The Two New Tools of Monetary Policy

Every basic exposition of how monetary policy is conducted before about 2008 is soon to become obsolete. The three basic monetary policy tools that used to be taught in almost every introductory economics course were changing reserve requirements, changing the discount rate, and conducting open market operations. Because of the way in which monetary policy was conducted during the Great Recession, all three tools have become essentially irrelevant. In the future, The Federal Reserve will mainly influence interest rates through two quite different tools that didn't even exist before 2008: primarily by using the rate of interest that it chooses to pay on bank reserves, and secondarily using its new reverse repo facility.

There's no secret about these new tools.  For example, here's an explanation from September 16-17 meeting of Federal Open Market Committee:

• When economic conditions and the economic outlook warrant a less accommodative monetary policy, the Committee will raise its target range for the federal funds rate. 
• During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances. 
• During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate. 

Let's do a quick review of the old monetary policy tools, explain why they no longer work, and then introduce the new monetary policy tools.

In the old days before 2008, monetary policy worked because banks were required to hold reserves with the central bank, but baanks typically tried not to hold extra reserves, because it used to be that money being held with the central bank earned no return. The requirement that banks hold reserves gave the central bank leverage over how much credit banks were willing to offer, and led to what used to be considered the three main tools of monetary policy.

1) The central bank could alter the reserve requirement, which meant that banks had either more or less to lend than before.

2) If a bank reached the end of a business day and found that the last round of transactions had left it a little short of what it needed to be holding, one option was to borrow the additional funds from the central bank. When doing so, the bank would need to pay an interest rate called the discount rate. So by raising or lowering the discount rate, the central bank could influence whether a bank kept a fairly small or fairly large cushion of reserves over and above the required amount--and thus affect the bank's willingness to lend.

3) However, banks usually preferred not to borrow from the central bank, because doing so was often viewed as a danger signal that no other private bank was willing to lend to you. Instead, banks that were running a little short of reserves at the end of the day's transactions borrowed overnight from other banks and paid the so-called "federal funds interest rate." The Federal Reserve treated this federal fund interest rate as a target for monetary policy. It would buy or sell government bonds to set the federal funds interest rate at a desired level.

For example, here's  a figure (from the ever-useful FRED website run by the Federal Reserve Bank of St. Louis) showing the federal funds rate over time. You can tell the history of monetary policy back a half-century by the Fed reducing this federal funds rate in recessions (the gray bars) and increasing it when recessions were over and inflation seemed at least a potential threat.  You can also see how the Fed took this interst rate to near-zero during the Great Recession, and has held it there ever since, which is why there has been a need to use quantitative easing and forward guidance as tools of monetary policy since then.

Notice that all three of these traditional tools of monetary policy  rely in one way or another on banks being fairly close to the level of required reserves. However, as part of its "quantitative easing" response to the financial crisis, the Fed started buying large quantities of government debt and mortgage-backed securities. Instead of holding these bonds and securities, banks found that they were holding very large quantities of cash reserves, far above the legally required level. To be specific, U.S. banks were legally required to be holding $101 billion in reserves as of October 29, but they were actually holding $2,557 billion in reserves--about 25 times the required amount.

But when banks are holding large quantities of extra reserves, the old-style monetary policies don't work. Change the reserve requirement? Reducing it won't matter, and unless the central bank raises it by a multiple of 25, raising doesn't matter either. Also, no one wants to try to lock up these excess bank reserves, because the hope is that banks will find ways to lend this money. Altering the discount rate has no effect if banks don't need to borrow from the central bank, because there is no danger they will run short of reserves. And banks don't need to borrow much from each other at the federal funds interest rate, either, again because they are holding such high levels of reserves. Indeed, the quantity loaned and borrowed at the federal funds interest rate has dropped dramatically in recent years, as shown in this figure from economists at the Federal Reserve Bank of New York.

The situation of banks holding vastly more reserves than legally required, as a result of the quantitative easing policies of the Fed, seems likely to persist for years to come. So when the Federal Reserve decides that it wishes to raise the federal funds interest rate, what monetary policy tools will work in this situation?

The main monetary policy tool of the future is likely to be the amount of interest that the Fed pays on these bank reserves. Traditionally, the Fed paid zero percent interest on bank reserves. But a law passed in 2006 authorized the Fed to start paying interest on reserves as of 2011, and the Emergency Economic Stabilization Act of 2008 allowed the Fed to start paying interest on bank reserves as of October 1, 2008. The current interest rate paid by the Federal Reserve to banks on their excess reserves is 0.25 percent. By altering this interest rate, the Federal Reserve has a tool that can directly affect how much banks want to hold in reserves and how much they are willing to lend and at what interest rates. For example, say that the Fed gradually raised the interest rate it is paying on bank excess reserves. In that case, banks would be more likely to hold funds in the form of reserves with the central bank and less likely to make loans, including making overnight loans to each other in the federal funds market, which should tend to push up interest rates. In short, when the Fed decides that it's time to raise interest rates, the policy tool you should be watching is the interest rate charged on bank reserves.

What if this new policy tool doesn't work well? The back-up monetary policy tool, as the Fed said in the quotation above, is the "overnight reverse repurchase agreement facility," which will be used "only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate."

