On Wednesday I spoke at a World Bank conference on price statistics.  While price statistics are not usually thought of as a scintillating subject, I got a great deal of satisfaction out of preparing and presenting my remarks.  In part this was because my late father Robert Summers focused his economic research on International price comparisons.  It was also because I am convinced that data is the ultimate public good and that we will soon have much more data than we do today.

I made four primary observations.

First, scientific progress is driven more by new tools and new observations than by hypothesis construction and testing.  I cited a number of examples: the observation that Jupiter was orbited by several moons clinched the case against the Ptolemaic system, the belief that all celestial objects circle around the Earth.  We learned of cells by seeing them when the microscope was constructed.  Accelerators made the basic structure of atoms obvious.

Second, if mathematics is the queen of the hard sciences then statistics is the queen of the social sciences.  I gave examples of the power of very simple data analysis. We first learned that exercise is good for health from the observation that in 1940s London bus conductors had much lower death rates than bus drivers.  Similarly data demonstrated that smoking was a major killer decades before the biological processes were understood.  At a more trivial level, Moneyball shows how data-based statistics can revolutionize a major sport.

Third, I urged that what “you count counts” and argued that we needed much more timely and complete data. I noted the centrality of timely statistics to meaningful progress towards Sustainable Development Goals.  In comparison to the nearly six year lag in poverty statistics, it only took the USA about three and a half years to win World War II.

Fourth, I envisioned what might be possible in a world where there will soon be as many smart phones as adults.  With the ubiquitous ability to collect data and nearly unlimited ability to process it will come more capacity to discover previously unknown relationships. We will improve our ability to predict disasters like famines, storms and revolutions.  Communication technologies will allow us to better hold policymakers to account with reliable and rapid performance measures.  And if history is any guide we will gain capacities on dimensions we cannot now imagine but will come to regard as indispensable.

This is the work of both governments and the private sector.  It is fantasy to suppose data, the ultimate public good, will come into being without government effort.  Equally, we will sell ourselves short if we stick with traditional collection methods and ignore innovative providers and methods such as the use of smart phones, drones, satellites and supercomputers. That is why something like the Billion Prices Project at MIT, which can provide daily price information, is so important. That is why I am excited to be a Director and involved with Premise – a data company that analyzes information people collect on their smartphones about everyday life, like the price of local foods – in its capacity to mobilize these technologies as widely as possible. That is why Planet Labs, with its capacity to scan and monitor environmental conditions, represents such a profound innovation.

Catherine Rampell’s column this week reminded me of an issue that has long interested me as an economist and as a president of Harvard.

I remember many years ago listening to some monetarist quote Milton Friedman one too many times with “inflation is always and everywhere a monetary phenomenon.”  I responded “what about grade inflation?”

I could never quite decide whether this was just a wisecrack or it captured something important.  The idea that it might well reflect is that inflation has much to do with different actors seeking to leapfrog each other and in the process setting off a spiral.

In any event, I think that the pervasiveness of top grades in American higher education is shameful. How can a society that inflates the grades of its students and assigns the top standard to average performance be surprised when its corporate leaders inflate their earnings, its generals inflate their body counts, or its political leaders inflate their achievements?

More than ethics classes this is a matter of moral education. And America’s universities are failing when “A” is the most commonly-awarded grade.  If we really valued excellence, we would single it out.

I did succeed in a small way as Harvard president in reducing the fraction of students graduating with honors from a ludicrous 90 percent to an excessive 55 percent.  I wish I had been able to do more. Even more I wish that today’s academic leaders would take up this issue.

It has seemed to me that a vast double standard regarding what constitutes prejudice exists on American college campuses.  There is hypersensitivity regarding prejudice against most minority groups but what might be called hyper-insensitivity with respect to anti-Semitism.

At Bowdoin College, holding parties with sombreros and tequila is deemed to be an act of prejudice against Mexicans.  At Emory, the chalking of an endorsement of the likely Republican Presidential candidate on a sidewalk is deemed to require a review of security tapes.  The existence of a college named after widely admired former US President has under the duress of a student occupation been condemned at Princeton.  At Yale,  Halloween costumes are the subject of administrative edict.  The dean of Harvard Law School has acknowledged that hers is a racist institution, while the Freshman Dean at Harvard College has used dinner placemats to propagandize the student body on aspects of diversity.   Professors acquiesce as students insist that they not be exposed to views on issues like abortion that make them uncomfortable.

All I have discussed in the past, this is in my view inconsistent with basic American values of free speech and open debate.  It fails to recognize that the a proper liberal education should cause moments of acute discomfort as cherished beliefs are challenged.

But, if comfort is elevated to be a preeminent value, the standard should be applied universally.  Unfortunately, there is a clear exception made on most university campuses for anti-Semitic speech and acts.

The State Department has made clear that it regards demonizing Israel or  “applying double standards by requiring of it a behavior not expected or demanded  of any other democratic nation” as anti-Semitism.   This makes obvious good sense.  Does anyone doubt that applying standards to African countries that were not applied to other countries or singling them out for sanction when other non-African countries were guilty of much greater sins would be deemed racism?

