Wednesday, May 31, 2017

Low Inflation at "Essentially Full Employment"

Yesterday, Brad Delong took issue with Charles Evans' recent claim that "Today, we have essentially returned to full employment in the U.S." Evans, President of the Federal Reserve Bank of Chicago and a member of the FOMC, was speaking before the Bank of Japan Institute for Monetary and Economic Studies in Tokyo on "lessons learned and challenges ahead" in monetary policy. Delong points out that the age 25-54 employment-to-population ratio in the United States of 78.5% is low by historical standards and given social and demographic trends.

Evans' claim that the U.S. has returned to full employment is followed by his comment that "Unfortunately, low inflation has been more stubborn, being slower to return to our objective. From 2009 to the present, core PCE inflation, which strips out the volatile food and energy components, has underrun 2% and often by substantial amounts." Delong asks,
And why the puzzlement at the failure of core inflation to rise to 2%? That is a puzzle only if you assume that you know with certainty that the unemployment rate is the right variable to put on the right hand side of the Phillips Curve. If you say that the right variable is equal to some combination with weight λ on prime-age employment-to-population and weight 1-λ on the unemployment rate, then there is no puzzle—there is simply information about what the current value of λ is.
It is not totally obvious why prime-age employment-to-population should drive inflation distinctly from unemployment--that is, why Delong's λ should not be zero, as in the standard Phillips Curve. Note that the employment-to-population ratio grows with the labor force participation rate (LFPR) and declines with the unemployment rate. Typically, labor force participation is mostly acyclical: its longer run trends dwarf any movements at the business cycle frequency (see graph below). So in a normal recession, the decline in the employment-to-population ratio is mostly attributable to the rise in the unemployment rate, not the fall in LFPR (so it shouldn't really matter if you simply impose λ=0).

https://fred.stlouisfed.org/series/LNS11300060
As Christopher Erceg and Andrew Levin explain, a recession of moderate size and severity does not prompt many departures from the labor market, but long recessions can produce quite pronounced declines in labor force participation. In their model, this gradual response of labor force participation to the unemployment rate arises from high adjustment costs of moving in and out of the formal labor market. But the Great Recession was protracted enough to lead people to leave the labor force despite the adjustment costs. According to their analysis:
cyclical factors can fully account for the post-2007 decline of 1.5 percentage points in the LFPR for prime-age adults (i.e., 25–54 years old). We define the labor force participation gap as the deviation of the LFPR from its potential path implied by demographic and structural considerations, and we find that as of mid-2013 this gap stood at around 2%. Indeed, our analysis suggests that the labor force gap and the unemployment gap each accounts for roughly half of the current employment gap, that is, the shortfall of the employment-to-population rate from its precrisis trend.
Erceg and Levin discuss their results in the context of the Phillips Curve, noting that "a large negative participation gap induces labor force participants to reduce their wage demands, although our calibration implies that the participation gap has less influence than the unemployment rate quantitatively." This means that both unemployment and labor force participation enter the right hand side of the Phillips Curve (and Delong's λ is nonzero), so if a deep recession leaves the LFPR (and, accordingly, the employment-to-population ratio) low even as unemployment returns to its natural rate, inflation will still remain low.

Erceg and Levin also discuss implications for monetary policy design, considering the consequences of responding to the cyclical component of the LFPR in addition to the unemployment rate.
We use our model to analyze the implications of alternative monetary policy strategies against the backdrop of a deep recession that leaves the LFPR well below its longer run potential level. Specifically, we compare a noninertial Taylor rule, which responds to inflation and the unemployment gap to an augmented rule that also responds to the participation gap. In the simulations, the zero lower bound precludes the central bank from lowering policy rates enough to offset the aggregate demand shock for some time, producing a deep recession; once the shock dies away sufficiently, policy responds according to the Taylor rule. A key result of our analysis is that monetary policy can induce a more rapid closure of the participation gap through allowing the unemployment rate to fall below its longrun natural rate. Quite intuitively, keeping unemployment persistently low draws cyclical nonparticipants back into labor force more quickly. Given that the cyclical nonparticipants exert some downward pressure on inflation, some undershooting of the long-run natural rate actually turns out to be consistent with keeping inflation stable in our model.
While the authors don't explicitly use the phrase "full employment," their paper does provide a rationale for the low core inflation we're experiencing despite low unemployment. Erceg and Levin's paper was published in the Journal of Money, Credit, and Banking in 2014; ungated working paper versions from 2013 are available here.

