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2009-12-31T23:59:00.000-08:00

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Economist's View - 4 new articles

2009-10-03T22:43:00.001-07:00

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop

Has Federal Reserve policy been able to break the "adverse feedback loop"?:

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop by Danielle DiMartino Booth and Jessica J. Renier, Economic Letter, Vol. 4, No. 7, September 2009, Federal Reserve Bank of Dallas: An adverse feedback loop takes hold when a weakening financial system and a slowing economy feed off each other. A crisis or shock curtails lending, hobbling the real economy; the more production and employment falter, the more lending contracts, causing further harm to the economy. The result is a downward spiral of business and financial activity.
The Federal Open Market Committee (FOMC) warned of the danger in late January 2008, when few analysts recognized that a recession had begun the previous month. It noted "the especially worrisome possibility of an adverse feedback loop; that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions."[1]

The financial crisis validated the FOMC's concern, igniting what has become the worst post-World War II economic downturn in terms of length and, by some measures, depth and breadth. Housing market troubles began in 2006 and deepened well into 2009. As the economy sank into recession, an October 2008 Fed survey found that two-thirds of banks had tightened standards for the highest-quality residential mortgages and over three-quarters had reined in business lending. The credit contraction sent spending down and unemployment up, exacerbating threats to the financial sector and dimming prospects for stability in housing.

Arresting the adverse feedback loop could prove to be the seminal challenge of early 21st century monetary policymaking. Since sounding the alarm in January 2008, the Fed has taken a series of actions—many unprecedented—to prevent additional damage to financial markets and restore lending activity. These policies have had some success in loosening the grip of the adverse feedback loop and may have finally positioned the economy for growth. Still, doubts linger. The risk remains that the actions may prove insufficient to put the economy on a clear path to rising employment and stable prices.

Knocked for a Loop An adverse feedback loop's seeds are often planted in good times. As the U.S. economy emerged from the 2000–01 recession, lax lending standards and excessive borrowing led to an unprecedented housing boom. Easy credit prompted many Americans to become first-time homeowners, putting upward pressure on housing prices and emboldening builders to borrow to meet the leverage-fueled demand.
The surge in risky lending couldn't have occurred without the pooling of loans for sale to investors as securities. Feeding these securitization markets was the rapidly growing, $11 trillion shadow banking system, a catchall term for nonbank financial institutions such as investment banks and hedge funds.

By late 2008, mortgages and home equity loans accounted for 109 percent of disposable personal income, up from 65 percent in 1995. In the fourth quarter of 2005, real estate investment in new homes hit a 54-year high of 6.3 percent of gross domestic product (GDP), well above the 5.7 percent average of the six housing construction-cycle peaks since 1955. Homeownership rates crested at 69.2 percent in late 2004, nearly 5 percentage points above the long-term average of 64.3 percent (Chart 1).
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The housing boom ended abruptly in late 2005, sending homeownership rates back down. Several factors were at work. First, a choking off of lending exiled the marginal buyers who had fueled the market. Second, delinquencies rose sharply as adjustable-rate loans reset to higher interest rates, sending shock waves through credit markets. Third, supply began to overwhelm demand, putting downward pressure on housing prices.

Key housing indicators went into full-fledged retreat. As lenders grew wary of risk and securitization markets turned balky, mortgage credit evaporated, particularly for the riskier segments that had been driving housing demand. Subprime mortgages fell from a peak of nearly $1 trillion in May 2007—a 10th of the U.S. mortgage market—to $560 billion in August 2009 (Chart 2A). The Alt-A market, which surpassed the subprime market in May 2007, dwindled from its peak of $1 trillion in August 2007 to $740 billion in August 2009.[2]

The quarterly rate of new foreclosures first broke prior cycles' records in the last three months of 2006 (Chart 2B). A forecast by the housing research firm Zelman & Associates calls for 3.51 million U.S. households to receive foreclosure notices in 2009 and for about 2.25 million of those to result in lost homes. In the four years through 2012, the forecast is for 10.7 million households to default and 6.5 million to lose their homes.
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Problems have been acute for adjustable-rate mortgages (ARMs), which surpassed fixed-rate loans as a share of new issues near the housing boom's height in March 2005. Even so, ARMs made up only 6.8 percent of total U.S. mortgages in the third quarter of 2007, but their rapid deterioration had a large impact. Some 43 percent of foreclosures started during the quarter were attached to subprime ARMs.[3]

Waning enthusiasm for high-risk mortgages curtailed housing demand. Meanwhile, rising foreclosures added to supply at a time when home builders hadn't yet heeded signals to cut new construction.

Vacant homes for sale, a measure that excludes occupied houses that could be pulled from the market, helps gauge overbuilding. After running at 1.4 percent for 50 years, the vacancy rate began to rise in late 2005, hitting a peak of 2.9 percent at the end of 2008 (Chart 2C). The rate has since declined to 2.5 percent, but the overhang still means supply exceeds demand by more than 830,000 homes.

When the housing troubles began, home prices hadn't fallen nationally since the Great Depression. So the confluence of tighter mortgage credit, rising delinquencies and excess supply produced a result that could only be regarded as extraordinary. The greatest home price appreciation in U.S. history—an 85 percent run-up in six years—gave way to a 35 percent plunge from the peak in 2006 (Chart 2D). Declining home prices remains the biggest challenge to arresting the adverse feedback loop. The Pain Spreads As housing prices started to tumble in early 2007, debate centered on whether the damage would be limited to the housing sector or spread to the wider economy. By the end of 2008, the housing bust began to affect consumer spending, employment and borrowing. It was clear the adverse feedback loop the Fed feared had arrived.

