From Sam Goldfarb at the Wall Street Journal:

What’s going on? Broadly, there are three messages bonds might be sending.

1) Directly, people might be expecting more inflation. More expected future inflation leads to higher bond yields, as people demand a greater return when they expect bonds to be paid back in devalued money.

2) People might be expecting higher short-term interest rates in the future. When one way of getting money from now to 10 years from now, rolling over short-term bonds, looks better, the other way of doing so, buying a long term bond, should get better too.

3) The end is nigh. People might be losing faith in our governments’ abilities to borrow and repay debt, and want to get out now ahead of the catastrophe.

These are all related. If people expect more inflation, then they might expect central banks to raise short-term interest rates in response to that inflation. People might expect central banks to keep interest rates low, but then to have to raise them more later on to fight larger inflation. People might see fiscal profligacy as a threat to inflation.

Which is going on now?

The FT opines:

traders rushed to bet on the European Central Bank raising its benchmark interest rate three times this year to contain an expected burst of inflation.

“Investors are starting to realise that we are moving into a mix of lower growth and higher inflation, combined with more fiscal stimulus and higher government spending,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price.

Investors are betting that public finances across the Eurozone “are going to deteriorate”, said Jean-François Robin, global head of research at Natixis CIB, as countries spend “a lot of public money” to absorb the shock.

Following the start of the previous energy crisis in September 2021, €651bn was allocated and earmarked across European countries, including the UK and Norway, to shield consumers from rising energy costs, according to the Bruegel think-tank.

An oil price shock does not necessarily mean inflation. It takes government policies to turn a relative price shock into inflation. See “how to turn a price shock into inflation.” So, the bet is that euro area governments will respond to the price shock by sending people money to pay for higher oil and gas bills, and that fiscal largesse will cause inflation. I am glad to see fiscal theory being taken up :) Europe is also taking about price controls and other ham-handed interventions.

They are also betting that the ECB will react promptly to any inflation, which accords with what I have heard. The ECB took a full year to react to the last inflation, and the ECB understands that people are more attuned to inflation, and their faith that the ECB will aggressively fight inflation is weaker.

The US is a bit behind Europe on ham-handed policy, but the temptation to make things “affordable” to individuals (not to the country) will be strong. The Trump administration just announced as 60% rise in corn ethanol mandates. When someone advocates “industrial policy,” answer “corn ethanol.” It doesn’t save CO2, it doesn’t save much oil (it takes a lot of petroleum to make corn), and it uses land and drives up food prices.

The Fed will be interesting. It’s hard to see the Fed doing anything decisive in its fraught interregnum. It’s hard. Central banks are used to meeting output and employment declines with lower rates. They see lack of “demand” as the source of the problem and provide it. But sometimes, as with an oil shock, the problem is lack of “supply.” The economy can’t produce as much. Adding stimulus in the face of an inflationary supply shock gives a lot more inflation and only a little bit less bad output, at least in the conventional understanding of such things. Politically, restrictive monetary policy while governments are trying to “stimulate” is tough. I fear the Fed will try to square the circle with a big “quantitative tightening” rather than raise rates. The 1979 credit controls were a similar ill-fated effort. Darrell Duffie explains why balance-sheet reduction is hard and can cause financial damage. Much more coverage later.

To investigate a bit what’s going on, I plotted here the path of 10 year Treasurys along with 10 year indexed Treasurys. The lower line is shifted up by 2% so they fit on the graph together. This graph suggests that we are not seeing a direct inflation premium. Higher expected inflation would directly raise the Treasury yield leaving the inflation-protected yield alone. So the lower line is forecasting higher real interest rates. It may be forecasting that the Fed will raise interest rates, and prices being sticky that won’t have an effect on inflation. If it’s the end of the world, (I don’t think so) that would be an end with explicit write-down, and we are seeing a default premium, not a premium for default via inflation.

These graphs are also not suggesting a forecast recession, the point I’ve been debating with Niall Ferguson on Goodfellows lately. That would be revealed by lower real and nominal interest rates.

But first let’s get a grip. When I first made the interest rate graph, it popped up with a greater horizontal axis

What happened to the recent “spike?” It’s there, just put in perspective about just how bit it is compared to the usual ups and downs. So, hold on, maybe it’s not time to grab those gold bars and shut the bunker door quite yet. Moral: Always read the axes.

Sam Goldfarb, who wrote the Wall Street Journal graph on Saturday, added “Some fear the selling has taken on a momentum of its own, with the war-fueled market swings forcing hedge funds to shed bonds to cover bets made with borrowed money and other investors hesitant to step in while the threat of further losses linger.”

As I was looking up the reference Goldfarb posted

Yes,

Look at the axis again: another decimal point on the left, and the last day worth of data on the right.

Moral: The life of a markets reporter is not easy! Neither is the life of a bond trader. The life of a grumpy substacker is much easier : )

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Greece may benefit from a range of European Commission emergency measures aimed at tackling rising energy costs, EU Energy Commissioner Dan Jorgensen indicated ....

… Jorgensen signaled that Athens can make immediate use of a European Commission “toolbox” that includes state subsidies, tax reductions and flexible support schemes for households and businesses.

The proposed tools – including price caps on gas, expanded long-term energy contracts and relaxed state aid rules – could help shield vulnerable households and stabilize electricity costs. Jorgensen also pointed to the need to ease the link between gas and retail power prices.

Well, I’m glad that the EC has a pre-prepared “toolbox” of terrible ideas so that Member States don’t have to come up with terrible ideas all on their own.

How does a relative price shock — energy costs more than other goods—turn in to overall inflation? Largely by policy responses to the energy shock. Europe invented a doozy in the last price rise and looks set to do it all over again.

People are using 10 gallons of gas a week, at $5 per gallon (sorry, US units and California prices). Available gas goes down to 9 gallons a week. The price starts to rise to $6 per gallon. Left alone, people find ways to use less gas, with the price as an incentive.

The worst combination of these “tools” would be if the government says “we will pay for the extra cost.” So, you still pay $5 per gallon, and the government chips in the extra $1. Sounds good. Can you spot the problem?

Yes, with no incentive, people still use 10 gallons a week. There are still only 9 gallons around. Where does the price settle? Infinity.

Now, the “tools” are not quite that idiotic, though close. Suppose the government says “we’ll pay your extra expenses.” You still have to pay $6 at the pump, but the government gives you a check for $10 to cover the extra cost. People feel the marginal price, so do cut down on gas. But they use some of the extra $10 to buy other goods. That’s how a gas price rise turns in to general inflation. This is exactly how Europe responded the last energy price shock. And got general inflation.

“Price caps.” The government says, gas stations have to sell at $5. Welcome back to the 1970s. Long hair, silly clothes, and gas lines around the block.

“Ease the link between gas and retail power prices.” What do you think that means? Obviously, another witch hunt on “price gougers,” price controls and “windfall profits” taxes by another name. The emperor Diocletian tried that. It didn’t work then either.

The commissioner stressed the crisis is driven by high prices rather than supply shortages, noting Europe has significantly reduced reliance on Russian energy imports.

And dear commissioner, where did the high prices come from? Is there nothing going on in the Persian Gulf of note?

This is a media report. I sincerely hope the commissioner is misquoted. The point of my post is simply to remark on the fallacy of the ideas, which are pretty common.

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Last week was the 250th anniversary of the Wealth of Nations. For the Hoover “weekly rants” I looked up what must be the top two Smith quotes:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.

Looking at it again, I particularly like the second sentence. That proves the point, we all understand what motivates butchers, bakers, and brewers.

Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. …By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

(my emphasis). Though intending only private gain, the butcher, baker, and brewer (and even the banker) promotes the interest of society, and does so far more effectively than with philanthropy and other intentional measures.

Adam Smith Allegory. © Sally Fama Cochrane

The painting is a gift from my daughter Sally when she was in high school. (She has gone on to become a supremely accomplished artist IMHO.) Find the allusion to the butcher, baker, brewer, invisible hand, pin factory, and a subtle foreshadowing of trouble in the arrangement of the tools.

The Smith quotes attract my attention for their moral vision as well.

To this day, the ethics of the Bay Area hold that making money is a grubby business. Billionaires can only earn some forgiveness for their evil wealth accumulation by their philanthropy. After you’ve made your grubby money, do something good for society by giving it away. Mackenzie Scott is the saint, Jeff Bezos the sinner. Even the Stanford Business School is apologetic about making money.

Those ethics are still rooted in the view that one person can only get wealthy by taking things from another. For thousands of years, that was not a bad approximation. Roman emperors did not gain half the income of the empire by inventing iPhones.

But Smith points out that this is exactly backward. The billionaire who invents a personal computer, an iPhone, or Walmart and then Amazon’s logistics, creates hundreds of billions of value for the rest of us. He or she keeps a tiny fraction. And that fraction is usually left reinvested in the company, churning out more products and employment. Here is where he or she contributes to society, far more than in billionaires’ usually ham-handed efforts at Philanthropy. (They should buy more art, and less political doo-goodism.)

We celebrate Smith for his foundation of economics as a cause-and-effect discipline. Want greater national prosperity? Here’s what works: Economic freedom, under the rule of property rights and law, and disciplined by the competition that freedom engenders.

And wow did it work. Note the log scale. Average income is up a factor of 20 from Smith’s time. And GDP is a vast understatement of the benefits (consumer surplus) of growth. Lifespan and child mortality alone make the point. From thousands of years of misery, just a little economic freedom has brought us wonders. Even Smith’s Britain was full of restrictions on who could be in what business, what price they could charge, and so on. And the imperfect freedom we have now gives one hope that even more freedom can provoke additional wonders.

I generally stick to the practical case, not the moral case. We do not have to argue freedom vs. prosperity. We are lucky that the cause and effect is devastatingly true. But the moral case for freedom adds to its practical case. And underlies it as well. Societies that genuinely believe all wealthy people are evil, and the act of running a profitable company reprehensible, that instead prize redistribution especially of other people’s money, will not long allow economic freedom to prosper.

Freedom is also the only “ism”, the only vision for the economic organization of society, that is not in the end predicated on violently taking from A and giving it to B.

This year is also the 250th anniversary of Declaration of Independence. Our country’s founders shared a similar vision: rather than build a country around the hope that people and especially politicians would act benevolently, in a way they have not done for the last hundred thousand years or so, instead design a political system that channels self-interest to decent public outcome, as Smith points out that a free economic system does. That worked out pretty well too.

If we can keep it.

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For fun, here is as of Friday the history of oil prices (West Texas Intermediate Crude) stapled to oil futures prices. The red line is the price that you can pay today to lock in future oil, and it represents a market expectation of what will happen.

The runup has been sharp. But it is still less than the runup following the Russian invasion of Ukraine. The futures market sees a relatively swift return to about $65.

Expectation means average, and it will surely be wrong. Things will be worse or better, with about half a chance of each. Markets are presumably betting that the US, Israel, Saudi Arabia, Gulf States, and everyone who buys oil and LNG from the gulf will not let the straits stay closed for long, nor effectively decide to lose the war by handing Iran this perpetual trump card. But we have cut and run many times before.

Still, doom and gloom is not forecast by traders, so it represents a bet that things will be much worse than they foresee, for either political or economic reasons. Markets often are wrong and do not see major crises until they come. Still, it is a contrarian view.

To give a longer history, here is the real oil price (I deflated with the CPI) over a longer history. The current runup is not yet the size of the 1970s oil shocks, The big rise in 2008 is generally credited to “demand” not “supply,” but preceded a recession just as in 1973 and 1979. (See Jim Hamilton here.) Still, the current rise is in the same ballpark, just playing in the minor leagues so far.

Economists like me are usually quicker to look to substitution in demand and elasticity of supply than most people looking at such things. There is a lot one can do to use less oil when the price rises. And there is a lot of production capacity that is not worth tapping at $65 but very worth turning on at $100. I don’t know enough about oil to know how long it takes to turn on that supply. Paradoxically, the swift decline of futures prices reduces the incentive to turn on the taps. If futures prices were above $100 for years, people with marginal wells could turn them on and sell the expensive oil forward, risk free. I gather the strategic reserve is buying a lot of oil on futures markets, which is smart both financially and from a public policy perspective.

Over a long enough horizon of a few years, I presume that the “supply chain fragility” types will notice that running 20% of the world’s supply through an unstable choke point is not a great idea. More pipelines across Saudi Arabia, bringing Venezuela back on line, allowing fracking in Europe (sorry to harp on that) plus other energy sources, could basically make the straits irrelevant if they are not secured.

Recession? The US is much less dependent on both oil and imported oil and gas, thanks to fracking. (And over the loud objections of our energy policy establishment. What a good thing they didn’t have the power to ban fracking, as Europe chose to do, and the ban on LNG export terminals was overturned.) Prices still affect us, but we gain income. It is a much worse problem for importing countries. I still rate the economic effects as “headwind” not “recession” without some follow-on: an induced financial problem, or a ham-handed policy response. Ham-handed policy response is likely! Remember the 1970s for that, please. Subsidies so people can pay higher energy prices, as Europe did in 2022 turn oil prices into general inflation quickly. Price caps lead to gas lines. Rationing is worse than high prices. Price caps with government chipping in the difference leads to demand permanently above supply. Prices are a signal wrapped in an incentive, and with oil you want the signal screaming loudly to use less and produce more.

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Disclaimer: My comments are thus those of an “outsider” to the little sub-literatures, and I surely get some things wrong.

I’ll only make some points here of interest to general readers. The other papers were great, but their points are more technical, at least for my translating abilities.

Complete Pass-Through in Levels by Kunal Sangani Northwestern makes a dramatic empirical point: Companies pass along the dollar cost of their inputs, not the percentage cost.

Suppose a company sells widgets for $100 each, and the cost of materials is $50 per widget. Suppose cost of materials goes up $10. How much does the company raise its price? The empirical work came from commodity prices, but you can see the great relevance to tariffs.

Some say 0. The company absorbs the costs from lower profits, a lower markup of price over cost. (In my example, the markup is 2, price is twice marginal cost.) Much current economics says the company raises its price to $120, keeping its price a constant percentage markup over marginal costs (double here). The fact is $10. Within a few months, companies fully pass on the cost, but dollar for dollar not in percentage terms. The paper is, to me, utterly convincing on this fact.

Point: Retail coffee prices move dollar for dollar, not percent of, coffee bean prices.

Point: When rice prices went up, fancy rice and generic rise went up by the same dollar amount (lower graph). They did not go up the same percent, so rice inflation (measured as a percent) is lower for fancy rice. This is “cheapflation,” the tendency of lower priced goods to see more good-specific inflation rates in response to cost shocks.

Of course, you might say, if costs go up a dollar, companies charge a dollar more, not the log of a dollar more. How could you ever have thought otherwise?

Indeed, suppose raw coffee beans are only 1% of the cost of your double mocha Frappuccino. If the beans go up from 10 cents to 20 cents, it would be insane to think the cost of the Frappuccino should double from $8 to $16. And economists aren’t that dumb. The proposition is that firms charge a constant proportional markup over the sum of all their marginal costs. The graphs are actually, misleading as they show the response to a particular cost, not all marginal costs.

