the way of actual health... Finally, we have the education sector, which at 5.7 percent of GDP is also a big deal...Does college really train students with the skills and life experiences they need to be productive? Or is it just a hideously expensive way of proving to potential employers that you're smart and hard-working?... Together, just these three industries — finance, health care, and education — represent almost a third of America's economy... Obviously, we need all of them in some form: Without a finance industry, businesses couldn't launch or expand; without a health-care industry, we'd live horrible lives; and without education, we'd be unsuited for modern work. But the question is whether these industries, as a whole, create enough value to justify the huge amounts we spend on them. Because if they don't, then every American who works in finance or health care or education has to wonder whether his or her job is a "BS job." Read the whole thing here! ### Money for Nothing: The Negatives of a Negative Income Tax After a long political hibernation, basic income is back. Switzerland is set to vote on a referendum under which each Swiss citizen would receive approximately$2800 a month from the government as a minimum income. While it's unclear whether this proposal will actually pass (I suspect not), it has provoked a great deal of conversation on the topic. As Annie Lowry puts it, "[g]o to a cocktail party in Berlin, and there is always someone spouting off about the benefits of a basic income." I confess I haven't been to many cocktail parties in Berlin recently, but the idea has been all over the place in the wonkier parts of American media (see here, here, here, and here).

Compared to the messy, kludgy reality of existing social serviced, the pristine simplicity of the basic income idea has obvious appeal. Unfortunately, much of the discussion of basic income seems to be focused on the wrong things, or is based on misapprehensions. For example, Lowrey says that one of the big advantages of having a basic income is that '[p]overty would disappear."  That may or may not be true, but if it is true, this would have less to do with the actual effects of the basic income program than with how the poverty rate is calculated. As Tim Worstall recently noted, the poverty rate (at least in the U.S.) is calculated based on a person's income pre-taxes and transfers:

[T]he four major poverty reduction programs are Medicaid, SNAP, EITC and Section 8 vouchers. And we include none of them, not one single groat of that money spent, in our current estimates of poverty.
So, while our definition of poverty has not changed (three times a low-cost food budget for a household in the early 1960s upgraded for inflation) what we’re actually measuring is now completely different. The US poverty numbers today do not measure the number of people still in poverty after the aid given: they measure the number of people in poverty before aid is given.

If one were to take account of the effect of current anti-poverty programs, the poverty rate would be nearly zero. Similarly, if we were to replace existing anti-poverty programs with a basic income and didn't include that income in calculating the poverty rate, then the direct effect on poverty of enacting a basic income would be minimal.

The real difference between a basic income and the status quo is not how it would effect the poor, but how it would effect the middle class. Medicaid, SNAP, EITC, and Section 8 are all means tested programs, meaning that they aren't available to people who make over a certain income. By contrast, whether billed as a replacement for existing welfare programs or as an add on to it, basic income plans are typically not means tested. If you are a doctor making $200,000, you get the same government stipend as if you are making$10,000 working part time at Wal-Mart.

The fact that the basic income isn't means tested has its advantages. It means, for example, that low income workers don't face the high implicit marginal tax rates that can come from means tested programs. But it also means that any disincentive to work based on the extra income provided by the government will apply across the whole of society.

Which brings us to another issue with the current coverage of the basic income idea. As is typically noted in the recent coverage, back in the 1960s and early 1970s, basic income plans were all the rage. Martin Luther King, Jr. was supportive, as was Milton Friedman. Richard Nixon and George McGovern both put forward basic income proposals. And then, nothing. The idea kind of just faded out of existence. At least, that's the impression one gets from reading some of the recent accounts.