Instances of anti-Semitism by this standard are ubiquitous in American academic life.  Nearly a dozen academic associations have enacted formal boycotts of Israeli institutions and in some cases Israeli scholars.  Student governments at dozens of universities have demanded the divestiture of companies that do business in Israel or the West Bank.   Guest speakers and even some faculty in their classrooms compare Israel with Nazi Germany and question its right to continued existence as a Jewish state.

Yet, with very few exceptions, university leaders who are so quick to stand up against microagressions against other groups remain silent in the face of anti-Semitism.  Indeed, many major American universities including Harvard remain institutional members of associations that are engaged in boycotts of Israel.  The idea of divesting Israel is opposed only in the same way that divesting apartheid South Africa was opposed—as an inappropriate intrusion into politics, not as immoral or anti-Semitic.

That is why the recent statement of the University of California Regents is so welcome.  It is forceful and clear on anti-Semitism, while at the same time recognizing the importance of free speech.  It holds that “Anti-Semitism, anti-semitic forms of anti-Zionism and other forms of discrimination have no place at the University of California”.  Let us hope that similar statements will be made by the leaders of private and public universities across the country.

As the cover story in this week’s Economist highlights, the rate of profitability in the United States is at a near-record high level, as is the share of corporate revenue going to capital.   The stock market is valued very high by historical standards, as measured by Tobin’s q ratio of the market value of the nonfinancial corporations to the value of their tangible capital.  And the ratio of the market value of equities in the corporate sector to its GDP is also unusually high.

All of this might be taken as evidence that this is a time when the return on new capital investment is unusually high.  The rate of profit under standard assumptions reflects the marginal productivity of capital.  A high market value of corporations implies that “old capital” is highly valued and suggests a high payoff to investment in new capital.

This is an apparent problem for the secular stagnation hypothesis I have been advocating for some time, the idea that the U.S. economy is stuck in a period of lethargic economic growth.  Secular stagnation has as a central element a decline in the propensity to invest leading to chronic shortfalls of aggregate demand and difficulties in attaining real interest rates consistent with full employment.

Yet matters are more complex.  For some years now, real interest rates on safe financial instruments have been low and, for the most part, declining.  And business investment is either in line with cyclical conditions or a little weaker than would be predicted by cyclical conditions.  This is anomalous, as in the most straightforward economic models the real interest rate is the risk adjusted rate of return on capital.  And an unusually high rate of investment would be expected to go along with a high rate of return on existing capital.

How can this anomaly be resolved?  There are a number of logical possibilities.  First, the riskiness associated with capital investment might have gone up and so higher rates of return could be simply compensating for higher risk rather than implying attractive investments.  There are two major problems with this story.  One is that available proxies for risk are not especially high in recent years.  The chart below depicts realized stock market volatility and the VIX measure of expected volatility as implied by options.  Another problem is that if capital returns have become far more uncertain, then the stocks should have become less attractive in recent years rather than more.  In the last 7 years, the stock market has risen to 250 percent of its spring 2009 levels.

A second explanation could be that a heightened demand for liquidity and a shortage of Treasury instruments, perhaps created by quantitative easing programs, has driven down bond yields, widening the spread between the rate of profit and these yields.  This story does not provide a natural explanation for the relatively weak behavior of business investment.  Further as Sam Hanson, Robin Greenwood, Joshua Rudolph and I pointed out in earlier work, the market is today being asked to absorb an abnormally high rather than an abnormally low level of long term Federal debt.

On top of that, if Treasuries were in short supply, one would expect that they would have their yield bid down relative to market synthesized safe instruments.  Yet the so-called swap spread is actually negative and Treasury yields (vs swaps) are unusually high relative to history.

Third, it could be that higher profits do not reflect increased productivity of capital but instead reflect an increase in monopoly power.  If monopoly power increased one would expect to see higher profits, lower investment as firms restricted output, and lower interest rates as the demand for capital was reduced.  This is exactly what we have seen in recent years!

Is the increased monopoly power theory plausible?  The Economist makes the best case I have seen for it noting that (i) many industries have become more concentrated (ii) we are coming off a major merger wave (iii) there is some evidence of greater profit persistence among major companies (iv) new business formation has declined (v) overlapping ownership of companies that compete has become more common with the rise of institutional investors, (vi) leading technology companies like Google and Apple may be benefiting from increasing returns to scale and network effects.

The combination of the fact that only the monopoly power story can convincingly account for the divergence between the profit rate and the behavior of real interest rates and investment, along with the suggestive evidence of increases in monopoly power makes me think that the issue of growing market power deserves increased attention from economists and especially from macroeconomists.

The Mossavar-Rahmani Center for Business and Government at Harvard that I am privileged to direct has just issued an important paper by Senior Fellow Peter Sands and a group of student collaborators.  Sands’ paper makes a compelling case for stopping the issuance of high denomination notes like the 500 euro note and 100 dollar bill or even withdrawing them from circulation.