Tuesday, May 2, 2017

Do Socially Responsible Investors Have It All Wrong?

Fossil fuels divestment is a widely debated topic at many college campuses, including my own. The push, often led by students, to divest from fossil fuels companies is an example of the socially responsible investing (SRI) movement. SRI strategies seek to promote goals like environmental stewardship, diversity, and human rights through portfolio management, including the screening of companies involved with objectionable products or behaviors.

It seems intuitive that the endowment of a foundation of educational institution should not invest in a firm whose activities oppose the foundation's mission. Why would a charity that fights lung cancer invest in tobacco, for example? But in a recent Federal Reserve Board working paper, "Divest, Disregard, or Double Down?", Brigitte Roth Tran suggests that intuition may be exactly backwards. She explains that "if firm returns increase with activities the endowment combats, doubling down on the investment increases expected utility by aligning funding availability with need. I call this 'mission hedging.'"

Returning to the example of the lung-cancer-fighting charity, suppose that the charity is heavily invested in tobacco. If the tobacco industry does unexpectedly well, then the charity will get large returns on its investments precisely when its funding needs are greatest (because presumably tobacco use and lung cancer rates will be up).

Roth Tran uses the Capital Asset Pricing Model to show that this mission hedging strategy "increases expected utility when endowment managers boost portfolio weights on firms whose returns correlate with activities the foundation seeks to reduce." More specifically,
"foundations that do not account for covariance between idiosyncratic risk and marginal utility of assets will generally under-invest in high covariance assets. Because objectionable firms are more likely to have such covariance, firewall foundations will underinvest in these firms by disregarding the mission in the investment process. SRI foundations will tend to underinvest in these firms even more by avoiding them altogether."
Roth Tran acknowledges that there are a number of reasons that mission hedging is not the norm. First, the foundation may experience direct negative utility from investing in a firm it considers reprehensible-- or experience a "warm glow" from divesting from such a firm. Second, the foundation may worry that investing in an objectionable firm will hurt its fundraising efforts or reputation (if donors do not understand the benefits of mission hedging). Third, the foundation may believe that divestment will directly lower the levels of the objectionable activity, though this effect is likely to be very small. Roth Tran points out that student leaders of the Harvard fossil fuel divestment campaign acknowledged that the financial impact on fossil fuel companies would be negligible.


Monday, April 17, 2017

EconTalk on the Economics of Pope Francis

Russ Roberts recently interviewed Robert Whaples on the EconTalk podcast, which I have listened to regularly for years. I was especially interested when I saw the title of this episode, The Economics of Pope Francis, both because I am a Catholic and because I generally find Roberts' discussions of religion (from his Jewish perspective) interesting and so articulate that they help me clarify my own thinking, even if my views diverge from his. 

In this episode, Roberts and Whaples, an economics professor at Wake Forest and convert to Catholicism, discuss the Pope's 2015 encyclical Laudato Si, which focuses on environmental issues and issues of markets, capitalism, and inequality more broadly. Given Roberts' strong support of free markets in most circumstances, I was pleased and impressed that he did not simply dismiss the Pope's work as anti-market, as many have. Near the end of the episode, Roberts says:
when I think about people who are hostile to capitalism, per se, I would argue that capitalism is not the problem. It's us. Capitalism is, what it's really good at, is giving us what we want--more or less...And so, if you want to change capitalism, you've got to change us. And that's--I really see that--I like the Pope doing that. I'm all for that.
I agree with Roberts' point that one place where religious leaders have an important role to play in the economy is in guiding the religious toward changing, or at least managing, their desires. Whaples discusses this too, summarizing the encyclical as being mainly about people's excessive focus on consumption:
It's mainly on the--the point we were talking about before, consuming too much. It's exhortation. He is basically saying what has been said by the Church for the last 2000 year...Look, you don't need all this stuff. It's pulling you away from the ultimate ends of your life. You are just pursuing it and not what you are meant, what you were created by God to pursue. You were created by God to pursue God, not to pursue this Mammon stuff.
Roberts and Whaples both agree that a lot of problems that are typically blamed on market capitalism could be improved if people's desires changed, and that religion can play a role in this (though they acknowledge that some non-religious people also turn away from materialism for various reasons.) Roberts' main criticism of the encyclical, however, is that: "The problem is the document has got too much other stuff there...it comes across as an institutional indictment, and much less an indictment of human frailty."

