Books
- Asset pricing Revised Edition. This link gives you a sample chapter. Click here to go to the Princeton University press website where you can order the book. (It is sometimes cheaper at Amazon.com or Barnes and Noble.com. In Chicago, it’s available at the seminary COOP bookstore.)
- Additional materials for Asset Pricing, lecture notes, new chapters, and the online class are now moved to their own page here, or via the Asset Pricing link at left.
- Financial Markets and the Real Economy Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006. Edited volume of collected articles with an introduction surveying the field.
- The Squam Lake Report: Fixing the Financial System. Princeton: Princeton University Press 2010. With Kenneth R. French, Martin N. Baily, John Y. Campbell, Douglas W. Diamond, Darrell Duffie, Anil K. Kashyap, Frederic S. Mishkin, Raghuram G. Rajan, David S. Scharfstein, Robert J. Shiller, Hyun Song Shin, Matthew J. Slaughter, Jeremy C. Stein, and Rene M. Stultz
Some Notes
- Investments notes. Jan 2005. Notes for MBA investments classes. Summary of background (statistics, regression, time series, matrices, maximization) and a concise treatment of some of the standard topics (bond notation and expectations hypothesis, bond pricing)
- Time series for macroeconomics and Finance Jan 2005 Lecture notes for PhD time series course. This revision finally includes the figures!
- Continuous time. Note covering dz, dt, stochastic integrals, and how to do all of Asset Pricing Chapter 1 in continuous time.
- Continuous-time linear models
Foundations and Trends in Finance 6 (2011), 165-219 DOI: 10.1561/0500000037 Manuscript How to do ARMA models, opreator tricks, and Hansen-Sargent prediction formulas in continuous time. - A Brief Parable of Overdifferencing January 2012. This is a short note, showing how money demand estimation works very well in levels or long (4 year) differences, but not when you first-difference the data. It shows why we often want to run OLS with corrected standard errors rather than GLS or ML, and it cautions against the massive differencing, fixed effects and controls used in micro data. It's from a PhD class, but I thought the reminder worth a little standalone note.
- Solving real business cycle models by solving systems of first order conditions 1993 Set of old lecture notes. Still, underground copies are circulating, so you can get a fresh one here.
- Writing tips for PhD students May 2005. Some tips on how to write academic articles. Do as I say, not as I do. Chinese Translation, 2013. (Original source of chinese translation. Thanks to Shihe Fu)
- More notes, related to Asset Pricing book, classes, and online class, are on the Asset Pricing page.
Articles. By topic, in reverse chronological order
Asset Pricing and Financial Economics
OK, the whole point of my research agenda is that asset pricing and macroeconomics are the same thing, but it's still a little helpful to separate papers by their main focus.
- Macro-Finance. Update, Jan 23 2017. Forthcoming Review of Finance . This is a review paper. I survey many current frameworks including habits, long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes, and debt or institutional finance. I stress how all these approaches produce quite similar results and mechanisms: the market's ability to bear risk varies over time, with business cycles. I speculate with some simple models that time-varying risk premiums can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, rather than Keynesian flow constraints or new-Keynesian intertemporal substitution. The July 2016 manuscript contains a long section with thoughts on how to make a macro model based on time varying risk premiums, that got cut from the above final version. (This is the "manuscript" referenced in the paper.) The Data and programs (zip, matlab). The slides for the talk.
- The Fragile Benefits of Endowment Destruction. November 2015. Journal of Political Economy 123(5) 1214-1226. With John Y. Campbell. (JSTOR / JPE Link.) A rejoinder to Ljungqvist and Uhlig "Comment on the Campbell-Cochrane Habit Model" (formerly titled "Optimal Endowment Destruction under Campbell-Cochrane Habit Formation"). The benefits of endowment destruction depend sensitively on how you discretize the model. Lesson: It's better to use the the continuous time version and make sure discretizations make sense. There is a nice lesson on how to extend diffusion models to jumps too. Computer program.
- A New Structure for U.S. Federal Debt November 2015 In David Wessel, Ed., The $13 Trillion Question: Managing the U.S. Government's Debt, pp. 91-146. Washington DC: Brookings Institution Press. Last manuscript. I propose a restructuring of U. S. Federal debt. All debt should be perpetual, paying coupons forever with no principal payment. The debt should be composed of 1) Fixed-value, floating-rate, electronically transferable debt. Such debt looks like a money-market fund, or reserves at the Fed, to an investor. 2) Nominal perpetuities: This debt pays a coupon of $1 per bond, forever. 3) Indexed perpetuities: This debt pays a coupon of $1 times the current consumer price index (CPI). 4) All debt should be free of income, estate, capital gains, and other taxes. 5) long term debt should have explicitly variable coupons. 6) Swaps. The Treasury should adjust maturity structure, interest rate and inflation exposure of the Federal budget by transacting in simple swaps among these securities.
- Toward a run-free financial system. November 4 2014. In Martin Neil Baily, John B. Taylor, eds., Across the Great Divide: New Perspectives on the Financial Crisis, Hoover Press. This is an essay about what I think we should do in place of current financial regulation. We had a run, so get rid of run-prone liabilities. Technology and financial innovation means we can overcome the standard objections to "narrow banking." Some fun ideas include a tax on debt rather than capital ratios, the Fed and Treasury should issue reserves to everyone and take over short-term debt markets just as they took over the banknote market in the 19th century, and downstream fallible vechicles can tranche up bank equity.
- Challenges for Cost-Benefit Analysis of Financial Regulation. Journal of Legal Studies 43 S63-S105 (November 2014). Is cost benefit analysis a good idea for financial regulation? I survey the nature of costs and benefits of financial regulation and conclude that the legal process of current health, safety and environmental regulation can't be simply extended to financial regulation. I opine about how a successful cost-benefit process might work. My costs and benefits expanded to a rather critical survey of current financial regulation. It's based on a presentation I gave at a conference on this topic at the University of Chicago law school Fall 2013, with many interesting papers. JSTOR link with HTML and nicer pdf. The JLS issue with all conference papers.
