Sunday, June 28, 2015

The Keynesian monetarists

From my post Keynesian economics in three graphs

There seem to be a lot of closet Keynesian monetarists out there. I noticed that a large fraction of the massive deficit reduction in the U.S. from 2012 to 2013 was due to dividends paid by Fannie Mae and Freddie Mac, and the big question that's come out of it is whether it should count as a negative ∆G. That is to say we've apparently figured out it's relevant and now we're just arguing over the multiplier. And now the monetarists are the ones arguing that its multiplier should be large (in order to show that the Keynesian view is wrong, of course, but still).

Now I'm not really an economist; I just play one on the internet. I'm a physicist. But I have constructed an economic framework that allows you to build some basic monetarist and Keynesian models from information theory (the main purpose of this blog). In the most empirically accurate versions of the Keynesian model, all that really matters in a recession are strongly coordinated movements of government output. The negative impacts of tax increases would be diffused. Effectively the multipliers are large for spending and small for taxes, As a result you get the "paleo-Keynesian" finding that even deficit neutral expansions of government spending are expansionary in a recession. But the framework also allows you to construct a monetarist model (it's not as empirically accurate over the past few decades, though [1]), so that puts me right where ... well, where many modern Keynesians are as they believe in monetary policy when outside a liquidity trap and fiscal policy when in one.

The more traditional analysis of multipliers looks at their effect on people's behavior -- in particular current consumption. For example, government spending on a building a bridge employs someone who might not be otherwise employed (in a recession), financing their consumption which is spent at stores who then don't have to cut back the hours of their employees which finances their consumption, and so on. Integrating this effect results in a multiplier greater than 1 ... a bigger bang for your government spending buck.

Tax cuts have less of an impact in most (Keynesian) analyses. They apply to people already with jobs, and since the problem of a recession (in the Keynesian view) is an outbreak of frugality, they tend to get saved. At least if you're already saving money; tax cuts for people living paycheck to paycheck are more likely to get spent.

Roughly the opposite reactions with the same multipliers should occur for government "austerity" (increasing taxes and cutting spending).

So how do we treat the dividend payout from Fannie and Freddie?

Matt Yglesias viewed it at the time as being wasted -- it could have been better paid out as government spending, tax cuts or a "helicopter drop" of cash. And that's true.

Sumner says Matt said the "GSE dividends were a contractionary “disaster.”", but I think Matt's view is better characterized as a comparison between a positive and a zero multiplier use of the dividends -- between high multiplier spending and zero multiplier deficit reduction (he said thw word disaster, but not the word contractionary):
The only problem is that this gusher of federal revenue is actually an economic disaster. ...
... the profits aren’t letting us spend more, they aren’t letting us tax less, and they aren’t freeing up private investment capital either. They’re doing nothing. It’s as if the money were sitting around as cash in a storage locker somewhere.
Some commenters and even Sumner suggest that somehow the dividends should be treated as contractionary with a multiplier greater than zero. 

If we view the dividends as a confiscatory tax on those who would have done something with the money if they had held the stock, the multiplier would be small. It's a progressive tax increase applied to people already "saving" (holding the stock). It is unlikely to have financed current consumption. In that case it would be very slightly contractionary.

It could also be viewed as a tax on people paying their home loans, but unlike income taxes in the U.S. the people paying these taxes are getting something directly (housing) in return. It is not a tax that requires people to cut back their consumption. The contractionary effect would be very small indeed -- approximately zero.

Commenter LAL puts forward the idea that the money is leaving the flow of money around the economy and something like this is probably the best argument that it is contractionary. The effect would come though the "shortage of safe assets" view of a liquidity trap -- the dividends mean that additional US treasury bonds (safe assets) aren't issued. Every treasury bond gets us that much closer to a sufficient stock of safe assets that we exit the liquidity trap so in not issuing bonds we're deeper in the trap than we would be if we had.

However, all of these "it's a tax" views are based on a counterfactual world in which the dividends exist and end up in the hands of the private economy and we're looking at the contractionary effect of the opportunity cost.

My original take in a comment on Sumner's post was that the money could be treated as simply a 20 dollar bill on the sidewalk snatched up by the government. Fannie and Freddie were bankrupt and were bailed out. The money otherwise wouldn't have existed ... not otherwise be financing consumption. In that sense, it almost seems like seigniorage: the money booked by the Treasury when it prints physical currency. Before the currency existed, there was no money. Before the US government took over Fannie and Freddie completely, there was no (actually negative) company value or stream of profits.