Some definition of terms for those uninitiated in repurchase markets may be useful here. In a "repurchase agreement," one party sells a security to another, while simultaneously agreeing to repurchase it at a slightly higher price in the near future--often the next day. For the other party, the one which is agreeing to buy a security and then sell it back the next day, this is called a "reverse repurchase" or reverse repo agreement. The Fed is has been testing its ability to operate in the  repurchase market since September 2013, first selling and then buying back Treasury securities. Here's a description of reverse repurchase agreements from the Federal Reserve Bank of New York, which would be conducting these operations.

A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Desk [the New York Fed trading desk] sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.

For policy purposes, the key point here is the last sentence: a repurchase agreement is really a form of very short-term lending and borrowing. Investors who have a lot of cash are always looking for a chance to earn a return, even a small return. When an investor with cash buys a Treasury bond from the Fed, and then sells it back to the Fed the  next day, that investor has received, in effect, an interest payment on their cash. Thus, when the Fed conducts its repurchase operations, it is in effect setting the level of interest rates for very short-term overnight borrowing. Such overnight borrowing using Treasury bonds as collateral is very similar to the overnight borrowing that banks do with each other at the federal funds interest rate.

Jeremy Stein, who left the Federal Reserve Board of Governers in May, spells out how this will work in an interview last July with Ylan Q. Mui in the Washington Post. Basically, the notion is that the interest rate paid on reserves will establish a ceiling for the federal funds interest rate, while the interest rate embedded in the reverse repo facility will set a floor under that rate. But how much space there will be between the ceiling and the floor, and just how these tools will be used in setting monetary policy, is still very much a work in progress, waiting for when the Fed decides it is actually time to raise the federal funds interest rate.

For purely pedagogical reasons, I'm hoping the use of reverse repos doesn't come up too frequently and can largely ignored, because explaining that tool of monetary policy to an intro-level economics class will be just no fun at all.

Why Different Unemployment Measures Tell (Mostly) the Same Story

As the unemployment rate has decreased during the last few years, from its peak of 10% in October 2009 to 5.9% in September 2014, it's become common to hear a cynical reaction along the following lines: "Sure, the official unemployment rate was 5.9% in September 2014, but when you take into account those who have become too discouraged too for a job and those with a part-time job who would prefer full-time work, the real unemployment rate is twice as high at 11.8%."

This comment is usually made in a "gotcha" tone, with a eyebrow-lifting emphasis on official and real, as if those nefarious government economic statisticians are trying to pull a fast one on the unsuspecting public. But color me unsurprised that if you define "unemployment" in different ways, you get a different number. In fact, the Bureau of Labor Statistics has been publishing alternative unemployment rates quite openly since 1976.  Vernon Brundage lays out the distinction in "Trends in unemployment and other labor market difficulties," written as the November 2014 "Beyond the Numbers" from the U.S. Bureau of Labor Statistics.

Here are the six measures of unemployment produced by the BLS. U-3 is the official unemployment rate. (Wiggle eyebrows on official as needed.)

• U‑1: People who are unemployed for 15 weeks or longer as a percent of the civilian labor force.
• U‑2: Job losers, plus people who completed temporary jobs, as a percent of the civilian labor force.
• U‑3: Total number of people who are unemployed as a percent of the civilian labor force (official unemployment rate).
• U‑4: Total number of people who are unemployed, plus discouraged workers, as a percent of the civilian labor force plus discouraged workers.
• U‑5: Total number of people who are unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force.
• U‑6: Total number of people who are unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force.

When looking at how any economic statistic has changed over time, it's important to compare apples to apples. So if you are interested in the question of how the unemployment rate has changed, it's not useful to point out that different definitions of unemployment provide different answers. These six definitions of unemployment typically move pretty much together.

So if you want to focus on a broader measure of unemployment like U-6 that includes those who have become discouraged in looking for work and part-timers who would like full-time work, fair enough: That measure of unemployment was 17.2% in April 2010, and has fallen to 11.8% in September 2014. But pick a measure of unemployment, any measure of unemployment, and the U.S. economy is doing much better now than back in the dark days of 2009 and 2010.

Of course, the relationships between these measures of unemployment do change over time. For exmaple, the U-2 measure of unemployment has usually been higher that U-1, but they have been about the same in the last few years. Brundage explains:

For most of the history of these series, the number of persons unemployed for 15 weeks or longer (the numerator for U‑1) had been less than the number of people who had lost their jobs or completed temporary jobs (the numerator for U‑2), even during economic downturns. ... However, the two series began to converge shortly after the end of the recession, largely reflecting a greater increase in the number of people who were unemployed for 15 weeks or longer during the downturn. In December 2007, the number of people who had been unemployed for 15 weeks or longer (2.5 million) was well below the number of job losers (3.9 million). In September 2014, 4.4 million people had been jobless for 15 weeks or longer and 4.5 million had lost their jobs; thus, the U‑1 and U‑2 rates were very similar, at 2.8 and 2.9 percent, respectively.

The other change is that the ratio between the broadly defined U-6 unemployment rate and the U-3 official unemployment rate has risen. The broadly defined U-6 rate adds the official unemployment rate to the part-timers who would prefer a full-time job and to the "marginally attached" who have largely given up looking for work. As this figure shows, the number of the marginally attached  has actually not risen too much, but the number of part-timers who would prefer full-time work remains elevated since the end of the recession.