I remember that when the euro was being designed in the late 1990s, I argued with my European G7 colleagues that skirmishing over seigniorage by issuing a 500 euro note was highly irresponsible and mostly would be a boon to corruption and crime.  Since the crime and corruption in significant part would happen outside European borders, I suggested that to paraphrase John Connally it was their currency, but would be everyone’s problem.  And I made clear that in the context of an international agreement, the US would consider policy regarding the $100 bill.  But because the Germans were committed to having a high denomination note, the issue was never seriously debated in international fora.

The fact that – as Sands points out — in certain circles the €500 is known as the “Bin Laden” confirms the arguments against it.  Sands’ extensive analysis is totally convincing on the linkage between high denomination notes and crime. He is surely right that illicit activities are facilitated when a million dollars weighs 2.2 pounds as with the €500 note rather than more than 50 pounds as would be the case if the $20 was the high denomination note. And he is equally correct in arguing that technology is obviating whatever need there may ever have been for high denomination notes in legal commerce.

What should happen next?  I’d guess the idea of removing existing notes is a step too far.  But a moratorium on printing new high denomination notes would make the world a better place.  In terms of unilateral steps, the most important actor by far is the European Union.  The €500 is almost six times as valuable as the $100.  Some actors in Europe, notably the European Commission, have shown sympathy for the idea and ECB chief Mario Draghi has shown interest as well.  If Europe moved, pressure could likely be brought on others, notably Switzerland.

I confess to not being surprised that resistance within the ECB is coming out of Luxembourg (see also), with its long and unsavory tradition of giving comfort to tax evaders, money launderers, and other proponents of bank secrecy and where 20x as much cash is printed relative to GDP compared to other European countries.

These are difficult times in Europe with the refugee crisis, economic weakness, security issues and the rise of populist movements.  There are real limits on what it can do to address global problems.  But here is a step that will represent a global contribution with only the tiniest impact on legitimate commerce or on government budgets.  It may not be a free lunch, but it is a very cheap lunch.

Even better than unilateral measures in Europe would be a global agreement to stop issuing notes worth more than say $50 or $100.  Such an agreement would be as significant as anything else the G7 or G20 has done in years.  China, which is hosting the next G-20 in September, has made attacking corruption a central part of its economic and political strategy. More generally, at a time when such a demonstration is very much needed, a global agreement to stop issuing high denomination notes would also show that the global financial groupings can stand up against “big money” and for the interests of ordinary citizens.

I was privileged this morning to deliver keynote remarks at the release event for the Global Health Risk Framework Commission report on “The Neglected Dimension of Global Security: A Framework to Counter Infectious Disease Crises”.  The commission, convened by the National Academy of Medicine and chaired by Peter Sands, has delivered a very important report on what I think is the issue with the highest ratio of seriousness to policy preparation in the global system.  Indeed, for reasons I sketched in my remarks, I believe the threat to global well-being from pandemics over the next century is comparable to the threat from global climate change.

I began by expanding on why I think pandemics are such an important issue.  The global mortality rate from the flu pandemic of 1918 was 7000 times as large as from the recent Ebola outbreak.  AIDS profoundly changed the human experience in Africa.  No one knows the probability of a recurrence of these kinds of disasters.  History is too short to permit reliable estimates and in any event conditions are rapidly changing because of scientific improvements on the one hand, and huge increases in global interconnection on the other.

In the context of the Global Health 2035 report that Dean Jamison and I developed, we considered the economic benefit of mortality reduction using approaches derived from economic theory.  We noted that the well established fact that people demand higher pay to accept riskier jobs demonstrates that reduced mortality risk has economic value.  And we further showed that these benefits are very large relative to standard estimates of the economic impact of health interventions.

In related work, Dean and I with Victoria Fan calculate the potential cost of a 1918 flu recurrence, discounted by its chance of happening.  We expect to publish this work soon. On plausible assumptions we find an expected flu cost approaching $1 trillion a year going forward into the 21^st century. This underscores the urgency of doing all that can be done to counter pandemic risks.

Eisenhower famously said that “in preparing for battle, I have always found that plans are useless but planning is indispensable”. So also with the pandemic threat, which is what makes the GHRF report so important.  I have three main takeaways from its consideration of the Ebola experience and its stock-taking of the current global architecture.

First, this is an area where the urgent has crowded out the profoundly important.  In too many countries, pressing near term needs and budgetary pressures have prevented the establishment of necessary infrastructures for public health. Such resilient health systems would be a high payoff investment even if catastrophe never comes and would be transformative if and when catastrophe comes.

Second, the international system needs to do more to clarify responsibilities and authorities when the next emergency comes and to put in place financial mechanisms for rapid action.  Given the nonlinear exponential character of pandemic processes this is of the highest urgency.

Third, there is a need for more and better science both ex-ante and ex-post after a pathogen is identified.  I will never forget my friend Barry Bloom, former Dean of Harvard’s School of Public Health, asking me how I would prefer to have spent money in the 1950s: on scholarships for iron lungs or on supporting Salk and Sabin.  There is much here that science could be doing but currently is not.  Given that profiting hugely in time of pandemic is unacceptable, markets provide insufficient incentives for gaps to be filled. As such, pre-emptive research is fundamentally important.