- A mean-variance benchmark for intertemporal portfolio theoryJournal of Finance, 69: 1–49. doi: 10.1111/jofi.12099 (February 2014) (link to JF) (Manuscript) Applies good old fashioned mean-variance portfolio analysis to the entire stream of dividends rather than to one-period returns. Long-Run Mean-Variance Analysis in a Diffusion Environment is a set of notes, detailing all the trouble you get in to if you try to apply long-run ideas to the standard iid lognormal environment, and also discusses shifting bliss points a bit.
- Finance: Function Matters, not Size May 2013 Journal of Economic Perspectives 27, 29–50 JEP link (Previous title "Is Finance Too big?" December 2012.) Is finance "too big?" Is this the right question? .
- Discount Rates Joural of Finance 66, 1047-1108 (August 2011). My American Finance Association Presidential speech. The video (including gracious roast by Raghu Rajan) The slides. Data and programs (zip file) Price should equal expected discounted payoffs. Efficiency is about the expected part. The unifying theme of today's finance research is the discounted part -- characterizing and understanding discount-rate variation. The paper surveys facts, theories, and applications, mostly pointing to challenges for future research.
- Lessons from the financial crisis Jan 2010 Regulation 32(4), 34-37. The financial crisis is mainly about too big to fail expectations. The only way out is to limit the government’s authority to bail out.
- State-Space vs. VAR models for Stock Returns Manuscript July 24 2008. In a “state-space” model, you write a process for expected returns and another one for expected dividend growth, and then you find prices (dividend yields) and returns by present value relations. I connect state-space models with VAR models for expected returns. What are the VAR or return-forecast-regression implications of a state-space model? What state-space model does a VAR imply? I start optimistic. An AR(1) state-space model gives a nice return-forecasting formula, in which you use both the dividend yield and a moving average of past returns to forecast future returns. The general formulas leave me pessimistic however. One can write any VAR in state-space form, and we don’t really have solid economic reasons to restrict either VAR or state-space representations. Still, the connections between the two representations are worth exploring, and if you’re doing that this paper might save you weeks of algebra.
- Decomposing the Yield Curve Manuscript, first big revision, March 14 2008. With Monika Piazzesi. We work out an affine term structure model that incorporates our bond risk premia from “Bond Risk Premia” in the AER. There are lots of interesting dynamics – level, slope and curvature forecast future bond risk premia, and we discover that market prices of risk are really simple. We use the model to decompose the yield curve – given a yield (forward) curve today, how much is expected future interest rates, and how much is risk premium? How does the yield or forward rate premium correspond to the term structure of expected return premia? Was the conundrum a conundrum? Slides from 2010 AFA meetings Data and Programs.
- Portfolio theory Feb. 20 2007 This is a draft of a portfolio theory chapter for the next revision of Asset Pricing. I (of course) take a p = E(mx) approach to portfolio theory before covering the classic Merton-style direct approach. I emphasize the importance of outside income.
- The Dog that Did Not Bark: A Defense of Return Predictability Review of Financial Studies 21(4) 2008 1533-1575. Taken alone, returns may not look that predictable. However, price-dividend ratios vary, so either returns or dividend growth must be forecastable (or both). Implications for dividends, and long-run forecasts give strong statistical evidence against the null that returns are not forecatsable. I address the Goyal-Welch finding that forecasts do badly out of sample, and the long literature criticizing long-run forecasts. The most important practical takeaway: even if you assume that all variation in market p/d ratios comes from time-varying expected returns, and none corresponds to dividend growth forecasts, you will typically find that market-timing strategies based on fitting the regression don’t work. Corrected Table 6. Three numbers were wrong in the published version. Thanks to Camilla Pederson for catching it.
- Two Trees (with Francis Longstaff and Pedro Santa-Clara), Review of Financial Studies 21 (1) 2008 347-385. We solve the model with two Lucas trees, iid dividends and log utility. Surprise: it has interesting dynamics. If one stock goes up it is a larger share of the market. Its expected return must rise so that people are willing to hold it despite its now larger share.
- Financial markets and the Real Economy in Rajnish Mehra, Ed. Handbook of the Equity Premium Elsevier 2007, 237-325. Everything you wanted to know, but didn’t have time to read, about equity premium, consumption-based models, investment-based models, general equilibrium in asset pricing, labor income and idiosyncratic risk.
- This article appeared four times, getting better each time. (Why waste a good article by only publishing it once?) The link above is the last and the best. The previous versions were NBER Working paper 11193, Financial Markets and the Real Economy Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006, and in Foundations and Trends in Finance1, 1-101, 2005.
- Bond Risk Premia with Monika Piazzesi. American Economic Review 95:1, 138-160 (2005). We forecast one year bond excess returns with a 44% R2! More importantly, a single factor, a single linear combination of yields or forward rates, forecasts one-year returns of all maturity bonds. Read here the Appendix with lots of extra analysis. (Updated Sept 2006 to fix typos in forward rate formulas.) The NBER working paper has lots of cool stuff, including links to macro and the covariance with level result, that got trimmed from the published paper. Data and programs. Look at the pretty plot of how our forecasts work out of sample since we wrote the paper (Until the 2008 financial crisis, in which the Fama-Bliss procedure breaks down.) Read the Response to Ken Singleton regarding his criticism of our results in a paper with Dai and Yang, and then published in his book Empirical Dynamic Asset Pricing (Princeton, 2006). Overheads, useful if you want to teach the paper A summary with color graphs, and treatment of the period since the 2008 financial crisis, in lecture note form. Start on p 567.