In short, there's no conspiracy here by government statisticians to lowball the official unemployment rate. Each measure of unemployment is defined differently. Each one conveys different information about the labor market. And that's why the Bureau of Labor Statistics quite openly and transparently publishes six different measures.

Credit Without Banks: Shadow Banking

One of the vivid lessons of the 2007-2009 recession and financial crisis is that in the modern economy, one can't just think about the financial sector as made up of banks and the stock market. Other financial institutions can go badly wrong, with dire consequences. The Global Shadow Banking Monitoring Report 2014 from the Financial Stability Board helps give a sense of these other non-banking financial institutions--especially those that sometime act in bank-like ways by receivin funds from investors, lending out those funds, and receiving interest payments.

The Financial Stability Board is an international working group that bubbled up in 2009 in the wake of the financial crisis. As it describes itself: "The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. It brings together national authorities responsible for financial stability in 24 countries and jurisdictions, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts."

The FSB starts with a measure of "Other Financial Institutions," which includes "Money Market Funds, Finance Companies, Structured Finance Vehicles, Hedge Funds, Other Investment Funds, Broker-Dealers, Real-Estate Investment Trusts and Funds." Here's a figure showing how these "other financial institutions" (the red and blue bars) compare in size with the banking sector (the yellow bars) in a number of countries. In the U.S., for example, the "other financial institutions" are bigger than the banking sector.

What's up with the huge size of the "other financial institutions" in the Netherlands? The report says: "In the Netherlands, Special Financial Institutions (SFIs) comprise about two-thirds of the OFIs sector and thereby explain most of the size of the shadow banking sector. There are about 14 thousand SFIs, which are typically owned by foreign multinationals who use these entities to attract external funding and facilitate intra-group transactions." For a discussion of what some of these Dutch Special Financial Institutions are doing, you can check my post from last June on the Double Irish Dutch Sandwich. 

Obviously, not all of these "other financial institutions" are engaged in bank-like activities outside the banking sector. Some are acting in ways that don't involve bank-like activities making a loan and expecting an interest payment--for example, they may just be investing in stock of companies or in land, or working with financial derivatives that involve commodity prices or exchange rates or interest rate movements. Some of these are interconnected with banks in ways that means they are covered by the bank regulatory apparatus, So the FSB tries to subtract these activities out, and get an estimate of the "shadow banking" sector by itself. For the U.S., shadow banking is estimated at about half of the total of "other financial institutions," at roughly $13 trillion in assets.

I've discussed the concerns with shadow banking on this blog before (for example, here and here). The short story is that we learned long ago that economic instability can interact with instability in the banking sector in a way that causes economic and financial weakness to feed on each other in a vicious circle. This is why pretty much every country in the world has bank deposit insurance (to prevent bank runs) and bank regulation (to prevent banks from taking too much risk). But there are lots of "other financial institutions" that receive funds and make loans. This "shadow banking" sector too can be part of a vicious circle of economic and financial instability, as we learned from 2007-2009, and since. ere's the FSB explanation of what shadow banking iis and why it matters. 

The “shadow banking system” can broadly be described as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” or non-bank credit intermediation in short. Such intermediation, appropriately conducted, provides a  valuable alternative to bank funding that supports real economic activity. But experience from the crisis demonstrates the capacity for some non-bank entities and transactions to operate on a large scale in ways that create bank-like risks to financial stability (longer-term credit extension based on short-term funding and leverage). ...

Like banks, a leveraged and maturity-transforming shadow banking system can be vulnerable to “runs” and generate contagion risk, thereby amplifying systemic risk. Such activity, if unattended, can also heighten procyclicality by accelerating credit supply and asset price increases during surges in confidence, while making precipitate falls in asset prices and credit more likely by creating credit channels vulnerable to sudden loss of confidence. These effects were powerfully revealed in 2007-09 in the dislocation of asset-backed commercial paper (ABCP) markets, the failure of an originate-to-distribute model employing structured investment vehicles (SIVs) and conduits, “runs” on MMFs and a sudden reappraisal of the terms on which securities lending and repos were conducted. But whereas banks are subject to a well-developed system of prudential regulation and other safeguards, the shadow banking system is typically subject to less stringent, or no, oversight arrangements.

One part of the report focuses on the Americas, and here's a figure I found thought-provoking. The horizontal axis shows "other financial institutions" relative to GDP, while the vertical axis shows the banking sector relative to GDP. At the far upper right is the Cayman Islands, with a very large banking sector and a very large "other financial institutions" sector relative to GDP. The other two countries with very large banking sectors relative to GDP are Panama and Canada. To put it another way, Panama has a banking sector like the Cayman Islands, but much less of the "other financial institutions."



To me, the interesting comparison is between the U.S. and Canada--both high-income countries with sophisticated financial sectors. Clearly, the U.S. has a larger share of financial activity happening in the "other financial institutions" area, while Canada has a larger share of its financial activity happening explicitly in the banking sector. The Canadian economy is of course closely tied to the U.S economy. But the recession in Canada was milder than in the U.S., perhaps in part because Canada's financial sector was less exposed to the issues of shadow banking. Given that the banking sector is far more regulated in both countries, this offers a sort of natural experiment or comparison as the economies of the two countries evolve.