While I'm sure there were many reasons basic income lost its luster, one big factor was the results of a series of experimental implementations of the idea. Between 1968 and 1982, the government sponsored four separate randomized trials, providing $63 million in basic income to more than ten thousand individuals. These studies concluded that a basic income set at the current poverty rate significantly reduced the average amount of time worked by recipients by the equivalent of 2-4 weeks of full time employment, as compared to the existing welfare system. The experiments also seemed to suggest that providing a basic income increased the likelihood of family breakup. While there have been a few smaller studies since then that are more encouraging, it's not surprising that many policymakers reacted to these studies by concluding, in the words of Jim Manzi, of basic income that it "is a fascinating and useful thought experiment, but it's not useful public policy." Personally, I remain a fan of the Earned Income Tax Credit, which, unlike basic income proposals, is tied to work (and, unlike such proposals, has been successfully implemented and expanded for decades). But while I admire the simplicity of the basic income idea, I'm afraid I'm with Jim Manzi. ## Sunday, November 17, 2013 ### God and SuperGod Every Sunday, Miles Kimball does a post about religion. This week, it's a guest post by none other than Yours Truly. Head over to Miles' place to find out why God can't ever be certain that He's really God, and why this tells us what we humans ought to be doing with our lives! ## Thursday, November 14, 2013 ### New Foreign Affairs article: Will Japan choose neoliberalism? I have a new article at Foreign Affairs, which draws heavily on the ideas in this blog post from a few months back, as well as this earlier post. The article about the monumental economic and social choice facing Japan: Whether to embrace neoliberalism. Some excerpts: Faced with economic stagnation in the late 1970s and early 1980s, most of the world’s rich countries made a fateful choice. They lowered taxes; slashed government regulation in labor, financial, and other markets; opened their economies to global trade and finance; and privatized government functions...[M]ost [economists] concur that the reforms at least contributed to higher inequality, increased economic insecurity, and, at least temporarily, faster economic growth... Buoyed by the last spurt of its postwar catchup growth, Japan managed to sail through the 1980s without having to face hard choices about the structure of its economy... Many features of the Japanese economy that are commonly attributed to culture are, in fact, the result of Japan trying to run a modern economy without neoliberal reform: powerful but inefficient corporations, little job mobility, low unemployment, a relatively equal income distribution, and a job market that is heavily rigged against women... In order to enact meaningful structural reform, Abe will have to reverse Japan’s most important economic policy decision of the last half century. He will have to embrace neoliberalism... [T]he third arrow of Abenomics is not just about lifting Japan out of its long economic slump. It is about making a grave choice that will determine the fabric of Japanese society. The failure of the third arrow means continued corporatism, and the preservation of Japan’s social model even at the cost of a slow slide into economic backwardness. Abe’s trade and labor reforms offer a way out into a frightening and uncertain future -- but one that is potentially freer. Read the whole thing here! ## Monday, November 11, 2013 ### The Price and Future of Bitcoin Guest post by Evan Jenkins. It’s time for some Real Talk about Bitcoin. This past month’s Bitcoin boom has brought out the usual derp from both the True Believers and the Cryptoskeptics. The True Believers point to rising prices as evidence of the impending Fiatpocalypse, while the Cryptoskeptics point to the same rising prices as evidence that Bitcoin is a mere faddish bubble, destined to pop as soon as its so-called investors get kicked out of their parents’ basements and need to pay for food and shelter. What we haven’t seen enough of is analysis of Bitcoin as an asset. Whatever you may think of Bitcoin, it's an actual commodity with an actual price, and we can use that price to make inferences about its future. You’re welcome to unskew my analysis using whatever set of Bayesian priors you hold, but I hope this will at least give a basis for some actual dialog about the future of Bitcoin. Bitcoin is a purely speculative asset (that is, you will never be paid anything just for holding it), which makes its pricing model particularly simple. To further simplify things, we’ll make the not entirely realistic assumptions of a zero risk-free rate and risk-neutral investors, or equivalently, a discount factor of 1. What this means is that the price of Bitcoin now is equal to the expected price of Bitcoin at any time in the future. As I write this, the price of a Bitcoin is hovering around$300. Does this mean that twenty years from now, the price of a Bitcoin should still be around $300? Of course not! Twenty years from now, either the True Believers or the Cryptoskeptics will be proved right. If the Cryptoskeptics are right, Bitcoins will be worthless in twenty years. If the True Believers are right, they’ll be worth a lot more than they are now. Determining exactly how much more is a tricky issue. The chart in Guan’s post shows several potential implied values for Bitcoin, based on the total value of all Bitcoins in existence growing to various levels. These values are possibly reasonable short-term goals for the True Believers, but I can’t imagine the Bitcoin hype stopping at any of those levels. In order for Bitcoin to really reach a stable value level that can reliably be used worldwide for online transactions, it’s going to need to become a sizable portion of the world’s currency. One estimate puts the current total value of currency in the world at$58.9 trillion. Let’s say that in the long run, Bitcoin will need to become 1% of that, or $589 billion. This corresponds to a price of about$28,000. (This is a larger value but lower price than the last entry in the table: I’m having this take place in the future, when there will be more total Bitcoins.)