- International Risk Sharing is Better Than You Think, Or Exchange Rates are Too Smooth with Michael Brandt and Pedro Santa Clara. Published Journal of Monetary Economics 53 (4) May 2006 671-698. Original July 2001 (NBER WP 8404) The equity premium means that marginal rates of substitution are very volatile, with more than 50% standard deviation. Exchange rates are the ratio of marginal rates of substitution, and they only vary by about 12%. Therefore, marginal rates of substitution must be highly correlated across countries. Risk sharing is better than you think.
- Liquidity, Trading and Asset Prices. NBER reporter, Jan 2005. A review of these issues in asset pricing.
- Stocks as Money: Convenience Yield and the Tech-Stock Bubble. May 2002. The “arbitrage opportunity” in Palm vs. 3Com stock might be like the arbitrage opportunity between money and treasury bills. I document many similar features, including high turnover in the “overpriced” security. Presented at the Chicago Fed Conference on asset price bubbles, April 2002.
- The Risk and Return of Venture Capital (published version) Journal of Financial Economics, Volume 75, Issue 1, January 2005, 3-52. Last Manuscript Estimates the mean return, standard deviation, alpha and beta of venture capital investments, correcting for selection bias that we only see returns for successful projects. Even if you don’t like venture capital, the selection bias correction is interesting. Original December 2000. Appendix containing data and program descriptions plus extra algebra. See above data and programs link for data and programs.
- Review of Famous First Bubbles: The Fundamentals of Early Manias Journal of Political Economy 109, (October 2001),1150-1154. Review of the very nice book by Peter Garber, looking at the facts behind the tulip “bubble” and related myths. It turns out they are mythical. I had a lot of fun with this one.
- “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior” Journal of Political Economy, 107, 205-251 (April 1999) (With John Y. Campbell) JSTOR Manuscript with extra appendices A utility function with a slow-moving habit generates slow-moving countercyclical risk aversion. In turn this generates time-varying price/dividend ratio that forecasts stock returns, does not forecast dividends, and so forth. Balancing intertemporal substitution with precautionary savings gives a constant interest rate, the usual problem with habit models. The NBER working paper version includes a time-varying interest rate, which also generates yield spreads that forecast bond returns.
- Explaining the Poor Performance of Consumption-Based Asset Pricing Models (With John Y. Campbell). Journal of Finance 55(6) (December 2000) 2863-2878. The CAPM outperforms the consumption-based model in artificial data from the habit persistence model used in "By force of Habit.."
- Beyond Arbitrage: Good-Deal Asset Price Bounds in Incomplete Markets (With Jesus Saa-Requejo.) Journal of Political Economy 108, 79-119, 2000 We add a Sharpe ratio or discount factor volatility constraint to the standard no-arbitrage restriction and obtain useful bounds on option prices in environments that don't allow perfect replication. Most importantly we show how to do this in multiperiod and continuous-time, continuous-trading environments, and there are lots of applications and pretty pictures. Final manuscript with algebra appendix
- "Good-deal option price bounds with stochastic volatility and stochastic interest rate." (With Jesus Saa-Requejo) Manuscript Jan 1999 A real continuous-time, two-state variable application of the good deal technology.
- A rehabilitation of stochastic discount factor methodology Manuscript, July 2000 A short note showing how Kan and Zhou (1999) went wrong. Adapted from comments I gave to Jagannathan and Wang given at the spring 2000 NBER asset pricing meeting. The Journal of Finance does not publish corrections, even to flat-out mistakes, alas.
- A trio of review papers: These are fun, but I updated the themes and expanded them in subsequent reviews, including Asset pricing, Discount Rates and Financial markets and the real economy.
- New Facts in Finance Economic Perspectives XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), also NBER working paper 7169. This is a review essay of the transition from unpredictable returns and CAPM to predictable returns and multifactor models.
- Portfolio Advice for a Multifactor World Economic Perspectives XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), also NBER working paper 7170. This is a review and interpretation of how portfolio theory should adapt in a multifactor, predictable world described in New Facts in Finance. See especially the three dimensional update of the two fund theorem.
- "Where is the Market Going? Uncertain Facts and Novel Theories" Economic Perspectives XXI: 6 (November/December) 1997 (Federal Reserve Bank of Chicago), also NBER Working paper 6207. Will stocks average 9% for the next 50 years? The equity premium, return predictability, and a review of theories and facts.
- Rethinking Production Under Uncertainty Manuscript 1993. Standard production technologies y(t) = shock(t) f(k) allow transformation across time but not across states of nature. Hence, the marginal rates of transformation needed to construct a true “production based asset pricing model” are undefined. This paper starts to think about how one might sensibly construct a technology that allows producers to transform goods across states of nature, and hence to construct a real “production-based” model, independent of preferences. Also did not result in a published paper, as I got stuck on an identification problem.
- Production Based Asset Pricing 1988. NBER working paper 2776. This one uses two technologies and two states to infer contingent claims prices from production decisions, and matches the equity premium and term premium. It has nothing to do with the “Production-based” papers that came later in the Journal of Finance and JPE. I abandoned the project because it’s too easy – there are no probabilities in firm decisions with this standard technology, so it’s very easy to get contingent claims prices that differ from probabilities.
Recent work by Frederico Belo and Urbann Jermann may finally break through the identification problems and make the approaches of these last two papers work. - “A Cross-Sectional Test of an Investment-Based Asset Pricing Model” Journal of Political Economy, 104 (June 1996) A factor model with two investment returns (roughly, investment growth) to explain the cross section of stock returns. It is also where I first thought about conditional vs. unconditional models, scaling factors in GMM, and (somewhat dangerous) plots of average returns vs. predicted.