The proposition of proportional markup rather than dollar for dollar markup looks just like a classic mistake in units. Of course firms pass on dollar costs not proportional costs. But in fact proportional markups are pretty much the standard baseline adopted by people who look at this sort of thing.

We had a fun discussion. Proportional markups come from the convenient constant elasticity of substitution demand. So, more complex “demand systems” came up, and many comments about behavioral pricing behavior.

I find it hard to believe that something so simple needs more complexity. It looks to me like a much simpler explanation holds: to first order, perfect competition. The goods at the point that makes pricing decisions — the individual coffee shop or gas station — are pretty good substitutes. Intense competition drives prices down to costs quickly. Firms raise prices by the minimum they need to in order to stay in business.

Yes, was the answer, but that doesn’t explain the markups we observe. Really, say I? Markup is price in excess of marginal costs. How did you measure marginal costs? The markup literature thinks these markups are big, but profits are not huge because someone has to pay fixed costs. What’s really a fixed cost? In the end, to serve another Frappucino you need more baristas, more or bigger stores, as well as more cups, sugar, milk and so on.

****

Monopsony, Markdowns, and Minimum Wages by Ester Faia, Benjamin Lochner, and Benjamin Schoefer comes next in my review. Now we’re looking at “markdowns,” not “markups.” This is the alleged ability of the same Starbucks to pay wages substantially below the marginal product of baristas. Adding another Barista might make $25 an hour additional profit for the company, the story goes, but the local Starbucks can exploit workers by paying $10. Lack of competition among coffee shops stops another shop from opening up next door, paying $12, or charging less (see markup above). So, the story goes, minimum wages force companies to pay something more to employees out of that same “markup.” Again, I’m not sure how that adds up, as there is no pool of “profit” and Starbucks has to pay a competitive return to capital too.

Not so fast, says the paper. Imposing a minimum wage did nothing to change the “markdown.” Maybe there wasn’t much of one to start with (the latter is my conclusion).

This is a great paper in part because it offers a negative result.Journals usually only publish positive results, papers that find an effect consistent with a model. Journals are typically also disposed to results that support the minimum wage narrative.

Germany, surprisingly enough, did not have a minimum wage. Then in 2015, they imposed one.

What you happens to the distribution of wages when you raise the minimum wage?

Clearly, firms stop paying less than minimum wage. And we see a sharp hump right at and just above the minimum wage.

Here is my favorite graph of what happens to the measured “markdown.” The paper scales the result by what should happen according to the monopoly model, which is that the markdown rises from 0 to 1. Instead, the markdown goes nowhere after the minimum wage is imposed.

A null result! Like other negative result papers, they jump through hoop after hoop to show it’s robust.

Pandemonium erupted. Well, not pandemonium but an apparently devastating critique by Simon Mongey.

You can see the first issue in the above graphs. The wage distribution graph seems to answer the question right there: Look at all those people who used to be paid minimum wage, and now are being paid more. How could the estimate have missed that? The authors have a good reply: Don’t assume that the workers now being paid more than minimum wage have the same marginal products as the workers that used to be paid less than minimum wage. Even when they are the same people at the same firm, employers make people work harder, make schedules less flexible, hire different workers, invest in more equipment, and in other ways make marginal products rise to match wages. Mechanically, that’s how the estimates work: They estimate that the marginal products rose with the wages, so the markdown, if there was one, remains the same.

The second issue is that the authors assumed that employees who benefited from the minimum wage are then paid their marginal products, with no markdown at all. But minimum wage may not have fully raised their wage to the marginal product. If their marginal product was $12 per hour, they were paid $8, and the minimum wage is $9, they are still being “underpaid.” On the other hand, the minimum wage may have raised others’ wages to above their marginal product. A long discussion whether it matters followed.

So what does it mean? One answer is that markdowns are just badly measured. And they are. A business hires a young person to sweep up and see if he works out. How do you measure how much extra the firm makes per hour from this employee? The authors, like everyone else in this business, does it with heroic assumptions. They write a production function at the firm level, and then estimate the marginal product of all workers.

But if markdowns are badly measured, how do we know the supposed stylized fact that started this all, the notion that employees are systematically paid a lot less (60 - 80%) of their actual marginal products? That’s the message I take.

****

A lot of macroeconomics now is concerned with these markups and markdowns. It is said that companies, even small stores, routinely charge prices as much as 50% above their marginal costs. They are able to do this because each store’s product is special. Where are all the profits from such high prices? They get dissipated in fixed costs, and the owners only get the competitive return to capital (which we measure). But clearly, distinguishing fixed from marginal costs is hard. It is said that companies, even small stores, pay employees a lot less than their marginal products, again because competition between stores is weak. Where are all the profits from the yawning gap between marginal product and wage? They get dissipated too though I’m not sure where. But clearly, measuring marginal product of an employee is hard.

You can see the general pattern. We write economic models to try to decide what prices should be. Prices are something else. We declare a puzzle that markets are not functioning. But Hayek taught us long ago that it’s nearly impossible to determine what a price should be. Finance incorporated this fact long ago, recognizing that investors have more information than we do. So modeling what stock prices “should be” and then declaring a puzzle is a fraught business, and usually labeled fallacy.In microeconomics we call it “unobserved individual heterogeneity.” We can’t model all the ways in which one person is different than another, or one price is different from another. It is still interesting to try to measure what a price should be, and to be periodically reminded how hard that is. But I’m slower to think when it fails that something is wrong with the world.

The view that even coffee shops are routinely described as having a lot of pricing power—the ability to charge twice the price that would hold with perfect competition—and wage-paying power—the ability to pay people only a bit more than half what a fully competitive market would pay—pervades today’s macroeonomics. It entered as a convenience. In the real business cycle era, macro models wrote perfect competion, in large part because that was easier. The new-Keynesian economists introduced imperfect competition at the firm level, but a lot of that was for convenience. It let them write down models in which firms could set prices in a “sticky” manner, but still let markets clear rather than deal with who is rationed as in the much harder earlier Keynesian literature (Barro and Grossman). Then micro-macro economists go out and try to measure markups, and came back with surprisingly high markups.

I grant that I go to a conference precisely to catch up. Maybe there is a web of convincing evidence about markups, and against the perfect competition view, that I have not considered. That was the sense of what people said to these comments at the conference, and conferences tend not to synthesize work for outsiders.

I was interested to note that an “Economic Fluctuations and Growth” conference had zero papers on fluctuations and only one tangentially related to growth. No recessions, no inflation, no central banks. It looks like what macroeconomists do these days is more “economy level industrial organization.” A colleague pointed out the need for the adjective: in his view real IO looks at each market in isolation and thinks of then as all different. That’s not good or bad, it’s just an observation on what people seem to do. In principle, estimating markups, markdowns, and so forth are ingredients to a larger macroeconomic view and inform macroeconomic policy, but nobody is making those connections. It seems to mostly inform microeconomics policies, such as competition and minimum wages.

****

A minor point has been irritating me lately, and I’ll illustrate by picking on Aggregate Productivity with Heterogeneous Agents by David Baqaee and Ariel Burstein. This is a sophisticated paper on how to measure welfare effects of policy and other changes with and without transfers, by measuring an equivalent change in aggregate productivity. Its major contribution is to theory.

The authors include the following table evaluating the effect of the China shock on the US, modeled here as an increase in China’s productivity. More A is better. The calculation uses a detailed model including “9 regions (Canada, China, France, Germany, Great Britain, Japan, Mexico, U.S., and the rest of the world) and 30 industries in each country.” The model considers the question whether people who work in losing industries get compensated or not. With “tariffs and lump-sum transfers”, China becoming more productive is a benefit to the US (0.008). With “Laissez-faire,” no transfers and tariffs, it is bad for the US (-0.235)

This calculation echoes much of the common discussion of China shocks, trade shocks, and so on. Unless the federal government protects categories of newly unproductive industries with tariffs, or transfers money to people who were hit by the China shock, we can’t say that something obviously good for the economy as a whole is a good thing to do.

At this point in the usual conversation, I object. The China shock is a tiny fraction of the turbulence in our market economy. Must we give protection and cash payments to rustbelt industry workers when the south became more productive? Must we protect taxis and pay them subsidies when Uber comes in? Must the employees of Yahoo be compensated, and tariffs imposed, when Google comes along with a better product? How does the government know who is hurt by what shock anyway? Some individuals suffer more, others not at all or even end up better off with new jobs. How long must tariff protection for outmoded industries go on? Should we have imposed tariffs against Guternberg’s darn moveable-type printing press that threatened all the monk’s jobs of copying manuscripts, and should they still be in place now their great great great great grandchildren inherited the jobs because we protected the industry? More seriously, should we have kept Volksvwagen and Toyota out of the US because there aren’t even more subsidies to union auto workers?

Most of all, we have a social safety net. Is not the answer to provide a social safety net, that calibrates incentives vs. job risk insurance, for people hit by all sorts of shocks and not just China, rather than try to identify who got hit by what shock? Why should an ex steel worker who used to be paid $80,000 get more than an ex warehouse worker who never earned ore than $40,000 anyway?

With these thoughts in mind, I notice that the model in the above table does not include a safety net in its “laissez faire’’ calculations. But we do have a safety net. The all-in marginal tax rate implicit in our social programs is between 50% and 100% from $0 to about $60,000, and then continues through regular taxes and phase outs as income increases. Equivalently, the US provides about 50 cents to a dollar extra income per dollar of lost market income. Computing costs of policies, based on the harm to the losers, while completely ignoring the tax and transfer system we already have in place to buffer losers seems profoundly misleading.

So my larger complaint, which has shown up in half of the workshops I’ve attended lately, is that authors compute “policy simulations” that they don't take seriously. On the basis of Table 1, I’m sure the authors would not in public say this is how bad the China shock was, given that we did not have tariffs or payoffs. So why make such computations? We should take economics more seriously.

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Update on a graph I’ve been following for a few years, most recently last year, this one courtesy of Niall Ferguson.

Of course, this is just for fun. It’s easy to find spurious patterns like this in all sorts of data. And everything is calm in Iran today, unlike the Feb 1979 revolution and consequent oil price spike.

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The results are stunning. The comments it offered were on the par of the best comments I’ve received on a paper in my entire academic career. And more concise and organized than the best ones. They aren’t perfect, but the kind of analysis the program is able to do is past the point where technology looks like magic. I don’t know how you get here from “predict the next word.”

Here are its main comments:

Operationalizing the “fiscal news” narrative

The core episode claim in Ch. 2.3 is that inflation “started” when agents learned in early 2021 that a material share of deficits would not be repaid, and “ended” in mid-2022 when expectations shifted regarding future unfunded programs. As currently written, the evidentiary support risks circularity: the text leans on the occurrence of inflation to infer that debt was perceived as “unbacked,” while offering mostly qualitative narrative signals.

To carry the identification burden, this narrative requires operationalizing. Ch. 4 explicitly claims recent history offers unusually clean “experiments.” To substantiate this, the text needs a tighter set of dated, externally visible observables—specific legislative hurdles, “debt doesn’t matter” rhetoric, or election probabilities—tied to sign and timing predictions for inflation expectations and long-bond prices. Without pinning the “news” to specific dates distinct from the inflation series itself, the episode reads as a post hoc overlay rather than a discriminating application of the FTPL mechanism.

The program found the core episode and summarizes the main argument of an 80 page paper. I did write a disclaimer that finding separate measures of the present value of surpluses is not possible, and that my goal was to establish plausible rather than proof. But I was lazy, and the program suggests the obvious way in which I should tighten up the presentation, within the realm of the possible. Back to work.

Clarifying the fiscal regime distinction in the “completeness” claim

The manuscript repeatedly asserts completeness, noting in Ch. 3 (”Now, stop and admire what we have accomplished. We have a full, complete… theory…”) and Ch. 4 (”the only known, complete, economic theory… consistent with current institutions”). However, Ch. 4.5 also correctly notes that “All of the equations… are in fact the same” between FTPL and New Keynesian (NK) models.

For the academic audience, the claim that the standard NK model “Doesn’t Work” (Ch. 6.1) or is incomplete creates immediate friction unless the distinction regarding regime closure is explicit early on. The substantive disagreement is not the presence or absence of the valuation equation, but the fiscal regime: does the equation determine prices (FTPL), or does it determine future surpluses via a “passive” fiscal assumption (NK)? Reframing the critique would strengthen the argument. Rather than stating the NK model fails on internal logic, the text should argue it requires an empirically untenable assumption of passive fiscal behavior during the 2020–2022 episode.

The point is fair, and a good case of how the program improves writing. There is a tension between the observational equivalence theorem and my claim that recent experiments tell us which model is right. The answer is in the paper — observational equivalence is only about observed time series, and we can use what we know about how central banks behave from other sources to think about what regime is plausible. Central banks don’t threaten explosive behavior to select equilibria. But that’s spread out in the paper. I didn’t really stress the causal interpretation of the valuation equation issue — does the valuation equation express how inflation causes surpluses or how surpluses cause inflation. (Like the 50 year old debate whether MV=PY expresses how money supply causes inflation or inflation causes money demand accommodated by supply.) The model picked this up on its own, likely by being trained on previous FTPL controversies. Back to work

Resolving ambiguity in the transmission mechanism

There is a tension in how the text describes the transmission of interest rate hikes. In Ch. 3.1 and Fig. 3.2, the argument is that rate hikes can produce short-run disinflation by lowering the nominal market value of outstanding bonds (the numerator in the valuation equation). However, Ch. 2.2 and Ch. 4.5 emphasize that discount rates and interest costs are central to the present value of surpluses (the denominator).

A rise in real rates that compresses bond prices also generically lowers the present value of surpluses via discounting or raises interest costs. This can push the price level upward, creating a “stepping on a rake” effect where the central bank shifts inflation across time. The policy conclusions (”should promptly raise rates,” Ch. 3.1–3.2) need to be reconciled with this mechanism. The text should explicitly partition what the central bank can achieve alone (via the valuation effect on the numerator) versus what requires fiscal adjustment, and clarify when the disinflationary channel is generic versus conditional on duration duration.

Here too, the model caught my habit of introducing an idea and then later refining it. The long-term debt mechanism is a way that higher future interest rates can result in lower inflation today. And the typical persistent shock links higher current and future interest rates. But sticky prices work against that mechanism. With sticky prices, higher nominal rates mean higher real rates which means higher interest costs on the debt which raises inflation. I sort of dribbled that out in several places. This may or may not be a good idea. I don’t like to overwhelm readers right away. But the program makes me think about that choice.

And more, which I won’t bore you with.

It also found algebra errors, such as a negative sign that slipped in the solution of a differential equation.

And that’s the free mode! I’ll rush back in paid mode (much more extensive) after I finish incorporating these comments.

****

This is the first time I’ve seen AI at work in something I do daily, and it really is revolutionary.

Refereeing and evaluating papers is one of the more unpleasant and time consuming tasks in our profession. I’ve read a lot of referee reports in my 40 years as an economist, and this is top 5% for sure. Most referee reports do not identify the major point of the paper, and do not assess if the paper backs up that point. They do not notice glaring gaps of logic, basic theorems violated, econometrics advice 101 ignored. Editors are lucky if one out of three reports is vaguely useful. Clearly, this task is going to be radically impacted by AI. If I were an editor, I’d feed every paper to refine on receipt. Or, I would require the author to spend the $50 and send in the last refine report! I will surely get refine’s opinion before any referee report I write in the future.

