Economist Channel

DB's Torsten Sløk writes in his regular email analysis:

Yesterday I participated in the annual US Monetary Policy Forum here in Manhattan, and the 96-page paper presented concluded that we don’t really know if QE has worked. This was also the conclusion of the discussion, where several of the FOMC members present actively participated. Nobody in academia or at the Fed is able to show if QE, forward guidance, and negative interest rates are helpful or harmful policies. 

Despite this, everyone agreed yesterday that next time we have a recession, we will just do the same again. Eh, what? If we can’t show that a policy has worked and whether it is helpful or harmful how can we conclude that we will just do more next time? And if it did work, then removing it will have no consequences? There is a big intellectual inconsistency here.

Investors, on the other hand, have a different view. Almost all clients I discuss this topic with believe that QE lowered long rates, inflated stock prices, and narrowed credit spreads. Why? Because when the Fed and ECB buy government bonds, then the sellers of those government bonds take the cash they get and spend it on buying higher-yielding assets such as IG credit and dividend-paying equities. In other words, central bank policies lowered risk premia in financial markets, including in credit and equities. As QE, forward guidance, and negative interest rates come to an end, risk premia, including the term premium, should normalize and move back up again. And this process starts with the risk-free rate, i.e. Treasury yields moving higher, which is what we are observing at the moment.

These lovely paragraphs encapsulate well the academic and industry/policy view, and the tension in the former.

I'm interested by the latter tension: Industry and media commenters are deeply convinced that the zero interest rate and QE period had massive effects on financial markets, in particular lowering risk premiums and inflating price bubbles.



I'm deep in the academic view. The industry view forgets that the Fed does not just suck up bonds, it issues interest-bearing reserves in exchange. For every $1 of bond the market does not hold, the market has to hold $1 of additional reserves.  Industry analysis is very insightful about individual traders and investors and the mechanics of markets but forgets about adding up constraints and equilibrium which are the bread and butter of academia. You personally may sell a bond and put the money in to stocks. But someone else has to sell you that stock and hold the reserves.

The risk premium is the same if you borrow at 2% and lend at 4% than if you borrow at 4% and lend at 6%. So there is no relationship at all in basic economics between the level of interest rates and the risk premium, or between the maturity structure of outstanding government debt (reserves are just overnight government debt) and the risk premium. That one cannot see any movement at all in 10 year rates or inflation with QE is also noteworthy.

But us academics need to listen as well as to lecture. Often industry people know something we don't.    So I find this striking difference interesting. Though I haven't changed my mind yet.
Torsten wrote back:

TS: But that argument only holds in a closed economy, no? In other words, what if the US based seller of Treasuries to the Fed took the proceeds of their sale of US Treasuries and invested it in Indonesian government bonds?

JC: Then the seller of Indonesian government bonds now is sitting on US reserves.

TS: And what it the European insurance company used the cash they get for selling bunds to the ECB to buy US IG credit?

JC: Then the seller of US IG credit is now sitting on reserves. Someone is sitting on reserves. And reserves are now just very short term Treasury debt.

TS: Anyways, you may say the market view is partial equilibrium but almost everyone in the industry saw the portfolio substitution with their own eyes and believe that it is real.

JC: That helps. Yes, but they saw one side of the portfolio susbstitution. They did not see the other side of that substitution! I think in the end it's mostly foreign banks now sitting on the reserves, so those banks took deposits from someone who sold securities to your industry contacts.
A fascinating conversation..

The monetary policy forum is here. The paper is "A Skeptical View of the Impact of the Fed’s Balance Sheet'' by David Greenlaw (Morgan Stanley, so not everyone in industry has the industry view!) Jim Hamilton, Ethan S. Harris (Bank of America Merrill Lynch), and Ken West. It's excellent. It takes 96 pages (plus graphs) to put to rest verities that have been passed around unquestioningly for 8 years. Excerpts from the abstract:

"Stepping on a Rake: the Fiscal Theory of Monetary Policy" is new paper, just published in the European Economic Review. This link gets you free access, but just for the next few days. After that, I can only post the last manuscript. (I held off sending this hoping the EER would fix the figure placement in the html version, but that didn't happen.)

The paper is about how the fiscal theory of the price level can describe monetary policy. Even without monetary, pricing, or financial frictions, the central bank can fix interest rates. In the presence of long-term debt higher interest rates lead to lower inflation for a while. Interest rate targets, forward guidance, and quantitative easing all work by the same mechanism. The paper also derives Chris Sims' "stepping on a rake" paper which makes that point, and integrates fiscal theory with a detailed new Keynesian model in continuous time.

Source: Wall Street Journal

So, what's up with Bitcoin? Is it a "bubble?'' A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some "excess valuations" in stock markets, gold and commodities, and money itself.

Let's put the pieces together. The first equation of asset pricing is that price = expected present value of dividends. Bitcoin has no cash dividends, and never will. So right off the bat we have a problem -- and a case that suggests how other assets might have value above and beyond their cash dividends.

Well, if the price is greater than zero, either people see some "dividend," some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called "convenience yield," the latter is a "rational bubble."

"Rational bubbles" are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The "greater fool" or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let's think about "convenience yield." Why might someone be willing to hold bitcoins even though their price is above "fundamental value" -- equivalently even though their expected return over a decently long horizon is lower than that of stocks and bonds? Even though we know pretty much for sure that within our lifetimes bitcoin will become worthless? (If you're not sure on that, more later)


Well, dollar bills have the same feature. They don't pay interest, and they don't pay dividends. By holding dollar bills, you are holding an asset whose fundamental value is zero, and whose expected return is demonstrably lower than that of, say, one-year treasuries. One year Treasuries are completely risk free, and over a year will give you about 1.5% more than holding dollar bills. This is a pure arbitrage opportunity, which isn't supposed to happen in financial markets!

It's pretty clear why you still hold some dollar bills, or their equivalent in non-interest-bearing accounts. They are more convenient when you want to buy things. Dollar bills have an obvious "convenience yield" that makes up for the 1.5% loss in financial rate of return.

Also, nobody holds dollar bills for a whole year. You minimize the use of dollar bills by going to fill up at the ATM occasionally. And the higher interest rates are, the less cash you hold and the more frequently you go to the ATM. So, already we have an "overpricing" -- dollars are 1.5% higher priced than treasurys -- that is related to "short-term investors" and lots of trading -- high turnover, with more overpricing when there is more trading and higher turnover -- just like bitcoin. And 1999 tech stocks. And tulip bubbles.

Some of the convenience yield of cash is that it facilitates tax evasion, and allows for illegal voluntary transactions such as drugs and bribes. We can debate if that's good or bad. Lots of economists want to ban cash (and bitcoin) to allow the government more leverage. I'm less enthusiastic about suddenly putting out of work 11 million undocumented immigrants and about half of small businesses. The US tends to pass a lot of aspirational laws that if enforced would bring the economy to a halt. To say nothing of the civil liberties implications if the government can track every cent everyone has ever spent.

But US cash is largely stuffed in Russian mattresses. It is even less obvious that it is in our interest to enforce Russian laws on taxation or Russian control over transactions. Or Chinese, Venezuelan, Cuban, etc. control.