A North American Vision

When talking about the U.S. role and prospects in a globalizing economy, it's common to read discussions of issues relating to China, Japan, the European Union, and the "emerging market" countries. But perhaps when thinking about the U.S. economic and geopolitical future, a more basic building block should be to establish closer ties across North America. A report from the Council on Foreign Relations argues this case in "North America: Time for a New Focus" (Independent Task Force Report No. 71, David H. Petraeus and Robert B. Zoellick, Chairs Shannon K. O’Neil, Project Director). Here's a taste of the overall tone:

"[W]e believe that the time is right for deeper integration and cooperation among the three sovereign states of North America. Here is our vision: three democracies with a total population of almost half a billion people; energy self-sufficiency and even energy exports; integrated infrastructure that fosters interconnected and highly competitive agriculture, resource development, manufacturing, services, and technology industries; a shared, skilled labor force that prospers through investment in human capital; a common natural bounty of air, water, lands, biodiversity, and wildlife and migratory species; close security cooperation on regional threats of all kinds; and, over time, closer cooperation as North Americans on economic, political, security, and environmental topics when dealing with the rest of the world, perhaps focusing first on challenges in our own hemisphere. ...  

The people of North America are creating a shared culture. It is not a common culture, because citizens of the United States, Canada, and Mexico are proud of their distinctive identities. Yet when viewed from a global perspective, the similarities in interests and outlooks are pulling North Americans together. The foundation exists for North America to foster a new model of interstate relations among neighbors, both developing and developed democracies. Now is the moment for the United States to break free from old foreign policy biases to recognize that a stronger, more dynamic, resilient continental base will increase U.S. power globally. “Made in North America” can be the label of the newest growth market. U.S. foreign policy—whether drawing on hard, soft, or smart power—needs to start with its own neighborhood."

The report stresses four main areas for cooperation: energy, cross-border economic ties, security concerns, and what it calls "community." Here are a few words on each.

North America and Energy

North American already has tied together its energy markets in various ways: "For many years, virtually all of Canada’s energy exports—including oil, gas, and electricity—went to the United States. ... The North American countries are also connected through their electricity grids; this is especially true for the United States and Canada. The Eastern Interconnection grid—encompassing parts of Eastern Canada, New England, and New York—and the Western Interconnection grid—stretching from Manitoba through the U.S. Midwest—are mutually dependent and beneficial configurations. Though the U.S.-Canada electricity trade constitutes less than 2 percent of total U.S.
domestic consumption, the interchanges provide resiliency in case of power overloads or natural disasters. U.S.-Mexico interconnections are more limited, though the two countries are linked in southern California and southwestern Texas."

Pipeline connections are happening as well. Natural gas pipelines being built from Texas producers into Mexico. The report advocates construction of the Keystone pipeline from Canada into the United states. More broadly, it notes: "The construction of North America’s energy infrastructure has delayed oil and gas development. ...  North Dakota’s Bakken formation, one of the United States’ largest shale formations, continues to flare nearly one-third of its natural gas because of infrastructure
limitations. North America should build new pipelines and upgrade older ones, both within and among the three countries, to address the bottlenecks. Without adequate pipeline capacity, energy companies have increasingly turned to the rails, roads, and waterways."

In Mexico, the big news is that oil production has been falling, which in turn has led the Mexican government to start expressing some openness to foreign investment. "In contrast, Mexican oil production has fallen nearly 25 percent since 2004 to 2.5 million b/d in 2012. The downturn reflects the declining output at Cantarell—once the world’s second-largest oil field—combined with lower-than-expected production levels in newer fields, such as the Chicontepec Basin. The decline can also be traced to underinvestment, inefficiencies, and limits on technology and expertise at the state-owned energy company Petróleos Mexicanos (Pemex). Nevertheless, Mexico’s energy potential is substantial. The EIA and Advanced Resources International (ARI) estimate that the country has the world’s sixth-largest recoverable shale gas resources and significant tight oil potential. Mexico has now made a historic move: its energy reform of December 2013 will encourage private companies to invest in Mexico’s energy sector for the first time since the 1930s."

For decades, I've been reading and hearing and writing about the risks and costs of U.S. dependence on faraway sources of energy in the Middle East. In a global economy, energy markets will inevitably be intertwined. But the U.S. energy picture is being fundamentally reshaped with the growth of U.S. oil and gas drilling. If combines with the broader development of North American energy resources, the economics and international power dynamics of energy production could be transformed.

North American Economic Ties

Economic ties across North America don't always get lots of attention, but they are large. "The United States exports nearly five times as much to Mexico and Canada as it does to China and almost twice as much as to the European Union. Mexico and Canada sell more than 75 percent of their exports within North America." Here's one figure showing the rise in North American trade, and another showing the rise in foreign direct investment in North America.

As the report notes: "North America also shares a workforce: companies and corporations now make products and provide services in all three countries. With integrated supply chains, employees in one country depend on the performance of those in another; together, they contribute to the quality and competitiveness of final products that are sold regionally or globally." I would add that the economic evidence shows the North American Free Trade Agreement had a modest but clearly positive effect on the U.S. economy.

As I see it, there are two underlying point here. First,  the world economy seems to be organizing itself into regions that rely on global supply chains that cross over between higher-income and lower-income countries. For example, in Asia there are supply chains running from Japan and Korea to Thailand and China. In Europe there are supply chains running from western to eastern Europe. North American has been building its own global supply chains between the U.S., Canada, and Mexico. Second, and more broadly, a U.S. economy that wants to prosper from growth happening elsewhere in the world economy needs to start thinking internationally. Thinking internationally in terms of Mexico and Canada is a start in that direction.