I would add, though, that just as markets reflect human wants, so do institutions, whether deliberately designed or developed and evolved more organically. So it is not totally clear to me that we can separate "indictment of human frailty" and "institutional indictment." No economic institutions are totally value-neutral, even free markets. Institutions and preferences co-evolve, and institutions can even shape preferences. And the Pope is of course the head of one of the oldest and largest institutions in the world, so it does not seem beyond his role to comment on institutions as an integral part of his exhortation to his flock.

Friday, April 7, 2017

Happiness as a Macroeconomic Policy Objective

Economists have mixed opinions about the degree to which subjective wellbeing and happiness should guide policymaking. Wouter den Haan, Martin Ellison, Ethan Ilzetzki, Michael McMahon, and Ricardo Reis summarize a recent survey of European economists by the Centre for Macroeconomics and CEPR. They note that the survey "finds a reasonable amount of openness to wellbeing measures among European macroeconomists. On balance, though, there remains a strong sense that while these measures merit further research, we are a long way off reaching a point where they are widely accepted and sufficiently reliable for macroeconomic analysis and policymaking."

As the authors note, the idea that happiness should be a primary focus of economic policy is central to Jeremy Bentham's "maximum happiness principle." Bentham is considered the founder of utilitarianism. Though the incorporation of survey-based quantitative measures of subjective wellbeing and life satisfaction is a relatively recent development in economics, utilitarianism, of course, is not. Notably, John Stuart Mill and many classical economists including William Stanley Jevons, Alfred Marshall, and Francis Edgeworth were deeply influenced by Bentham.

These classical economists might have been perplexed to see the results of Question 2 of the recent survey of economists, which asked whether quantitative wellbeing analysis should play an important role in guiding policymakers in determining macroeconomic policies. The responses, shown below, reveal slightly more negative than positive responses to the question. And yet, what macroeconomists and macroeconomic policymakers do today descends directly from the strategies for "quantitative wellbeing analysis" developed by classical economists.

Source: http://voxeu.org/article/views-happiness-and-wellbeing-objectives-macroeconomic-policy
In The Theory of Political Economy (1871), for example, Jevons wrote:
"A unit of pleasure or pain is difficult even to conceive; but it is the amount of these feelings which is continually prompting us to buying and selling, borrowing and lending, labouring and resting, producing and consuming; and it is from the quantitative effects of the feelings that we must estimate their comparative amounts."
Hence generations of economists have been trained in welfare economics based on utility theory, in which utility is an increasing function of consumption, u(c). Under neoclassical assumptions-- cardinal utility, stable preferences, diminishing marginal utility, and interpersonally comparable utility functions-- trying to maximize a social welfare function that is just the sum of all individual utility functions is totally Benthamite. And a focus on GDP growth is very natural, as more income should mean more consumption.

The focus on happiness survey data I think stems from recognition of some of the problems with the assumptions that allow us to link GDP to consumption to utility, for example, stable and exogenous preferences and interpersonally comparable utility functions (that depend exclusively on one's own consumption). One approach is to relax these assumptions (and introduce others) by, for example, using more complicated utility functions with additional arguments and/or changing preferences. So we see models with habit formation and "keeping up with the Joneses" effects.

Another approach is to ask people directly about their happiness. This, of course, introduces its own issues of methodology and interpretation, as many of the economist panelists point out. Michael Wickens, for example, notes that the “original happiness literature was in reality a measure of unhappiness: envy over income differentials, illness, divorce, being unmarried etc” and that “none of these is a natural macro policy objective.”

I think that responses to subjective happiness questions also include some backward-looking and some forward-looking components; happiness depends on what has happened to you and what you expect to happen in the future. This makes it hard for me to imagine how to design macroeconomic policy to formally target these indicators, and makes me tend to agree with Reis' opinion that they should be used as “complements to GDP though, not substitutes.”