And more so bitcoin. This is the obvious "convenience yield" of bitcoin -- the obvious reason some people are willing to hold bitcoin for some amount of time, even though they may know it's a terrible long-term investment. It certainly facilitates ransomware. It's great for laundering money. And it's great for avoiding capital controls -- getting money out of China, say. As with dollars there is a lot of bad in that, and a lot of good as well. (See Tyler Cowen on some parallel benefits of offshore investing.)

But good or bad is beside the point here. The point here is that there is a perfectly rational demand for bitcoin as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth -- even if people holding it know that it's a terrible long-term investment.

On top of this "fundamental" demand, we can add a "speculative" demand. Suppose you know or you think you know that bitcoin will go up some more before its inevitable crash. In order to speculate on bitcoin, you have to buy some bitcoin. I don't know if you can short bitcoin, but if you wanted to you would have to borrow some bitcoin and sell it, and in the process you would have to hold some bitcoin. So, as we also see in high-priced stocks, houses and tulips, high prices come with volatile prices (so there is money to be made on speculation), and large trading volumes. Someone speculating on bitcoin over a week cares little about its fundamental value. Even if you told him or her that bitcoin would crash to zero for sure in three years, that would make essentially no dent in their trading profits, as you can make so much money in a volatile market over a week, if you get on the right side of volatility.

Now to support a high price, you need restricted supply as well as demand. There are only so many bitcoins, as there are only so many gold bars, at least for now.  But that will change. The Achilles' heel of bitcoin's long term value is that there is nothing to stop people from creating bitcoin substitutes -- there are already hundreds of other similar competitors. And there is nothing to stop people from creating private claims to bitcoin -- bitcoin futures -- to satisfy speculative demand. But all that takes time. And none of my demands were from people who want to hold bitcoin for very long.  Ice cream is also a fast-depreciating asset, but people hold it for a while. In this view, however, Bitcoin remains a terrible buy-and-hold asset, especially for an investor who plans to pay taxes.

In sum, what's going on with Bitcoin seems to me like a perfectly "normal" phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and limits on short-selling, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand -- no annual reports on how much the Russian mafia wants to move offshore next week -- that's plausible too.

This view says that price surges only happen with restricted supply, and accompany price volatility, large trading volume, and short holding periods. That's a nice testable link, which seems to hold for bitcoin. And other theories, such as madness of crowds, no not explain that correlation.

Bitcoin is not a very good money. It is a pure fiat money (no backing), whose value comes from limited supply plus these demands. As such it has the huge price fluctuations we see. It's an electronic version of gold, and the price variation should be a warning to economists who long for a return to  gold. My bet is that stable-value cryptocurrencies, offering one dollar per currency unit and low transactions costs, will prosper in the role of money. At least until there is a big inflation or sovereign debt crisis and a stable-value cryptocurrency not linked to government debt emerges.

(This view is set out in more detain in a paper I wrote about the tech stock era,  Stocks as Money in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003. Alas not available online, but the link to my last manuscript works.)

Update: Marginal Revolution also on bitcoin today.

This is a talk I gave for Hoover, which blog readers might enjoy. Yes, it puts together many pieces said before. This post has graphs and uses mathjax for equations, so if it isn't showing come back to the original. Also here is a pdf version which may be more readable.

Background

As background, the first graph reminds you of the current situation and recent history of monetary policy.

The federal funds rate is the interest rate that the Federal Reserve controls. The funds rate rises in economic expansions, and goes down in recessions. You can see this pattern in the last two recessions. Since about 2012, though, when following history you might have expected the funds rate to rise again, it has stayed essentially at zero. Very recently it has started to rise, but very slowly, nothing like 2005.

The black line is reserves. These are accounts that banks have at the Fed. Crucially, these bank accounts now pay interest. Starting in 2008, reserves grew dramatically from about $20 billion to $2,500 billion. The three cliffs are the three quantitative easing' episodes. Here, the Fed bought bonds and mortgage backed securities, giving banks reserves in exchange.

Inflation initially followed the same pattern as in the last recession. It fell in the recession, and bounced back again in 2012.Inflation has been slowly decreasing since. 10 year government bonds have been quietly trending down, with a bit of an extra dip during the recession.

The next graph plots US unemployment and GDP growth.

You can see we had a deeper recession, but then unemployment recovered about as it always does, or if anything a little faster. You can see the big drop in GDP during the recession. Subsequent growth has been overall too low, in my view, but it has been very steady. If anything, both growth and inflation are steadier in the era of zero interest rates than they were when the Fed was actively moving interest rates around.

These central facts motivate my heresies: Inflation, long term interest rates, growth and unemployment seem to be behaving in utterly normal ways. Yet the monetary environment of near-zero short term rates and huge QE is nothing but normal. How do we make sense of these facts?

Heresy 1: Interest rates

• Conventional Wisdom: Years of near zero interest rates and massive quantitative easing imply loose monetary policy, "extraordinary accommodation,'' and "stimulus.''
• Heresy 1: Interest rates are roughly neutral. If anything, the Fed has been (unwittingly) holding rates up since 2008.

What does a central bank look like that is holding interest rates down? Such a bank would lend money to banks at low interest rates, that banks could turn around and re-lend at higher interest rates. That's how to push rates down.

What does a central bank look like that is pushing rates up? Such a bank takes money from banks, offering to pay banks a higher interest rate than they can get elsewhere.

What's our central bank doing? In bigger format, the top panel of the next graph presents excess reserves. This is money that banks voluntarily lend to the Fed, and on which they receive interest.

Top: Reserves. Bottom: Interest on excess reserves, Fed funds rate and 1-month Treasury rate

The bottom panel is the interest that the Fed pays on excess reserves, along with the Federal Funds rate and the rate on one month treasurys, to give a sense of market rates. As you can see, the Fed pays more than banks can earn elsewhere. So, on this basis, the Fed looks like a central bank pushing rates up, if anything.

Now, as we used to say at the University of Chicago, ok for the real world, but how does that work in theory? How can it be that zero interest rates -- lower than we have seen since the great depression -- are not an unusual stimulus?

Well, it's certainly possible. Remember, the nominal interest rate equals the real interest rate plus expected inflation. If the real interest rate is, say negative 1.5%, and inflation is +1.5%, then a nominal interest rate of zero is neutral.

And, there are plenty of reasons to suspect that the "natural'' real rate has been negative for much of the period since the financial crisis. More savers than investors, low marginal product of capital in a real slow growth environment, and so on are easy stories to tell.

In this view, by the way, as the real rate recovers along with the economy, if the actual nominal interest rate is stuck at zero, then inflation should gently decline. That is also what we see.

Plus, after 8 years, if monetary policy were really "stimulating'' quite so much, where is the inflation and boom?

Heresy 2: Quantitative easing

As we have seen, in its quantitative easing (QE) the Fed bought nearly $3 Trillion of Treasurys and mortgage backed securities, giving banks interest-paying reserves in return.

• Conventional Wisdom: QE lowered long-term interest rate rates, and provided a big stimulus. QE's stimulative effect is permanent and continues to this day, so unwinding QE is vital to "normalizing'' policy.
• Heresy 2: QE did basically nothing to interest rates, or to stimulus.

The next graph is a plot of ten year rates and mortgage rates along with reserves. Again, the steep rises in reserves are the QE episodes.