Will all the referees be out of jobs? No! You still have to read and evaluate what refine offers. But the speed, accuracy, and quality of reports will jump. And economists will save a lot of time.

Before anyone asks me for comments on a paper, I’m going to ask “did you submit it to refine?” That will save a lot of time too.

And it should produce much better written papers, which will also save a lot of time.

It does feel weird writing defensive prose to an AI program, as I do to the thoughtful humans who offer me comments. The last comment brings this up

Strengthening the discrimination against the Monetarist alternative

Ch. 4.2’s flagship discrimination claim is that Monetarism predicts QE should be inflationarily equivalent to helicopter transfers, and that the observed contrast falsifies Monetarism. However, the manuscript emphasizes the institutional reality of Interest on Reserves (IOR) and “ample reserves.” A sophisticated “money view” would invoke precisely these facts to argue that reserves and T-bills are near-perfect substitutes under IOR, making QE neutral while transfers are not.

If the Monetarist benchmark—invoked here to be knocked down—is not the strongest version consistent with the institutional realism the book champions, the adjudication in Ch. 4 loses credibility. To persuade the readers most likely to scrutinize this section, the text should address why the FTPL explanation dominates even a sophisticated Monetarist view that accounts for IOR, rather than only the primitive version that ignores it.

Yes, I did leave out the liquidity value of treasury debt. But is there really a serious school of thought that thinks treasury debt is a perfect substitute for money, so that we should think of the whole stock of treasury debt as the monetary base? That would mean open market operations are completely irrelevant, undoing a lot of standard monetarism. And the famous “stability” of the M2-nominal GDP ratio is totally absent for total debt, which has fluctuated form 25% of GDP in the 1970s to 100% now. Velocity shocks? Perhaps the paid version will send me some cites so I know if I really have to deal with it.

But one way or another it is astonishing that a computer program came up with this logical possibility, which is at least a worthy whatabout seminar comment from the back of the room.

In the meantime, I also tried Claude to update some graphs. My prompt was just “write a matlab program that fetches data series xyz from Fred using the API, and make a graph that..” with pretty detailed description of the graph. It ran right out of the box, even doing a decent job of “put text labels on the graph in a way that doesn’t conflict with the plotted time series.” Claude did not do a good job of finding which Fred data series would work, but that was a small task. And it produced code using a lot of commands I don’t recognize. Making sure programs do what you think they do will be a new challenge. It went on and did things I didn’t ask for, like offer summary statistics! Still, an hour job took 5 minutes.

This is all old news to most of my colleagues, who are integrating AI into workflows with great speed. But if you’re not using these tools, the time to start is now.

(I used no AI to write this substack, and have not done so in the past. I’ll acknowledge when I do. As I included refine in the thanks of the inflation booklet.)

Update

On reflection I have started to worry again. In 10 to 20 years nobody will read anything any more, they just will read LLM digests. So, the single most important task of a writer starting right now is to get your efforts wired in to the LLMs. Nothing you write will matter if it is not quickly adopted to the training dataset. As the art of pushing your results to the top of the google search was the 1990s game, getting your ideas into the LLMs is today’s. Refine is no different. It’s so good, everyone will use it. So whether refine and its cousins take a FTPL or new Keynesian view in evaluating papers is now all determining for where the consensus of the profession goes.

Communicating with a journal editor, I can see the usefulness of a version tailored for evaluating papers. For example, “did the author incorporate and respond to the referee’s comments?” “do the referee’s comments make any sense?” “which of the referee’s comments address the paper’s correctness or importance, and which are merely suggestions for further work?” and so forth. However, capture of the LLM still strikes me as a potential problem, either by a wing —economists love nothing more than a methodological fight, “this paper uses outdated structural/reduced form methodology,” “this paper ignores important behavioral/general equilibrium analysis” etc — or by the “settled science” — imagine the LLM reaction in recent years to climate, gender, public health, inequality, etc. papers if trained on the “consensus.” I should test refine on some controversial topics. Also how it does on the bullshit benchmark, a really important problem in economics academia. We need a quantitative bullshit evaluation — bs wrapped up in fancy equations.

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As a reminder, the first Fed-Treasury Accord in 1951 (see last post) reestablished Fed independence. From WWII to 1951, the Fed had committed to buy as many US Treasury bonds as necessary to keep the long term interest rate below 2.5%. It found itself buying a lot of bonds, which it felt was causing inflation. In the Accord, the Fed won the right to buy bonds only when it thought prudent, and to allow long-term interest rates to float upward.

That background is important. A lot of commentary accuses Warsh of becoming Treasury Secretary Bessent’s puppet at the Fed, and setting the Fed up to finance deficits without complaint. I think this is exactly the opposite of what is likely to transpire. Warsh has spent over a decade saying that the Fed needs to buy less government bonds, shrink its footprint on markets, let long-term interest rate go where they want to go, and do less overall. By doing less, in less political areas, the Fed can retain and strengthen its independence. The invocation of the Accord, in which the Fed won the right not to buy bonds tells you what’s up. Otherwise, it would be “repeal the accord.”

Of course the success of any new accord depends on what’s in it. But I see a few areas where a new accord would make a lot of sense and do a lot of good. Fiscal and monetary policy overlap. To the extent they can be separated, it’s a good idea to be clear who has responsibility for what. To the extent that they cannot be separated, it’s a good idea to have a clear channel of communication and cooperation.

The Fed and Treasury need to be clear that the Treasury is in charge of fiscal policy. Only by staying away from fiscal policy can the Fed hope to be independent. Independent agencies cannot be in charge of taxing and spending. That’s a job for politically accountable agencies, that face the voters periodically.

In practice what does that mean? First, Fed and Treasury need to agree who is in charge of the maturity structure of government debt. The Treasury balances issuing long term vs. short term debt. It’s just like choosing a fixed vs. floating mortgage when you buy a house. The long term debt is a little bit more expensive on average. But then, if interest rates rise, the payments stay the same and you’re not at risk of losing the house. Once the Treasury issues long-term debt, higher interest rates do not cause additional budget deficits, at least for the maturity of the debt.

In its various Quantitative Easing programs, the Fed bought long-term debt and gave out overnight debt (interest paying reserves) in return. That undoes some of the interest rate protection the Treasury bought. The wife went to the bank, and got the 30 year fixed. The husband went back to the bank and said no, no, swap that back to half floating. Interest rates went up, the wife thought “how wise I was.” The husband must admit sheepishly what happened and how their mortgage payments are going up. We can pretend only he lost money, but in the end they’re married. Likewise, the Fed and Treasury pretend to be separate but in the end, the Fed’s losses end up with the Treasury, and thus the taxpayer. Right now the US is paying a trillion dollars a year of interest costs on the debt. That’s not all the Fed’s fault. I’ve been arguing for a decade that the Treasury should have borrowed much longer to buy just this protection, and even issue perpetual debt. But the Fed did make that substantially worse by undoing a lot of the Treasury’s long term debt issues.

When I have asked in the past, Treasury officials said “we issue the debt, the Fed is independent.” The Fed of course denies any fiscal concerns. But that’s untenable. Someone needs to be in charge of the overall maturity structure and its risk-reward consequences for the taxpayer. In my view, this is a job for the Treasury. If the Fed wants to buy lots of Treasury debt in order to provide lots of bank reserves, then the Fed should buy only short-term bonds, or issue reserves via collateralized lending as the ECB does, without buying Treasury debt. If the Fed needs to buy long term debt temporarily for “market function” reasons, then it needs to swap out the interest rate risk with the Treasury, or exchange that promptly for short-term debt. To be clear, I think claims of “dysfunction” are overblown and the Fed props up markets far too much. But if anyone is going to do that, it should be the Fed. That’s what independence is for. The Treasury is going to be much too swayed by bankers and rent-seekers that any price dip is a crisis.

The treasury could help this a lot by issuing fixed value, floating rate, electronically transferable debt in the first place. (As well as perpetuities and fixed-for-floating swaps between the two.) If it’s right for the government overall to issue more short-term and overnight debt, why does the Treasury issue long term debt, then the Fed has to buy it up and issue short term debt in its place? The treasury doing so could free the Fed from a huge headache. Indeed, if the Treasury were to offer such debt that would free the Fed from more mountains of headaches, including the persistent demand for narrow banks, money market funds, segregated accounts, stable coins, and other private intermediaries who want to hold overnight debt, issue stable claims, offer transactions services, earn a small spread, and undercut the big banks’ deposit oligopoly.

In sum, Accord Item #1: Treasury is in charge of the maturity structure of US government debt.

Second, the Fed needs to get out of credit allocation. Buying mortgage backed securities to funnel low interest loans to homeowners rather than businesses is a political decision. Again, maybe ok if there is some short-run financial dislocation, but not for years and years. (I may disagree with a lot of the Fed’s financial policies, and its endless put option for markets, but that is the Fed’s job, and that’s our point here.) If that’s going to happen, then the Treasury should buy the mortgage backed securities directly. That’s already happening, with the recent $200b purchase. Again, in my view it’s a bad policy, but it is correctly made by the politically accountable branch of government, which is in charge of all the other subsidies and take from Peter to pay Paul policies of the government, and faces the taxpayer’s wrath.

Third, Fed and treasury need to prepare for the next crisis. This is the hard one, and goes right to the issues of 1951. In 2020, the Fed cried “dislocation” and promptly monetized $3 Trillion of new treasury debt, holding down long term interest rates just as if it were WWII again. That’s part (a small part in my view, but larger in may others’ view) of why we got a big inflation. Not funding deficits in a crisis is a much bigger deal than not funding deficits in every day affairs. A new crisis will come, will that happen again?

I would prefer a very strong anti-inflation mandate, and then Congress can declare a crisis, and allow the Fed to temporarily ease. The Congress passed the TARP in 2008, allowing the Fed unusual tools. It can happen. Congress should own the responsibility for inflation, vs. the heat for limiting the government’s response to a crisis. This is not a decision that a politically independent Fed can really make.

That’s just the tip of the iceberg. Then there is financial regulation, where the Fed steers lending here and there, protects big banks, bails out here and there in crises, and now offers explicit price support as for corporate bonds in 2020. These are political. The Fed usually offloads the explicit credit risk to the Treasury, but not the decisions.

In sum, the coverage of this event paints it as reversing the accord and making the Fed subservient to the Treasury. The Accord was the Fed’s singular achievement of being able to say “no.” It looks to me that Warsh commendably wants to say “no” more often, shrinking the Fed’s footprint, make the Treasury take the heat for its decisions, and thereby preserving Fed independence.

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After World War II ended, the Fed continued its wartime pegging of interest rates. The Treasury-Fed Accord, announced March 4, 1951, freed the Fed from that obligation. Below, we chronicle the dramatic confrontation between the Fed and the White House that ended with the Accord.

The Fed pegged long term interest rates at 2.5% during WWII, to hold down interest costs and keep up the prices at which the government sold debt. Inflation surged in 1947 and 1948 when price controls were lifted, but inflation quickly came down again once the price level had caught up. The Fed already wanted to raise rates in the recovery of 1950. The resurgence of inflation during the Korean War in 1951 set the stage for the great battle for independence: Would the Fed continue to peg at 2.5%, printing money to buy bonds as needed? Or should the Fed’s job to contain inflation take precedence? (More technically, the Fed exchanged bonds for bank reserves, accounts banks hold at the Fed, which are freely transferrable to cash and before 2008 did not pay any interest.)

The article is notable for the politics of the “tussle” between Fed and Treasury, which I heartily recommend. I focus more on the economic issues.

Why did inflation break out in 1951?

Interestingly, the Truman administration was not running deficits to fight the Korean War. It planned to finance the war through current taxes, unlike the standard (today) economic advice.

Truman and the leadership in Congress believed that deficit financing had caused the World War II inflation… At the urging of the Administration, Congress raised taxes sharply in September 1950 with the Revenue Act of 1950 and again in January 1951 with an excess profits tax….

My graph is the total deficit, including interest costs on the debt. The latter are a back of the envelope 2.5% x 80 = 2% of GDP, so the primary surplus is positive throughout. The fiscal issue was not issuing new bonds or financing new deficits, but just prices of outstanding bonds and a bit of roll over. The Fed was not printing up money to finance new bond sales. If you like Phillips curves, the economy was growing, but not 10%-inflation booming.

However, we forget now how uncertain the world was at the time. There was a justifiable fear that the Korean War would quickly spiral to become WWIII against the USSR and China.

On November 25 and 26 [1950], the Chinese army, 300 thousand strong, crossed the Yalu River. Suddenly, the United States faced the possibility of a war with China and, if the Soviet Union came to the aid of its ally, of World War III… Anticipating the reimposition of wartime controls and shortages, consumers rushed out to buy consumer durables. On world markets, commodity prices soared. For the three-month period ending February 1951, CPI inflation was at an annualized rate of 21 percent.

…The prospect of a prolonged war created the likelihood of government deficits and the issuance of new government debt. Additional debt would force down the price of debt unless the Fed monetized it…

The rational-expectations fiscal theorist smiles. Prospective future deficits, and the likelihood of future price controls and rationing are pretty clearly the impetus for a surge of inflation.

Why did inflation go away?

The article does not remark on it, but look back at my graph of interest rates and inflation. One would expect that inflation surges to 10%, the Fed wins the battle over the 2.5% peg, the Fed swiftly raises short term rates to above 10%, long term rates surge on their own to wherever they were headed absent Fed pegging, and we repeat 1980 to get inflation under control.

Nothing of the sort happened. You can barely see the long-term rate cross the 2.5% line. You can barely see short term rates rise at all. There was no recession. Inflation just melted away.

The fiscal theorist smiles again. By June 1951, the odds of all out war with China and the USSR had clearly diminished. A one-time fiscal shock creates a one-time surge of inflation, just as in 2021-2022.

The other narrative is “whatever it takes,” restored credibility. On the announcement of the accord, people believed that the Fed would, in the future, raise interest rates as needed to control inflation, so the Fed didn’t actually have to do anything, and inflation goes away on its own.

If you like to think in terms of Phillips curves, inflation = expected inflation + k x output gap. There was clearly no high lowering the output gap, so just as clearly the news of mid 1951 changed expectations. Rational expectationsers can smile in any case; beyond that the fiscal vs. Fed story is an interesting debate.

Why not raise rates?

Why was the Treasury so keen to maintain the peg? Again, there were no large current deficits, so it was not to issue new bonds at high prices. Interest costs on long-term debt are locked in, so only relatively small re-funding of short term debts impinges on the budget.

The article mentions two concerns. First, the Treasury wanted to keep up the secondary market prices for the bonds, so that those who bought bonds in WWII could sell them for good prices rather than wait for maturity.

Truman felt that government had a moral obligation to protect the market value of the war bonds purchased by patriotic citizens. He talked about how in World War I he had purchased Liberty Bonds, only to see their value fall after the war.