P.S.

Brad is unpersuaded by my response.  He is broadly right in my view that models function both as discovery tools and as ways of organizing and codifying thought. The danger comes when too primitive a model is regarded as too powerful a discovery. Thus Krugman was right to recognize that first generation models of currency crises were an inadequate basis for making policy in response to many actual currency crises.

On the issue at hand my judgement is that excessive spending and fear of a sudden stop can push the IS curve back leading to contractionary capital outflows. I cite the work of Blanchard et al in support of this proposition. With a bit of political economy, the argument can be extended. Suppose countries in danger of high inflation are more likely to turn populist.  It was Keynes after all who introduced animal spirits and warned Roosevelt about business confidence.

Again, I don’t think any of this is of concern for the US right now and I think my track record in favor of fiscal expansion notably in my work with Brad is clear enough.

The point though is that responsible policy makers like Janet Yellen and Stan Fischer may sometimes come to judgements different from mine. I find it unhelpful and likely wrong to attribute this to a failure to understand and appreciate basic macroeconomics.

P.P.S.

Paul now offers some observations. He is right that we are not all very far apart. I agree with him that one needs more than attitude, one needs a logically consistent view of how the world works. As my response to Mike Spence and Kevin Warsh illustrates I too am impatient with fear mongering attitude as an approach to analysis.

We have I think two remaining disagreements. First, I am more willing than Paul to credit the possibility that people with substantial experience and even a track record of making money by predicting markets, have important insights even if they cannot speak the language of “models” in the way I teach in economics. Hyman Minsky is an example of a scholar whose warnings were ignored in part because they were not formalized not because they were incoherent or illogical.

Second, on the issue of confidence crises I think Paul is way too serene for reasons Blanchard’s work makes clear. If loss of confidence in their government or economy makes people less wealthy, they will spend less and that is contractionary. This objection may for some reason be wrong but I do not see why it should be dismissed apriori. This is a case where I think reliance on formalism may lead people astray.

Brad Delong and Paul Krugman accept my criticisms of Fed thought regarding their monetary policy strategy but disagree with my assertion that it reflects an excessive attachment to existing models and modes of thought.

Their argument is that standard IS-LM leads to the conclusion you should not raise rates in the present environment so no move away from orthodoxy is necessary to reach this conclusion.  I think the issue is more on the supply side than the demand side.  If I believed strongly in the vertical long run Phillips curve with a NAIRU around five percent and in inflation expectations responsiveness to a heated up labor market, I would see a reasonable case for the monetary tightening that has taken place.

Since I am not sure of anything about the Phillips curve and inflation is well below target I come down against tightening.  The disagreement does it seems to me come down to the Fed’s attachment to the standard Phillips curve mode of thought.  My disagreement is reinforced by other judgmental aspects that are outside of the standard model used within the Fed.  These include hysteresis effects, the possibility of secular stagnation, and the asymmetric consequences of policy errors.

I am sure Paul and Brad are right that a desire to be “sound” also influences policy.  I am not nearly as hostile to this as Paul.  I think maintaining confidence is an important part of the art of policy.  A good example of where market thought is I think right and simple model based thought is I think dangerously wrong is Paul’s own Mundell-Fleming lecture on confidence crises in countries that have their own currencies.  Paul asserts that a damaging confidence crisis in a liquidity trap country without large foreign debts is impossible because if one developed the currency would depreciate generating an export surge.

Paul is certainly correct in his model but I doubt that he is in fact. Once account is taken of the impact of a currency collapse on consumers’ real incomes, on their expectations, and especially on the risk premium associated with domestic asset values, it is easy to understand how monetary and fiscal policymakers who lose confidence and trust see their real economies deteriorate as Olivier Blanchard and his colleagues have recently demonstrated.  Paul may be right that we have few examples of crises of this kind but if so this is perhaps because central banks do not in general follow his precepts.

I do not think this is a pressing issue for the US right now.   But the idea that policymakers should in general follow the model and not worry about considerations of market confidence seems to me as misguided as the view that they should be governed by market confidence to the exclusion of models.

Bernie Sanders had an op Ed in the New York Times on Fed reform last week that provides an opportunity to reflect on the Fed and financial reform more generally. I think that Sanders is right in his central point that financial policy is overly influenced by financial interests to its detriment and that it is essential that this be repaired. At the same time, reform requires careful reflection if it is not to be counterproductive. And it is important in approaching issues of reform not to give ammunition to right wing critics of the Fed who would deny it the capacity to engage in the kind of crisis responses that have judged in their totality been successful in responding to the financial crisis.  The most important policy priority with respect to the Fed is protecting it from stone age monetary ideas like a return to the gold standard, or turning policymaking over to a formula, or removing the dual mandate commanding the Fed to worry about unemployment as well as inflation.