Security Issues

National security issues are not my bailiwick, so I don't have much to say here. But I'll make the commonplace observation that one often hears concerns about terrorist groups who might be able to ship people or materials into the U.S. by way of Canada or Mexico. There are also concerns about how epidemics might spread, or about how to deal with natural disasters. There are obvious advantages in all of these cases to not just thinking in terms of the U.S. border, but to also think about a sort of border around the continent of North America. Deeper sharing of economic and energy relationship could easily be combined with some coordination of security and other measures. I'm all in favor of stopping terrorist plots before they cross the U.S border.

Community

This is the catch-all word that the report uses for demographic, travel, and immigration issues. Here is some discussion of the demographic issues:

Compared to the rest of the world, North America enjoys an enviable demographic pyramid: the region’s population is relatively young and fertile. North America benefits from larger families—averaging just over two children per family versus 1.6 in Europe and 1.7 in China—with the advantage coming largely from Mexico’s younger population  and slightly higher birth rates. In fact, Mexico is currently in the middle of its “demographic bonus”—the country’s working-age adults outnumber children and the elderly. By comparison, the United States’ and Canada’s demographics are more mature, but their age pyramids have been tempered by their relatively open immigration policies. The region’s future workforce size—a fundamental factor in calculating future economic growth—also compares favorably, with 22 percent of North Americans below thirty years old, compared to 16 percent in both China and Europe. North America has yet to make the most of its demographic advantages.

Here's some discussion of cross-border movement and residence in North America:

"Some thirty-four million Mexicans and Mexican-Americans and more than three million Canadians and Canadian-Americans live in the United States. Nearly one million U.S. expatriates and a large number of Canadians live, at least part of the year, in Mexico. Another one million to two million U.S. citizens and a growing number of Mexicans live in Canada. Shorter stays are numerous. U.S. citizens choose Mexico for their getaways more than any other foreign locale. Mexicans and Canadians return the favor, comprising the largest groups of tourists entering the United States: a combined thirty-four million visitors each year who contribute an estimated $35 billion to the U.S. economy. Workers, students, and shoppers routinely cross the borders; there were 230 million land border crossings in 2012, or roughly 630,000 a day. Indigenous communities also span the border, with residents frequently crossing back and forth."

Finally, there's the ever-touchy subject of immigration. I've posted my thoughts on immigration policy before, for example here and here, or the five consecutive posts on immigration policy back in February 2012: here, here, here, here, and here. I won't rehearse all the arguments again here, but a couple of points seem worth making.

First, Mexico seems to be evolving from a country that mostly experienced emigration. A couple of years ago, net emigration from Mexico essentially stopped.  Now, Mexico is experiencing a certain degree of immigration--often in the form of former emigrants who are returning. The report says:

As a traditional country of emigration, Mexico’s immigration policies are different from those of its northern neighbors. These dynamics are beginning to change. With roughly 1.4 million former emigrants returning to Mexico between 2005 and 2010, the country can utilize the skills and capital that migrants bring home. Mexico also now faces an inflow of people born abroad—immigrants grew from just under five hundred thousand in 2000 to almost one million in 2010. More than three-quarters of these immigrants were born in the United States; the vast majority are children under the age of fifteen.

For this reason, thinking about the potential for emigration from Mexico to the US in terms of the experiences of the 1980s or the 1990s is likely to be misleading.

In addition, , I find myself wondering if thinking about migration from Mexico in a broad North American context might not offer an alternative approach to the U.S. debate over immigration. Imagine a scenario in which it was relatively easy and legal for people from Mexico, Canada and the United States to work in each other's countries, but each county could keep its immigration rules with regard to all other countries in the world. Imagine further that people from Mexico, Canada, and the United States could work in each other's countries but would not become citizens of the other country (unless they separately applied to do so) and would not be eligible for income support programs in the other country (unless the host country passed specific laws offering such support).

Of course, this in-between approach to cross-border migration wouldn't please either those who want to open the borders or those who want to close them. It requires thinking about freedom of movement across North American countries in a different way than we have traditionally done. But the greater freedom of movement might be useful in offering legal status, short of citizenship, for Mexicans who are already working and living in the United States. And if the freedom of movement was limited to North America, then some of the concerns about opening U.S. borders to the world's ultra-poor would be ameliorated. I haven't thought through the possibilities of such an arrangement in detail, but as part of thinking about what a true North American geopolitical collaboration might look like, it seems worth pondering.

The Excessive Sameness of Politics and Hotelling's Main Street

A lot of politicians may sound like they have differentiated view on the campaign trail, but either during the campaign or after being elected, they seem to become homogenized and squishy in their views. Thus, many voters of all political dispositions are continually frustrated because they feel as if all politicians are discomfortingly alike. Maybe you want to vote for someone who isn't a hanging-off-the-ideological-cliff extremist, but you would like to vote for someone with clear and definite views--even if you differ with some of those views. To quote a phrase associated with the Goldwater presidential campaign of 1964, but applicable to all sides of the political spectrum, many voters feel that they want "a choice, not an echo."