- “Asset Pricing Explorations for Macroeconomics”,1992 NBER Macroeconomics Annual 115-165. (With Lars Peter Hansen) Many variations on Hansen-Jagannathan bounds, including bounds that reflect the low correlation of consumption growth with asset returns, and bounds that reveal interest rate variation by variation in the conditional mean discount factor. A plea to take macro-finance seriously, aimed both at macro and finance audiences. It’s the only way to tell or even define if prices are “rational”, and what else sets marginal rates of transformation to marginal rates of substitution?
- “Explaining the Variance of Price-Dividend Ratios” Review of Financial Studies (1992) 5:2, 243-280 Variance of p/d = its ability to forecast returns + its ability to forecast dividend growth. It’s all the former, none the latter. The paper includes an alternative to Campbell-Shiller decomposition, and discount factor bounds coming from price-dividend moments.
- “Volatility Tests and Efficient Markets: A Review Essay” Journal of Monetary Economics 27 (May 1991) 463-485. A review essay supposedly about Shiller’s book. It got me to think hard about volatility tests, and prove that they are exactly equivalent to regressions that forecast returns from price-dividend ratios.
- Production-Based Asset Pricing and the Link Between Stock Returns and Economic Fluctuations. Journal of Finance 46 (1) (March 1991) 209-237. The q theory works pretty well if you difference it – investment growth is nicely correlated with stock returns, and the I/K ratio forecasts future stock returns. JSTOR
Macroeconomics, Monetary Economics, and Fiscal Theory of the Price Level
"A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money." (Adam Smith, Wealth of Nations, Vol. I, Book II, Chapter II. Thanks to Ross Starr for the quote).
- Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates December 2016. This paper combines the talk by that title with a much revised "Do Higher Interest Rates Raise or Lower Inflation," which no longer exists as a separate paper. The fact that inflation is quiet and stable at zero rates cleanly invalidates the standard old-Keynesian model, which predicts a deflation spiral, and almost as cleanly invalidates new-Keynesian sunspots. New Keynesian price stickiness plus fiscal theory selection works well. Stable inflation suggests a higher rate will raise inflation. That conclusion is very hard to escape, even temporarily. One fiscal theory mechanism with long term debt does it. Even that does not rescue traditional views of monetary policy. It would not be possible or wise to exploit even that negative sign.
- Stepping on a Rake: Replication and Diagnosis Decmember 2016 (First draft August 2016). A replication of Chris Sims's "stepping on a rake" paper. I also boil it down to the central ingredient, showing how even frictionless fiscal theory can deliver temporarily lower inflation after an interest rate rise. The replication is useful if you want to know how Sims derived his model or solved it; also useful as a guide to solving continuous-time sticky-price models with jumps. Previously titled "How to step on a rake." matlab program archive
- The New-Keynesian Liquidity Trap Revised again again June 2016. (A big revision). matlab program. In standard solutions, new-Keynesian models produce a deep recession with deflation at the zero bound. Useless government spending, technical regress, and capital destruction have large positive multipliers. The recession, deflation and policy paradoxes are larger when prices are less sticky, and news has larger effects for events further in the future. These features are all artifacts of equilibrium selection. For the same interest-rate policy, equilibria that limit a downward jump of inflation on news of the trap, for the same interest rate policy, reverse all these predictions. They predict mild inflation, little output variation, and negative multipliers during the liquidity trap. Their predictions approach the frictionless model smoothly, and promises in the far-off future have less effect today. Fiscal theory of the price level suggests the equilibria with limited jumps and effects. The previous draft
- Do Higher Interest Rates Raise or Lower Inflation? October 16 2015. This paper is superseded by Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates December 2016., full entry above.
- A response to Sims (2013) January 2015. Chris Sims' (2013) "Paper Money" seems to include a criticism of my "Determinacy and Identification with Taylor Rules". In fact, there is no fundamental disagreement between the two papers.
- Monetary Policy with Interest on Reserves Journal of Economic Dynamics & Control 49 (2014), 74-108. ( ScienceDirect link to published version, html and pdf) I analyze monetary policy with interest on reserves and a large balance sheet. I argue for the desirability of this regime on financial stability grounds. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy -- buying and selling government debt with no effect on surpluses -- can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though not with the usual signs in this model. Figures 2 and 3 are the best part -- the effects of monetary policy with and without fiscal coordination. I address theoretical controversies, and how the fiscal backing of monetary policy was important for the 1980s disinflation. A concluding section reviews the role of central banks. Matlab program.
- Inflation and Debt National Affairs 9 (Fall 2011). html An essay summarizing the threat of inflation from large debt and deficits. The danger is best described as a "run on the dollar." Future deficits can lead to inflation today, which the Fed cannot control. I also talk about the conventional Keynesian (Fed) and monetarist views of inflation, and why they are not equipped to deal with the threat of deficits. This essay complements the academic (equations) "Understanding Policy" article (see below) and the Why the 2025 budget matters today WSJ oped (on oped page).
- Determinacy and Identification with Taylor Rules. Journal of Political Economy, Vol. 119, No. 3 (June 2011), pp. 565-615. Online Appendix B. JSTOR link, including html, pdf, and online appendix.
Manuscript with Technical Appendix The technical appendix documents a few calculations. Don't miss starting
on Technical Appendix page 6 a full analytical solution to the standard three equation model. I include the manuscript just so equation references in the Technical Appendix will work, the previous links to the published version are better.
Most people think Taylor rules stabilize inflation: Inflation rises, the Fed raises interest rates; this lowers “demand’’ and lowers future inflation. New-Keynesian models don’t work this way. In the models, the Fed reacts to inflation by setting interest rates in a way that ends up increasing future inflation. Inflation is “determined” as the unique initial value that doesn't set off accelerating inflation. Alas, there is nothing in economics to rule out accelerating inflation or deflation. I conclude that new-Keynesian models with Taylor rules don’t determine the price level any better than classic fixed interest rate targets. Price level determinacy requires ingredients beyond the Taylor principle, such as a non-Ricaridan fiscal regime. I survey the new-Keynesian literature to verify that no simple answer to this problem exists. All of the fixes slip in a commitment by the government to blow up the world at some point.