Ten year treasury rate, 30 year mortgage rate, and reserves

Maybe the first QE is associated with a one percentage point drop in rates. But it bounces right back. Large transactions can move prices, but in the rest of finance we see these as temporary, not permanent movements. In the second and third QE, interest rates rise during the QE episode, exactly the wrong sign.

The bottom panel takes a longer view of interest rates Here you can see that interest rates have been on a steady downward trend since 1985. Can you see any difference in the behavior of these interest rates during the QE period from the late stages of the last three expansions? I can't.

Well, again, so much for the real world, how does it work in theory. As Ben Bernanke himself recognized, QE "works in practice'' or so he thought, but not in theory. We should worry about any proposition that has no theoretical basis. Sometimes facts are ahead of theory, but not often.

The Fed is in essence a huge money market fund. Banks sell bonds to the Fed, and get a money market account, backed by the Fed's holdings of the bonds. Just how much difference does it make for banks to hold treasurys through the Fed rather than directly?

We can think of them as open change operations. Reserves are government debt. So it's as if the Fed took a bunch of your $20 bills and gave you 2 $5s and a $10 in exchange. It's hard to see that having a big effect on your spending.

QE is catch 22. The usual story told is that bond markets are "segmented.'' The 10 year treasury market is cut off from other markets. Then, if the fed buys a lot of them it can raise the prices of 10 year treasurys. But the point of QE was not to lower Treasury rates, it was to lower rates that might influence investment. To affect the economy, the markets must not be segmented. For the Fed to affect the 10 year rates, they must be segmented, and the rates don't spill over to the rest of the economy.

Finally, the Treasury has been selling faster than the Fed has been buying. The next graph has all Federal debt, and federal debt less the part bought by the Fed. That bottom line is still growing. So, the Fed did not remove any bonds from the market. Overall, markets held more debt.

Federal Debt held by the public, and the same less debt held by the Fed.

Moreover, the Treasury was trying to move to a longer maturity structure. Treasury debt is much like your mortgage. If you take the 30 year fixed, you protect yourself against interest rate increases. If you take the floating rate ARM, you get a lower rates, but if rates go up you might be in a squeeze. The Treasury chose the fixed rate, trying to move to longer bonds. The Fed bought those long bonds right back up, issuing short term debt (reserves) instead, and undoing the insurance that the Treasury bought. Fed and Treasury need to get together and decide who is in charge of the maturity structure!

Heresy 3: Low rates, QE and financial markets

• Conventional Wisdom: QE and low interest rates set off a "reach for yield,'' "asset price bubbles,'' though artificially low risk premiums.
• Heresy 3: The risk premium is not unusually low for this stage of the business cycle. In any case, the Fed has nothing to do with risk premiums.

A quote from one of my otherwise favorite financial analysts expresses the view nicely:

"QE and negative interest rates manipulated prices of risk-free assets, and by artificially boosting risk-free assets central banks have sent investors on a hunt for yield, which in turn artificially boosted prices of risky assets and significantly distorted prices in financial markets.''

Again, this story gets passed on and on, but does it line up with the facts, and does it make any sense?

Risk premiums are about the spread between borrowing and lending. You take on risk by borrowing to invest. Now, if you borrow at 1 % and lend at 3%, that is exactly the same thing as borrowing at 3% and lending at 5%. Risk taking depends on the spread between risky and risk free rates, not the level of rates.

Yes, we can cook up stories, involving the affairs of specialized intermediaries. But recognize those are second-order stories, and hard to get risk premiums on widely traded stocks and bonds to go substantially wrong for years.

Let's look at the facts. Are there unusually low risk premiums or high asset prices, and are those tied to low interest rates or QE?

Spread between BAA and 10 year Treasury rate

This graph is the interest rate spread between Baa corporate bonds and 10 year Treasuries, a sign of the premium for holding the risk of corporate defaults. The premium is low now. But we are in the late September of the business cycle, and the corporate spread was even lower in each of the last three business cycles.

Risk premiums are always low in late stages of the business cycle. Risk is low, people are doing well, and willing to take risks despite low premiums. In fact, corporate premiums are still if anything surprisingly high for this stage of the business cycle, a fact often attributed to bank's unwillingness to trade much under the more stringent capital standards.

The next graph presents Bob Shiller's long-run price/earnings ratio. The price/earnings ratio is high. But it's also always high at the late stage of expansions, as people are more willing to take stock market risk in good times.

Price-earnings ratio on S&P500. Source: Robert Shiller

Moreover, looking at this century of data, the current time period with zero rates and massive QE does not stand out as particularly different from events we have seen many times before.

(Not: ignore the interest rate in the chart. It is the nominal interest rate, which reflects inflation, and is not relevant to the question here. I just copied Shiller's chart so didn't remove the line.)

Even so, it still seems high, but the price earnings ratio reflects the level of interest rates as well as the spread. The classic Gordon growth formula states that the price / earnings ratio equals one divided by the stock's rate of return minus the growth rate of dividends. We can also break down the stock rate of return into a real risk free rate and a risk premium. \[ \frac{P}{E} = \frac{1}{E(r)-g} = \frac{1}{r^f + E(r-r^f)-g} \] Now, suppose the real risk free rate goes down by one percentage point, leaving the risk premium alone. If the price/earnings ratio starts at 25, or expected returns four percentage points above growth, \[ \frac{P}{E} = 25 = \frac{1}{0.04} \] a 1% decline in real rate gives \[ \frac{P}{E} = 33 = \frac{1}{0.03} \] with no change in risk premium. That's just about the amount by which the price/earnings ratio is unusually high

Heresy 4: Real rates

All of my heresies revolve around the question of low interest rates, and you might object that yes, interest rates are low, but that's because you think the Fed is keeping interest rates low.

• Conventional Wisdom: The Fed is the primary force behind movements in the real rate of interest and GDP growth rates.
• Heresy 4: The Fed has little to do with real interest rates or economic growth rates (past $\approx$ 1 year).

This is just economics 101. The two most basic economic descriptions of interest rates are \[ \text{real rate} = \text{impatience} + (\approx 1-2) \text{growth rate} \] \[ \text{real rate} = \text{marginal product of capital} \] If people are impatient, you have to pay them higher interest rates to get them to save. If the economy is growing quickly, and people know they will be better off in the future, you have to pay them higher interest rates to get them not to consume today. And the interest rate is determined in the end by companies' ability to make real returns from borrowed money.

As we go in to an economic expansion, with higher growth, real interest rates will naturally rise, Fed or no Fed. As we go into a period of low or no growth and poor investment opportunities, real interest rates will be low, Fed or no Fed.

And after a few years, growth comes from productivity only, not anything the Fed can arrange.

Now, there are many stories told for low growth and low "natural '' real rates -- a "savings glut,'' a demographic bulge of middle age savers, low investment productivity from distorting taxes and regulation, and so on.

Moreover, real rates are low everywhere in the world. It isn't specific to the Fed.

In sum, the Fed is nowhere near as powerful as conventional wisdom suggests.

Heresy 5: Is the economy stable?

• Conventional wisdom: If interest rates are stuck or pegged, inflation or deflation will spiral out of control. The economy, on its own, is unstable. The Fed must constantly move interest rates, like the seal must move his nose, to keep inflation under control.
• Heresy 5: The economy is stable. If interest rates don't move, eventually inflation will adjust to that interest rate minus the natural real rate of interest.