Sanders is right that Fed governance has been and is overly tied up with the financial sector. Each of the 12 regional Fed s has a board of directors that is made up of 9 people—three banking representatives, three private sector non-banking representatives and three public interest representatives. The fact that a member of Goldman Sachs’ board at the time of the 2008 crisis was the “public interest” Chairman of the New York Fed board is to put it mildly indefensible.

More generally, it is not clear why a government institution with vital policy responsibilities should have a role in governance for the private sector. Yes, advice on market conditions and the like is needed but this can be sought from advisory committees. Yes, Dodd Frank did clean things up some by removing bankers from the selection process for regional bank presidents and orienting regulatory responsibility towards the Washington. But it is hard to imagine an appropriate governance activity for business figures with respect to the Federal Reserve System. Nor is it clear why banks should in any sense be “shareholders” in the Federal Reserve System.

I am less certain as to whether Sanders particular reform of making regional presidents senate confirmed is wise given the dysfunctionalities of the Senate process. Also, I suspect that this reform would strengthen the NY Fed with its close ties to Wall Street and hawkish regional presidents in ways that Sanders would not like.

A separate issue from Sanders concern with governance is his concern with who holds the full time senior positions within the Fed.  He asks rhetorically whether the CEO of Exxon should be head of the EPA or FCC should be stuffed with former Verizon executives. This is a difficult issue.  There is a tension between acquiring expertise and avoiding cooptation or cognitive capture. In fact many FCC chairs have had industry backgrounds including both Obama FCC chairs who pushed net neutrality approaches that industry loathed. It would be a valuable study but it is not my impression that as a general matter officials who come from industry have been systematically softer on industry than those who have come from other backgrounds.   It is worth pondering that figures much respected for their commitment to aggressive financial regulation like Arthur Levitt came into their positions from full time roles in industry whereas the principal regulators in place before the 2008 crisis—Bernanke, Geithner, Cox– came from public sector backgrounds. Franklin Roosevelt was hardly a pushover to the financial industry. He famously made former stock-operator Joseph Kennedy the inaugural leader of the SEC on the theory that it takes a thief to catch a thief.

Sanders proposes to make the Fed more transparent and accountable by releasing not just minutes but transcripts six months after meetings rather than the current five years. I am not sure I understand the logic here. Monetary policy accountability is essential but so is accountability for decisions of war and peace or protection of the environment. No one expects transcripts from the Pentagon’s war room or the EPA senior staff meetings. The Supreme Court Justices meet alone, without clerks or stenographers, because the best decisions tend to come when policymakers can deliberate privately before reaching conclusions. This encourages out of the box thinking and forceful dissent while minimizing grandstanding. Why should monetary policy be different? It seems to me that Janet Yellen has done great work over the years in pushing the Fed to be more open and that if further steps are to be taken, they should be in the directions she has pioneered such as more frequent press conferences.

With respect to proposals to audit the Fed, I think the issues are really of truth in labeling. There is no question that the Fed like every other part of government should be subject to independent audit. My understanding is that this is currently the case. If there are lacunae in current procedures, these should be pointed up and repaired. This is not the focus of current proposals like those of Ron and Rand Paul who would prefer to abolish the central bank and whose ideas are not so much about auditing the Fed as subjecting it to political control and straitjacketing it.  Surely Senator Sanders should not wish to curtail the Fed’s ability to act with discretion to insure a continued flow of credit to businesses and households in the event of an economic downturn or financial crisis.

On the substance of monetary policy, I have been clearly on the dovish side of the Fed for quite sometime and think the risks of the last rate increase exceeded the benefits so I agree with Sanders general thrust. I prefer the “do not raise rates until you see the whites of inflation’s eyes” to Sanders rather arbitrary 4 percent unemployment target.

I did not feel strongly but am inclined to agree with Sanders that the Fed should not have paid interest in excess reserves while it was setting the Fed funds rate in the zero range.  However, when rates are raised it is a matter of necessity that the Fed either pay interest on reserves or what is essentially equivalent offer Treasury bills to banks which soak up their excess cash. In a positive interest rate environment, there is no way that banks will or should hold on to zero interest rate cash. I do not think there would be any expert support for Sanders views here.

On regulatory policy, no one is for gambling with insured deposits. But Sanders fails to recognize some of the tensions that make regulatory policy so difficult. Loans to small businesses which he likes are far riskier than holdings of securities that are marked to market on a daily basis so if banks focused on traditional lending they would be riskier than they are today. Indeed the majority of the world’s banking crises over the last three centuries and over the last quarter century have come from traditional lending especially against real estate.  Making banks safer means reducing their dependence on traditional lending activities so balances must be struck.

Sanders asserts as many do that Glass Stegall’s repeal contributed to the crisis. I may not be objective as I supported this measure as Treasury Secretary but I do not see a basis for this assertion. Virtually everything that contributed to the crisis was not affected by Glass Steagall even in its purest form. Think of pure investment banks Bear and Lehman, or the GSEs Fannie and Freddie, or the banks Washington Mutual and Wachovia or AIG or the growth of the shadow banking system. Nor were the principle lending activities that got Citi and Bank of America in trouble implicated by Glass Stegall.