As I said I am not an economist, so I'm not sure what the correct treatment should be. I will ask Robert Waldmann, the only Keynesian who'll (potentially) take my questions at this point. From my rudimentary knowledge (and the workings of the information transfer model) it seems that the multiplier should be in the small to zero range.

Overall, there is a strange methodology at work here, though. The monetarist premise seems to be that the Keynesian theory multiplier must be large (m ~ 1) in order for the Keynesian theory to be wrong. That is just odd to me. The evidence is that if the Keynesian theory (K) is correct, the multiplier is small (m ~ 0)

P( m ~ 0 |K) >  P( m ~ 1 |K) ≈ 0

So that the Bayesian view with Keynesian prior is:

P(K | m ~ 0) =  P(m ~ 0 | K) P(K)/P(m ~ 0)

which is greater than zero here. But the monetarist premise contains the factor:

P(m ~ 1 | K) P(K)

where they are trying to show both probabilities are near zero. But P( m ~ 1 |K) is small (approximately zero), so P( m ~ 1 |K) P(K) ≈ 0 even without P(K) ≈ 0.

Basically the result you should get out this analysis is that the multiplier isn't large, not that the Keynesian view is wrong.

[1] Actually, it can be written as a single model that has two limits: an ISLM-like model and a QTM-like model. The ISLM limit is more accurate today, while the QTM limit was more accurate in the 1970s. At least for the U.S. -- other countries like Russia and China are in the QTM limit, Japan is in the ISLM limit, and Canada is at the transition.


  1. Great fun Jason. I love this back and forth.

  2. So are you saying that monetarists are trying to show that P(m ~ 1 | not K) is large?

    1. Way late getting back to this question -- but in a sense, yes. That's why it is a weird methodology ... because you don't have a multiplier m in the case of "not K".

  3. I see now your seignorage/created value is interesting, I guess it depends on the timing, if the government grew money on farms and let the local townspeople use it as currency for a while before coming into town to collect it, it seems like an empirical question what would be the effect...i'm not willing at the moment to consider the ricardian equivalence vs underwater homes...

  4. on notation: in standard macro notation G refers to government consumption plus investment, that is government purchases of goods and services. Taxes TA and transfers TR aren't included. Your question is should Fannie Freddie dividends be counted like a tax.

    My view is that the Fannie/Freddie dividends are wealth created by a government program which is kept by the government and not a tax. Without the US government there would be no Fannie nor Freddie (first because they were originally a government agency before Johnson split them and privatized them and second because they would be bankrupt without the rescue). Their profits are produced by the Federal Government then kept -- they are not a tax.

    I guess the question is what counterfactual are we considering ? Without government intervention Fannie and Freddie would be bankrupt so
    Under laissez faire, Fannie and Freddie would no longer exist. No one would get their profits. Also the housing industry would be much smaller. The (Bush administration's) rescue (including the dividends going to the Federal Government) made GDP much larger.

    If the profits were given to the public, the whole operation would be even more expansionary.

    2008 was extraordinary. However, the idea that the state can create wealth by bearing risk also applies in normal times. It is the basis of John Quiggin's argument against privatization (therefore in favor of partial socialism). lt also has the enthusiastic support of Miles Kimball (google: kimball sovereign wealth fund).

    I can't find good key words to google my thoughts on the topic. Here is one typical post

    1. Hi Robert,

      Thank you for weighing in.

      Yes definitely, the source of those dividends was the government's risk-bearing capacity. That is probably the best way to put it.

  5. more terminology paleo Keynesian vs new Keynesian. Also In new Keynesian models a balanced budget increase in G and T (T= taxes minus transfers = TA-TR) is expansionary. The difference is that in the most popular new Keynesian model, tax cuts do not stimulate, so the effect of a tax financed increase in G and a deficit financed increase in G are the same.

    Krugman's post is a useful illustration
    note he doesn't mention taxes at all -- the timing of taxation is irrelevant in the model and the present value of tax revenues must be equal to the present value of G.

    There is no basis in old or new Keynesian theory to treat the budget deficit (or the cyclically adjusted budget deficit) as the one indicator of the stance of fiscal policy. This is an almost universal practice, but it makes no sense at all.

    A rigidly micro founded standard new Keynesian should look only at G -- government consumption plus investment. A paleo Keynesian should look at G-cT where c is the marginal propensity to consume and is less than 1. In fact Keynesians of both types (and those who are ambivalent) generally look at adjusted G-T.