A famous long-ago economist named Harold Hotelling proposed a classic explanation for this phenomenon back in a paper called "Stability in Competition," published in the March 1929 issue of the Economic Journal (39:153, pp. 41-57).

In one of his illustrations, Hotelling discussed the of two sellers of a product who are thinking about where to locate along Main Street. For simplicity, imagine that the addresses along the street are numbered from 1-100. The working assumption is that customers are spread evenly along Main Street, and the customers will go to whichever store is located closer to them. In this situation, if one store locates at, say, 10 Main Street, the other store will then choose to at 11 Main Street. The first store will then get all the customers from 0-10, and the second store will get all the customers from 11-100. The first store will then relocate to 12 Main Street, to snag the majority of customers, and the two stores will keep leap-frogging each other and relocating until they end up located side by side, right in the middle of Main Street.

As Hotelling pointed out back in 1929, this clustering is not ideal. From the consumers's point of view, it would be more useful to have the two stores located at 25 Main Street and 75 Main Street, because then no consumer along the street from 1 to 100 would be more than 25 away from a store. But the dynamics of competition can lead to excessive clustering.

Hotelling argued that this excessive sameness is apparent in many aspects of public competition, including competition between firms introducing new products, and competition between Republicans and Democrats. He wrote:

"Buyers are confronted everywhere with an excessive sameness. When a new merchant or manufacturer sets up shop he must not produce something exactly like what is already on the market or he will risk a price war ... But there is an incentive to make the new product very much like the old, applying some slight change which will seem an improvement to as many buyers as possible without ever going far in this direction. The tremendous standardisation of our furniture, our houses, our clothing, our automobiles and our education are due in part to the economies of large-scale production, in part·to fashion and imitation. But over and above these forces is the effect we have been discussing, the tendency to make only slight deviations in order to have for the new commodity as many buyers of the old as possible, to get, so to speak, between·one's competitors and a mass of customers.

So general is this tendency that it appears in the most diverse fields of competitive activity, even quite apart from what is called economic life. In politics it is strikingly exemplified. The competition for votes between the Republican and Democratic parties does not lead to a clear drawing of issues, an adoption of two strongly contrasted positions between which the voter may choose. Instead, each party strives, to make its platform as much like the other's as possible. Any radical departure would lose many votes, even though it might lead to stronger commendation of the party by some who would vote for it anyhow. Each candidate " pussyfoots," replies ambiguously to questions, refuses to take a definite stand in any controversy for fear of losing votes. Real differences, if they ever exist, fade gradually with time though the issues may be as important as ever. The Democratic party, once opposed to protective tariffs, moves gradually to a position almost, but not quite, identical with that of the Republicans. It need have no fear of fanatical free-traders, since they will still prefer it to the Republican party, and its advocacy of a continued high tariff will bring it the money and votes of some intermediate groups.

Of course, it's not literally true that Republican and Democratic politicians both locate exactly in the middle of the political spectrum. Hotelling was describing a tendency to push to the middle, but in politics, there is also a need to assure your voters that you share their beliefs. Thus, there's a saying that American politics is a battle fought between the 40-yard lines. (For those unfamiliar with the line markers on an American football field, the statement suggests that the political battle is fought between the addresses of 40 and 60 on a Hotelling-style Main Street.) Mainstream politicians thus face a continual dynamic where they seek to reassure their more ardent partisans that they are on their side, while shading and tacking as needed to pick up voters in the middle. At an intuitive level, politicians recognize that offering "a choice, not an echo" is part of what led Barry Goldwater to a loss of historic magnitude in the 1964 US presidential election.

Political competition that is usually between centrists, whether right-of-center or left-of-center, does have some benefits. Extremists are much less likely to win high office. And even when the other side wins, it's reassuring to think that the person who won is at least closer to the center than the true believers at the extreme of that side. But every now and then, many of us yearn for a few more conviction politicians, who say what they mean and mean what they say, who play a greater role in driving the public debate, and who are OK with the possibility that doing so might end up costing them an election.

[For the record, using  the metaphor of a football field to describe the range of political choice seems to have originated with the 1970 best-seller The Real Majority: An Extraordinary Examination of the American Electorate, by Ben Wattenberg and Richard M. Scammon. But they used the image to discuss how political conflict might sometimes be between those near the middle and sometimes between those at with more extreme positions. The claim that American politics usually  happens between the 40 yard-lines is one of those statements that seems to have evolved afterwards, without a clear single author.]

Is Better Communication Longer and More Complex?

Twenty years ago, when the Federal Reserve Open Market Committee wanted to change interest rates, it didn't make any announcement. It just took action, and market participants observe those actions. Mark Wynne of the Federal Reserve Bank of Dallas explains in “A Short History of FOMC Communication”:

The first time the FOMC issued a statement immediately after a meeting explaining what action had been decided was on Feb. 4, 1994. That statement simply noted that the committee decided to “increase slightly the degree of pressure on reserve positions” and that this was “expected to be associated with a small increase in short-term money market interest rates.” By way of explanation for why the committee was announcing its decision, the statement said that this was being done “to avoid any misunderstanding of the committee’s purposes, given the fact that this is the first firming of
reserve market conditions by the committee since early 1989.” In February 1995, the committee decided that all changes in the stance of monetary policy would be announced after the meeting.