Moreover preventing financial institutions from diversifying into multiple activities can actually make them more likely to fail. Imagine how much better the outcome would have been if Lehman had sold itself to a large bank during 2008. There is the also the further point that without the repeal of Glass Stegall it would have been much more difficult to aggressively use the discount window to contain panic following Lehman s fall.

We currently have a system in which institutions have higher capital requirements if they are larger, more complex or more interconnected. I think there is a good case to be made that capital requirements should be further increased and further graduated with size and complexity. This would tend to encourage deconsolidation and is I think the right 21^st century response to the concerns about concentration in banking.

Finally, stepping back from Sanders specifics, I agree with his core claim that the excessive power of financial interests shapes financial policy to an unhealthy extent. I saw this during the debate on Dodd Frank when there were nearly five registered lobbyists for every member of Congress. It’s worth pondering how policy would be different if special interests were kept in check. Here are my top five:

First, the financial regulatory agencies would be adequately resourced and would not be under pressure to kowtow to legislators pushing their contributors interest. CFTC head Tim Massad had it right when he condemned the recent budget agreement as undercutting the ability to regulate derivatives in a serious way.

Second, the Balkanized character of US banking regulation is indefensible and would be ended. The worst regulatory idea of the 20^th century—the dual banking system—persists into the 21^st. The idea is that we have two systems one regulated by the States and the Fed and the other regulated by the OCC so banks have choice. With ambitious regulators eager to expand their reach, the inevitable result is a race to the bottom.

Third, the current SEC and CFTC would be combined and charged with regulating in a coherent way all financial markets with respect to market integrity, manipulation issues, insider trading, transparency, fairness of execution, and systemic risk. When there were securities markets and commodity markets it may have made sense. It no longer is defensible when the vast majority of “commodity trading” is in financial derivatives. The current system persists only so that multiple congressional committees can maintain jurisdiction over financial regulation and reap the benefits in terms of campaign contributions.  Quite possibly, it would be a good idea to give the new agency if it was strong jurisdiction over fiduciary rules for investment and pension advisors.

Fourth, either the new agency formed out of the SEC and CFTC or the existing FSOC would take on systemic risks associated with asset management in a serious way. While the asset managers have the better side of the argument when they claim not to be systemic in the sense of JP Morgan or Goldman Sachs, their activities are systemic and egregiously under regulated. It took far far too long to reach a still unsatisfactory solution with respect to money market funds. And ETFs are as likely as anything else to be the source of the next major bit of financial drama.

Fifth, there would be appropriate taxation of financial activities and the financial sector. Among the obvious reforms held back only by special interests are the highly preferential treatment of carried interest, the privileged treatment of dividends and capital gains, the ability of financial institutions to reduce their tax liabilities by using off shore tax havens and the tax deductibility of huge fines paid to resolve allegations of wrongdoing.

Senator Sanders is right that there is more to be done to respond to the long standing problems pointed up by the financial crisis and he is right in his concern about the way in which special interests distort the process. These notes will have served their purpose if they help to channel legitimate energy in the most constructive directions.

The Hutchins Center for Fiscal and Monetary Policy at Brookings is having a conference launching an important new volume on federal debt management policy.  Just as in the Great War in became clear that war is too important to be left to generals, so too in the Great Recession it became clear that (government) debt management is too important to be left to the parochial world debt managers. The composition of federal debt is itself often a useful tool for economic policy, particularly in the current low rate environment in which the Federal Reserve will frequently be unable to cut rates as much as it would like and will instead be reliant on “unconventional” policies intended to effect the price of government debt.

Edited by David Wessel the volume contains two chapters that I coauthored with Robin Greenwood, Sam Hanson, and Josh Rudolph as well as some separate comments of mine.  There is also a provocative paper by John Cochrane and a variety of perceptive commentaries by people with experience in debt management policy.

I think the volume makes a case for quite radical revisions in thinking about debt management policy.  Here are my 10 main takeaways starting where I am most confident.

