Fiscal Policy

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Fearing the Japan Scenario

There is a major underlying fear among US policymakers: that the US will suffer the same longtime stagnation that Japan has suffered since the bubble burst in the early 1990s. This useful op-ed by Larry Summers in the Washington Post is a prime example of this concern.

In fact, many of the current crop of senior officials spent a decade loudly advising the (unreceptive) Japanese on the necessity to stimulate their economy, and telling themselves that the US would never make the same policy errors. Hubris has been followed by dismay.

In fact, there are three major historic analogies that often play in policy minds. Japan is one. Another is 1937, when the Fed arguably prolonged the depression by prematurely raising interest rates. And another is the experience of the 1970s, when the Fed likely overestimated slack in the economy, leading to the Great Inflation.

Athanasios Orphanides, at the time a Fed researcher (and later Governor of the Bank of Cyprus) wrote a series of papers on the later argument. He argues that the Fed (and others like CBO) suffered from very serious misperception of the output gap and natural rate of unemployment at the time.

Consistent with the natural rate hypothesis, maintaining the unemployment rate slightly above the perceived “natural” rate was meant to be the optimal approach for restoring price stability. The “optimum feasible path”, of course, became the Great Inflation. Accepting that this activist policy was optimal, the policy disaster of the 1970s cup deb attributed to bad luck – an adverse shift in the “natural” rate of unemployment that could not have reasonably been expected to be correctly assessed for some time. But a more fundamental flow can be readily identified – concentrating policy efforts towards targeting the economy’s elusive full employment potential.

If that also eerily sounds like recent Fed talk about optimal policy and the need to pay close attention to employment potential… it is.

So what do we make of this? First, many current Fed officials would argue that if they had their choice of bad outcome, inflation is likely preferable to endless stagnation or depression. At least the Fed can raise interest rates to head off inflation. But it also suggests that there is usually a balance to be struck between, and trusting completely in one particular analogy can produce huge policy errors. People have a remarkable tendency to “fight the last war”, or repeat the mistakes of the past. We naturally reason in terms of historic analogies, and naturally commit patterns of errors as a result. We have to be careful about which “last” analogy we evoke – Japan in the 1990s, or the US in the 1970s or 1930s.

The other point is that people also tend to cherry-pick analogies to fit with their preconceived policy views, and usually fail to explore similarities and differences in historic situations in any depth. For foreign policy hawks, every foreign crisis is Chamberlain at Munich all over again. For doves, it is Dr Strangelove and the Vietnam War.

So Larry Summer’s piece is an excellent analogy by a Democratic economist to Japan. But it is always worth asking what is left unsaid or overlooked in policy analogies. Japan has also engaged in massive fiscal stimulus for twenty years, so much so its debt/GDP ratio is almost 230% of GDP. And stagnation endured.

The most relevant differences are more likely the structural flexibility of the two economies.



By | December 17, 2013|Central Banks, Current Events, Economics, Federal Reserve, Fiscal Policy, Japan, Monetary Policy|Comments Off on Fearing the Japan Scenario

“The best you can do is make sure your vision isn’t getting distorted.”

One of the most important things to do in these emotional, partisan situations is keep the right degree of detachment.

Peggy Noonan is one of the old (GOP) wise heads, and writes in the WSJ yesterday:

We’re all limited in our judgments by what we’re capable of seeing. Our political perceptions are skewed by our passions—we can’t help think everyone else cares about or responds to what we care about and respond to. We’re limited by what we’ve experienced. The last government shutdown took place within a certain context and ended a certain way, so this one probably will too. We’re limited by the realities in which we individually rose, by the facts that reigned in that world. Someone once said: “Show me the headlines a man saw in his 20s and I’ll tell you what he thinks.”

So everyone is seeing the shutdown through a certain prism, and the best you can do is know the prism is there, allow for it and do your best to keep it from distorting your vision.

It’s rarely the gossip or latest breathless media story that matters, but the prism. The best you can do is make sure your vision isn’t getting distorted. But you usually won’t get that from media reporting.


By | October 7, 2013|Confirmation bias, Current Events, Fiscal Policy, Perception, Politics|Comments Off on “The best you can do is make sure your vision isn’t getting distorted.”

How a default could happen

“A U.S. Default Seen as Catastrophe Dwarfing Lehman’s Fall,” says this Bloomberg story. But the market doesn’t believe it is going to happen. We are down half a percent so far today on the S&P. But that still leaves us just a sliver beneath the historic all-time high in equities.  The 10-year Treasury bond is at 2.608%, down 30bp from two weeks ago. That too, of course, is still remarkably low by the standards of the last three decades.

I agree with the market sense that there is a vanishingly small chance of a default. In this game of chicken, both sides would prefer to turn the wheel and swerve rather than crash the cars.

But one good principle in making decisions is to consider the opposite. One variation of that is a technique called the pre-mortem. Let us assume you are told by an absolutely certain message from the future that in fact the US defaults on October 19, 2013.

How did it happen?

The point is to set aside all the dozens of reasons there are to ignore disconfirming evidence that points the other way. In any given catastrophe, there is always evidence that was ignored at the time. The mind is very good at picking up information that is consistent with what you think and expect, and very bad at noticing the opposite. If you assume the catastrophe has happened, you turn this tendency the other way around.

So here goes.

The most likely reason the default happens is both sides tried to swerve at the last possible moment – but the steering wheel doesn’t turn in time. Logistical obstacles are the biggest potential source of a default.