Even if the new-Keynesian model did work, The parameters of the Taylor rule relating interest rates to inflation and other variables are not identified. You can't measure "off equilibrium" behavior from data in an equilibrium. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.
The appendix uncovers an interesting mistake in the classic Obstfeld and Rogoff (1983) attempt to prune inflationary equilibria, but also shows that reversion to a price level target can do the trick. The Techical Appendix has algebra for determinacy regions and solutions of the three-equation New-Keynesian model, as well as other issues.
This article supersedes the two papers titled "Inflation Determination with Taylor Rules: A Critical Review"and "Identification with Taylor Rules: A Critical Review" (September 2007).
"A Response to Sims (2003)" January 2015. Chris Sims' (2003) "Paper Money" seems to include a criticism of "Determinacy and Identification." In fact, there is essentially no fundamental disagreement between the two papers.
- Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic. January 2011 European Economic Review 55 2-30 ScienceDirect Link.
Why there was a big recession; will we face inflation or deflation, can the Fed do anything about it? Many facets of the current situation and policy make sense if you ask about joint fiscal and monetary policy. A fiscal inflation will look much different than most people think. Slides that go with the paper. Appendix with the algebra for government debt valuation equations. A short simple version, my presentation at the Fall NBER EFG conference. A video of a short presentation given to the University Alumni Club in New York, October 2010. Slides for the New York talk if you were there - Can Learnability Save New-Keynesian Models? Journal of Monetary Economics 56 (2009) 1109–1113. JME link .This is a response to Bennett McCallum’s “is the New-Keynesian Analysis Critically Flawed” which says yes. I think McCallum got it backwards -- the bounded equilibrium is not learnable, the explosive ones are learnable. Furthermore, I’m not convinced that a hypothetical threat by the Fed to take us to an “unlearnable” equilibrium is a satisfactory foundation for price level determination.
- Money as Stock Journal of Monetary Economics 52:3, (2005) 501-528. Revision of NBER Working Paper 7498 Feb. 2000. The fiscal theory of the price level made simple. The `government budget constraint' is not a constraint. I reopen the security market at the end of the day in a cash in advance model, and show that the price level is still determinate. I also resolve the criticism that the fiscal theory mistreats the "government budget constraint."
- "Long term debt and optimal policy in the fiscal theory of the price level" Econometrica 69, 69-116 (2001). The fiscal theory with long term debt, and how to match the fiscal theory with business-cycle variation in debt and inflation. We typically write fiscal theory models with one-period debt, but the maturity structure turns out to matter a lot. For example, if the government pays off a perpetuity, then the price level is determined by the coupon coming due each year and that year’s taxes, with no present value of future taxes. I also resolve the empirical puzzle that inflation and deficits seem not to commove. That’s exactly what we expect of a government that’s trying to smooth inflation in the face of fiscal shocks.
- The fiscal foundations of monetary regimes (paper, and powerpoint presentation) January 2003. The choice of monetary regime – interest rate rule, exchange rate peg, currency board, dollarization, etc. depends on fiscal constraints, especially for developing countries. Talk given at the 2003 NBER/NCAER Neemrana conference, India.
- The Fed and Interest Rates – a High Frequency Identification American Economic Review 92 (2002), 90-95. With Monika Piazzesi (previously NBER WP 8839) . We measure monetary policy shocks by how they surprise daily bond markets. There's a beautiful Taylor rule in interest rate forecasts.
- A Frictionless model of U.S. Inflation, in Ben S. Bernanke and Julio J. Rotemberg, eds., NBER Macroeconomics Annual 1998 Cambridge MA: MIT press, p. 323-384. My first foray into the fiscal theory. It includes a proof that you can't test for regimes -- the government debt valuation equation and the money demand equation hold in both equilibria, and there is no Granger causality prediction. I also explain the intuition of the fiscal theory. The goal was to write a "Fiscal history", to understand the path of US inflation via the fiscal theory. That turns out to be harder than I thought, and is still an ongoing project.
- What do the VARs Mean? Measuring the Output Effects of Monetary Policy Journal of Monetary Economics 41:2 April 1998 277-300 (Revision of NBER WP 5154 June 1995; (Manuscript with a bit clearer pdf). Responses to monetary policy shocks seem long and drawn out. Do we need models with extensive frictions? No, because the response of policy to policy shocks is also drawn out. If you allow expected policy to affect output and inflation, you can make sense of drawn out impulse-response functions with a very short structural response, but a long-lasting impulse.
- Macroeconomics in Russia” in Economic Transition in Eastern Europe and Russia: Realities of Reform, Edward Lazear Ed., Hoover Institution Press, 1995. Imagine for a moment that the Federal Reserve imposed the following policies in the United States: Every company must pay for all its inputs before they are shipped, and taxes must also be prepaid. But there is no trade credit, and banks do not make working capital loans to purchase inputs. Checks take 90 days to clear… Chaos would result… This is roughly what happened in Russia during the summer of 1992. The story… points to the importance of macroeconomic policies, and the unintended macroeconomic effects of policy, in understanding developments in Russia and the Former Soviet Union. It also suggests that many macroeconomic problems are not inevitable consequences of the transition to a market economy, but rather that they are avoidable unintended effects of partial liberalizations.
- “Shocks” Carnegie-Rochester Conference Series on Public Policy 41, (December 1994) 295-364. A comprehensive look at which shocks matter and which don’t, including technology, money, oil and credit. None of the above accounts for much of economic fluctuations or inflation. Monetary policy shocks in particular account for very little output fluctuation and zero inflation variation. “Consumption” shocks, reflecting information agents see but we do not see do a pretty good job, but are harder to integrate into economic theory.