Conventional wisdom makes a clear prediction. When the interest rate gets stuck at zero, deflation will spiral out of control. The next graph gives a simulation of a standard (adaptive expectations, ISLM) model. A deflationary shock hits, and inflation declines. The Fed lowers interest rates, but soon runs in to zero. When the interest rate hits zero, the deflation spiral breaks out.

The model in this figure is: \begin{align*} x_t &= -\sigma (i_t - \pi_{t-1} - v^r_t)\\ \pi_t &= \pi_{t-1} + \kappa x_t; \\ i_t &= \max[i^\ast + \phi (\pi_t -\pi^\ast),0] \end{align*}

Simulation of an old-Keynesian deflation spiral at the zero bound.

The facts deny this central clear prediction. Remember the lesson of the first graph, on what happened when interest rates hit zero and stayed there. There was no spiral.

Modern theory and fact agree: Inflation and economy are stable with fixed rates.

That does not mean that fixed interest rates are a good thing. They are possible, but not necessarily desirable. Remember \[ \text{interest rate} = \text{real rate} + \text{expected inflation} \] If interest rates are fixed, then as real rates vary -- remember, real rates should be low in recessions and high in booms -- inflation must vary, and in the opposite direction. Prices are a bit sticky and volatile inflation is not desirable. So even in the view that inflation is stable with fixed interest rates, it is still a good idea for the Fed to raise rates in boom times and lower them in recessions. The Taylor rule is alive and well. But the zero bound or slightly slow to move rates are not a spiral-tempting disaster.

Heresy 6: How does this thing work anyway?

• Conventional wisdom: Raising interest rates lowers inflation, & vice-versa.
• Heresy 6 (Implication of stability & modern theory). After a short run negative effect, persistently higher interest rates raise inflation.
• Are we past bump, at the point that persistently low rates have led to low inflation?

If inflation is stable around fixed interest rates, then if you raise rates and leave them there, inflation must eventually rise to meet the interest rates.

It's not as nutty as it seems. Most of our experience is the short run relationship, which is negative.

However, this possibility -- this consequence of stability -- suggests that after 8 years near zero, we have gotten over any negative response of inflation to rates, and low interest rates are attracting low inflation. And that if the Fed raises rates, it will eventually cause the inflation that it will, in the event, pride itself for foreseeing.

Consistent with this view, consider Japan and Europe in the next plot. Both of them have lower -- negative -- interest rates than we do. And inflation is drifting down in both places. Which is the chicken, and which is the egg?



Heresy 7: The Phillips curve

Conventional wisdom, largely reflected in Federal Reserve statements, has a clear view of where inflation comes from.

• Inflation comes from "tight markets,'' principally tight labor markets.

As I write, conventional wisdom says that the low unemployment rate, and other measures such as many unfilled job openings presage wage inflation, which will be passed through to price inflation. This view motivates the hawkish case for raising interest rates, even though current inflation remains below the Fed's 2% target, and accounts for the fact that the Fed has raised rates at all.

The conventional view of monetary policy acts through this causal channel. Lower interest rates will stimulate aggregate demand, which will stimulate output, which will cause companies to hire more people, which will tighten labor markets, which will lead to higher wages, which will lead to higher prices.

Sometimes, the correlation between inflation and unemployment is read the other way. (We economists seem to specialize in reading correlations as causal relationships, and forgetting that there are two curves that may shift in any set of observations.) In the recession, if only the Fed could raise inflation, the story went, it could thereby reduce unemployment. Bring on the helicopters full of money.

In any case, even the Phillips curve correlation has vanished, if it ever was there.

Core inflation and unemployment. Top: time series. Bottom: Inflation (y) vs. unemployment (x) since 2007

The top panel of this graph shows the time series of inflation and unemployment through the last two recessions. You can see inflation blip down and unemployment rise in the bottom of a recession. Even that correlation vanishes though in the subsequent expansion and most of all in the last one. Inflation quickly bounces back to a bit below 2%, while unemployment remains high. There is just no relation all between the level of labor market "slack'' and the rate of inflation.

The bottom panel shows the data since 2008 as a scatterplot, with inflation on the left and unemployment on the bottom. Your eye may wish to draw a negatively sloped line. But really the evidence there is on the right hand side -- inflation dipped down and came back up while unemployment stayed high. The traditional scatterplot is a bit misleading because the points are not randomly chosen, but follow each other as you can see in the first plot.

The plot really shows that there is essentially no relationship between inflation and unemployment -- the line is flat. Furthermore, there is a lot of vertical scatter -- the line isn't really a line.

(A clever Fed economist once parried, yes, the line is nearly flat! That's great news. It means if we could only get inflation up half a percent we would instantly cure unemployment. The vertical scatter emphasizes that the line is really just mush, not an exploitable flat line.)

Well, once again, so much for the real world, how does it work in theory? Nothing seems more obvious than the proposition that if labor markets are tight, if there are more jobs than people who want to work, that employers will offer higher wages, right?

No, as a matter of fact. If employers want to attract more workers, they must offer higher wages relative to prices. Saying "I'll pay you in pennies'' doesn't do any good. Both prices and wages rising at the same time does nothing to attract workers. If wages are "sticky'' then the only way to have wages rise is for product prices to fall -- we should expect tight labor markets to result in less inflation in goods prices!

Likewise, perhaps inflation comes from tight product markets, and what could be more natural than the idea that if there is more demand than supply that companies should raise prices. But that also only works for relative prices.

This is one of the first, most important, and most forgotten lessons of macroeconomics. What works for an individual market does not work for the economy as a whole. The overall price level is a different object than (relative) prices or wages. (And, similarly, trying to raise everyone's income by raising everyone's relative income, handing out protections to each industry and to labor, is equally doomed. No, we cannot pull ourselves up by our bootstraps.)

Now (of course) there are economic theories of the Phillips curve, and good ones. To get the overall level of prices and wages to correlate with labor or product market slack, you need some second-order effect, some "friction.'' The easiest one to understand is Bob Lucas' classic theory. In this context, employers can fool people into working harder for a little while by posting higher wages. If the people don't know that prices are going up too, they will think the real wage (relative to price) is higher, and not realize they are just being paid in devalued currency. Once they figure it out, of course, the boost to employment vanishes. (Also, this is a theory of causality from unexpected inflation to higher employment, not the other way around.)

The point here is not that there is no theory of the (apparently vanished) Phillips cure. The point here is that the simple commonsense idea that tight markets cause inflation is wrong. If you want a theory, you need to go past obvious supply and demand and add some friction to pricing or to information processing, and then you need to think the Fed understands and can exploit this friction to guide us to better outcomes than we get to on our own.

Maybe that's not how the economy is wired. Maybe labor market "tightness'' and "slack'' is not the root of inflation.

Heresy 8: Inflation Dangers

Source: CBO

• Conventional Wisdom: The danger of inflation comes if the Fed does not raise rates quickly enough. Then we have a positive spiral.
• Heresy 8: The inflation danger comes from fiscal policy. A Greek unwind. As past low-rates and pegs evaporated due to fiscal problems. And then Fed will be powerless to stop it.