    This makes no sense.

    Krugman often looks at G and GDP. This data analysis is entirely consistent with his theoretical post (see the link above and note the date -- looking at G and ignoring T was his favored approach in 2008 before the data were collected)

  6. Thanks Jason, I really appreciate your carefully reasoned approach.

    I continue to find the argument between Keynesians and Monetarists tiresome. I believe the market monetarists have developed a better monetary policy, which Keynesians should support, even if they don't buy some of the monetarist ideas. Further, I think prediction-market-driven NGDP targeting would create a practical framework that could enable us to forecast when fiscal stimulus is needed, and maybe even how much. The monetarists should recognize that advantage, and embrace the possibility that the market could determine that fiscal stimulus would be needed for the Fed to hit its NGDP level target, even if they imagine that would never happen in practice.

    I would be delighted if you could apply your framework to the following question: is prediction-market-driven NGDP level targeting a better monetary policy than current policy, and if so, how much better? It's a difficult question to get a firm grip on, because you have to define "better" (perhaps in terms of hitting the dual mandate, perhaps focusing on periods where a low Wiksellian real rate plus low inflation winds us up in a liquidity trap a lot of the time). And then you have to define "current policy", which is really hard when it seems arbitrary sometimes, but perhaps we could define it as providing as much AD as possible while trying to make sure inflation never goes over 2% for long, while taking into account "long and variable lags" and the limitations of interest rate targeting (i.e., ZLB).

    What I would love to see is solid analysis of this policy comparison. I feel we have such a huge opportunity to improve monetary policy. What will it take to make this happen? If you are up for it, let me know. I am open to supporting a serious effort here.


    Kenneth Duda
    Menlo Park, CA

    1. Hi Ken,

      Sorry for the delay in getting back to you -- I had to think about it a bit. In the framework I've put together, futures markets are not necessarily reliable. Given "fundamentals" -- i.e. some kind of objective state of the world (in oil futures markets, the actual quantity of oil being extracted ostensibly exists and could in principle be measured), markets have a tendency to represent that allocation information fairly well (too much oil, lower prices; too little, higher prices). In that case, I'd say the information in the oil allocation demanded approximately matches the information in the allocation supplied.

      By information, I mean the number of bits required to describe a given allocation -- in the simple case of distributing 0 or 1 cars to 10 people, you need 10 bits and a given distribution can be mapped to a binary number like 1010011101. For oil, imagine it as barrels of oil distributed over geographic locations on Earth. In information equilibrium, the supply information is equal to the demand information: I(D) = I(S).

      However, in general I(D) represents an upper bound for I(S): I(D) ≥ I(S). Sometimes information is lost. When we don't saturate that upper bound, we have what Fielitz and Borchardt called non-ideal information transfer. In economics, this means that the price falls below its (information) equilibrium price: p < p*, independent of the fundamentals. The reason? I don't know for sure, but it seems to follow from coordinated human actions (especially panics).

      An NGDP futures market would be subject to occasional bouts of non-ideal information transfer where the price of a futures contract would drop precipitously -- independent of the fundamentals -- triggering the central bank following the futures market to erroneously pump money into the economy.

      That is to say it has the potential to make the macroeconomy more unstable, not less.

      Now this is really just some theory I'm working on that hasn't even gone through peer-review; lots of people think prediction markets are useful -- notably IARPA.

  7. Why don't tax cuts count as government spending, at least in the short term? It seems to me that for the government to give, say, $100 per day to families in homeless shelters counts as government spending. Similarly, if it gave $500 to tax filers who earn between $20,000 and $50,000 per year, that would also be government spending. But if it simply reduced their taxes by $500 that would not come to the same thing?

    1. For budget allocation they usually do; for Keynesian macro effects, they have different multipliers. For example a tax cut usually goes to someone who has a job (and more of the total amount goes to people who make more money) while government spending can potentially employ someone who otherwise would have been unemployed. The latter person has a larger marginal propensity to consume than the former, hence the multiplier is larger.

  8. Jason, I do not believe there would be any multiplier effect from these dividend payments.

    1. Hi Scott,

      I may have mis-read your take on Matt Yglesias's post; I thought you showed it to support an argument that it was possible the dividend payments were contractionary -- hence had a non-zero multiplier.

      (Also, I was using the word "large" in the sense of not close to zero out of habit from physics -- a multiplier of 0.3 would be "large".)

  9. Jason, I do not believe there would be any multiplier effect from these dividend payments.


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