- Inflation Stabilization in the Reforming Socialist Economies: The Myth of the Monetary Overhang” Comparative Economic Studies 33:2 (1991) 97-122. (With Barry W. Ickes.)
- A Simple Test of Consumption Insurance” Journal of Political Economy 99:5 (October 1991) 957-976. Are consumers effectively insured against idiosyncratic shocks, either by formal institutions such as charities, private insurance, government programs, or by informal mechanisms such as gifts and “loans” from relatives, friends and neighbors? I test for insurance using regressions of consumption growth on exogenous variables. Thinking through the specification of the regressions is not easy. I reject full insurance for long illness and involuntary job loss, but not for spells of unemployment, loss of work due to a strike and an involuntary move.
- “The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives” American Economic Review 79 (June 1989) 319-337. Many tests of the permanent income model or consumption based asset pricing models exploit predictions that imply trivial utility costs. For example, adjusting consumption when you get the check rather than when you get the news can have utility costs of a few cents. Since our models abstract from small real-world costs and frictions, I proposed the idea of using the region of trivial utility costs as a measure of “economic standard errors” for model predictions.
- The Return of the Liquidity Effect: A Study of the Short Run Relation Between Money Growth and Interest Rates” Journal of Business and Economic Statistics 7 (January 1989) 75-83. In the short run, we expect money growth and interest rates to be negatively correlated – the “liquidity effect.” In the long run, they should be positively correlated – the “inflation effect.” I used bandpass filters to isolate the “runs” and confirmed this prediction. This paper was part of my PhD thesis, and inspired by reading a misleading graph in a Wall Street Journal Op Ed that claimed we were in a new “super-neutrality” regime in which the correlation was always positive.
This was my job market paper, many years ago. Morals: write your thesis on something interesting, not a complex extension of your adviser's latest theory. Do something fun in your job market talk, like demonstrate bandpass filters by swinging your keys. Have Lars Hansen discover a really interesting mistake in technical Appendix C of your job market paper. You too might get a job at Chicago
Health insurance, health economics
- After the ACA: Freeing the market for health care Sept 2015 In The Future of Healthcare Reform in the United States Edited by Anup Malani and Michael H. Schill, p 161-201, University of Chicago Press. An essay on health care, first presented at the conference, The Future of Health Care Reform in the United States, at the University of Chicago Law School. Most of the policy discussion is focused on health insurance. But the health care market is dysfuctional, and needs to be fixed as well. Where are the Southwest Airlines, Walmart and Apple of health care, bringing cost saving, efficiency, and innovation? I argue that we need a big freeing up of health care markets. I also focus more than usual on supply restrictions. It doesn't do much good for people to pay with their own money if suppliers cannot respond to that demand. Last manuscript in case of copyright problems with the published version above.
- Health-Status Insurance. Feb. 18 2009. In Cato's Policy Analysis No 633. If you get sick and lose health insurance you are stuck -- your premiums skyrocket or you may not be able to get insurance at all. The article shows how private markets can solve this problem. If you get sick, your health premiums go up but a separate "premium increase insurance contract" pays a lump sum so that you can afford the higher health premiums. The big advantage is freedom and competition: now health insurance can freely compete for all customers all the time. This piece is written for a nontechnical popular audience, with a lot of policy discussion. This paper explains the basic framework of Time-Consistent Health Insurance (next) and thinks through lots of real-world issues and answers to "what ifs." "What to do about pre-existing conditions" in the Wall Street Journal August 14 2009 and Health Status insurance Investors Business Daily (local link) April 2 2009 are op-eds explaining the basic idea.
- “Time-Consistent Health Insurance” Journal of Political Economy, 103 (June 1995) 445-473. None of us has health insurance, really. You get sick, you lose your job or get divorced, and now you have a preexisting condition. This paper shows how to implement “premium increase insurance” that gets around the problem. If you get sick, you get a lump sum that allows you to pay higher insurance premiums. It allows a private-market solution to the main problem of health insurance attracting regulation.
Time-series; Unit roots; Permanent and transitory components
- A Brief Parable of Overdifferencing January 2012. This is a short note, showing how money demand estimation works very well in levels or long (4 year) differences, but not when you first-difference the data. It shows why we often want to run OLS with corrected standard errors rather than GLS or ML, and it cautions against the massive differencing, fixed effects and controls used in micro data. It's from a PhD class, but I thought the reminder worth a little standalone note.
- Continuous-time linear models Foundations and Trends in Finance 6 (2011), 165–219 DOI: 10.1561/0500000037 Manuscript How to do ARMA models, opreator tricks, and Hansen-Sargent prediction formulas in continuous time. Why, you ask? I needed to teach myself these tricks in order to solve a Linear-quadratic asset pricing economy with complex habits and durability. In turn, I was hoping that model would provide a good example for A Mean-Variance Benchmark for Intertemporal Portfolio Theory. It didn't, but now I, and I hope you, know how to do all the discrete-time tricks in continuous-time models.
- Time series for macroeconomics and Finance Jan 2005 Lecture notes for PhD time series course. This revision finally includes the figures!
- Permanent and Transitory Components of GNP and Stock Prices” Quarterly Journal of Economics CIX (February 1994) 241-266. This is my favorite solution to the permanent/transitory decomposition issue for GNP and stock prices. I use bivariate autoregressions of consumption and GNP, and of dividends and stock prices. Consumption and dividend growth are unpredictable, so act as stochastic trends for GNP and stock prices. A movement in stock prices with no current change in dividends is completely transitory, so can be labeled an “expected return” shock. A movement in stock prices with a change in dividends is permanent and so is a “permanent earnings” shock. Note the QJE switched Figure II and III.
- A Critique of The Application of Unit Root Tests Journal of Economic Dynamics and Control 15 (April 1991) 275-284. Running a battery of unit root/cointegration tests and then imposing the answers on subsequent analysis is a bad idea. Alas, there is no substitute for plotting the data and thinking about what makes sense.