Interestingly, Truman did not feel that permanently devaluing the same bonds through inflation was such a bad thing.

The other consideration is that the Treasury knew full well that though Truman might finance Korea with current taxes, WWIII was going to take borrowing on a massive scale:

The Treasury wanted the Fed to commit publicly to maintaining the existing interest rate structure for the duration of hostilities in Korea. In early December, President Truman telephoned Chairman McCabe at McCabe’s home and urged him to “stick rigidly to the pegged rates on the longest bonds.” McCabe replied that he “could not understand why we would. . . allow the life insurance companies to unload [their bonds] on us” (FOMC Minutes, 1/31/51, p. 9). Truman followed up by writing McCabe: [T]he Federal Reserve Board should make it perfectly plain. . . to the New York Bankers that the peg is stabilized.. . . I hope the Board will. . . not allow the bottom to drop from under our securities. If that happens that is exactly what Mr. Stalin wants. (FOMC Minutes, 1/31/51, p. 9)

The Fed was not preparing for the next war.

All in all, was Truman wrong?

If Korea had turned in to a long, expensive war, surely the US would have turned to war finance again: spend like crazy, borrow, print, hold down rates, and eventually price controls; some inflation implements a state-contingent default. Maybe Truman’s “geostrategic” view wasn’t so dumb after all, at least before it was clear WWIII would not break out.

This is the major issue before us now for Fed independence. It’s not the Phillips curve, or how soon the Fed should adapt to a forecast productivity increase due to AI.

Suppose a major crisis breaks out, like a Taiwan blockade or heaven forbid a war. The US will want to invoke war finance again as it did under Covid; just as it might have had to do in Korea, and as it did in WWII. Spend, borrow, Fed buy a lot of debt to hold down rates, and eventually regulations and controls to force people to hold that debt. A bit of inflation be damned. We didn’t want to lose WWII on the altar of no inflation.

The Fed went along in Covid as it did in WWII. It might want to fight that inflation in the next crisis as it decided it wanted to fight inflation during the Korean War. Does the Congress really want the Fed to do that, refuse to buy debt, let long and short term rates rise, and make the crisis fighting effort all that much harder?

I actually think the Fed should be much tougher than it was in Covid, and much tougher still in the post-covid blowout. It should fight back hard on all the fiscal excesses that the US tends to in time of crisis. But that is an issue we should debate.

Lots of other interesting economic issues percolate through the article. Plus ça change.

Whatever it takes

Again, the pressing issue was not financing new debt, but rather managing the outstanding debt and to a lesser extent rolling over short term debt.

Throughout 1950, the 2 1/2 percent ceiling on bond rates had not been binding.. Eccles advocated that their price be allowed to fall somewhat so that they would trade just below 2 1/2 percent.

That fall in the bond price would still leave in place the sacrosanct 2 1/2 percent rate peg. However, it would address [I think this is a typo and the authors mean “create”] an immediate problem. The threat of a major, protracted war created the real possibility that the bond rate would rise to its 2 1/2 percent ceiling. Life insurance companies, which held the bonds, then had an incentive to sell them immediately to avoid a capital loss as bond prices declined. The Fed did not want to monetize an avalanche of bond sales [to enforce the peg]. …. The Treasury, in contrast, saw the problem as one of the Fed’s own creation. If the Fed would only publicly commit to maintaining indefinitely the current price of bonds, it believed, bond holders would no longer have an incentive to sell.

“Whatever it takes” had better be whatever it takes. Then it doesn’t take a lot. If you waver on a peg, it takes a lot more.

the FOMC then reduced slightly its buying price for long-term bonds. Secretary Snyder saw that action as creating a fear of capital loss that hindered the success of the refunding.

An upward sloping demand curve for bonds. If you lower the price, you reduce demand as people fear more price declines.

Monetarism foreshadowed?

The article presents the Fed as thinking in surprisingly monetarist terms, given that this was 1951. Some of that may be the author’s interpretation, but some of the quotes document that view too.

It was not private speculation or government deficits that caused inflation, but rather reserves and money creation by the central bank. Eccles said:

“[We are making] it possible for the public to convert Government securities into money to expand the money supply.. . . We are almost solely responsible for this inflation. It is not deficit financing that is responsible because there has been surplus in the Treasury right along.”

The latter point is right. It’s not ISLM flow deficits for sure. But prospective future deficits, well, one can excuse a central banker in 1951 for not thinking of that one!

Footnote 10 adds, after a long discussion,

Fed economists thus recognized the importance of monetary policy and its relation to inflation some 20 years before the economics profession began to debate seriously that possibility.

and

On January 25, Governor Eccles…testified:

“As long as the Federal Reserve is required to buy government securities at the will of the market for the purpose of defending a fixed pattern of Interest rates established by the Treasury, it must stand ready to create new bank reserves in unlimited amount. This policy makes the entire banking system, through the action of the Federal Reserve, an engine of inflation. (U.S. Congress 1951, p. 158)”

However, as you apply the lesson to today, remember that today the Fed pays interest on reserves, and back then it did not. Buying long term bonds and issuing interest-paying reserves is not so obviously inflationary. On the other hand, it’s not obvious that the Fed could peg long-term nominal rates in that fashion. The Fed bought finite quantities of bonds in the QE effort to lower long-term rates, and possibly so we and it would not test the limits of its pegging abilities. The Bank of Japan recently tried to peg long-term bonds and gave up.

Carter’s credit controls foreshadowed:

“The Treasury maintained the position that direct controls on credit were preferable to increases in interest rates (FOMC Minutes, 3/1/51, p. 117). “

Independence restored

Again, do read the article for the political tussle. Great tactics: if you want someone to do what you say, leak that they have agreed to the press. Then it’s much harder for them to say no, you didn’t agree. In the end, Truman gave in because his general political standing fell after firing MacArthur.

After the Fed won the battle, its Chair Thomas McCabe resigned, feeling fatally wounded by the tussle. President Truman appointed Assistant Secretary of the Treasury, William McChesney Martin.

“Leach recalls that the initial reaction both among Board staff and on Wall Street to Martin’s appointment was that the Fed had won the battle but lost the war. That is, the Fed had broken free from the Treasury, but then the Treasury had recaptured it by installing its own man. However, as FOMC Chairman, Martin supported Fed independence. Some years later, Martin happened to encounter Harry Truman on a street in New York City. Truman stared at him, said one word, “traitor,” and then continued.” Leon Keyserling (1971, p. 11), chairman of the Council of Economic Advisers from 1950 through 1952, said later: “[Truman] was as strong as any President had ever been in recognizing the evils of tight money.. . . He sent Martin over to the Treasury to replace McCabe. Martin promptly double-crossed him.”

In his speech accepting an appointment to the Board of Governors, Martin (1951, p. 377) said:

“Unless inflation is controlled, it could prove to be an even more serious threat to the vitality of our country than the more spectacular aggressions of enemies outside our borders. I pledge myself to support all reasonable measures to preserve the purchasing power of the dollar.”

Martin here reflects some of my own hawkish views. Don’t state-contingent-default too often. Here he is also explicitly addressing the “geostrategic” consequence of too easy inflation. A great reputation for repayment might be a better way to borrow a lot in the next war than too-quick financial repression.

The analogy for our own time is fun to think about. Trump is the obvious politician who “recogniz[es] the evils of tight money.” Powell, like McCabe, is the Fed chair, who experienced a lot of inflation mostly not his fault in my reading — the $5 trillion unfunded fiscal blowout, and the confidence-destroying additional Biden-era spending would have been hard for any Fed to fight. Like McCabe, Powell has been a powerful and courageous force for keeping the Fed independent. Kevin Warsh, who I playfully think of as the Dog Who Caught The Car for all the troubles he will face going ahead, is the obvious Martin analogue. And it is certainly quite possible that he will follow suit in Martin’s role. Trump is certainly more locatious in his disapproval than Truman!

Updates

I left out some interesting financial engineering — exchange of 2.5% bonds for non-marketable bonds paying higher interest, and a pledge to support shorter term bonds for a limited period.

On independence and history, don’t miss Ed Nelson’s excellent new paper “The Practice of U.S. Monetary Policy Independence from Martin to Greenspan.” Ed is a master of economic and institutional history. He starts with 22 — 22! — common fallacies about Fed independence.

In correspondence with Ed, he passes on a little gem, source here, on the view that expected future deficits and price controls were a key impetus to inflation. Also, everyone seemed to think higher taxes were needed to stem inflation. This statement is also discussed in Ed’s biography of Milton Friedman.

Note also the lovely distinction between relative prices and price level. We can’t buy more of everything if we don’t have the money to do it. However, to get the zeitgeist of the era, read on to p. 172 for the statement signed by four pages of economists.

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Here is a table of contents to whet your appetite. Comments welcome, it needs one last big revision before I turn it in to the publisher.

I realize I never posted the actual lecture. If you like videos, here it is.

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Thanks much to the conference organizers for giving me the opportunity to put together these thoughts.

My talk starts at 1:27 in the YouTube video below.

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THE 1950S: A NOT-SO-GOLDEN AGE

What was the best era for the U.S. economy?

Many people say was the 1950s, when, as the fable goes, the economy was growing robustly, manufacturing was strong, there were good union jobs for not very skilled people, and a man (sorry, it was a man) could buy a house and support a family on such a job.

Not so fast.

Look at standards of living. Real gross domestic product per capita, which is also national income per capita, sat below $19,000 in 1955. In 2025 it approached $69,500. These figures are expressed in 2017 dollars, thus accounting for inflation. The average American is about 3.7 times better off today than in 1955. It’s not even close.

Yes, GDP grew faster in the 1950s. Real GDP per capita grew 28 percent from 1949 to 1959, and only 18.3 percent from 2009 to 2019. Slowing growth is a major economic problem today. Be that as it may, we eat levels, not growth rates. We might not be getting even better off as fast as we were then, but we’re still 3.7 times better off.

How about jobs? In August 2025, 163 million people were employed in the United States; in August 1955, 63 million. America created 100 million jobs over those seven decades. This growth occurred even as manufacturing employment shrank and machines took over. People found better—and better-paying—jobs, most in services. Has any evangelist for union jobs of the 1950s considered how dirty, dangerous, and mind-numbing it was to work on an assembly line? Isn't being a desk drone, a nurse, a bank employee, or any of a hundred mid-level service jobs a lot nicer in addition to better paid? In 2025 the unemployment rate, the fraction of workers looking for a job, stood at 4 percent, just about what it was in the 1950s and what economists think of as a normal labor market.

The great 1950s union labor market was great only if you were a straight white man, and usually one with connections. “We don’t want nobody nobody sent” was the great saying of Chicago Machine job allocation. Women, African Americans, other minorities, and immigrants faced bleak prospects. One of the great achievements of the U.S. economy since the 1950s has been to expand the labor force as well as opportunities for high-paying jobs to all sorts of people who were excluded then. Civil rights, the emancipation of women, and the increasing acceptance of gays, foreigners, Catholics, and Jews (not so true in the 1950s)—these are nothing to sneeze at. The unions made good jobs for white men, relative to other jobs at the time, in part by excluding others.

What about those easy-to-buy houses? The average house in the 1950s was about 1,000 square feet. The famous Levittown houses were 750 square feet. One bathroom. Today, the average house is about 2,500 square feet, even though the average number of people in it declined from 3.4 in 1950 to 2.5 in 2024. People are choosing larger and better homes.

To men of my age, 1950s cars evoke nostalgia. But they were awful, unsafe rust buckets compared to today’s boring SUVs.

What about those easy to buy houses? The average house size in the 1950s was about 1,000 square feet. The famous Levittown houses were 750 square feet. Today is it about 2,500 square feet, even though the average number of people in it has declined from 3.3 to 2.5. And modern houses are much better. People are choosing larger and more expensive homes. 1950s cars, to men of my age, evoke nostalgia. But they were awful unsafe rust buckets compared to today’s boring SUVs.

THE MYTH OF AN EGALITARIAN UTOPIA

GDP isn’t everything, though it is a lot. Was health care cheaper in the 1950s? Yes, though for many diseases, including heart conditions and cancer, treatment then consisted of asking whether you wished to see a priest, a minister, or a rabbi to send you off to the next world. Life expectancy at birth has increased by a full decade, rising from 65.6 to 75.8 for men and from 71.1 to 81.1 for women.

Pollution in the 1950s was atrocious, especially in those industrial areas so beloved by nostalgic left-wing professors. (I grew up on the south side of Chicago. I remember coal dust that accumulated on anything outside.) The fraction of people living in extreme poverty has plummeted, even as the goalpost keeps moving. And we all benefit from nearly free technological marvels undreamed of in the 1950s. Most homeless people have cell phones.

Our prosperity is, in fact, widely shared, though the inequality warriors would have you believe otherwise. Most research on income inequality doesn’t account for taxes and transfers, especially in-kind transfers. Consumption inequality is much lower than income or wealth inequality, and has expanded a good deal less. You just can’t have that many vacation homes. Wealth inequality largely consists of high stock market values in a low-interest-rate environment. Just how much social harm is Elon Musk’s huge holding of Tesla stock doing, remaining invested in the company, and producing cars and rockets?

Some observers regard the 1950s as a sort of egalitarian utopia because the rich faced high statutory tax rates. Yes, the highest federal income tax rate stood at 91 percent for most of the decade. But people confronted with sky-high tax rates go talk to their lawyers fast. Even the far-left economists Thomas Piketty, Emmanuel Saez, and Gabriel Zucman found that the top 1 percent of American households paid on average 42 percent of their income in taxes in the 1950s. Six decades later, at a time of supposedly stark inequality, that number had fallen only slightly, to 37 percent.

These figures account for all forms of taxes. In the 1950s, the top 1 percent paid, on average, an effective rate of just 16.9 percent in federal income taxes, as the Tax Foundation documents. How could they pay so little when the top federal tax rate reached 91 percent? The answer is: loopholes—many, many loopholes. Celebrities incorporated themselves and bought oil wells for the write-offs.

MISPLACED NOSTALGIA

Much has changed since the 1950s, of course. There was no federal food-stamp program in the 1950s; as of 2024, more than 41 million Americans received supplemental nutrition assistance. Back in the 1950s, there was no Medicare, Medicaid, or Obamacare. Social Security benefits were much less generous. Today, a homeless person in San Francisco can receive cash payments of up to $714 per month, just for staying homeless. Depending on your perspective, this expansion of the welfare state may strike you as great progress or perhaps an area of concern, given the large increase in healthy adults who do not work.

Public schools and state universities of the 1950s were arguably much better than they are today. In the 1950s, only about one in twenty children was born out of wedlock; by 2023, 40 percent of births were to unmarried women. Meanwhile, the overall birth rate has plummeted. The failure to build public infrastructure makes life unpleasant in many ways, especially in cities beset by problems of traffic, parking, and basic livability.

So yes, we have troubles. But would you turn back the clock? No way. The 1950s was not Grease.

When was the best year for the U.S. economy? The answer: 2025. With 2024 a close second.