1. Debt management is too important to leave to Federal debt managers and certainly to leave to the dealer community. This is because, especially when interest rates are near zero, it implicates directly monetary and fiscal policy and economic performance in the short run, and questions of financial stability in the medium run.
2. Whatever one’s view about desirable policy, it is fairly crazy for the Federal Reserve and Treasury, which are supposed to serve the national interest, to pursue diametrically opposed debt management policies. This is what has happened in recent years with the Federal Reserve seeking to shorten outstanding maturities and the Treasury seeking to term them out.
3. Standard discussions of QE — which focus on the size of Fed purchases of long term bonds and ignore the scale of Treasury sale of these instruments — are intellectually incoherent. It is the total impact of government activities on the stock of debt that the public must hold that should impact financial markets.
4. The preceding point is highly significant for the United States. Despite QE the quantity of long term debt that the markets had to absorb in recent years was well above, rather than below, normal.  This suggests that if QE was important in reducing rates or raising asset values it was because of signaling effects regarding future monetary policies not because of the direct effect of Fed purchases.
5. The standard mantra that Federal debt management policies should seek to minimize government borrowing costs is some combination of wrong and incomplete. It is wrong because it is risk adjusted expected costs that should be considered.  It is incomplete because it is hard to see why the effects of debt policies on levels of demand and on financial stability should be ignored.
6. The tax smoothing aspect, which is central to academic theories of debt policy, is of trivial significance. Even far larger levels of tax variability than we observe, or than could be offset by altered debt management policies, have only trivial impacts on levels of income.  It is much more important to understand debt management policy impacts on financial stability than on tax variability.
7. The idea of rollover risk that is ever present in policy discussions is very confused. If there is the possibility that a period will come when the government’s borrowing rate will be very high this obviously needs to be considered in setting policy.  But the problem is not one of rollover.  To see this, think about long term floating rate debt.  Such debt does not offer insulation in the hypothetical circumstance where rollover would be difficult, because in such a situation floating rate debt yield will rise precipitously.
8. Yield curves typically slope upward. The “carry trade” of borrowing short and lending long is a hedge fund staple.  Rather than providing this opportunity Treasury should reverse the trend towards terming out the debt.  Issuing shorter term debt would also help meet private demands for liquid short term instruments without encouraging risky structures like banks engaged in maturity transformation.
9. Institutional mechanisms should be found to insure that in the future the Fed and Treasury are not pushing debt durations in opposite directions. The Treasury terming out the debt which the Fed then buys in an effort to quantitatively ease serves only to enrich the dealer community.
10. Now that we are in a “secular stagnation” world of low interest rates, it is likely that debt management tools will be more important to stabilization policies in the future than in the past.

An ebook containing the papers and presentations from the European Central Bank’s central banking forum conference in Sintra Portugal is now available. Mario Draghi and his colleagues are to be greatly commended for running a forum that is so open to profound challenges to central banking orthodoxy.

The volume contains a paper by Olivier Blanchard, Eugenio Cerutti and me on hysteresis and separately some of my reflections asserting the need for a new Keynesian economics that is more Keynesian and less new. Here I summarize these two papers.

Hysteresis Effects

Blanchard Cerutti and I look at a sample of over 100 recessions from industrial countries over the last 50 years and examine their impact on long run output levels in an effort to understand what Blanchard and I had earlier called hysteresis effects. We find that in the vast majority of cases output never returns to previous trends. Indeed there appear to be more cases where recessions reduce the subsequent growth of output than where output returns to trend. In other words “super hysteresis” to use Larry Ball’s term is more frequent than “no hysteresis.”

This finding does not in and of itself establish the importance of hysteresis effects. It might be that when underlying growth rates fall recessions follow but that recessions have no causal impact going forward. In order to address this issue we look at the impact of recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long run output effects suggesting the presence of hysteresis effects.

In subsequent work Antonio Fatas and I have looked at the impact of fiscal policy surprises on long run output and long run output forecasts using a methodology pioneered by Blanchard and Leigh. Since fiscal policy effects operate primarily through aggregate demand, this provides a way to avoid the causation question. We find that fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis.

I was struck that in a vote taken at the conference close to 90 percent of the participants indicated that they believe there are significant hysteresis effects. While there is much more work to be done, I believe that as of right now the right presumption is in favor of hysteresis effects despite their exclusion from the standard models used in almost all central banks.

Towards a New Macroeconomics

My separate comments in the volume develop an idea I have pushed with little success for a long time. Standard new Keynesian macroeconomics essentially abstracts away from most of what is important in macroeconomics. To an even greater extent this is true of the DSGE (dynamic stochastic general equilibrium) models that are the workhorse of central bank staffs and much practically oriented academic work.

Why? New Keynesian models imply that stabilization policies cannot affect the average level of output over time and that the only effect policy can have is on the amplitude of economic fluctuations not on the level of output. This assumption is problematic at a number of levels.

First, if stabilization policies cannot effect average levels of employment and output over time they are not nearly as important as if they can. Beginning the study of stabilization with this assumption takes away much of the motivation for doing macroeconomics.

Second, the assumption is close to absurd.  It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak.

Third, contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s.

The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention.  As well they should. US output is now about 10 percent below a trend estimated through 2007. If one attributes even half of this figure to the effects of recession and assumes no catch up on this component until 2030 the cost of the financial crisis in the USA is about 1 year’s GDP. And matters are worse in the rest of the industrial world.

As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world. Maybe we can call it the Keynesian New Economics.

Paul Krugman suggests that I have had some kind of change of heart on secular stagnation and converged towards his point of view, citing the publication of the transcript of a 2011 debate which we both participated in. I certainly appreciate the gravity of the secular stagnation issue more than I did a few years ago, given the continuing decline in global real interest rates. But I think Paul exaggerates the change in my views considerably.

The topic of the debate was: “North America faces a Japan-style era of high unemployment and low growth.” Paul argued in favor. I opposed the motion – not on the grounds that the US economy was in good shape, but on the grounds that our demand deficiency problems should be easier to solve than Japan’s.