If inflation is indeed stable, then small mistakes in monetary policy will not lead to spiraling inflation.

Inflation, like all crises, usually comes from unexpected sources. Our fiscal situation leads to a chance of inflation. If interest rates rise to 5%, our government will have to pay $ 1 trillion per year of additional debt service. It can't. This event could pile on top of a new financial crisis and recession occasioning a few more trillion dollars of borrowing, on top of unreformed taxes and entitlement spending. People seeing that crisis coming will unload government debt, try to buy real things, and drive inflation. If that happens, there is nothing the Fed can do about it.

This possibility is not a forecast. It's a risk, and a small risk, like living above an earthquake fault that breaks every few hundred years. That doesn't mean you should rush out of the house right now. But that doesn't mean we're safe either. Bond markets still trust the US to sort out our fiscal mess. But if they ever lose that faith, we get inflation -- stagflation -- that will seem to the Fed, and to conventional wisdom, to have come from nowhere.

To illustrate MV = PY. (It was MV=PT then.)  In  Irving Fisher, "The Equation of Exchange 1896-1910," The American Economic Review Vol. 1, No. 2 (June, 1911), pp. 296-305, via JSTOR.

The real questions the Fed should ask itself.  This is a cleaned up and edited version of a previous blog post, commenting among other things on Janet Yellen's Jackson Hole speech in favor of most of Dodd Frank, that appeared in the Chicago Booth Review. When you think of the Fed, think more of the giant regulator than about where interest rates go.

The newspapers report today that President Trump has decided to nominate Jerome Powell to replace Janet Yellen as Fed Chair.

The Federal Reserve's mandate is to "promote maximum employment, stable prices, and moderate long- term interest rates." Ms. Yellen can look back with pride on these outcomes during her term:



All three variables are doing better than they have in half a century. Many people complain about many things at the Fed, including me, but relative to the stated mandate, she has every right to put these charts on the wall of her new office.

One could complain that Ms. Yellen didn't face any particular challenges. As presidents are tested in wartime, so Fed chairs are tested by events. Ms. Yellen didn't face a recession or financial crisis. In this quiet late summer of the business cycle, her job was largely to do nothing, and resist calls from people who wanted her to take big steps. The Fed's major tool is the federal funds rate, has barely moved.


True, but she did not screw up either. So much of monetary history consists of unforced errors, that not making one is an accomplishment. The late summer of business cycles has historically been a time when central bankers over or under react.  And there has been no lack of loud voices calling for drastic action one way or another. In particular, the siren song of "macro prudential policy" that the Federal Reserve should manipulate stock and housing prices has been strong. Her predecessor, Ben Bernanke, will be much more written about for the Fed's management of the 2008 crisis and recession, as well for its failure to see it coming in 2007.  Not screwing up doesn't earn you as big a place in history, but perhaps it should.

No matter how one feels about monetary policy, and the more important (in my view) question of Fed financial regulation, President Trump is breaking with tradition by not reappointing her. The tradition that if the Fed chair has done a reasonable job, he or she is reappointed is a good one for maintaining the independence of the Fed. Let us hope that it is not gone for good.

Good luck to Ms. Yellen in her next endeavor. And to Mr. Powell in this one.

I might as well share with blog readers my favorite for the Fed: John Taylor.

A preface is in order though.

Monetary policy is not, right now, the flaming hot mess that characterizes so much of the Federal Government. And all the candidates are good.
The Fed's official mandate is low interest rates, low inflation, and maximum employment -- as large as monetary policy can make it. Interest, inflation, and unemployment are each lower than they have been in living memory. The stock market is high yet surprisingly quiet (low volatility).

One may question whether this is because or despite the Fed. (My view, largely despite.) One may quibble about low growth and labor force participation. One may worry about over-regulation, though Congress mandated most of it. But by the standards of the Fed's mandate, we must admit that the outcomes we see are fine. In any other branch of the Federal government, performance like this relative to mandates, together with a tradition of reappointment, would argue for Ms. Yellen's swift reappointment.

Ms. Yellen's critics, such as the Wall Street Journal editorial page, are forced to argue that she might fall short faced with future challenges. She might keep interest rates too low for too long, and let inflation pick up. (Inflation is still nowhere in sight.) She might raise interest rates too fast if the economy does start to grow more, in fear of inflation, and choke off supply side growth. (Yes, the two criticisms are inconsistent.) She might not handle the next crisis well.

Indeed. And taking the measure of people and trying to figure out how they will deal with future challenges is just what this process is supposed to be about. One can also complain that the process of monetary policy has too much discretion, too many speeches, and needs a more stable rules based approach. I have complained that the Fed is massively over-regulating finance, and this will cause a less competitive and efficient financial system in the future.

But recognize that all this is hypothetical, and there is little to complain right now about in the outcomes we tasked the Fed to achieve.

Still, let us suppose Mr. Trump decides he wants a new person at the Fed. Why John?

John is, quite simply, the top monetary economist of his generation. He understands the theory, he understands the empirical work, he deeply knows the history. He took the baton from Milton Friedman.


After it became clear that central banks could not operate by controlling the quantity of money in the 1980s, they went back to interest rate targets. But standard monetary doctrine said interest rate targets could not work. (Friedman 1968 is classic on that.) John's "rule" describes how interest rate targets can, and should work. John's work here is not high tech math, but very transparent and intuitive. And it has had enormous impact on the world of policy. Pretty much every central bank now frames its actions with reference to Taylor's rule, or its descendants such as an inflation target.

Now, usually being a great academic is not much of a recommendation for a top Washington job however. You can fill in your own list of Nobel Prize winners, justly lauded for their intellectual accomplishments, who would be disasters in any actual job.
Still, John's stature as an academic means that he understands monetary policy, the limits of our knowledge about monetary policy, amazingly well. John knows what the equations in the staff papers mean, and can push back. Nobody will bamboozle him.
More importantly, John would, in my view, be superb in the job. He also has served in Washington, has many deep connections there, and understands the practicalities of policy.

John's great contribution is the "Taylor rule." He is unfairly tarred with the ignorant calumny that he wants to tie Fed policy to a mechanical formula. If you just listen for a moment to what John says about that, you will understand why I use such harsh language to describe his critics.

John's description of how his rule would operate is that it is mostly like a "rule" you might announce to your spouse: I'll be home for dinner by 6. You both understand that if traffic is bad, if the boss has a sudden request, if there is trouble picking up the kids from school, you'll be late. But rules engender good incentives and coordinate expectations. The spouse who shops and cooks has a good idea when and what to expect, and the spouse coming home by 6 has a special reason to really work hard to fulfill the promise. He or she will be expected to provide an explanation for deviations, but reasonable deviations are part of the game.

So too monetary policy rules are largely about stabilizing expectations, and getting past this state that markets are hanging on every word uttered by the high priests. Also, given that fact, I would hardly expect John to charge in and do anything dramatic. The point of rules is not to surprise markets after all, and most implementation of Taylor rules put a big coefficient on past interest rates, meaning one moves slowly.

The process of picking a Fed chair is not about voting on the direction of interest rates. Most of the media paints it this way -- pick one or the other depending on whether you want rates up or down. The Fed chair runs a committee and a big organization. John will be good at this too.