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Recently I found out that P.J. O’Rourke’s masterpiece of political philosophy, Parliament of Whores, is online, for free. In your archives of classics, this book should go alongside Plato, Macchiavelli, Hume, and the Federalist Papers. (And George Will’s Conservative Sensibility.) People only don’t take it seriously because it is so hilarious.

One day, P.J. decided to see if he could balance the budget. Start on p. 99. (I won’t indent. All the rest if from P.J.)

****

The good news is I balanced the budget. It took me all morning but I did it. You’re probably wondering how a middle-aged amateur—who is under the impression that double-entry bookkeeping is what you do when you have to explain that you spent the taxpayer’s money on obscene performance art and who can’t count three without removing a mitten—did this. It helps that I am not up for reelection to the position of being me. I also tried to avoid looking for ridiculous examples of government waste. This is the first mistake made by most budget critics. They page through the minutiae in the “Notes and Appendices to the U.S. Budget,” sifting the “Detailed Budget Estimates by Agency” section until they come up with something like the Department of the Interior’s Helium Fund. Which really exists:

The Helium Act Amendments of 1960, Public Law 86-777 (50 U.S.C. 167), authorized activities necessary to provide sufficient helium to meet the current and foreseeable future needs of essential government activities.

Then the budget critics grow very indignant or start making dull, budget-critic-type helium jokes. The Helium Fund is amazingly stupid, even by government standards, but it only costs around $19 million—.0015 percent of 1991 federal spending. This chapter would be as large as the budget itself if I tried to balance that budget by eliminating Helium Funds. And, if you think about it, running a Helium Fund is just the kind of thing our politicians should bedoing. It’s much less expensive and harmful to the nation than most of what they do, plus, with any luck, they’ll float away.

The other secret to balancing the budget is to remember that all tax revenue is the result of holding a gun to somebody’s head. Not paying taxes is against the law. If you don’t pay your taxes, you’ll be fined. If you don’t pay the fine, you’ll be jailed. If you try to escape from jail, you’ll be shot. Thus, I—in my role as citizen and voter—am going to shoot you—in your role as taxpayer and ripe suck—if you don’t pay your share of the national tab. Therefore, every time the government spends money on anything, you have to ask yourself, “Would I kill my kindly, gray-haired mother for this?” In the case of defense spending, the argument is simple: “Come on, Ma, everybody’s in this together. If those Canadian hordes come down over the border, we’ll all be dead meat. Pony up.” In the case of helping cripples, orphans and blind people, the argument is almost as persuasive: “Mother, I know you don’t know these people from Adam, but we’ve got five thousand years of Judeo-Christian-Muslim-Buddhist-Hindu-Confucian-animist-jungle-God morality going here. Fork over the dough.” But day care doesn’t fly: “You’re paying for the next-door neighbor’s baby-sitter, or it’s curtains for you, Mom.”

Armed with these tools of logic and ethics, I went to work. I took the original 1991 Bush budget because, as I mentioned, it was the only budget available in detailed form and, also, because—for all the budget-crisis noise—the Bush budget was not very different from the final budget approved by Congress. I turned to the “Federal Programs by Function” section, being careful to work in the “outlays” column, which shows what we really spend, rather than the “budget authority” column, which shows what we say we’re spending. I ignored all appropriations of less than half a billion dollars—even NEA grants—as chump change. And I used the “unified budget” figures to avoid most off-budget spending dodges.

Then I cut all international security assistance (it hasn’t generated any international security that I’ve noticed), all foreign information and exchange activities (if foreigners want information, they can subscribe to Time) and all international-development and international financial program funds (let them spend their own money for a change). In fact, I cut the entire international affairs “budget function,” as they call it, except for food aid, refugee assistance and conduct of foreign affairs (because the State Department gives us a way to ship Ivy League nitwits overseas). Total savings: $13.6 billion.

In the interest of the free-market ideology, for which America is a symbol worldwide, I cut the whole energy budget (leaving only the Nuclear Regulatory Commission, because it upsets tree huggers). Total savings: $2.7 billion. In the natural resources and environment budget function I cut all spending for water resources (if they want water out West, they can go to the supermarket and get little bottles of it the way the rest of us do) and recreational resources (people who can afford Winnebagos can afford national park entrance fees). Total savings: $6.1 billion.

I cut all farm income stablization: $12.7 billion. And I made the Postal Service pay for itself or sell out to Federal Express: $2.1 billion. I dumped savings-and-loan bailout costs (which are seriously underestimated in the Bush budget, by the way) back on the savings-and-loan industry, where they belong, and cleaned out the rest of the government’s involvement in mortgage credit and deposit insurance: $13 billion. And I ditched other advancement of commerce (if it advances commerce so much, why isn’t it paying for itself?): $2.1 billion.

I got rid of all transportation spending. Let ‘em walk: $29.8 billion.

You may have noticed how well community and regional development has worked. Examine Detroit or downtown Newark. This is also the part of the budget where the government recently found $500,000 to restore Lawrence Welk’s birthplace and make Strasburg, North Dakota, a tourist attraction. I eighty-sixed all of this except for disaster relief: $6.6 billion.

Per-pupil spending on public school education has increased by an inflation-adjusted 150 percent since 1970, while reading, science and math scores have continued to fall. The hell with the little bastards: $21.7 billion.

Training and employment is properly the concern of trainees and employers: $5.7 billion. Insurance companies should gladly pay for consumer and occupational health and safety: $1.5 billion.

If I outlaw rent control and discriminatory zoning and give landlord the right to evict criminals and deadbeats, I should be able to cut housing assistance in half: $8.8 billion.

And I just lowered food prices by eliminating farm subsidies, so I can also cut food and nutrition assistance by 50 percent: $11.7 billion.

If unemployment insurance is really insurance, it ought to at least break even: $18.6 billion.

So-called other income security, except what goes to refugees or the handicapped, probably does not meet the gun-to-mom’s-head test: $19.9 billion.

And federal litigative and judicial activities should turn a profit in these days of white-collar crime and RICO seizures: $4.3 billion.

That’s $180.9 billion cut from the budget already, and I haven’t even touched defense or the larger entitlement programs. Next let me “means test”—that is throw the rich people out of—Social Security, federal and railroad employee pensions, Medicare and veterans’ benefits. The government figures it loses $19.8 billion per year by making only half of Social Security benefits liable to income tax. That $19.8 billion is 8.25 percent of Social Security spending. I’ll take that 8.25 percent plus another 8.25 percent from well-off geezers, and I’ll bounce the richest 3.5 percent of the old farts from the system entirely. Thus, I can cut Social Security—and analogous programs—by 20 percent, for a savings of $71.9 billion.

National defense is tough. I like having lots of guns and bombs. Besides, you can always turn an aircraft carrier into a community center (plenty of space for basketball courts), but just try throwing a rehabilitated drug addict at a battalion of Iraqi tanks. Nonetheless, something has to go. I had friends at Kent State, so screw the National Guard: $8.4 billion. And I cut air force missile procurement by half since, for the moment, we don’t have anyone to point those missiles at: $3.6 billion. I also cut military research and development by 25 percent and sent the weapons wonks back to playing Dungeons & Dragons on college computer systems: $9.2 billion. Military construction can stop (if they need money for paint or something, they can sell a few bases to the idiots at the savings-and-loan bailout’s Resolution Trust Corporation, who’ll buy anything): $5.5 billion. And I turned the Corps of Engineers over to private enterprise. Just let the Mississippi wash the Midwest away if people won’t pay their flood-control bills: $3.3 billion. This gives me $30 billion in military cuts.11

Add it all together, and I’ve cut $282.8 billion, leaving a federal budget of $950.5 billion, to which I apply O’Rourke’s Circumcision Precept: You can take 10 percent off the top of anything. This gives me another $95 billion in cuts for a grand total of $337.8 billion in budget liposuction.

Now for revenues. I’m a real Republican (unlike some current presidents of the United States I could name), so I won’t raise taxes; but since I’m temporarily in charge of the federal budget, I don’t mind squeezing the bejabbers out of the people who pay them. There’s an appendix to the federal budget called “Tax Expenditures.” These are revenues that the government loses because of things you can deduct when you figure your income taxes. It takes fourteen pages just to list them all. Tax expenditures used to be called loopholes when they were mostly for rich people. And some tax expenditures still mainly benefit the rich: Keogh plans and deductions for mutual-fund-management expenses, for instance. These cost the government $2.1 billion. But most TEs are middle-class subsidies of one kind or another. The revenue lost to home-mortgage-interest deductions alone is $46.6 billion. Taxes not paid on employer-provided pension-plan contributions, insurance premiums and health benefits equal $89.8 billion. Deductions of state and local taxes cost another $34.3 billion. Combine these with untaxed interest on life-insurance savings, home-sale capital-gains exemptions, tax deferrals on savings-bond interest, employee stock plans, IRA contributions, child- and dependent-care expense deductions and earned income credit, and the middle-class take from tax expenditures is $209.9 billion.

Various businesses get another $6.9 billion in egregious tax expenditures—oil- and mineral-depletion allowances, indulgent accounting rules for corporations with branches overseas, special treatment for credit unions and timber companies and tax credits for investing in Puerto Rico andGuam. And tax-free state and municipal bonds cost the federal government $21.6 billion. All told, at least $240.5 billion worth of tax expenditures should be just plain taxes.

Not only is the PJ budget balanced, but every taxpayer will get a $5,000 rebate check from the government this year, and next year there will be a 39-percent cut in all personal and corporate income tax rates. This ought to set the economic Waring blender on puree and make up for whatever minor inconveniences I’ve caused with lowered government spending and elimination of tax deductions. Was that so hard?

My budget cuts are (what fun) ham-fisted. But smarter, fairer people who know what they’re talking about could cut this much and more. Why don’t they? They don’t because they don’t quite have to yet. Despite the alleged panic over the budget of ‘91, the deficit and the national debt aren’t big enough to wreck America. In the 1980s the annual budget deficit averaged 4.1 percent of the gross national product. This isn’t so bad compared with the average deficit of 22.8 percent of GNP during World War II. And our total national debt now stands at 56 percent of the gross national product, not much worse than the 53 percent of GNP national debt we had at the end of the Great Depression. The problem is we aren’t in a world war or a great depression (although both those options are being explored). In a relatively peaceful, relatively prosperous era, there’s no excuse for these budget trends. There’s also no likelihood that they’ll change. The problem isn’t a Congress that won’t cut spending or a president who won’t raise taxes. The problem is an American public with a bottomless sense of entitlement to federal money.

If just two of our federal programs—Social Security and Medicare—continue to expand at their present rate, they will cost the nation $1.4 trillion in 2010, more than the whole current budget. Maybe our future economy will survive this expense. But is it wise in any case to put the awesome power of such spending in the hands of our silly government? This is not a matter of being conservative or liberal. Do you want Teddy Kennedy or Newt Gingrich to run your life? Yet everybody is asking for a federally mandated comprehensive national-health-care program.

Selfishness consumes our body politic. The eighteenth-century Scottish historian Alexander Tytler said:

A democracy cannot exist as a permanent form of government. It can only exist until a majority of voters discover that they can vote themselves largess out of the public treasury.

Our modern federal government is spending $4,900 a year on every person in America. The average American household of 2.64 people receives almost $13,000 worth of federal benefits, services and protection per annum. These people would have to have a family income of $53,700 to pay as much in taxes as they get in goodies. Only 18.5 percent of the population has that kind of money. And only 4.8 percent of the population—12,228,000 people—file income tax returns showing more than $50,000 in adjusted gross income. Ninety-five percent of Americans are on the mooch.

***
Of course, this is a bit out of date. But not as much as you think, if you just multiply all the numbers by about 5. I would prioritize different things. I’m more attuned to fixing disastrous incentives, especially health care. The habit of doling out money to states and NGOs was not quite as prevalent back then. But it does make clear that balancing the federal budget is an easy economic question. And it’s a lot of fun. The rest of the book is even better.

The end of the book expands on this insight. Ruminating on the town meeting of Blatherboro New Hampshire, supposedly the archetype of democracy, trying to ban a golf course:

***

The whole idea of our government is this: If enough people get together and act in concert, they can take something and not pay for it. And here, in small-town New Hampshire, in this veritable world’s capital of probity, we were about to commit just such a theft. If we could collect sufficient votes in favor of special town meetings about sewers, we could make a golf course and condominium complex disappear for free. We were going to use our suffrage to steal a fellow citizen’s property rights. We weren’t even going to take the manly risk of holding him up at gunpoint.

Not that there’s anything wrong with our limiting growth. If we Blatherboro residents don’t want a golf course and condominium complex, we can go buy that land and not build them. Of course, to buy the land, we’d have to borrow money from the bank, and to pay the bank loan, we’d have to do something profitable with the land, something like . . . build a golf course and condominium complex. Well, at least that would be constructive.

We would be adding something—if only golf—to the sum of civilization’s accomplishments. Better to build a golf course right through the middle of Redwood National Park and condominiums on top of the Lincoln Memorial than to sit in council gorging on the liberties of others, gobbling their material substance, eating freedom.

What we were trying to do with our legislation in the Blatherboro Town Meeting was wanton, cheap and greedy—a sluttish thing. This should come as no surprise. Authority has always attracted the lowest elements in the human race. All through history mankind has been bullied by scum. Those who lord it over their fellows and toss commands in every direction and would boss the grass in the meadow about which way to bend in the wind are the most depraved kind of prostitutes. They will submit to any indignity, perform any vile act, do anything to achieve power. The worst off-sloughings of the planet are the ingredients of sovereignty. Every government is a parliament of whores.

The trouble is, in a democracy the whores are us.

****

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The Journal does not link to sources of numbers, and I won’t play the numbers game. I’m more interested in the economic logic of the essay. Three principles stand out: Correlation vs. causation, budget constraints and accounting identities, and repeated game theory.

The essay has two main themes: Tariffs and foreign investment.

with the help of tariffs, we have cut that federal budget deficit by a staggering 27% in a single year, and even more incredibly, we have slashed our monthly trade deficit by an astonishing 77%…

The entire Trump economic agenda deserves credit for this explosion of growth and good news, including our record tax cuts, unprecedented regulation cuts, pro-American energy policies and much more!

But without question, the credit for this economic success must go to what the Journal itself described as “the largest economic policy shock” in more than 50 years—my tariffs! We have proven, decisively, that, properly applied, tariffs do not hurt growth—they promote growth and greatness, just as I said all along.

Because or despite? Relatively small income tax rate cuts (sorry, 1980s and 1920s were bigger; especially in marginal rates), unheralded regulation cuts, and revolutionary energy policies plausibly get credit for growth. Tariffs (higher taxes on imports) plausibly have something to do with lower trade deficits and have generated some revenue. But the oped offers no evidence that tariffs “promote growth and greatness,” contrary to basic economics.

At the same time, I have successfully wielded the tariff tool to secure colossal Investments in America, like no other country has ever seen before…. In less than one year, we have secured commitments for more than $18 trillion, a number that is unfathomable to many.