Quoting from my response to Paul’s arguments:

“You’re right the United States has a serious demand deficiency. You’re right that not enough is being done to contain that demand deficiency. You’re right that we will suffer needless unemployment and stagnation until more is done to address that demand deficiency….

My thesis is that as serious as that problem is, it is dimensionally much less than the problems that Japan faced in four respects. Japan’s problems were different in magnitude, different in the depth of their structural roots, different in the relative perspective they had — relative to the rest of the world — and different in the degree of resilience their system had for adapting to them…

…It will take time. There are steps that need to be taken but we are a society that works. We are a society whose principal problems — we all up here agree — can be addressed by a change in the printing of money and the creation of infrastructure.”

Paul responded in part by saying:

“The question is, are we going to be stuck in a state of depressed demand of the kind that Larry has talked about. Larry and I agree that that is what has been happening… I think Larry and I agree almost entirely on the economics, on what needs to be done”.

(Full transcript available here).

I think we have both been focused on demand and the liquidity trap for a long time.

There are, though, two areas where I have had somewhat different views from Paul. I believe that structural issues are often important for demand and growth. I have often asserted that “business confidence is the cheapest form of stimulus”, and quoted to President Obama Keynes’ famous 1938 letter to Roosevelt:

“Businessmen … are … at the same time allured and terrified by the glare of publicity, easily persuaded to be ‘patriots’, perplexed, bemused, indeed terrified, yet only too anxious to take a cheerful view, vain perhaps but very unsure of themselves, pathetically responsive to a kind word. You could do anything you liked with them, if you would treat them (even the big ones), not as wolves or tigers, but as domestic animals by nature, even though they have been badly brought up and not trained as you would wish… If you work them into the surly, obstinate, terrified mood, of which domestic animals, wrongly handled, are so capable, the nation’s burdens will not get carried to market; and in the end public opinion will veer their way.”

Second, I have never related well to Paul’s celebrated liquidity trap analysis. It has always seemed to me be a classic example of economists’ tendency to “assume a can opener”. Paul studies an economy in liquidity trap that will, by deus ex machina, be lifted out at some point in the future. He makes the point that if you assume sufficiently inflationary policy after this point, you can drive ex ante real rates down enough to stimulate the economy even before the deus ex machina moment.

This is true and an important insight. But it seems to elide the main issue. Where is the deus ex machina? Where is the can opener? The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will over any interval revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era.

Any analysis that assumes restoration of previous equilibrium is, from this perspective, missing the main issue.  I was glad to see Paul recognize this point recently.  I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.

My friends Mike Spence and Kevin Warsh, writing in yesterday’s Wall Street Journal, have produced what seems to me the single most confused analysis of US monetary policy that I have read this year (Brad DeLong has expressed related views).  Unless I am missing something — which is certainly possible — they make a variety of assertions that are usually exposed as fallacy in introductory economics classes.

My problem is not with their policy conclusion, though I do not share their highly negative view of QE.  There are many harshly critical analyses of QE such as those of Martin Feldstein that are entirely coherent and consistent with the macroeconomics of the last 50 years.  My differences are based on judgements about empirical magnitudes and relative risks not questions of basic logic.

Spence and Warsh do not focus on the inflation risks, financial stability risks or distributional risks from overly expansionary monetary policy.  Instead they assert a proposition that I have not encountered in 40 years as a professional economist—that overly easy monetary policy reduces business investment.  Indeed they blame the weakness of business investment during the current recovery on the Fed.

This line of argument is to say the least surprising.  Every major macroeconomics textbook whether Keynesian monetarist or classical in orientation teaches students that investment increases as real interest rates decline.  This is motivated in a variety of quite compelling ways.  It is noted that lower rates raise the present value of the returns from investment and so make them more attractive.  It is observed that lower rates mean lower borrowing costs or lower costs of drawing down liquid asset holding making the purchase of capital goods more attractive.  For these reasons millions of students have been taught that Hicks famous IS curve slopes downward.  Hundreds of empirical studies have found that investment responds to capital cost as theory predicts though the magnitude is open to debate.

What arguments do Spence and Warsh offer for their heterodox conclusion? They note rightly that monetary policy has been easy and investment has been weak in the current recovery.  This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer.  One would expect in a weak recovery that investment would be weak and monetary policy easy.  Correlation does not prove causation.

They then argue that low rates somehow promote corporate stock buybacks and this is an alternative to real new investment.  I confess that I cannot follow the logic here.  I would have supposed that the choice between real investments and share repurchases would depend on their relative price.  If as Spence and Warsh assert QE has raised stock prices this should tilt the balance towards real investment.

Likewise I would have thought that by making the return to holding cash less attractive, easy money would tend to drive firms into making real investments.  And for the many firms that do not have huge hoards, it would bring down borrowing costs.

Perhaps Spence and Warsh are on to something that I am missing.  I’m curious whether they can point to any peer reviewed economic research or indeed any statistical work that backs up their views.  I am certainly open to any new evidence or new argument after all that has happened in recent years that easy money reduces business investment.  And there is plenty of room for debate over policy.  For now though I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.