What you don't want in a Fed chair, especially an academic, is someone who comes in with an agenda determined to push it. Milton Friedman might have made a bad Fed chair. I suspect he might have clung to monetary targets too long. Despite the rule, Taylor is not that guy.

Taylor listens. Actually, to a fault. We run a few things together at Hoover, and there are times when he should just come out and say to me "John, that's a lousy stupid idea." Instead he listens, offers a gentle thought in the other direction, and gradually guides me to figuring out for myself just what a stupid lousy idea it was.

I also experience disagreements with John. For example, he is currently in favor of a smaller base of reserves, that don't pay interest. I like lots of excess reserves. He handles disagreement like this very well. He listens, he tells me his view, we look for different assumptions underlying our different conclusions.

This flexibility will be important. One thing we know for sure is that the next crisis will challenge any intellectual framework. It will challenge even more someone who does not have an intellectual framework and can't get back to the assumptions and logic of opposing views.

As I have prognosticated many times before, monetary policy -- raising and lowering interest rates -- is likely to be a small part of what characterizes the Fed going forward. Regulation and supervision is going to be much more important. I was a bit disappointed that Ms. Yellen seems so comfortable with the current regulatory direction. John is no fan of regulation. He has worked deeply in the area, for example on reforming bankruptcy so that banks could actually be put through it. But John is no fan of the big bank's idea of deregulation either -- keep the rules in place as barriers to entry, but lower capital and liquidity standards so we can make lots of money again. The really big question is what will happen with supervision and regulation. John will be a great chair to come to a reasonable repair of the Dodd-Frank mess.

Well, that's my case for John. As I said before, it is not a case against Ms. Yellen, or any of the other people currently under consideration. They may share many of these traits. I just don't know them that well.

Disclaimer, in case it was not obvious: John's office is next to mine at Hoover, and he's a great guy. So I'm obviously horribly biased.

Monetary policy, central banking and inflation are hard. It's well to remember that. Today's blog post adds up a few things that seem like they're obvious but are not.

Inflation is hard. 

Central bankers are puzzled at persistently low inflation.  From WSJ,

Ms. Yellen said, as the “biggest surprise in the U.S. economy this year has been inflation.” 

“My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year,” Ms. Yellen said, adding that “most of my colleagues on the [interest-rate-setting Federal Open Market Committee] agree.”

Of course, they've been expecting that for several years now.  And she seems fully aware that they may be wrong once again:

She cautioned, however, that U.S. central bankers recognize recent low inflation could reflect something more persistent. “The fact that a number of other advanced economies are also experiencing persistently low inflation understandably adds to the sense among many analysts that something more structural may be going on,”  

"Something more structural" is a pretty vague statement, for the head of an agency in charge of inflation, that has hundreds of economists looking at this question for years now! That's not criticism. Inflation is hard.

Why is it so hard? The standard story goes, as there is less "slack" in product or labor markets, there is pressure for prices and wages to go up. So it stands to perfect reason that with unemployment low and after years of tepid but steady growth, with quantitative measures of "slack" low, that inflation should rise, as Ms. Yellen's first quote opines.

That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get "tight," companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company's products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor's prices are all rising does nothing to get it to produce more.

So, in fact, standard economics makes no prediction at all about the relationship between inflation -- the level of prices and wages overall; or (better) the value of money -- and the tightness or slackness of product and labor markets! The fabled Phillips curve started as a purely empirical observation, with no theory.


To get there, you need some mechanism to fool people -- for workers to see their wage rise, but not realize that other wages and prices are also rising; for companies to see their prices rise, but not realize that wages, costs, and competitors' prices are also rising. You need some mechanism to convert a rise in all prices and wages to a false perception that everyone's relative prices and wages are rising. There are lots of these mechanisms, and that's what economic theory of the Phillips curve is all about. The point today: it is not nearly as obvious as newspaper accounts point out. And if central bankers are a bit befuddled by the utter disappearance of the Phillips curve -- no discernible relationship, or actually now a relationship of the wrong sign, between inflation and unemployment, well, have a little mercy. Inflation is hard.

By the way, the oft-repeated mantra that "inflation expectations are anchored" offers no solace. In fact, it makes the puzzle worse. The standard Phillips curve says inflation = expected inflation - (constant) x unemployment. Variation in expected inflation is usually an excuse for a Phillips curve failure. Steady expected inflation means the Phillips cure should work better! (But beware that anchor. Is it anchored, or just not moving?)

Is policy tight or loose right now? 

You'd think this were an easy question. The newspapers ring with "years of extraordinary stimulus" and "unusually low rates."  And indeed, interest rates are low by historical standards, and relative to rules such as John Taylor's that summarize the successful parts of that history.

But ponder this. What does a central bank look like that is holding interest rates down? Well, it would be lending out a lot of money to banks, who would turn around and re-lend that money at higher interest rates. What does our central bank look like? Our central bank is taking in $2.2 trillion  from banks, and is paying them a higher interest rate than they can get elsewhere. Right now, the Fed is paying banks 1.25% on their reserves.  But Treasury bills are 1%. Even commercial paper is 1.13-1.2%. It looks every bit like a bank that is pushing rates up. And has been doing so for a long time.

How is this remotely possible? Well, historical interest rates reflected different circumstances. Interest rates around the world are lower than in the US. EU policy rates are about  -0.5% and stuck there. Real interest rates are negative all over the world. If real interest rates are very low, and inflation is very low, nominal interest rates will be very low, no matter what they were historically.

For example, when interest rates hit 10% in the 1970s, higher than ever before seen, did that mean monetary policy was incredibly tight? No, as it turns out.

Supply vs. demand.

The central bank's main job, at least as monetary policy is currently construed, is to distinguish "supply" from "demand" movements in the real economy. If GDP falls because of "lack of demand," it is the Fed's job to stimulate by lowering interest rates, and then by other means such as QE and speeches. If GDP falls because of "lack of supply" however, the Fed should not respond, as that will just create stagflation.

It's really hard to tell supply from demand in real time. Here again, most commentary just assumes it's one or the other, and usually all demand -- a failing that is common throughout economic policy. Textbook models assume that central banks observe and respond to shocks, and know where those shocks come from. Not so in life.

Policy for growth? 

This issue came up sharply in the last two days. The Wall Street Journal's "Fed for a growth economy" and George Shultz and John Cogan's "The Fed Chief America Needs" pose the question, how should monetary policy adapt if there is an era of supply-side growth, triggered by cuts in marginal tax rates and deregulation?

Pop quiz: How should monetary policy be different in a time of supply-side growth?

I bet you said "keep rates lower for longer." Maybe you're right. The growth is not a sign of future inflation, via the usual excess demand - more growth - more inflation channel. But didn't we (and the Journal) just say the Phillips curve is broken?

More importantly, an economy that grows faster should have higher real, and therefore nominal, interest rates. The first equations of macroeconomics are


If we're growing faster, tomorrow is better than today, and interest rates need to be higher to convince people to save rather than spend today. If we're growing faster, it's because investment is more productive, and we need higher interest rates to attract capital to that investment.

So, higher growth should be accompanied by higher interest rates. Like everything else in economics, there is supply and demand. Higher rates can choke off demand. But higher rates can reflect good supply. The question is just how much higher! I did not say this would be easy.