- Multivariate Estimates of the Permanent Components in GNP and Stock Prices Journal of Economic Dynamics and Control, 12 (June/July 1988) 255-296. (With Argia M. Sbordone). This paper sits halfway between the “random walk in GNP” JPE and “permanent and transitory components” QJE. The “random walk” is univariate. Here, we realized that consumption could tell you a lot about the permanent component of GNP. Here, we use that insight in spectral and variance-ratio calculations. The answers are the same as in “permanent and transitory components”, but I now prefer the simpler VAR treatment in that paper. When GNP or stock prices are cointegrated with a random walk the subtle long-horizon and “nonparametric” techniques needed in the “random walk in GNP” really are no longer needed; short order models to produce good long-term forecasts.
- How Big is the Random Walk in GNP? Journal of Political Economy 96 (October 1988) 893-920. Short-order ARMA models suggest that GNP looks a lot like a random walk. But short-order ARMA models are fit to match one-step ahead forecasts, and can do a poor job of capturing long-term forecastability. I used a variance-ratio statistic (variance of long-term differences / variance of one-year differences) to show that there is a lot of mean-reversion in GNP that short-order ARMA models miss. I think the subsequent “permanent and transitory components” answers the substantive question better, but the warning about using long-term implications of short-term models remains worthwhile today.
Talks and Comments
(Most are written, some are published, a few are only the slides)
- Comments on "A Behavioral New-Keynesian Model" by Xavier Gabaix. Comments presented at the October 21 2016 NBER EFG meeting. The model is really important. It is an alternative to active Taylor rules in NK models, solving zero bound and other problems. But it puts a lot of irrationality deeply at the heart of monetary economics. Slides
- Volume and information. Comments on "Random Risk Aversion and Liquidity: a Model of Asset Pricing and Trade Volumes" by Fernando Alvarez and Andy Atkeson. Comments presented at the Conference in Honor of Robert E. Lucas Jr., Becker-Friedman Institute, October 7 2016. Andy and Fernando have a nice paper, which I pretty much ignored and summarized some thoughts on the big puzzle of volume instead.
- Michelson-Morley, Occam and Fisher: The radical implications of stable inflation at the zero bound Slides for talk at the European Financial Association, August 2016. This will become a paper sometime in the fall. It's an evolution of the similar slides for my talk given at the Columbia-New York Fed conference honoring Michael Woodford May 18-19 2016. The ZLB is a deeply revealing moment for monetary economics, like Michelson-Morley's famous experiment. Nothing happened. Many theories say big things should have happened, and those theories are wrong. (Well, unless you add epicycles, ether drag, or other ugly complications. Hence Occam's razor.) In the new version I incorporate Sims' insight for how to get a temporary negative inflation out of a rate rise. In the same vein slides for a 1.5 hour MBA class covering all of monetary economics from Friedman, Sargent-Wallace, Taylor, Woodford, and FTPL.
- Equity-financed banking and a run-free financial system Talk given at the Minneapolis Federal Reserve's "Ending too big to fail" symposium, May 16 2016.
- Comments on 'Global Imbalances and Currency Wars at the ZLB,' by Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas. Comments presented at the conference, "International Monetary Stability: Past, Present and Future," Hoover Institution, May 5 2016. The paper. The paper models "Global imbalances," "savings gluts," "safe asset shortages," and so forth, with a dramatic "tipping point" at the zero bound. At the bound "inability to produce safe assets" in one country spills over to output gaps at another one. I outline a different world view and contrast the two worlds.
- The fiscal theory of the price level and monetary policy: An agenda April 1, 2016. Slides for a talk at the Next Steps for the Fiscal Theory of the Price Level conference at the Becker-Friedman Institute, April 1 2016. The Fiscal Theory is that the real value of nominal debt equals the present value of primary surpluses. The agenda is making this fact come alive in the analysis of history, of data, of policy, and of better monetary and fiscal regimes. To that end, I argue we've paid to much attention to surpluses, and not enough to discount rates or to debt and monetary policy. I show how we need discount rates to understand the cyclical variation of inflation, and how monetary policy is quite strong in the fiscal theory, by the ability to control nominal interest rates and thus expected inflation.
- Comments on Bauer and Hamilton. Nov 5 2015. Comments on Robust Bond Risk Premia by Michael Bauer and Jim Hamilton, at the 5th Conference on Fixed Income Markets, San Francisco Federal Reserve, Nov 5 2015. I look at the evidence whether macro variables help to forecast bond returns. It turns out a trend does even better, pushing the R2 up to 62 percent! That finding suggests that specification issues rather than distribution theory are the central problems. I don't find that the Bauer-Hamilton effect size distortion is big. I document measurement errors in the data, which are a good target for econometric help. I opine we need to spend less attention on one asset at at time forecasting and more attention on the factor structure of expected returns across assets, and how that structure lines up with covariances of returns with shocks. There is also a little example of perfect non-spanning in a term structure model; bond yields have an exact one factor model, but a non-spanned factor drives expected returns. Programs and data (zip)
- Comments on "How Can Central Banks Deliver Credible Commitment and be 'Emergency Institutions'" By Paul Tucker. In John H. Cochrane and John B. Taylor, Eds., Central Bank Governance and Oversight Reform, Hoover Institution Press May 2016, p. 31-36. (Chapter pdfs available here) Comments presented at the Hoover conference by the same name, May 21, 2015. Tucker's paper here. Tucker wisely advocates rules for mop ups, lender of last resort, bailouts, etc. I agree, but wouldn't lots more equity so you don't have to mop up be simpler?
- Comments on Gary Hansen and Lee Ohanian, "Neoclassical Models of Aggregate Economies" at the Conference on the Handbook of Macroeconomics, Volume 2, Hoover Institution, April 11 2015.