But over the years, these announcements of Fed policy have become longer and more complex. Rubén Hernández-Murillo and Hannah Shell of the Federal Reserve Bank of Cleveland have created a vivid figure to show the change in "The Rising Complexity of the FOMC Statement." The colors of the circles show who was leading the Fed at the time: blue for Greenspan, red for Bernanke, and green for Yellen. The area of the circle shows the number of words in the statement: clearly, the statements have been getting wordier over time. And on the vertical axis, the FOMC statements were run through a standard diagnostic tool for determining their "reading grade level." In short, the statement back in the mid-1990s were often pitched at about a 12th grade level. But over time, and especially after the financial crisis hit, the FOMC statements ratcheted up to a "19th grade" level, which is to say that they were pitched at readers with post-college graduate study.

This trend raises a question last spotted among the "advice to the lovelorn" columnists: Is communication better if it is longer and more complex? As an editor, I confess that I'm suspicious of length and complexity. A wise economist friend used to point out to me that in academia, specialized terminology always serves two purposes: it streamlines and simplifies communication among specialists, and it shuts out nonspecialists. Of course, all academics like to believe that we are only using specialized terminology for the loftiest of intellectual purposes, not because we are as much of an in-group as an set of gossiping teenagers, with our own slang devised to define membership in the group and to separate ourselves from others.

But even my cynical side remembers a fundamental rule of exposition often attributed to Albert Einstein is that "Everything should be made as simple as possible, but not simpler."

It make sense that as the Federal Reserve statements became longer and more complex as the Fed began to specify a numerical range for its interest rate policies in the late 1990s; and then began to describe how it saw future risks in 1999; and then began to specify how quickly it expected to adjust future monetary policy in 2004; and then began its "quantitative easing" policy in 2008.

In December 2012, as Wynne points out, the Fed altered its communication substantially by saying that “this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the committee’s 2 percent longer-run goal and longer-term inflation expectations continue to be well anchored.” In other words, the Fed for the first time had announced that it would keep interest rates at a certain level until a certain economic statistic--the unemployment rate--had moved in a certain way. But then when the unemployment rate fell beneath 6.5% in April 2014, this earlier statement had led to expectations that the Fed would then start raising interest rates, which as it turned out, the Fed wasn't yet quite ready to do.

How the Federal Reserve and other major central banks carry out their policies has been fundamentally transformed during the last six years. Explaining these changes is important. But if the explanations are pitched at a level that only makes sense to PhD economists, they aren't much help. And as the personal advice columnists remind us, if someone is talking and talking but not giving you a straight answer that you can understand, you have some reason to mistrust whether they know their own mind--and even whether they are really trying to tell you the truth. I'll give the last word here to Hernández-Murillo and Shell:

As the Fed returns to using conventional monetary policy tools, it is likely that the reading levels of its statements will decline. However, if the Fed continues to use unconventional instruments for a considerable period, it may need to consider how to explain its policy actions in simpler terms to avoid volatility in financial markets. 

Should Voting be Compulsory?

Just to put my cards face up on the table right here at the start, I'm not in favor of compulsory voting. But I think the case for doing so is stronger than commonly recognized. Let me lay out the arguments as I see them: low turnover, what the penalties look like in some other countries for not voting, the free speech/constitutional issues, and whether any resulting differences in outcomes would be desirable.

[This post was originally published on Election Day, November 6, 2012.]

The starting point for making it compulsory to vote begins with the (arguable) notion that democracy would be better-served if participation in elections was higher. Here's a figure from a post of mine a couple of months ago on "Voter Turnout Since 1964." With some variation across age groups, voter turnout in presidential elections has been sagging over the last few decades.


Some nations have responded to concerns over low voter turnout by passing laws that make it a requirement to vote. Here's a list of countries with such laws, and the penalties that they impose for not voting, taken from a June 2006 report from Britain's Electoral Commission. The penalties are categorized from "Very Strict" to "None." But honestly, even the "Very Strict" is not especially onerous.

In talking with people on this subject, I've found that one immediate response is that that compulsory voting must be a violation of freedom of free speech in some way. I have some of this reaction myself. But while one may reasonably oppose the idea of compulsory voting, the case that it violates a specific law or constitutional right is difficult to make. Indeed, the original 1777 constitution of the state of Georgia specifically called for a potential penalty of five pounds for not voting--although it also allowed an exception for those with a good explanation. If the U.S. government can require you to pay money for taxes, or compel you to serve on jury duty, or institute a military draft, it probably has the power to require that you show up and vote. Of course, a compulsory voting law would almost certainly include provisions for conscientious objectors to voting, and you would be permitted to turn in a totally blank ballot if you wish. The penalties for not voting would be an inconvenience, but far from draconian.

For a review of the various legal and constitutional ins and outs of compulsory voting, along with some of the practical arguments, I recommend this anonymous 2007 note in the Harvard Law Review, called "The Case for Compulsory Voting."

The author points out (footnotes omitted): "Approximately twenty-four nations have some kind of compulsory voting law, representing 17% of the world’s democratic nations. The effect of compulsory voting laws on voter turnout is substantial. Multivariate statistical analyses have shown that compulsory voting laws raise voter turnout by seven to sixteen percentage points."