You can tell in the WSJ commentary a feeling that Ms. Yellen and the standard way of thinking about monetary policy would get this wrong, and raise rates too much -- responding to growth, thinking that inflation is still just around the corner, on the belief that growth is always "demand" rather than supply. I'm not agreeing with this, just stating the implicit view.

How would the Taylor rule do here? Pretty well, actually. Taylor's rule specifies that the Fed should respond to the output gap -- the difference between the level of output and the full employment, or supply side limit -- not to the output growth rate. So if "potential GDP" rises from supply improvements, the gap increases, and Taylor's rule says to keep rates low. When the economy achieves the gap, return to normal. The rule might have to adjust to the new higher trend interest rate -- a higher r* in Fed parlance -- but it would not mistake growth.

That is, if the Fed correctly measured "potential" GDP and recognized that supply side improvements have increased potential. Standard calculations of potential GDP do not factor in marginal tax rates or deregulation, and look to me largely like two-sided moving averages. Again, distinguishing supply from demand, in real time, is hard. 

A pure inflation or price level target might do even better, by getting the Fed out of the business of trying to diagnose supply vs. demand. But, advocates of a Taylor rule with a strong output component, or of the current Fed might say, by reacting to output (and relying on the Phillips curve) you can stabilize inflation better anyway, but nipping it in the bud. An the Fed has an explicit employment mandate that can't be ignored.  I didn't say this was going to be easy.

How's this thing work anyway? 



The wizard of OZ, charmingly, announced he didn't know how the thing works. Does the Fed? Just how are interest rates related to inflation? This is our last on the list of things that seem obvious but aren't obvious at all.


If you just plot inflation and interest rates, they seem to move together positively. Teasing out the notion that higher rates lower inflation from that graph takes a lot of work. My best guess, merging theory and empirical work, is that higher rates -- moved on their own, not in response to economic events -- temporarily lower inflation, but then if you stick with higher rates, inflation eventually rises. And vice versa, which accounts for very low inflation after interest rates have been stuck low for a long time. Maybe yes, maybe no, but even this much is not certain.

Tyler Cowen has a good thought on the Fed chair question. The next chair has to be a good politician, in all the positive senses of that word, more than a good technocrat:

The Fed has functioned as a technocracy for a long time, but might the future bring a Fed that is irrevocably split between competing factions? ...the future could bring a Fed divided over how much it should assert its political independence, how much it should assume responsibility for possible asset bubbles, how it should respond to an international financial crisis, or how much it should align with an “America First” mindset. .... 

The backdrop is this: Ben Bernanke’s Fed, with its bailouts during the financial crisis, ate up a lot of the Fed’s political capital, though arguably for the worthwhile cause of saving the financial system. As a result, the Fed no longer has its pre-crisis credibility. As long as the American economy is on the path of a slow and steady recovery, with relatively high asset prices, that’s bearable. 

But the next time major economic volatility comes around, Fed decisions will be scrutinized and politicized like never before. This will happen in the mainstream media, on social media, and perhaps by our very own president in his tweets or offhand remarks. The key factor for any Fed leader will be the ability to maintain and project a coherent, unified voice at the Fed, so that the Fed remains an island of relative sanity in the polarized nation. This will be a problem of crisis management, but unlike Bernanke’s crisis management it will be fought first and foremost in the trenches of public opinion.

(The open vice chair positions are good ones for technocrats, who need to be able to translate the abstruse language of the staff.)

My related thought: We focus a lot on interest rate policy, but most of what the Fed does these days is financial regulation and supervision, and those decisions are likely much more important going forward.  The challenging question there is "macro-prudential." Is it the Fed's job to worry about "asset bubbles," and to micromanage "credit booms" and their eventual busts? Or is it better for the Fed to limit its authority, to preserve independence, credibility, and insulation from political demands for action and political criticism of its actions, by pronouncing there are economic events beyond its scope?

Moreover, if the Fed is to limit the scope of its financial dirigisme, it had better do so beforehand not afterwards. If everyone expects the Fed to set prices and bail out hither and yon, and then the Fed gets religion (perhaps under relentless political pressure), the crisis will be so much worse. Bernanke also benefitted from acting far beyond expectations of what he would or could do. The next chair will be in the opposite situation, have to set limits of crisis reaction, and disappoint expectations. It's much better to do that ahead of time -- and much harder for an institution like the Fed to scale back people's expectations, and to renounce and pre-commit against attractive-sounding powers.

Update: 

Narayana Kocherlakota predicts Jerome Powell. In line with some of the above thoughts, Narayana's view basically is that monetary policy is doing fine. Low unemployment, low inflation, low interest rates, low macro and financial volatility. Mission accomplished. Moreover, if there is a hawk vs. dove question, President Trump looks likely to be on the dove side of it. (Sadly, I doubt that rules and precommitment vs. discretion is ringing in the appointment decision.) However, supervision and regulation is the key issue going forward, and Narayana views Powell as Yellen monetary policy plus a regulatory/supervisory reform.

(I learned to use both words from Ms. Yellen's Jackson hole speech. Regulation is rules, supervision is sending Fed people to look over banks' shoulders. It's a good distinction.)

Even at my point in life, the moment of publishing an academic paper is a one to celebrate, and a moment to reflect.

The New-Keynesian Liquidity Trap is published in the Journal of Monetary Economics -- online, print will be in December. Elsevier (the publisher) allows free access and free pdf downloads at the above link until November 9, and encourages authors to send links to their social media contacts. You're my social media contacts, so enjoy the link and download freely while you can!

The paper is part of the 2012-2013 conversation on monetary and fiscal policies when interest rates are stuck at zero -- the "zero bound" or "liquidity trap." (Which reprised an earlier 2000-ish conversation about Japan.)

At the time, new-Keynesian models and modelers were turning up all sorts of fascinating results, and taking them seriously enough to recommend policy actions. The Fed can strongly stimulate the economy with promises to hold interest rates low in the future. Curiously, the further in the future the promise, the more stimulative.  Fiscal policy, even totally wasted spending, can have huge multipliers. Broken windows and hurricanes are good for the economy. And though price stickiness is the central problem in the economy, lowering price stickiness makes matters worse. (See the paper for citations.)

The paper shows how tenuous all these predictions are. The models have multiple solutions, and the answer they give comes down to an almost arbitrary choice of which solution to pick. The standard choice implies a downward jump in the price level when the recession starts, which requires the government to raise taxes to pay off a windfall to government bondholders. Picking equilibria that don't have this price level jump, and don't require a jump to large fiscal surpluses (which we don't see) I overturn all the predictions. Sorry, no magic. If you want a better economy, you have to work on supply, not demand.

Today's thoughts, though, are about the state of academic publication.

I wrote the paper in the spring and summer of 2013, posted it to the internet, and started giving talks. Here's the story of its publication:

September 2013. Submitted to AER; NBER and SSRN working papers issued. Blog post.
June 2014. Rejected from AER. 3 good referee reports and thoughtful editor report.
October 2014. Submit revision to QJE.
December 2014. Rejected from QJE. 3 more thoughtful referee reports and editor report.
January 2015. Submit revision to JME.
April 2016. Revise and resubmit from JME. 3 detailed referee reports and long and thoughtful editor report.
June 2016. Send revision to JME
July 2017. Accept with minor revisions from JME. Many (good) comments from editor
August 2017. Final revision to JME
September 2017. Proofs, publication online.
December 2017. Published.