- Comments on Gauti Eggertsson and Neil Mehrotra, "A Model of Secular Stagnation," slides presented at the NBER EFG meeting, July 2014.
- Comments on Aytek Malkhozov, Philippe Mueller, Andrea Vedolin, and Gyuri Venter, "Mortgage Risk and the Yield Curve," slides presented at the NBER AP meeting, July 2014.
- Having your cake and eating it too: The maturity structure of US debt November 12 2012 How the US Treasury can both lengthen and shorten its debt at the same time, to buy insurance against interest rate rises and provide "liquidity." A short paper diguised as comments on Greenwood, Hanson, and Stein “A Comparative Advantage Approach to Government Debt Maturity” at the Second Annual Roundtable on Treasury Markets and Debt Management , US Treasury, Nov. 15 2012
- Comments on "Volatility, the Macroeconomy and Asset Prices, by Ravi Bansal, Dana Kiku, Ivan Shaliastovich, and Amir Yaron, and “An Intertemporal CAPM with Stochastic Volatility” by John Y. Campbell, Stefano Giglio, Christopher Polk, and Robert Turley. Also slides. April 13 2012 Comments presented at the spring NBER asset pricing meeting. I took the opportunity to offer a sceptical apparisal of long-run risks, and whether stochastic volatilty really works as a state variable, especially in the long run.
- The Fiscal Theory of the Price Level and its Implications for Current Policy in the United States and Europe November 19, 2011 This is the text of my presentation at the concluding panel of the conference, “Fiscal Policy under Fiscal Imbalance,” hosted by the Becker-Friedman Institute and Federal Reserve Bank of Chicago.
- Quantitative Easing 2, March 3 2011 Comments on Jim Hamilton and Jing Wu, 2011, "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment", at the spring NBER Monetary Economics meeting. Slides. (The Op-ed section contains several op-eds and blog posts on qe2.)
- Nova/Atrium Lecture in Macro/Finance. (Video) (Also web page on the event) Lecture given at NOVA school of business and economics in Lisbon, Portugal, 2010. Thinking through fiscal and monetary policy, along the lines later written up in Inflation and Debt and Understanding fiscal and monetary policy in the great recession.
- Bond Supply and Excess Bond Returns May 2008. Comments on Robin Greenwood and Dimitri Vayanos’ paper for the IGM “Beyond Liquidity ” conference at the GSB Gleacher center, May 9-10 2008. The paper from Dimitri’s website . I learned two important lessons in reading and thinking about this paper. 1) When arbitrageurs are limited by risk-bearing capacity, “downward-sloping” demands depend on correlations. The paper and my comments have a lovely example in which arbitrageurs are asked to hold more long-term bonds and less short-term bonds. The result is that all yields go up! Why don’t long yields go up and short yields go down? Because risks are described by a one-factor model, so all that matters is how much overall duration risk arbitrageurs have to hold. 2) We’re probably doing a bad job of correcting for serial correlation in all predictive regressions. Typically, we think expected returns move slowly over time. The right hand variable also moves slowly over time, but doesn’t capture all of the expected return variation. This situation means that residuals have a slow-moving AR(1) plus an unforecastable component, which is the same thing as an ARMA(1,1). This structure will be very poorly captured by standard “nonparametric” procedures such as Newey-West, since you’re unlikely to put in enough lags to capture the long-run component, and also poorly captured by parametric procedures like fitting an AR(1). “Short” samples make the problem worse. More in the comments.
- Risks and Regimes in the Bond Market. April 2008. Comments on Atkeson and Kehoe’s paper for the 2008 Macroeconomics Annual. Risk premia are important for understanding interest rates, and monetary policy. I see no evidence for “anchored expectations” in interest rate data. Once you take account of risk premiums, expected long run interest rates are still very volatile. The yield curve has not become more downward sloping on average, as it should if inflation risks have decreased. If anything, risk premia in long-term bonds are increasing. Atkeson and Kehoe advocate a fascinating view that risk premia cause monetary policy, not vice versa.
- Daily Monetary Policy Shocks and the Delayed Response of New Home Sales by James D. Hamilton. April 2007 Comments given at NBER Monetary Economics program meeting, NY. Includes some new thoughts on what a monetary policy shock is.
- “The Returns to Currency Speculation” by Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski and Sergio Rebelo. Comments given at Jan 2007 AEA/AFA meetings. (Slides only)
- ‘Macroeconomic Implications of Changes in the Term Premium’ by Glenn Rudebusch, Brian Sack and Eric Swanson. Comments given at the conference “Frontiers in Monetary Policy Research” at the St. Louis Federal Reserve, October 19 2006. Of course, I can’t stick to the topic and offer a survey instead. In particular, lots of salty comments on the “conundrum” in long bond prices (silly, in my view). The paper from the St. Louis Fed website.
- Anomalies by Lu Zhang, 2004 presented at the November 2004 AP meeting. A great paper, but a first-order condition is not an "explanation."
- “A new measure of Monetary Policy” by Christina and David Romer, presented at the July 2004 EFG meeting.
- What ends recessions? by David and Christina Romer, 1994 NBER Macroeconomics Annual 58-74. JSTOR What are monetary policy shocks? The fed never says “and another 50 bp for the heck of it.” This led to “What do the VARs mean?” above
- “Why Test the Permanent Income Hypothesis? European Economic Review 35 (4) May 1991. Comments on ‘The Response of Consumption to Income: a Cross-Country Investigation’” by John Campbell and N. Gregory Mankiw, Why indeed, now that we think of equilibrium models, not a “consumption function.”
- What Should Macroeconomists Know About Unit Roots? 1991 NBER Macroeconomics Annual 6, (1991), 201-210. Comments on ‘Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots’” by John Campbell, JSTOR Another blistering critique of the (mis) use of unit root econometrics.