Monday, March 27, 2017

Interview with Ricardo Reis: Macro and Reservism

The EconReporter website (an independent Hong Kong journalism project) has been publishing a series of interviews with prominent economists. In particular, a two-part interview with Ricardo Reis caught my eye. In the first part "The Performance of Macroeconomics is Not that Bad!" (posted February 9, 2017), Reis offers a limited and qualified defense of macroeconomics in the aftermath of the financial crisis; in the second part, "How to Use Interest on Reserve for Inflation Targeting" (posted February 11, 2017), Reis describes his current thinking about "reservism," or the practice of conducting monetary policy by having the central bank pay an interest rate on bank reserves. A few tidbits from the interviews:

Comparing forecasting in macroeconomics and epidemiology
"Economics is a field that has at best 200 years of systematic study. More likely we have less than a 100 year of actual systematic and sustained study. The budget for research in the US, or even in the UK, that goes to economics maybe just 1/1000 of the pounds or dollars that are invested in infectious diseases.
"Given the incredibly small amount of resources that we invested in economics, given the fact that economics have been studied for only 200 years where in medicine we have been studying infectious diseases in a systematic way for 2000 plus years, I think it is quite remarkable that economics models do such a good forecasting job when compared to infectious diseases models.
"We do not think that medicine is in a crisis whenever a new virus appears, even if that virus turns out to be quite deadly. Again, they have a budget that is a thousand time bigger than ours. They have hundreds of more people working on it. They have been doing ten times more years than we have in economics. If you think about that in this perspective, I actually think the performance of economics, compares to other fields of knowledge, is actually not bad at all."

The failures of macroeconomics during the Great Recession were about forecasting, not understanding
"When we look back at the financial crisis, the main question is why economists did not predict what has happened in 2007 to Bear Sterns and Lehman Brothers. Economists felt that they have a bunch of apparatus that allow us to understand what was going on. So it was a failure of forecasting but not a failure of understanding.
"It didn’t take very long for economists to understand that their models of bank runs, asymmetric information models and the importance of the financial sector could be used to understand what was going on. It is not the case that back at the 2007 economists felt, `Wow! Something happened and we don’t even know how to think about it!'
"No, we had all sorts of ways to think about it. We may not have forecast it but we have some tools. What you have seen is that as we have the tools, there were attempts using them, attempts in understanding in what ways those tools were lacking, and attempts in improving those tools and understand them better. But there was not a feeling that we do not even have the tools to even understand what was going on."
How central banks have shifted their basic monetary policy tools to paying interest on reserves
"In the last six years, the world of central banking, the way central banks operate, the way they set monetary policy, has changed radically. Even most people I admired don’t even quite understand it. The main radical change is that we went from a system in which central banks do the so-called open market operations, where they brought a few million bonds here and there, and in doing so affect the interest rate. Back in the days, central banks were using a fairly tiny balance sheet. Now we instead have a system which central banks’ balance sheets are very large.
"Why are the balance sheets very large now? Because on the liability side, there are a huge amount of reserves, i.e. the deposit of banks in the central bank. That means nowadays that the way that central banks actually control inflation is not through some Federal Reserve fund market, nor some interbank markets in the Europe, but rather by actually choosing an interest rate on reserves. It is not like the target of the Federal Fund rate, it is an actual interest paid by the central bank. ...  Reserves in the central banks used to be an asset that was essentially zero on the balance sheet. ... Now it is one of the largest financial assets in the US. So, we have this new asset which is fundamental to the financial market, to the monetary policy, and it has fundamentally changed what the central bank balance sheet does.
"A lot of my research in last year has been focused on understanding what does it mean and what does it imply for the control of inflation, for the risk of central bank insolvency and among others. That’s what I called Reservism, trying to understand what is the role of this new asset called reserve has on the economy and the central bank policy.
"Once you understand that these reserves in the central banks are very large, the next thing one can do to understand what effect they have is to try to understand to what extent they could be different. Reserve right now are overnight deposit in central bank by banks, they are paid a given interest rate but once you started thinking about what they are, you realized that those could be different. They could, instead of promising an interest rate, promising a different payment. They could be, instead of overnight, a 30-day deposit. They could be lots of different things. That is what led to some of the more recent research.
What about a monetary policy of paying an inflation-adjusted interest rate on bank reserves? 
"The intuition is as following: the reserve is a very special asset that has one particular property – reserves are the unit of account in the economy. One dollar of reserves defines what the dollar is. ... [R]eserve is the unit of account of the economy. One unit of reserve always worth one dollar.
"Now imagine that instead of promising to pay them the nominal interest rate, you promise that the interest rate, i.e. the remuneration of the reserves, is indexed to the price level. So, de facto, the reserve essentially pay a real payment in the same way that the inflation-indexed government bonds do. There is no barrier to doing this. After all, it is the same way government issued the inflation-indexed bonds, so can the central bank. ... 
"On the other hand, there is a real interest rate pinned down in the economy that has to do with investment opportunities and how impatient people are. If the central bank promises a real payment, under the no-arbitrage condition, this pinned down the real value of the reserves today, as the real payment tomorrow divided by the real value today is equal to the real return. ... So, if we have pinned down the real value, what also have we pinned down? We have pinned the price level. This is because the real value of one dollar of reserves is precisely given by the price level. ...
"Let me make it clear that this is an academic work, in the sense that I am not saying that the central banks should do it tomorrow. ...
"The [inflation-adjusted interest] payment on reserve rule, on the other hand, is not what we called a feedback rule. It doesn’t say how you should adjust interest rate to what inflation is at some point. .... [I]n the Taylor Rule [for monetary policy] one needs to track not just current inflation but also certain things like natural rate of interest or natural rate of unemployment to know how to adjust the nominal interest rate. Under the payment on reserve rule, what you need to track is not any of these natural and unobserved factors, but instead, an observable variable, i.e. the current real interest rate in the economy."
More discussion from Reis follows. I don't know if having the central bank pay an inflation-adjusted return on bank reserves is a good idea, but I certainly agree with Reis's premise that thinking about different ways conduct monetary policy through interest on bank reserves is really just getting underway.