The world’s largest auto companies are now investing over $70 billion in America. Taiwan Semiconductor Manufacturing Co., Micron, Nvidia, Apple and others are investing hundreds of billions to build cutting-edge semiconductors and chips in the U.S. The world’s largest pharmaceutical companies are investing some $500 billion to reshore production of critical medications. …

…Korean companies are investing $150 billion to revive the domestic shipbuilding industry in the U.S. Japan will help us construct one of the largest natural-gas pipelines in the world, in Alaska, to export American energy to our allies in Asia. …

Tariffs as negotiating bludgeon is something that I and fellow economists underestimated last spring. A threat of something that hurts the US, but hurts the foreigner more—and especially hurts politically more than economically — can be used to coerce all sorts of behavior.

But how are foreigners supposed to get the dollars to invest in the US? There is only one way: They have to sell us stuff, more than they buy from us. You can argue about behavior and incentives, but this is an accounting identity, a budget constraint. More investment means more trade deficit. Another way to understand it, as all economics, is to look past the money. Money is just a way of keeping track of real things. How can Korea invest in the US? It must put things on boats and plant them here. It can put capital goods (shipbuilding equipment) on boats directly, or it can put cars on boats, sell them here, and buy shipbuilding equipment. Without a higher trade deficit, all these moves can do is displace private and voluntary capital investment.

The President and his team have a good instinct there. Investing in the US is good for the US economy. But it doesn’t add up with their instinct that trade deficits are bad for the economy. Making money for the US from foreigners is a good thing. But the only point of making money from foreigners is to spend it on foreign goods and services.

Another good economist question: Why weren’t these investments being made anyway? A first instinct is that the return to investing in the US was not as good as the return to investing abroad. If so, forcing investment in the US is not a great idea. Better for the US to make the more profitable investment abroad. Or, to figure out why the investment in the US was not profitable. Plausibly, that’s because there were too many regulatory and legal barriers to making the investment or making a profit on it in the US. The Biden restrictions on Chips Act factories were a hilarious progressive wish-list. Removing those barriers is a good idea, and many Trump appointees are working quietly to do that. But if successful, we don’t need to bludgeon other countries with tariffs to get the investment. Moreover, government-directed investment from other governments is not usually known for its focus on efficiency.

…Since Liberation Day, I have made historic trade deals with China, the U.K., the European Union, Japan, South Korea, Vietnam, Indonesia, the Philippines, Malaysia and others covering a majority of all U.S. Trade… the agreements are forging more sustainable relationships with many of our allies and partners, expanding our military alliances into the realm of economic security for the first time.

Trump’s tariffs are always an answer with five questions, and the foreign policy angle is interesting. The threat of tariffs has made many countries jump on foreign and security policy questions. Not always to Trump’s advantage. Without tariffs, the Conservatives would surely have won the last election in Canada.

“..expanding our military alliances into the realm of economic security” is a fascinating line. Tariffs combine with industrial policy to think of the economy as pieces in the giant geopolitical chessboard. “Economic statecraft” is a big theme of my national security colleagues here at Hoover, which we enjoy debating.

In any case, this function of tariffs is on another planet from David Ricardo, wine and wool, comparative advantage, accounting identities and economic efficiency which motivates economists.

I worry though about the repeated game theory aspect. Tariffs put on are hard to take off. Domestic producers get used to protection and want more. The multilateral approach allowed the President to say “I’d love to give the chicken-wing industry protection but those darn international treaties won’t let me.” That’s gone.

More importantly, in the economic statecraft angle, we have now bludgeoned allies to do our bidding and carve up markets. They are hurting from the humiliation, and see a more dog-eat-dog world When China blockades Taiwan, we will want to call them up and say “we really need your help to enforce our sanctions on China.” Will the Europeans, Canadians, and Latin Americans really forsake profitable trade with China to help us on that geopolitical quest? Sometimes flowers and chocolates are better than a big stick.

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I did this interview with Tom Clougherty while visiting the Institute of Economic Affairs in London last September. Yes, there is an openly free-market think tank in the UK! It just came out. Youtube link here if you don’t like the embed.

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Thanks to the nudge by the excellent marketing team at Hoover, I’m doing a weekly “grumpy economist rant” of short videos. The collection is here. So far I’ve done

• “Just let them build,” on housing supply and what happens if you subsidize demand without fixing supply

• “The trouble with tariffs.” Free trade basics.

• “The price control trap” Price controls don’t work, even in natural disasters

• “Where does inflation come from?” You probably know where I’m going on that one.

• “Your EV is a non-starter.” They don’t reduce carbon emissions, because what you don’t burn someone else will.

• “Taxes without distortion.” If the question is how to raise revenue with minimal economic damage the answer is a pure consumption tax.

More are coming each week. I welcome suggestions. What makes you grumpy? Or, what insights can simple economics offer to the issues of the day?

These might also be useful as discussion starters in economics classes.

I also had a nice discussion of Fed independence with Art Rolnik (formerly director of research at the Minneapolis Fed, among many other things) and Gary Stern (former president of the Minneapolis Fed), via the Heller-Hurwicz Economics Institute. And a good AIER podcast on independence with Veronique De Rugy and Tom Hoenig.

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Trump’s Monetary Policy Desires Aren’t Crazy

The policy world is aghast, but President Trump’s desires for monetary affairs aren’t as crazy as conventional wisdom portrays.

I see three broad desires: Interest rates should be lower, in part to lower interest costs on the debt. The Federal Reserve should be less independent, subject to more democratic accountability. And “exorbitant privilege” or “reserve currency status”—that the world wants to hold our money and buy our debt, sending us goods in return—damages the U.S.

The standard response: Lower interest rates will quickly lead to more inflation. But how soon, and how much? The best empirical estimates find that lower interest rates lead to no or slightly lower inflation for a year or so, then slightly higher inflation after two or three years. Even that response is barely significant statistically. And since the unexpected interest rate hikes these estimates study typically fade within a year or so, they say little about persistently lower interest rates.

Mainstream, or “new Keynesian,” economic theory predicts that a permanently lower interest rate will eventually lower inflation, other things (especially fiscal policy) held constant, even though inflation may temporarily rise. This is an unsettling implication that the theory’s largely center-left practitioners have trouble applying to reality, but there it is. Sure, maybe decades of consensus theory is all wrong. Economists have pursued wrong theories before. But if it’s in the equations of your own models, the proposition at least bears consideration.

The historical record is also mixed. That inflation went nowhere over a decade of near-zero interest rates, and three decades in Japan, seems to confirm this theoretical view that inflation is stable with a fixed interest rate—and that inflation will eventually follow higher or lower interest rates. Yes, low interest rates that financed large deficits contributed to inflation in many countries. But if a government doesn’t expand fiscal policy, the record is less clear. Yes, low interest rates in response to “supply” shocks, such as in the 1970s and 2020s, coincided with inflation. But the exact effect of low rates, and of other fiscal and nonfiscal responses, is also murky.

We economists don’t know with certainty just if, how, under what circumstances or how quickly low interest rates lead to inflation. I believe they do, despite the equations of my models, but that’s far from science.

The Fed has vastly expanded its scope of operations, propping up asset prices, monetizing debt, channeling credit, directing banks how to invest, straying into climate and inequality, and denying whole business models such as narrow banks and segregated accounts. These actions are political and cross over into fiscal policy and credit allocation. It has had no reckoning with its great institutional failures, including 10% inflation and repeated bailouts.

Independence isn’t an absolute virtue. Our constitutional order doesn’t include completely independent officials who can print money and regulate banks as they wish. It is reasonable to discuss reform. Either the Fed must be more “democratically accountable,” which is the same thing as “politically influenced” when the other party is in power, or it must be reformed to a narrow, enforced and accountable mandate so it can remain independent. As a small-government advocate, I favor the latter. But limited-government reforms are out of fashion and perhaps unrealistic. In any case, simply pulling up the drawbridge, hoisting the “independence” flag, and pouring boiling scorn on the barbarians at the gate isn’t a viable response.

In the consensus view, if the world wants our money and debt so much that we can just print it, send it abroad, and get consumer goods in return, the proper answer is a nice thank-you note. But one must admit this strategy has had downsides. Spain and Portugal minted the world’s money when they found gold and silver in the Americas and used it to buy consumer goods. Their industries languished and then ended up poor. Money is a form of the “resource curse” that befalls many producers of oil and other vital commodities. Switzerland refuses the world’s offer and remains productive.

Even neomercantilists have a little point buried in a heap of fallacies. Countries that run perpetual trade deficits to finance consumption, borrowing abroad to do so, eventually must pay back the debt. Saving and investing rather than borrowing and consuming is good for an economy as it is for a family.

The central problem in our case—and in much of history—is the bounty was consumed rather than invested. That choice flows from government deficits to finance consumption, and legal, tax and regulatory barriers that make private investment less profitable. Thus tariffs, capital controls, securities taxes and industrial policy will all make matters worse. Get out of the way instead. But in all three cases, there is some merit to the basic point, worthy of examination and not immediate disdain.

Mr. Cochrane is a senior fellow of the Hoover Institution and an adjunct scholar at the Cato institute.

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Who cares? We do. As we head to our own monetary-fiscal collision, the experience of other countries around the world is going to be a lot more useful than trying to squeak just a tiny bit more information out of the 1001th VAR run on benign US data. Of course these are also lovely fiscal theory of the price level episodes.

From 1947 to 1986, Brazil had chronic high (50%) inflation, with occasional higher surges. Starting 1986, “after the end of the military rule, .. the new democratically elected government introduced the first of what would become a series of six stabilization plans to fight inflation.” Beware selection bias. Failed stabilizations are as interesting as successful ones.

The first few plans of this series targeted inflation inertia instead of inflation expectations. They temporarily froze prices and exchange rates, prohibited wage indexing, or would introduce new currencies that cut three zeros from the former. All five plans before the 1994 Plano Real failed: inflation shot back up a few months later.

We forget the prevalence and power of old macroeconomic ideas. Lots of economists thought that inflation was all about wage-price spirals, indexing, inertia, self-fulfilling expectations, price-setting rules and more. Many still do. Today’s conventional policy framework either has no “nominal anchor,” or buries it in footnotes, viewing inflation as just the collection of price increases. We may not know what’s right, but failures teach us a lot about what’s wrong, and what not to repeat.

The early stabilization attempts also failed to address forward looking inflation expectations through credible reforms. None of the plans prior to the Plano Real implemented meaningful fiscal reforms.

Another persistent habit is to regard policy as a sequence of actions — interest rates up or down, taxes up or down this year — rather than regimes and institutions, by which people plan for what the future will bring.

By 1993 Brazil was experiencing a full blown hyperinflation. Then came the 1994 Plano Real, as classic an end of hyperinflation as one can ask for.

The plan included another interesting round of monetary reforms. The government instituted a parallel unit of account, the URV (unit of real value), and pegged to the dollar. “Prices were listed in both URVs and Cruzeiros Reais, but transactions still occurred in Cruzeiros Reais. A few months later, “the URV was replaced by the new currency, the Real, which initially had a crawling peg to the Dollar.” The idea was to try to break expectations without price controls. “The central bank gained more autonomy.” The National Monetary Council “was reduced to only three key members: the central bank governor, the finance minister, and the planning minister” Well, not complete autonomy. The central bank increased reserve requirements — monetarist thinking was included.

But the real novelty relative to the previous reforms was fiscal. “In 1993, in preparation for the Plano Real, the government introduced new taxes to prevent a fiscal imbalance when seigniorage revenues fell the following year.” The taxes worked, providing a permanent increase in revenue from about 25% to 32% or so of GDP. This is a very large increase. A credible fiscal situation and agreements under the Bradly plan reopened access to international capital markets. As in other circumstances, credibility in paying it back allows governments to borrow more, even right after hyperinflation. “…the government also started announcing fiscal targets and enacted the fiscal responsibility law, imposing more constraints on spending that ensured the surpluses that Brazil saw in the early 2000s.” Confidence in expected future surpluses, in a change of regime not temporary and reversible austerity is, in fiscal theory eyes, the key to stopping inflation. “Finally, after 1994, the government continued to promote microeconomic reforms such as privatizing state-owned enterprises and bank reform.” Microeconomic reform lets the economy grow faster, which is good for the long-run budget.

It worked, as you see above. “Inflation dropped dramatically, from 4,005% in July 1994 to 27% the following year, and hyperinflation did not return.”

My maxim: The end of a serious inflation almost always comes with the combination of monetary, fiscal, and microeconomic reform.

Alas it did not stick forever. In the 2000s, Brazil saw three waves of over 10% inflation. More stories for us.

Prior to the 2002-2003 inflation, there were no significant deviations in monetary aggregates or fiscal spending. However, Luiz Inácio Lula da Silva (Lula), who was then a presidential candidate, rose in the presidential polls and won the elections. He had advocated for national debt renegotiation and even default in the past and his rise caused a change in expectations of future fiscal policy. It is widely agreed that the 2002 inflation was driven by uncertainty over the continuity of the macroeconomic reforms implemented by the Plano Real (Ayres et al., 2021). Fear of a default led to a significant devaluation of the exchange rate (passing through as higher import prices) and an increase in interest rates on government debt. Inflation expectations recorded by the Central BankFOCUS survey unanchored from the target rate in October, between the first and second rounds of the election.

As I explain fiscal theory, it points to several scenarios.

A deficit that people expect to be repaid causes no inflation. A deficit that people do not expect to be repaid causes inflation. And a loss of faith with no current deficit can cause inflation. Lula seems like a good story for the latter. (The fourth possibility, not graphed, a rise in the real interest cost on government debt, that the government cannot or will not pay for with increased surpluses, causes inflation.)

Even “Blanchard (2004) concluded that Brazil experienced fiscal dominance during this period…”

However, not all populist leftists govern that way, at least all the time:

Once elected, however, Lula bowed to markets by committing to maintain the Plano Real era macroeconomic policies — and kept his promise. The central bank raised rates, and inflation slowed by the end of 2002. During his administration, the government recorded fiscal surpluses, GDP per capita grew under the tailwinds of a global boom in commodity prices, Brazil accumulated foreign reserves, and external public debt fell (Ayres et al., 2021).

Monetary policy clearly did not start the 2002 inflation. But what role did it take in ending the inflation? Rates did rise, but as I look hard at the plot, rates rose less than the magic one for one needed in standard theory for rates to bring inflation down. Rates rose even about one for one in the US in the 1970s. Also there was no 1980-82 US style recession to bring down inflation through the Phillips curve. My fist guess is that restored fiscal and growth credibility did the trick on its own, and the central bank did no more than keep the real rate about constant, and perhaps signal that it would not monetize debt should things get out of control again.

The merry go round continued.

After Lula’s re-election in 2006, policy shifted to more extensive state intervention.. These policies expanded deficits…“creative accounting” made measures of fiscal deficits even more difficult to estimate… and eroded the fiscal credibility achieved in the late 1990s after the Plano Real reforms (Ayres et al., 2021).

In the mid-2010s, Brazil experienced another period of double-digit inflation under President Dilma Rousseff, followed by disinflation and stringent fiscal measures implemented by her successor, President Michel Temer. There were no significant changes to monetary policy rules between the two administrations, but there was a radical shift in fiscal policy.

Under the Rousseff administration (2011-2016), government expenditures continued to increase with the expansion of social welfare programs, while at the same time, no significant tax or microeconomic reforms were enacted. ..