This is about typical. Most of my papers are rejected at 2-3 journals before they find a home, and 3-5 years from first submission to publication is also typical. It's typical for academic publishing in general. Parts of this process went much faster than usual. Three months for a full evaluation at QJE is fast. And once accepted, my paper sped through the JME. Another year or two in the pipeline between acceptance and publication is typical.

Note most journals count average time to decision. But what matters is average time to publication of the papers they publish, and what really counts is average time to publication in the journal system as a whole.

Lessons and thoughts?

• Academic journal publication is not a useful part of communication among researchers or the communication between research and policy. 

Anyone doing research on zero bound in new-Keynesian models in the last 4 years, and carrying on this conversation, interacted with the working paper version of my paper (if at all), not the published version. Any work relying only on published research is hopelessly out of date.

Interest rates lifted off the zero bound quite a while ago, so in the policy conversation this publication at best goes into the shelf of ideas to be revisited if the next recession repeats the last one with an extended period of zero interest rates , and if we see repeated invocation of the rather magical predictions of new-Keynesian models to cure it. If the next recession is a stagflation or a sovereign debt crisis, you're on your own.

Rather than means of communication,

• Journal publications have become the archive, 

the ark, the library, the place where final, and perfected versions of papers are carved in stone for future generations. (Some lucky papers that make it to graduate reading lists more than 5-10 years after their impact will be read in final form, but not most.)

And this paper is perfected. The comments of nine very sharp reviewers and three thoughtful editors have improved it substantially, along with at dozens of drafts.  Papers are a conversation, and it does take a village.  The paper also benefitted from extensive comments at workshops, and several long email conversations with colleagues.

The passage of time has helped as well. When I go back to a paper after 6 months to a year, I find all sorts of things that can be clearer. Moreover, in the time between first submission and last revision, I wrote four new papers in the same line, and insights from those permeate back to this one.

So, in the end, though the basic points are the same, the exposition is much better.  It's a haiku.  Every word counts.

But such perfection comes at a big cost, in the time of editors and referees, my time, and most of all the cost that the conversation has now moved on.

The sum length of nine referee reports, four reports by three editors, is much longer than the paper. Each one did a serious job, and clearly spent at least a day or two reading the paper and writing thoughtful comments. Moreover, though the reports were excellent, past the first three they by and large made the same points. Was all this effort really worthwhile? I think below on how to economize on referee time.

Of course, for younger people

• Journal articles are a branding and sorting device. 

Many institutions give tenure, chairs, raises, and other professional advancement based at least in part on numbers and placement of publications. For that purpose, timeliness of publication is less of a problem, but with a six year tenure clock at many places and five year lags, timeliness of acceptance the quality rating is a big problem. The sorting and branding function isn't working that well either. But having journals outsource quality evaluation was always an imperfect institution.  Maybe we should just have star ratings instead -- seriously, start up a website devoted to crowd-sourcing working paper evaluation. Or, perhaps tenure committees will have to actually start reading papers. I don't think the journals see this as their main function either. They're set up to publish papers, not judge people's tenure, so improving journals as a tenure granting mechanism will be a hard sell.

There is some good news that this data point represents, relative to state of journal publishing 15-20 years ago. (See Glenn Ellison's superb "The slowdown in the economics publishing process," JSTOR, undated, one of my proudest moments as a JPE editor.)

• Journals are doing fewer rounds, more desk rejection, more one round and up or out.  

Journals had gotten in to a rut of asking for round after round of revisions. Now there is a strong ethic of either rejecting the paper, or doing one round of revisions and then either publishing with minor changes or not. Related,

• Journal editors are more decisive. 

Journal editors have become, well editors.  The referees provide advice, but the editor thinks about it, decides which advice is good and not, and makes the final call. Editors used to defer decisions to referees, which is part of the reason why there were endless revisions.  This change is very good. Referees have little incentive to bring the process to a close, and they don't see the pipeline of papers to the journal. They are not in a good position to find the right balance of perfection and timeliness.

In my case, editors were very active. The referees wrote thoughtful reports, but largely made similar points. In fact, the strongest advice to reject came at the JME. But the AER and QJE editors were not impressed in the end by the paper, and the JME editor was.

So, with this state of affairs in mind, how might we all work to improve journals and the publication process?

I will take for granted that greater speed, and making journals more effective at communication and not just archiving and ranking is important. For one reason, to the extent that they continue to lose the communication function, people won't send articles there. Already you can notice that after tenure, more and more economists start publishing in conference volumes, invited papers, edited volumes, and other outlets. (blogs!) The fraction willing to take on this labor of love for journal publication declines quickly with age.  Research productivity and creativity does not take quite such a parallel decline. (I hope!)

Always the free-market economist, I note that conference volumes, edited volumes, and solicited papers in regular journals seem to be healthy and increasing, which is a natural response to journal slowdown. This is a way to get papers in print more quickly.  In the early days of the internet I had a rule never to publish in volumes, as they disappeared to library shelves and could not be found electronically. Now many of them have solved that problem. The NBER macro annual and Carnegie-Rochester conferences are good examples. The Review of Finance editor recently solicited my "Macro-finance" essay which therefore sped through publication. My active editors are also often taking a more active role in soliciting promising working papers. This helps to break the editor-to-paper match. But this isn't an ideal state of affairs either. Conference volumes tend towards commissioned work. Original work by people out of the social network of the conference organizers and editors has a tough time. (The market responds, organize more conferences.)

Suggestion one:

• Adopt the golden rule of refereeing

Around any economist cocktail party, there is a lot of whining that journals should do x y and z to speed things up. I start with what you and I can do. It is: do unto others as you would have them do unto you. If you complain about slow journals, well, how quickly do you turn around reports?

My recommendation, which is the rule I try to follow: Answer the email within a day. Spend an hour or two with the paper, and decide if you will referee it or not. If not, say so that day. If you can give a quick reaction behind your reason, that helps editors. And suggest a few other referees. Often editors aren't completely up to date on just who has written what and who is an ideal fit. If you're not the ideal fit, then help the editor by finding a better fit, and do it right a way.

If you agree to do a report, do it within a week. If you can't do it this week, you're not likely to be able to do it 5 weeks from now, and say no.

More suggestions:

• Reuse referee reports

• Simultaneous submission. Competition (heavens!)  

Journals insist that you only send to one journal at a time. And then wait a year or more to hear what they want to do with it. Especially now that we are moving towards the editor-centric system, and the central question is a match with editor's tastes, why not let journal editors share reviewer advice and compete for who wants to publish it? By essentially eliminating the sequential search for a sympathetic editor, this could speed up the process substantially.

I don't know why lower-ranked journals put up with this. It's the way that the top journals get the order flow of best papers. Why doesn't another journal say, you can send it to us at the same time as you send it to the AER. We'll respect their priority, but if they don't want it we will have first right. The AER almost does this with its field journals. But the JME could get more better papers faster by competing on this dimension.

The journals say they do this to preserve the value of their reviewer time. But with shared or open reviews, that argument falls apart.

We advocate competition elsewhere. Why not in our own profession?

Update: An email correspondent brings up a good point:

• Journals should be the forum where competing views are hashed out.