Thursday, March 16, 2017

Cautious Optimism about Fed Independence

Unsurprisingly, the FOMC decided to raise its federal funds rate target by 25 basis points at its March 15 meeting. The move was widely anticipated, especially following the strong recent employment report. The day before the meeting, the New York Times wrote that the "Fed's challenge, after raising rates, may be existential," anticipating greater-than-ever threats to the Fed's independence from the President and Congress.

In the past few years, Republicans have been more frequent critics of low interest rates than Democrats. During the campaign, in September, Trump accused Yellen of keeping interest rates artificially low to boost support for Obama and the Democrats. However, a few months prior, in May, he expressed support for the Fed's low interest rate policy, primarily because of its favorable impact of the U.S. trade position with China and on government borrowing costs.

And since the election, it can again be presumed that he favors the maintenance of low rates. Why? For the same reason that most Presidents favor lower rates--to boost employment and growth (at least in the short run), and, in turn, Presidential approval. This is exactly why most central banks are granted independence: if Presidents set monetary policy, it would tend to be too loose, and therefore inflationary.

With Trump, this desire to boost employment and growth as a means to gain personal approval is especially acute. Trump is brazen in his desire to pass off job growth as a marker of his personal success:

So the worry reflected in the New York Times piece and elsewhere is that by raising rates, Yellen and the Fed are opposing the President's desires and risking retribution. The retribution could come in the form of legislation that would reduce the Fed's power or discretion, or in the form of Presidential appointments to the Board of Governors who would be more susceptible to Presidential persuasion. Trump will also have the opportunity to reappoint or replace Yellen as Chair next year. It seems, at first blush, that Federal Reserve independence is in serious danger.

While I don't want to undersell that danger, I do want to point out reasons to maintain at least a drop of optimism. First, fear of Presidential or Congressional retribution did not lead the FOMC to avoid this rate hike. Yellen is not willing to play by Trump's rules to ensure her reappointment. That was probably already obvious to anyone familiar with her career and reputation, but it is still noteworthy enough to reflect on. While the Fed's de jure independence is in tact for now, its de facto independence seems to be as well.

Second, with a President this polarizing and with approval ratings so low, Presidential attacks on the Fed could actually be just what the Fed needs. So far, Trump has avoided tweeting about the FOMC decision. But suppose Trump does criticize the Fed on Twitter soon. This might not be all bad-- it could be a case of "all press is good press." The biggest obstacle to the Fed's communication strategy, and in turn to accountability, seems to be its lack of a broad audience, and Trump--with 27 million twitter followers to the Fed's 402,000--could inadvertently provide the Fed with the communication platform it has so severely been lacking. The key will be for the Fed to use any newly-gained pulpit to convincingly argue why independence is worth protecting. This will be more effective if combined with discussions of how the Fed intends to hold itself more accountable to the public in the future.

Monday, February 13, 2017

Thoughts on Angrist and Pishke's "Undergraduate Econometrics Instruction"

Joshua Angrist and Jörn-Steffen Pischke, coauthors of "Mastering 'Metrics," have just released a new NBER working paper called "Undergraduate Econometrics Instruction: Through Our Classes, Darkly." They argue that pedagogy has not kept pace with trends in economic research in the past few decades:
In the 1960s and 1970s, an empirical economist’s typical mission was to “explain” economic variables like wages or GDP growth. Applied econometrics has since evolved to prioritize the estimation of specific causal effects and empirical policy analysis over general models of outcome determination. Yet econometric instruction remains mostly abstract, focusing on the search for “true models” and technical concerns associated with classical regression assumptions. Questions of research design and causality still take a back seat in the classroom, in spite of having risen to the top of the modern empirical agenda. This essay traces the divergent development of econometric teaching and empirical practice, arguing for a pedagogical paradigm shift.
The "pedagogical paradigm shift" they call for would include three main components:
One is a focus on causal questions and empirical examples, rather than models and math. Another is a revision of the anachronistic classical regression framework, away from explaining economic processes and towards controlled statistical comparisons. The third is an emphasis on modern quasiexperimental tools.  
Since I am relatively new to both teaching and economics-- I didn't major in economics as an undergraduate, and did my Ph.D. from 2010 to 2015-- the first economics course that I designed and taught at Haverford quite naturally adhered to many of Angrist and Pischke's recommendations. The course, which I taught in Fall 2015 and Fall 2016, is called Advanced Macroeconomics, but is essentially an applied econometrics course on empirical macroeconomic policy analysis. The students in the course are typically juniors and seniors who have already taken econometrics.

