Subrational Expectations and Borrowing Constraints

1. Subrational Expectations and Borrowing Constraints Discussion at the Federal Reserve Board Consumption Meeting May 14, 2012 Miles Kimball

2. Key Elements of Stefan Nagel’s “Macroeconomic Experiences and Expectations: A Perspective on the Great Recession” 1. Subrational Expectations a. For some, less than fully rational expectations based on personal experience rather than all available information. b. Market equilibrium with fully rational traders. 2. Borrowing Constraints a. Current and possible future b. Interaction with house prices c. Little interaction with stock prices

3. I. Tracking Subrational Expectations A. Model: NY Fed’s collaboration with RAND’s American Life Panel to track πe. B. Stock market expectations also already tracked on the ALP. House price expectations measured on UM’s Cognitive Economics Survey. C. But what about the next asset that might attract irrational exuberance? Aggressive forward-looking tracking needed.

4. II. Tracking Synchronizing Ideas A. In the presence of rational traders, only (somewhat) synchronized movements in subrational expectations move markets. • Not all expectations that need to be tracked are encoded in people’s brains as easily accessed quantities • “The Internet will change everything.” • “There has never been a decline in house prices at the national level.” • Earlier history of “asset bubbles”

5. II. Tracking Synchronizing Ideas (cont.) C. To predict emerging issues, identify the epidemiological properties of asset-price- relevant ideas early on. 1. Fecundity: have the experimental subjects read about the idea, then survey them later to see how many they told. 2. Fidelity of transmission: in the lab, can it survive the telephone game (grapevine, broken telephone, whisper down the lane, Chinese whispers)

6. III. Borrowing Constraints • Fed action may often operate in part by loosening borrowing constraints. • Because of newly inspired caution in the financial industry, borrowing constraints have not been easy to loosen during the Great Recession.

7. IV. Dealing with Borrowing Constraints • Raising aggregate demand by inducing unconstrained PIH households to spend may look very different than what usually works. • Hard to read the situation with one’s usual pattern recognition. • Example: inducing PIH households to spend on luxuries instead of inducing homebuilding. • May take a lot to get PIH households to spend more. • Even with the high elasticity of intertemporal substitution of log(C) utility, spending is only proportional to the present discounted value (PDV) of lifetime resources. • Raising the PDV of lifetime resources enough may require the value of financial wealth rising enough that the Fed will face heightened criticisms that it is igniting another bubble.

8. IV. Dealing with Borrowing Constraints (cont.) • A Proposal: “Federal Lines of Credit” (FLOC’s/NLOC’s) • In between traditional monetary and traditional fiscal policy. (Fed authority would allow speedy use.) • Alternative to tax rebates: for example, a $2000 line of credit for each adult instead of a $200 tax rebate. Useable for anything. Relatively low rate. • Could be implemented with a federally issued credit card, with repayment over a 5 to 10 year period through the tax system. • Works through a combination of (a) relaxing borrowing constraints, (b) reassuring about future borrowing constraints, and (c) subsidizing consumer interest rates to get around the zero lower bound. • Achieves a much higher ratio of additional aggregate demand to additional national debt than traditional stimuli such as typically used transfers or government purchases.