I firmly believe that if Obama and Congress are confronted with a real, actual, imminent default they will do almost anything to avoid it. Obama would sign an executive order and fight out whether he had the power to do so in the Supreme Court later. Congress would pass a temporary vote. Perhaps Treasury could even set up a temporary daylight loan from the Fed.

The problem is all these things take time – not very much time, but if there is a last minute legal obstacle ( a clause in the Antideficiency act, say) or it takes time to set up payment instructions in the Treasury computer – deadlines could be missed.

And the risk is Congress is used to flexible deadlines. Time works in a very different way from financial markets. Most deadlines on the Hill (apart from elections) can be waived or ignored or made subject to exceptions. But a scheduled bond payment is a fixed deadline. It will not wait for Congressional deals or Presidential deliberation. It either happens or it does not. Two systems of perception of time could crunch into each other.

There are other potential causes of last minute accidents. Sometimes opponents calculate they can benefit from a full-on crash in situations, and a few tea party members may think this way. Or they may believe they may lose proportionately less in a catastrophe (hence the theories of fighting a “limited” nuclear war in the 1970s.)

But believers in default are very few here. The unknowns and potential ripple effects of a US default would be enough to scare most in Congress to want to avoid it, and certainly all those in positions of power or responsibility.

The other reasons chicken games sometimes go very wrong are:

  • pre-binding  commitments. One of the drivers unscrews the steering wheel altogether and throws it out the window. He can’t back down, even if he wanted to. But these don’t exist in this situation. Commitments for and against a “clean CR” can be revised, at the cost of looking like a loser.
  • miscommunication and miscalculation. This is less likely given that all the players know each other and act within the same political system. It is not like Kennedy facing Khruschev in the Cuban missile crisis, for example, across different political cultures and systems, different languages, different power bases, different conceptions of great power interests.

The upshot is the most significant risk is unintended infrastructural or logistical details, that slow down a resolution enough to cause a default. Like the Larry Summers weekend banking crisis scenario, the players might simply run out of time because of unforeseen delays or miscalculation of how close to a bond market deadline they could go.

So it pays to watch Treasury and OMB statements about the nuts and bolts of the situation, more than Boehner or Reid. If you dance too close to the edge of the precipice, you can slip even if you don’t intend to. That said, I still think the chance is extremely small.

By | October 7, 2013|Confirmation bias, Crisis Management, Current Events, Fiscal Policy, Politics|Comments Off on How a default could happen

Hysterical chickens and the government shutdown

Two teenagers drive cars towards each other at a hundred miles an hour. The first one to swerve away from the fatal crash becomes the humiliated “chicken.” Game theorists love this scenario, which comes from a 1955 James Dean movie. It’s also the way politics increasingly works in the US, which is why we are on the brink of a government shutdown tonight.

The most important thing if you’re playing chicken is to make loud apocalyptic claims  in order to try to make your opponent swerve first. So there is lots of hysteria about how you are not going to budge and your course is fixed and the consequences for your opponent are terrible.

You need to see through the media narratives which tend towards “GOP/Democrats will never win an election again”, “American public will be enraged at x.”  Fearful predictions of disaster are an intrinsic part of the game.

Here’s what is really happening. Each side is testing their resolve, and playing to their own supporters to increase commitment and contributions. The base rate – the usual case-  is that these confrontations always go slightly past any “final”  deadline before a deal is done. That means a technical shutdown of “non-essential” government is likely tonight – enough to cause mess and discomfort, but no serious long-term damage. Government statistics may be delayed, but social security checks will still be sent out.

This is also a dress rehearsal for both sides to get a sense of public reaction for the more important confrontation over the debt limit in a few weeks time. There is already dark muttering about impeaching the President if he spends over the debt limit, although that seems to be coming more from Democrats than the Republicans who would actually instigate such a move. “Constitutional crisis” is the new meme.

Don’t be too sure how the public will react. Democrats thought imposition of the sequester would be a disaster for the Republicans last year. It didn’t happen. Granted, most of the Republican establishment is highly worried about being blamed for a shutdown, and Democrats are counting on winning the confrontation and using public rage at a shutdown to abolish the debt limit.  However, the most conspicuous feature of public opinion in the last few years has been volatility , going from whiplash speed from tea party success in the 2010 midterms to Obama’s conquest of Romney in 2012.

The most likely outcome is short-term deals which postpone confrontation.   If you can’t get a permanent deal, make it a year. If you can’t get a continuing resolution for a year, make it three months. There is some scope for compromise on partial delay of Obamacare, given many of the exchanges are not ready to begin operating and IT problems are cropping up.

Part of the game is you don’t want to swerve your car and be the chicken until the very last moment. It makes for good media fodder, more exciting than the usual bland legislative blather, with lots of opportunity to bemoan the terrible state of the Republic and how things haven’t been this bad since 1861.

In fact, the system of checks and balances is working as it usually does. It’s not the end of the US system, no matter how much it may look like that from overseas, where it is much easier for a more unified elite to push policy through. It is hard to get anything major done in the US system, by design. It is true that the current mood has become hyperpartisan. But the US has got through much worse before.

There is a small risk of miscalculation and accidents in these confrontations, so that the teens do actually end up crashing into each other. But for now, the yelps and shouting and yelling at opponents is more obvious than any intent to crash.


By | September 30, 2013|Current Events, Fiscal Policy, Politics|Comments Off on Hysterical chickens and the government shutdown