The anonymous author also offers what seem to me ultimately the two strongest arguments for compulsory voting. The first argument is that a larger turnout will (arguably) provide a more accurate representation of what the public wants, and in that sense will strengthen the bond between the electorate and its elected representatives. The second and more subtle argument is that compulsory voting would mean that political parties could focus much less on voter turnout. Less money and effort could go into turning out the vote, and more into persuasion. Those who now vote almost certainly have stronger partisan feelings, on average, than those who don't vote. So politicians aim their advertisements and strategies at that more partisan group. Many negative campaign ads attempt to reduce turnout for a candidate: if turnout was high, the usefulness of such negative ads could be diminished. A broader spectrum of voters would push candidates to offer a broader spectrum of messages to appeal to those voters, and groups that now have low turnout would find themselves equally courted by politicians.

The question becomes whether these potential benefits to the democracy as a whole are worth the imposition of compulsory voting. The anonymous writer in the Harvard Law Review offers what is surely meant to be an attention-grabbing and paradoxical-sounding conclusion: "Although there are several legal obstacles to compulsory voting, none of them appear to be substantial enough to bar compulsory voting laws. ... The biggest obstacle to compulsory voting is the political reality that compulsory voting seems incompatible with many Americans’ notions of individual liberty. As with many other civic duties, however, voting is too important to be left to personal choice."

How might one respond to these arguments? Perhaps the most obvious answer is that if one looks at the countries that have compulsory voting--say, Brazil, Australia, Peru, Thailand--it's not obvious that their politics are characterized by greater appeals to the nonpartisan middle, or that the bond between the population and its elected representatives is especially strong.

For a more detailed deconstruction , I recommend a 2009 essay by Annabelle Lever in Public Reason magazine, "Is Compulsory Voting Justified?" Basically, her argument comes down to a belief that the potential gains from compulsory voting are unproven and unsupported by evidence in countries that have tried it, while the lost freedom from compulsory voting would be definite and real.


In Lever's view, the evidence that exists doesn't show that political parties start competing for the middle in a different way, nor that outcomes are different. For example, northern European social democratic countries like Sweden don't have compulsory voting, and do have declining voter turnout.
f people are disinterested or disillusions and don't want to vote for the existing candidates, it's not clear that threatening them with a criminal offense for not voting will build connections from the population to elected representatives. If political parties don't need to focus on turnout, they will immediately turn to other ways of identifying swing groups and wedge issues. The penalties for not voting may not look large in some broad sense, but be clear: when we enter the realm of compulsory voting, we are talking about criminal behavior. will need to decide how large the fines or other penalties will be, and what happens to those (and there will be some!) who refuse to pay. If not voting is a crime, we will be making a lot of people into criminals--maybe guilty of only a minor crime, but still recorded in our information-technology society as breaking the law. It is by no means clear that having aright to vote should be reinterpreted as having a legal duty to vote: there are many rights that one may choose to exercise, or not, as one prefers. In a free society, the right to be left alone has some value, too. Lever concludes:

"I have argued that the case for compulsory voting is unproven. It is unproven because the claim that compulsion will have beneficial results rests on speculation about the way that nonvoters will vote if they are forced to vote, and there is considerable, and justified, controversy on this matter. Nor is it clear that compulsory voting is well-suited to combating those forms of low and unequal turnout that are, genuinely, troubling. On the contrary, it may make them worse by distracting politicians and voters from the task of combating persistent, damaging, and pervasive forms of unfreedom and inequality in our societies.

"Moreover, I have argued, the idea that compulsory voting violates no significant rights or liberties is mistaken and is at odds with democratic ideas about the proper distribution of power and responsibility in a society. It is also at odds with concern for the politically inexperienced and alienated, which itself motivates the case for compulsion. Rights to abstain, to withhold assent, to refrain from making a statement, or from participating, may not be very glamorous, but can be nonetheless important for that. They are necessary to protect people from paternalist and authoritarian government, and from efforts to enlist them in the service of ideals that they do not share. Rights of non-participation, no less than rights of anonymous participation, enable the weak, timid and unpopular to protest in ways that feel safe and that are consistent with their sense of duty, as well as self-interest. ... People must, therefore, have rights to limit their participation in politics and, at the limit, to abstain, not simply because such rights can be crucial to prevent coercion by neighbours, family, employers or the state, but because they are necessary for people to decide what they are entitled to do, what they have a duty to do, and how best to act on their respective duties and rights."

 I don't know of any recent polls on how Americans feel about compulsory voting, but a 2004 poll by ABC News found 72% opposed--a slightly higher percentage than a poll taken 40 years earlier on the same subject. These kinds of results from nationally representative polls pose an additional level of irony. If Americans as a group are strongly opposed to laws that would require compulsory voting, it seems problematic to glide around this opposition into an argument that, really, although they don't know it yet, they would feel better off with compulsory voting.

In a 2004 essay on compulsory voting (in this volume), Maria Gratschew points out that a number of countries in western Europe that used to have compulsory voting have have moved away from it in recent decades: Austria, Italy, Greece, and Netherlands. In discussing the decision by Netherlands to drop its compulsory voting laws in 1967, Gratschew writes: "A number of theoretical as well as practical arguments were put forward by the committee: for example, the right to vote is each citizen's individual right which he or she should be free to exercise or not; it is difficult to enforce sanctions against non-voters effectively; and party politics might be livelier if the parties had to attract the voters' attention, so that voter turnout would therefore reflect actual participation and interest in politics."

Compulsory voting is one of those intriguing roads that looks better when not actually traveled.