The budget steadily deteriorated, moving to deficit in 2014. Inflation peaked in July 2016.

Rousseff was impeached from office in mid-2016 due to an infringement of the fiscal responsibility law (enacted in the Plano Real period) linked to the so-called “creative accounting” tactics…Her successor, Temer (2016-2018), implemented landmark legislation to restore fiscal discipline later that year. This was in the form of a constitutional cap, formally enacted late in 2016, that limited the annual growth of federal spending to the previous year’s inflation rate, effectively freezing real government spending for up to two decades.

If Brazil can do it maybe we could think about it? Maybe after a few more bouts of inflation we will.

Brazilian Central Bank governor Campos Neto cites the series of 2017 fiscal and microeconomic labor reforms as policies that allowed the central bank to cut rates, as well as to lower its neutral rate target (Figure 5) (Campos Neto, 2023). Even before the reforms were approved, during the impeachment proceedings and provisional government period, there was clear political will and momentum which explains why expectations started to change in 2016. Figure 9 shows how inflation, the central bank policy rate and the real primary deficit evolved during this period. Vertical shading indicates the period of transition between the opening of impeachment proceedings against Rousseff, through Temer’s provisional government, and his inauguration. Notice how the policy rate responds to inflation throughout the entire period, and the main variation is in fact in the deficit figure.

The upward trend in deficit breaks, but the actual deficit does not move dramatically toward surplus in this picture. The disinflation seems to follow the script: disinflation happens on change of regime, in anticipation of policies, not necessarily when the policies actually happen, if the change is believable.

I run in to a lot of doubt about rational expectations, and ordinary people understanding events. Brazilians seem perfectly capable of it.

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Neale is also the director of the Stanford Institute for Economic Policy Research, of which I am a part. While SIEPR does not have “house views” and its fellows may write what they wish, as I do now, when the boss writes a New York Times oped in favor of price and rent controls, that inevitably tells you something about the strategic direction of the organization.

When even the Times, who chooses the title, has to start with “Economists Hate This Idea,” and your own oped acknowledges “this may terrify many economists, who have long dismissed price controls as failed policy,” maybe you should stop and think twice?

While Mahoney and Ramamurti pay lip service to standard objections, they miss the glaring elephant-in-the-room Econ 101 issue: Budget constraints. Every dollar of “relief” for one party is a dollar of “burden” for another, plus the inefficiencies of redistribution.

Sure, “sharply rising rents and utility bills wreak havoc on family budgets,” if the families don’t follow the screaming market signal to move. (Which is not painless, for sure. Incentives never are.) But the money comes from somewhere. Rent controls and energy price caps wreak havoc on landlord end electric utility budgets. The money must come from somewhere.

A rent control is the same as a tax on landlords used to subsidize the rents of current tenants. You may picture a giant corporation, but many landlords are sympathetic individuals who worked hard and saved and use the apartment to fund their retirement. Corporations are owned by the 401(k) plans of sympathetic workers too. But economists should know better than to tug on your heartstrings for who should get resources forcibly taken from who else. If you ask “what’s the optimal way to tax people in general in order to lower housing costs for a politically attractive group (current tenants)” the screaming answer is not “let’s tax the people who currently own the buildings.” Sure, “tax the rich.” If you want to go down this route, it’s a lot more efficient to tax all the rich. If you ask “what’s the optimal way to help families who just got stuck with higher rents,” the screaming answers is “send them a check, but then let them move to the apartment that best fits their needs.”

A rent control only makes rental “affordable” for the lucky recipient. It does not make rental housing more “affordable” for society as a whole. It does not increase the number of people who have housing. Indeed it reduces that number. It just changes who gets it. It does not even make housing more “affordable” on average. For those who want it must now pay with time, and inconvenience, or pay by foregoing the great opportunities that moving to the city provided.

The biggest losers of rent control are the young, the mobile, the ambitious, immigrants, and people without a lot of cash. If you want to move from Fresno to take a job in San Francisco and move up, and you don’t have millions lying around to buy, you need rentals. Rent control means they are not available. Income inequality, opportunity, equity, all get worse.

There is no blob of “government” money, or “policy” that can make something affordable for one without making something else less affordable for another.

Mahoney and Ramamurti pay lip service to the standard economic objections, and the long history of price-control failure:

They [price controls] jam the signal that high prices send to companies to enter markets or expand production, which can help lower costs over the long run. As any economist will tell you, capping prices below production costs causes shortages and rationing… Even caps that sit above current costs can deter maintenance and investment….

They offer similar half-acknowledgment of some of the correct response

For decades, the textbook policy response to high prices has been to increase supply, such as by offering tax incentives or reducing regulatory barriers to housing construction and energy production. But these solutions can take years to have an effect.

and of the standard policy response:

Demand-side fixes, such as subsidies or tax credits to offset the cost of expensive items, can sometimes provide short-term help. But in practice, these subsidies often create more demand chasing still constrained supply, pushing prices up and transferring most of the value of the subsidy to landlords or utility companies instead of the people who need it.

Absolutely. But instead of dismissing complaints — sometimes “textbook” is right — take them a bit more seriously. Supply does not need “tax incentives,” which are usually specific to a project and negotiated between developers and politicians. This is showy stadium construction finance, which does little for broader prosperity. Supply needs “get out of the way,” starting with reducing the taxes we have now. The problem with “regulatory barriers” is not that on removal it takes years to build housing, it’s that it takes decades to remove regulatory barriers. Remove the barriers tomorrow — zoning, planning, density and height restrictions, dozens of separate permits, labor restrictions (unions, high minimum wages), and so on — and you could get actual new housing before the next presidential election.

Everyone is focused on building, but “supply” is so much more than building. There is tremendous supply in using more efficiently what we have now. Most cities have laws against renting parts of single family homes, or sharing larger homes. Think how many spare bedrooms are empty every night. There is plenty of housing supply in the US, it’s just not in places where people want to move. Others moving out is “supply,” and greatly impeded. Older people stay in too-big houses and apartments, in locations close to work and school opportunities that young families desire, but the older people no longer need. Why? If they sell, they are taxed on capital gains, even just due to inflation. They lose property tax exemptions, and, of course, rent control protection. Each older person who cashes in, downsizes, or moves to a neighborhood more suited to them, supplies a house or apartment. The non-portable fixed rate 30 year mortgage, an invention of our federal housing subsidy regime, leads people to stay where they are rather than move to where they want to go, and free up a scarce house or condo for someone else. Strong apparently “consumer protection” laws in rental contracts dry up the supply, especially to the marginalized. If you can’t kick people out, you’re much more careful who you let in. Limits on short term rentals limit rentals. Remove rent controls, permanently, and houses and condos can be rented. Many houses and apartments need rehab, not new construction, which can happen very quickly once owners know they will not be robbed of their investment. Even “affordable” housing leads people to stay where they are, rather than move to better opportunities for them and free up an apartment for someone else, because it’s rationed with long waiting lists.

When Javier Milei ended rent control in Buenos Aires, rent went down. Instantly. Nothing had to get built. It can happen in Manhattan.

Nothing rings more true of our government than restrict supply, subsidize demand, and watch prices skyrocket. Universities and health care are poster children along with housing and energy. “Landlords” and “utility companies” are not, in fact, making a killing here. Land owners benefit. Energy faces rising costs like anything else. AI, not corporate apartment companies, electric utilities, and oil companies, are the hot stocks of the moment.

Contra Mahoney and Ramamurti’s assertion that price or rent controls are alternative to demand subsidies, they are exactly the same thing as a tax on suppliers used to fund demand subsidies. With a fixed supply, the number of people who have houses is fixed. The only effect of rent controls or demand subsidies is to change who gets the houses.

Because “sharply rising rents and utility bills wreak havoc on family budgets,” despite the well known issues, Mahoney and Ramamurti opine

there is a case for temporary, targeted price controls that hold down costs, paired with supply-side reforms that encourage new production. Rent caps focused on existing units, combined with government investment in new housing and reforms to zoning, permitting and other land-use regulations, can protect tenants from rent spikes, while encouraging new construction to build the three to four million homes

Oh, please. New York put in “temporary” rent controls in WWII. 80 years ago. Congress passed “temporary” Obamacare subsidies during the pandemic, and we just shut down the government for a month and a half over that. “Rent caps on existing units” have been tried by every single failed rent control regime in history. Tax away the hard-earned investment of existing landlords. But apartments need maintenance and even the Times (can’t find the link) runs stories of apartments vacant in Brooklyn because it’s not worth it for landlords to fix them, since they were built before the last “existing unit” freeze in 1974. Plus, every investor knows that what can be done “just this once” can be done again. “Government investment in new housing?” California specializes in that, featuring $1 million one bedroom units for homeless people. Come tour the ruins of Chicago’s housing projects. And once again, just where is this endless pot of money? Let’s see, 3 million homes at $500,000 per home is $1,500,000,000,000 yes one point five trillion if I got my zeros right. Not exactly couch change on the government budget.

But just maybe…. If Neale can get the “reforms to zoning, permitting and other land-use regulations” in place first, I might listen. Taking landlord’s hard-earned property with promises to someday reform is a lot more likely. We got where we are for a reason.

Similarly, a freeze on electric bills paired with government investments that expand solar, wind and other clean-energy production and transmission can shield household budgets until more power comes online.

You must live in quite a bubble not to know about the trillions of “government investment” in solar panels and windmills we already have. California leads the way. And also has the highest gas and electric prices in the nation. And you must have forgotten a lot of economics to not recognize that “household budgets” also have to pay the taxes that pay for these “investments.” California’s electric utilities and refiners are barely scraping by, rather than being effective pots of tax money, so that “shielding” of some household’s budgets will come from other households.

Energy prices have if anything more incentive effects than housing, and are more elastic in the short run. If gas prices go up, you can car pool, take transit, bike, or just drive less. Or move closer to work. Except rent controls mean you can’t. Energy is a smaller component of income. Another textbook rule of economics: don’t mess with price signals, especially of elastically demanded goods that are a small component of budgets, in order to transfer income. Energy subsidies do the opposite.

Oh, yes,

Policymakers should step in if there are signs of price controls becoming permanent or spreading to other parts of the market. Once enacted, price caps tend to stick, as interest groups mobilize to preserve them. Tenants who did not receive relief initially may argue for an expansion on fairness grounds.

Policymakers can reduce these risks by inserting sunset clauses, targeting controls to well-defined groups — such as existing tenants and low-income households — and backing long-term supply efforts with specific timelines and funding. But no government can fully bind its future self, and we may need to accept some trade-off between immediate relief and weaker long-run investment.

I hate the word “policymaker.” It’s every leftwing economists’ dream, I guess, to be installed as an aristocrat and “make policy.” This is politics, not policy, redistribution in the name of electoral gain, as Mahoney and Ramamurti make clear. There is no “policy.” There is politics. This is redistribution by force. For better or worse, but don’t sugar coat what you’re doing.

“Step in if there are signs of price controls becoming permanent or spreading to other parts of the market.” Hello? 80 years is not permanent enough? Are not “policymakers” like the new mayor of New York “stepping in” precisely to extend and expand controls? Sunset clauses are sunrise clauses. “Targeting controls to well-defined groups — such as existing tenants and low-income households.” After “budget constraint” lesson 2 of Econ 101 is “incentives.” When existing tenants get a big break, they have a big incentive to remain existing tenants, see above. When households experiencing low incomes (I refuse to use “low-income” as an immutable characteristic) receive benefits they have a big incentive to remain low income.

Well at least they are honest enough to say “accept some trade-off between immediate relief and weaker long-run investment.” Yes, existing renters got relief in 1942. We are stuck with the long run.

The final paragraph

In a cost-of-living crisis, the question isn’t whether to intervene, but how to do so in a way that delivers relief today without creating new problems tomorrow.

The last directly contradicts the grudging admission that indeed we will “accept some trade-off between immediate relief and weaker long-run investment.”

Leaving aside “crisis,” that is not the question. The question is what should economists offer when it is plainly clear that there is no way to deliver “relief” to everybody — that any relief to A comes out of the pockets of B, with a sieve along the way, and that as the article just admitted any attempt to transfer from B to A will create new problems tomorrow — just as today’s problems are completely the effect of yesterday’s price, building, and rental controls.

Why would two excellent economists pander in this way, selling obvious fantasies to justify price controls that have been tried since Diocletian (300AD) and failed every single time? Well

In New York, the democratic socialist Zohran Mamdani ran for mayor on a simple promise to “freeze the rent,”..

like it or not, voters are demanding short-term price relief, and temporary price controls may be the only viable way to provide it.

The insufficiencies of this policy playbook have helped create what we call the affordability conundrum: Voters want immediate cost relief, but standard policy tools can’t always provide it.

Apparently, when voters want something and politicians want to promise it, our jobs as economists is to offer somewhat fantastical “policy tools” to justify it.

I do not know Mahoney and Ramamurti’s motivation, and I make it a rule never to speculate on motivations. But I can warn against the motivations many feel to go down this kind of rabbit hole.

We all have partisan sympathies. It is tempting to buck up our team, right or wrong, especially against attacks by the “other side” which today each side views as an existential threat to the nation. We all want to be influential. It is tempting to offer what politicians want to hear, to become the darling of the moment, the adviser whispering into the ear of the powerful.

Republican economists are in a similar quandary regarding tariffs. If you want a job in the current Administration, or just influence in today’s dominant Republican circles, you better have written nothing critical of tariffs that Google can find.

If you want influence it’s better to pledge allegiance. It is tempting to write “economists hate the idea,” and “textbooks say it doesn’t work,” but then bemoan “the insufficiencies of this policy playbook” to deal with “China’s economic aggression,” or “hollowed out manufacturing,” and so forth. Dissemble, advocate that “policymakers” “insert.. sunset clauses, targeting controls,’’ or tie tariffs to specific pie in the sky promises, ignoring just how permanent, corrupt, and temporary tariffs have been in the past. I would expect a review of such a proposal from Mahoney and Ramamurti every bit as savage as what I have just offered.

You can, at least keep your mouth shut, and salvage your own reputation.

Better, we economists can do a lot better by patiently holding out, even for our own team, on what works, in time-tested cause-and-effect ways, and what does not. Many rent or price controls in the 1,700 years (and likely more) on this earth have promised to be temporary, targeted, combined with structural reforms. I cannot think of a single one that ever has done so. If you want Mamdani to succeed politically, you will do a lot better to advise him against self-delusion not to pander to his ill-informed instincts.

A last thought. Mamdani, if he does follow through on his policies, will indeed make Manhattan much more “affordable.” Chase away all the wealthy people, all the businesses and business owners, and apartments will be cheap. Detroit is affordable too. Be careful what you wish for, you just might get it.

Updates:

Another last thought. Too often public policy thinkers see a problem, and jump to what new policy do we need to add to fix it, as if we lived in some state-of-nature free market. Instead, we should always first figure out why it’s broken, and then

Ryan Bourne chimes in, focusing on political aspects.