All right, we have our setup. Right now, the price of a Bitcoin is $320. There are two possible futures: in the Cryptoskeptic future, a Bitcoin will be worth$0. In the True Believer future, a Bitcoin will be worth \$28,000. What is the probability of each future? If we let $$q$$ be the probability of the True Believer future, then $300 = P_{\operatorname{now}} = E(P_{\operatorname{future}}) = 28000 q,$ so $q = \frac{300}{28000} \approx 0.01.$ Thus, our model tells us that there’s only a 1% chance that the True Believers are right! The higher you think the future value of Bitcoin is, the less likely that that future will actually happen. (This is what makes the chart in Guan’s post so amusing!)

To finish up, I want to bring up two confounding factors, one of which is bad news for the future of Bitcoin, and one of which is good news for the future of Bitcoin but possibly bad news for the True Believers.

The first confounding factor is that the Bitcoin market, as it exists now, probably does a pretty bad job of pricing correctly. The problem is that it is very difficult for somebody who does not already hold Bitcoins to make a bet against the future of Bitcoin. The only people with the power to move the Bitcoin market down are those who have already bought into the Bitcoin market, and they likely have rosier visions of the future of Bitcoin than the rest of us. This, in my opinion, is the biggest piece of evidence in favor of calling Bitcoin a bubble. In order for the Bitcoin market to price Bitcoin correctly, there needs to be a good way to short Bitcoins. But until there is a reliable way to lend and borrow in Bitcoins, that won’t happen.

The second confounding factor is that if Bitcoin really does establish itself as a legitimate currency, we will need to throw our assumptions of how many Bitcoins there are out the window. In principle, there should be no more than 21 million Bitcoins ever produced. In fact, since Bitcoins can be irreversibly lost, we should actually expect the number of extant Bitcoins to start decreasing at some point. But, as much as the True Believers like to rail against fractional reserve banking, the truth is that once Bitcoins become a real currency, it will start being banked and invested like a real currency, which will effectively increase the number of Bitcoins in existence. Depending on how we measure total “amount of money” in US dollars is anywhere from 10 to 20 times the amount of physical currency in circulation. But there is reason to think that for Bitcoin, the mulitplier could be even higher, as Bitbanks would lack, at least initially, any sort of reserve requirement. This lowers the future price, and thus raises the probability, of the True Believer future. But is this the future that the True Believers want? Not really.

So, what conclusions do I choose to draw from this analysis? First, Bitcoin is in a massive bubble that will in all likelihood eventually pop. Second, even if I’m wrong and Bitcoin does manage to establish itself, it will end up looking a lot more like a traditional currency than the True Believers envision. Indeed, it’s possible that Bitcoin will succeed but still settle at a significantly lower price than it’s at now, due to the power of fractional reserve banking. But it’s hard to imagine a path from here to there. The True Believers are likely to resist any attempts to turn Bitcoin into a stable store of value precisely because the means to do so are antithetical to their cause. A Bitcoin future will require a concordance between the True Believers and the Cryptoskeptics, and right now, the cultural gap just seems too large to bridge. Some sort of cryptocurrency may indeed establish itself, but the signs right now do not point to Bitcoin.

Evan Jenkins is a Visiting Fellow at the Pinion Institute for Econotrolling. He occasionally rants about provincial urban development issues at his blog, Let the Midway Bloom. Follow him on Twitter at ejenk.