On the first day of class, we read excerpts from the 1968 paper "Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization" by Andersen and Jordan. The authors want to test whether "the response of economic activity to fiscal actions relative to that of monetary actions is (1) greater, (2) more predictable, and (3) faster." They use very simple regression analysis, essentially regressing changes in GNP on changes in measures of monetary and fiscal actions. This type of regression is now called a "St. Louis Equation," since Andersen and Jordan were at the St. Louis Fed. I ask my students to interpret the regression results and evaluate the validity of the authors' conclusions about policy effectiveness. With some prodding, the students come up with some ideas about potential omitted variable bias and data concerns. But they don't think about reverse causality or the idea of a "controlled statistical comparison." I introduce the reverse causality issue, and much of the rest of the course focuses on quasiexperimental tools.

The course has no textbook, but we use "Natural Experiments in Macroeconomics" by Nicola Fuchs-Schundeln and Tarek Hassan as the main reference. The course has four units: consumption, monetary policy, fiscal policy, and growth and distribution. In each unit, I assign natural experiment or quasiexperimental papers as well as other papers that attempt to achieve identification via other means, to varying degrees of success. The reading list was influenced by Christina Romer and David Romer's graduate course on Macroeconomic History at Berkeley, which introduced me to the notion of identification and ignited my interest in macroeconomics.

Angrist and Pischke also argue that "Regression should be taught the way it’s now most often used: as a tool to control for confounding factors" in contrast to "the traditional regression framework in which all regressors are treated equally." In other words, the coefficient of interest is on one of the regressors, while the other regressors serve as "control variables needed to insure that the regression-estimated effect of the variable of interest has a causal interpretation."

This advice on teaching regression resonates with my experience co-teaching the economics senior thesis seminar at Haverford for the past two years. Over the summer, my research assistant Alex Rodrigue read through several years' worth of senior theses in the archives and documented the research question in each thesis. We noticed that many students use research questions of the form "What are the factors that affect Y?" and run a regression of Y on all the variables they can think of, treating all regressors equally and not attempting to investigate any particular causal relationship from one variable X to Y. The more successful theses posit a causal relationship from X to Y driven by specific economic mechanisms, then use regression analysis and other methods to estimate and interpret the effect. The latter type of thesis has more pedagogical benefits, whether or not the student can ultimately achieve convincing identification, because it leads the student to think more seriously about economic mechanisms.

Sunday, January 8, 2017

Post-Election Political Divergence in Economic Expectations

"Note that among Democrats, year-ahead income expectations fell and year-ahead inflation expectations rose, and among Republicans, income expectations rose and inflation expectations fell. Perhaps the most drastic shifts were in unemployment expectations:rising unemployment was anticipated by 46% of Democrats in December, up from just 17% in June, but for Republicans, rising unemployment was anticipated by just 3% in December, down from 41% in June. The initial response of both Republicans and Democrats to Trump’s election is as clear as it is unsustainable: one side anticipates an economic downturn, and the other expects very robust economic growth."
This is from Richard Curtin, Director of the Michigan Survey of Consumers. He is comparing the economic sentiments and expectations of Democrats, Independents, and Republicans who took the survey in June and December 2016. A subset of survey respondents take the survey twice, with a six-month gap. So these are the respondents who took the survey before and after the election. The results are summarized in the table below, and really are striking, especially with regards to unemployment. Inflation expectations also rose for Democrats and fell for Republicans (and the way I interpret the survey data is that most consumers see inflation as a bad thing, so lower inflation expectations means greater optimism.)

Notice, too, that self-declared Independents are more optimistic after the election than before. More of them are expecting lower unemployment and fewer are expecting higher unemployment. Inflation expectations also fell from 3% to 2.3%, and income expectations rose. Of course, this is likely based on a very small sample size.
Source: Richard Curtin, Michigan Survey of Consumers