A nice twitter exchange updates Assar Lindbecks famous quote, “In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing.” Actually, rent control can be worse on the capital stock. (Obviously not on the people). Bombing and natural disaster destroys today’s housing capital, but leaves intact (or improves) incentives to build anew. Rent control leaves in place today’s capital, but destroys incentives for building and maintenance. Some economists have gone so far as to suggest that destroyed cities and parts of cities have an advantage in the end, for freeing up land for more appropriate development.

I found the reference. “Why New York City has 50,000 ghost apartments” by Matt Miller at The Free Press (of course). These are apartments were even the cost of rehab is not justified by the rent you can charge. Instant supply available!

I completely forgot the most important economics lesson. In Econ 101 we are taught that regulations flow from documented market failures: monopoly, externality, public good and so forth. Where is the market failure here? Hmm. Maybe that story does next to nothing to explain the regulation we actually have. The purpose of rent control is clear: tip the scales of bilateral negotiations in favor of a politically favored class. When you think about it, that motivation accounts for rent control, price controls, labor laws, consumer “protection” laws and more, a lot better than the econ 101 story.

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An extra year of college, or growing up in a better neighborhood might raise wages. But only a tiny fraction of why one person’s wage differs from another results from extra years of college or which neighborhood a person grew up in. Minimum wages might raise, some find, or lower, others find, employment. But only a tiny fraction of the huge variation in employment from one area to another or one person to another traces to variation in minimum wages. If you want employment, other levers are likely far more important. Demand shocks might move stock prices. But only a tiny fraction of stock price variation comes from demand shocks.

The causality revolution

The causality revolution has come to dominate empirical work in economics. And productively so. We want to know how x affects y. We might see a correlation between x and y. But our data don’t come from controlled experiments. Maybe y also causes x, maybe there are third variables that cause y and x. This is the central conundrum of empirical social science. College graduates have higher incomes. Does going to college raise your income? Well, rich men drive Porsches. That does not mean that driving a Porsche will make you rich.

So, we find a tiny slice of variation in x that is plausibly “exogenous,” like the random variation that a lab scientist could impose. The correlation of this tiny bit of x with a similarly tiny bit of variation in y can identify a causal effect of x on y. That’s great. This causality revolution has really improved empirical economics from the willy-nilly regressions we used to run. But that does not mean we understand the bulk of movement in y. The other causes of y may, and often do, dominate.

Throwing out variation

Start with a variable we want to understand y, perhaps employment. y is the sum of many causes, y = b1 x1 + b2 x2 + … First of all, we look just at the effect of one variable, x1, say minimum wages, leaving out all the others, including population, demographics, education, unionization, immigrants, rising or falling industries, social program disincentives (they often cut benefits by a dollar for each dollar you earn), and on and on. For most people, who earn far more than minimum wages, minimum wages are obviously irrelevant. Right off the bat, you know we will explain a tiny fraction of employment.

But states don’t enact minimum wage laws randomly. They respond to conditions. Maybe you’re looking at the effect of employment on minimum wages. Or maybe you’re looking at governments that enact a bunch of policies at the same time, more regulation with more minimum wages, and it’s the regulations that lower employment. So we start throwing out variation in order to find something that looks like truly exogenous variation.

A typical study might employ “differences in differences.” Look at changes in minimum wage (difference in time) across different states, and correlate that with the difference across states in employment growth. We’ve thrown out a lot of the variation of the original data, the level of minimum wage in each state.

Studies typically add “fixed effects.” In a regression, y(state, time) = state fixed effect + b x(state, time) + error. A state fixed effect means we look only at the variation in a variable within a state over time, not how the variable varies across states. A time fixed effect means we only look at the variation of a variable across states, and not how it varies over time. It is common to add both fixed effects. Yes, that’s possible. y(i,t) = a(i) + c(t) + bx(i,t) + error is not the same as y(i,t) = a(i,t) + bx(i,t) + error, which would not work. Let’s see if I can state the source of variation in words. (A great seminar question: can you please state the source of variation in x in words?) We’re looking at x in state i at time t relative to how much x is on average in state i, and relative to how much x is on average across all states at time t, and how that correlates to similar variation in y. Hmm, I didn’t do a great job of translation to English. (Stating the assumption on standard errors in words gets even more fraught. Just what did you assume is independent of what? Without using the word “cluster?”)

Other studies look only at states that share a border, or counties that share a border, in the hope that “other effects” are the same across the border. Great, but again we throw out all the variation in non-bordering states or counties.

Next, researchers add “controls.” Controls should be added judiciously: think about what else moves y, how it might be correlated with the x of interest, and then bring it in from the error term to the regression. Control for taxes, regulations, or other changes that might have happened at the same time as a change in minimum wage. Instead of y = b1 x1 + error, recognize that the error includes b2 x2 and that x1 and x2 are correlated, so run y = b1 x1 + b2 x2 + error. Drinking and cancer are correlated. But people who drink also smoke, so you want to look at the part of drinking not correlated with smoking to see if drinking on its own causes cancer. But we are now looking for that much smaller population of drinkers who don't smoke. Technically, controls are the same thing as looking only at the variation in x1 that is not correlated with x2. We throw out variation. Fixed effects are just one type of controls.

In fact, controls tend to be added willy nilly without thinking. Why is this control needed? What are we controlling for? That seems especially true of fixed effects and demographic controls. Extra controls and often destroying the causal implication of the regression. Tom Rothenberg, beloved econometrics teacher at Berkeley, offered two great examples. Regress left shoe sales on price and right shoe sales. The R2 goes up dramatically, the standard errors drop, the magic stars appear. But now you’re measuring the effect of price on how many people buy a left shoe without buying a right show. More seriously, regress wages on education, but “control for” industry. The R2 goes up, we explain much more variation of wages (sort of where this post wants to go, but not this way). But the point of education is to let you move from the burger flipping industry to investment banking, so controlling for industry destroys the causal interpretation of the coefficient.

But I digress. To our point, adding controls reduces the variation in x we are looking at. It is correct to do so: A lot of the variation in x was reverse causality or correlation with other causes, and we want to throw that out in order to learn about causality.

Next, researchers add “instruments.” To avoid the correlation is causation problem, we find some variable z that is plausibly uncorrelated with other influences on y, and then only use variation in x that is predicted by z. We throw out variation in x uncorrelated with z. (Great exam question: explain the difference between an instrument and a control?)

And so on. I am not criticizing. The improvement in causal inference from these techniques has been enormous. We also are now blessed by huge data sets, so we can can do it. Take all the people in the US, and drill down to the fact that Joe Brown really did move exogenously from Newark to Manhattan, compared to Sam Smith who was otherwise identical but stayed put, and see how they did. But obviously that tells us little about the actual distribution of income in the US.

Causality intersects with large data, also newly available. With large data, you can afford to throw out variation profligately to look for that needle of exogenous variation. Ideally, large data means we should be free from standard errors. Everything should be significant. That standard errors still matter tells you how much data we throw out in the quest for causality.

Yes, it is often overdone and not quite as casual as it seems.A “causally identified” “top 5” publication with three stars on the coefficients moves the average economists’ prior by about 1/10,000 of what Bayesian updating says it should do, if the causal identification were correct. (Jeff Smith gave a great recent Hoover seminar on this topic, slides here, on how sensitive many results are to small changes in specification.) We are either incredibly behaviorally stuck in our ways, or the new techniques on their own don’t fully identify causal effects automatically. But I’m not here to delve in to that question today, rather to point out that even if it were all perfectly identified, it only answers the question it says it answers.

Sometimes, of course, the jump is justified. Darwin figured out that natural selection accounts for finch beaks in the Galapagos. That must be 0.00001% of the variation in species. It turns out all the rest is also natural selection. But the Finch beaks alone don’t prove that.

Price pressure, and the 90% full glass.

This comment arose out of discussion at the NBER Asset Pricing Program over Aditya Chaudhry and Jiacui Li’s “Endogenous Elasticities” paper (review in my last post). Like the rest of the price pressure literature, they find surprisingly large elasticities of small changes stock quantities — an unexpected sale of 1% of the outstanding stock lowers the price 1-2%. (Their point is a declining elasticity. Roughly speaking, sales under 1% raise the price by twice the amount of sale, sales over 1% only by the same amount as the sale. But even 1 is a large elasticity.)

But most changes in price occur without any demand (or is it supply?) pressure. Earnings announcements move stock prices, and no shares need change hands. When the market goes down and your stock has a beta of one, the price moves, with no selling pressure to move it. This is the standard theory and fact of trading: when information hits the market symmetrically, prices move with no “buying or selling pressure”, and no volume at all. Indeed, here we are talking about 1% movements in price from occasional 1% movements in sales, but the average stock moves 1% every single day, and 50% or more in a typical year.

Thus, while one can causally identify that buying or selling pressure moves prices, that does not establish that most price movement comes from buying or selling pressure. R(t+1) = beta x(t+1) + error can have a beautifully identified beta and x. But the “error,” which consists of all the other x’s left out of the regression, can be huge. “Liquidity traders move stock prices” does not imply “stock prices mostly move because of liquidity traders.”

To be clear, neither Chaudhry and Li nor any other price pressure authors I have seen claim otherwise. But one does sniff that mis-interpretation hanging around.

Related but slightly different, most changes in quantity have no or tiny price effects, because they are anticipated. Most people trying to buy or sell financial assets are smart enough not to surprise the market. If you show up unexpectedly with a truck load of tomatoes outside of Whole Foods at 2 am, you’re not going to get full price for them. The Treasury, for example, routinely sells hundreds of billions of dollars of debt with essentially no price impact. Why? It announces the sales well ahead of time, and talks to bond traders about the sale. Quantitative easing purchases of hundreds of billions had some impact effect when announced, but no detectable price impact when the Fed actually bought securities. Initial offerings amount to an infinite percent increase in supply of shares. Investment banks exist to popularize offerings, announce them, line up investors, and limit any “sloping demand curve” price impact.

Moreover, we have long understood why selling drives prices down: people on the other side suspect you know something they don’t know. The price pressure literature tries to find selling or buying shocks that the other side ought to be able to figure out is not tied to information. For example, with the same data that price pressure authors laboriously dig up, you should be able to figure out that a mutual fund is selling stocks because its customers are pulling out money, not because its analysts know something you don’t. The mere fact that a fund is selling might mean that its analysts know something the trader does not know. Well, maybe high frequency arbitrageurs aren’t quite that good at parsing out who does and doesn’t know something when they sell.

This is a slightly different phenomenon, for which I don’t have a catchphrase: Just because your identified movement in x causes movement in y does not mean that all movements in x cause movement in y.

Macroeconomics

Macroeconomics should take a victory lap for being first to the table here. Chris Sims’ Vector Autoregressions taught us to look for the effects of a monetary policy shock by looking at the average events not following an interest rate rise per se, but only following unexpected interest rate rises. The trouble is, markets anticipate most interest rate changes very well, so true monetary policy shocks are few and far between. If we want to subdivide, for example to monetary policy shocks that persistently raise interest rates vs those that die out quickly, then we have fewer data points still. (In contemporary theory, persistent vs. transitory shocks have very different effects.) The result, identified monetary policy shocks explain next to none of the observed variation in prices, output, and employment, and standard errors plus the effects of small specification changes are huge.

Final thoughts

So, causality is great, but it isn’t everything. We often do want to know, “what are the major causes of growth vs stagnation, wealth vs. poverty, recession vs. boom, and why do stock prices wander around so much?” Causal identification can chip away at this question, but obviously there is a long way to go. And it’s not the obvious we will ever get there, since so much movement in the causes is and will always be endogenous.

Maybe one should rule out such big picture questions. Medicine doesn’t get far with “why are people sick?” but instead attacks drugs with small marginal power one by one. And clinical trials rightly focus on just the people in the trial, ignoring the vast number outside of the trial.

Still, then, one should not mistake the answer of the small causal question for the answer to the disallowed big picture question.

As I think about macroeconomics and finance, I think there is good work to be done that does not just follow the causal identification format, and allows us to address the big picture question. Sometimes broad facts fit one vs. another causal story in ways that cannot be captured by these techniques.

As a concrete example, I’ll plug again a recent paper, “Expectations and the Neutrality of Interest Rates.” Here I contrasted FTPL, old Keynesian, new-Keynesian and Monetarist explanations for the recent surge of inflation, the long quiet zero bound, the lack of a deflation spiral in 2008, and the immense difference between QE and the 2020-2021 asset purchases. I argue that one can sort out the theories with a little Occam’s razor, basic fundamental predictions, and elephant in the room facts. But I couldn’t think of an F test in a VAR to capture that common sense. This sort of examination of historical episodes remains productive. Tom Sargent’s plot of the end of the German hyperinflation did more than a thousand VARs to demonstrate the possibility of painless disinflation and its likely mechanism.

Growth theory also seems to find it very productive to look at basic facts, rather than slice and dice causal estimates. It started with Bob Lucas noticing that capital should be flowing in droves to poor countries. Why not? Tom Sowell is on my mind from his recent celebration. He documents facts that support one vs. another causal framework. For example, people who immigrate to the US from different countries or areas of countries, but Americans can’t tell them apart, have very different outcomes. Well, pure discrimination can’t be everything.

But this sort of thing takes thought and judgement, and is hard to publish.

Updates:

John Hand at UNC has a lovely paper documenting the phenomenon in accounting research. “Bigger Data + Tinier Results = The Wrong Direction.”

the explanatory power of the typical KIV [key independent variable of interest] in mainly regression-based accounting research papers has fallen ≈ 50X from 1.8% in 1995 to 0.04% in 2024.

I want to emphasize what this post is not about: It is not a critique of causal methods in applied economics and finance. It is only a criticism of how one might misinterpret the findings of those causal methods. Several correspondents are misreading this post as a critique of causal methods.

There is a burgeoning critique, which I slightly alluded to above by noticing how little people’s beliefs are changed by “statistically significant” results. It is undergoing its own replicability crisis, as the Jeff Smith slides I alluded to above discuss. Small changes in how one throws out 99% of the variance of a variable leads to quite different results. It is also criticized for looking at x variables that one might be able to measure, but that don’t really matter in the big scheme of things. It is belittled as “cuteonomics” or “blippies,”with some justice.

I find empirical research most credible when I can isolate the believable stylized fact underlying an estimate. It is, as I alluded to a bit, almost impossible to even state the stylized fact in words, let alone the assumed correlation structure of errors. I find empirical research most satisfying when I learn something about the world, summarized in an estimate but believable on its own. Abstracts of empirical papers especially on the job market are almost comical. After stating an interesting question, “we leverage a diff in diff strategy with controls, fixed effects and instruments….” Oh well.

Casual econometricians, however, are right to say that all of you old folks running dubious correlation regressions never got anywhere in the old days. What would you do better?

But all that is for another day.

Update 2:

I went to work today, and ran across a classic example at a seminar. A paper claims that rises in global temperatures raise mortality from heat waves. Leave aside fights over whether that’s right or not — death rates in Texas are not a lot higher than in New Hampshire each summer. If the question is “what accounts for deaths,” one degree higher temperature in a hundred years has to be in the thousandth of the effects of disease, pollution, poverty, and so on. If the question is “what can we do to reduce the death rate,” “buy an electric vehicle” in the millionths of the benefit/cost interventions.

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