A key factor was debt, which had piled up during the housing boom as rapidly rising home prices emboldened consumers to spend beyond their means. In the seven years leading up to 2008, U.S. households accumulated the same amount of debt as they did in the previous 26 years (Chart 3).
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Throughout the 2000–01 recession, Americans continued to increase spending. This time around, a tightening vise of debt and credit forced households to pull back, leading to the nation's first consumption decline since the fourth quarter of 1991. Wary consumers cut into companies' sales and profits, adding troubled businesses to the economy's downward spiral.

Businesses faced another obstacle—tightening credit markets. Even the largest corporations with the strongest credit standings had to pay higher interest rates to access working capital. Small businesses, which often rely on credit cards to pay operating expenses, faced even more severe restrictions. By the second half of 2008, a National Small Business Association survey found that 69 percent of companies were battling tighter terms on their credit cards.[4]

Falling revenues and constrained credit proved a toxic combination for many employers. Nearly 7 million American workers lost their jobs between the recession's start in December 2007 and August 2009—the biggest percentage drop in employment in any economic slump since 1949. By the conventional barometer, unemployment rose to 9.7 percent. A broader measure shows even greater pain. Effective unemployment, which includes those working part time for economic reasons and those who've given up looking for jobs, rose to 16.8 percent in August—its highest mark since the series began in 1994.[5]

Mortgage delinquencies initially gained momentum without a rise in the jobless rate, a phenomenon not seen in previous housing downturns. After the recession began, higher unemployment led to a feedback loop, providing a secondary spur to push delinquencies higher and extending troubles to even the most creditworthy homeowners.

In the 12 months ending June 2009, prime borrowers' share of fixed-rate conventional loans in arrears or foreclosure grew faster than any other mortgage market segment, doubling to 6.6 percent. Making matters worse was the increased number of ARMs that reset to higher interest rates. The adjustment is far from over. About $1.1 trillion in mortgages will reset over the next three years, including many of the more exotic Alt-A, jumbo, option-ARM and interest-only mortgages underwritten during the boom years.[6]

The feedback loop spiraled further down as untenable mortgage payments made it harder for households to meet other obligations. Credit card and auto loan charge-offs then climbed to record levels. So did delinquencies on home-equity loans.

For many, the debt burdens became too heavy. Personal bankruptcy filings per day have soared 136 percent since 2006, approaching levels last seen in 2005, before a new law made filing more arduous.[7] Business bankruptcy filings have risen at an even faster pace recently, a further indication of constrained credit's adverse feedback into the real economy.

Borrowers' mounting troubles led banks to tighten lending policies beyond the mortgage market. For example, lenders began reducing credit card lines for households and small businesses. Issuers cut $500 billion of credit card lines in the last three months of 2008, with predictions for an additional $2.7 trillion by the end of 2010.[8]

Borrowers were pulling back at the same time, further evidence of a growing reluctance to spend. By February 2009, American consumers had done something unprecedented. They reduced their credit card use and pushed balances below year-earlier levels—the first interruption of rising U.S. indebtedness on record (Chart 4). Automobile loans have also been declining, but at a slower rate. Overall, consumer credit outstanding has fallen $110 billion from its July 2008 peak—a 4.2 percent annualized rate.
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The unrelenting cycle of contracting credit bleeding into the real economy has severely hampered the housing market's ability to recover. In some cases, lenders appear to be holding foreclosed homes off the market, hoping for a rebound that would save them from posting losses. A four-state analysis by consultant RealtyTrac, made public in January, found that real estate listings included only a third of the foreclosures it had in its database.[9] The other two-thirds—the shadow inventory of homes—helps explain why foreclosure filings flowing into the pipeline haven't caused even larger price declines.

Over the past two years, the initial troubles in housing have spilled over to the broader economy, causing a downward cycle of distress in consumer spending, employment and credit markets and creating greater risks for the housing sector. Fears that continued deterioration in housing would lead to further losses led to Fed actions aimed at arresting the adverse feedback loop. The Fed Takes Action Early on, the Fed saw the possibility of an adverse feedback loop, and it has marshaled a combination of conventional and unconventional policies in an attempt to avert and then break the downward spiral. As the financial crisis sapped lending in 2008, the central bank acted to increase credit availability, or at least to reduce its cost, by aggressively cutting the federal funds rate, its primary policy tool for influencing borrowing costs. By December 2008, rates were close to zero, their lower limit.

While it was cutting rates, the Fed introduced programs to auction collateralized long-term loans to banks, extend discount window operations to primary dealers and create a lending facility to allow money market funds direct access to collateralized loans.

Financial market troubles deepened in the fall of 2008, prompting the Fed to take its response to another level with initiatives that might be characterized as credit easing for the broad economy. Some initiatives sought to mitigate collateral damage to the real economy stemming from the credit crisis. Others targeted falling home prices by addressing obstacles to residential mortgage lending.

Many business operations were hampered by the squeeze on short-term financing, a key source of working capital needed to prevent deeper reductions in inventories, jobs and wages. To this end, the Fed funded purchases of top-rated commercial paper through the commercial paper funding facility, announced in October 2008. Since then, commercial paper markets have seen wider issuance and narrower spreads—both signs of a return to normalcy.[10]

Unfreezing consumer lending beyond mortgages came into play with the term asset-backed securities loan facility, or TALF, announced in November 2008.[11] The TALF's first phase injected liquidity into the securitization markets for credit card, automobile and small business lending. Its second phase provided financing to the commercial real estate market, a sector that has increasingly threatened to destabilize banks' capital positions through a fresh wave of write-downs and losses.

In November 2008, the Fed made a direct assault on troubled housing markets through the purchase of residential mortgage-backed securities, a program expanded in March 2009. Since the program began, mortgage interest rates have generally declined, encouraging homebuying and refinancing (Chart 5). Refinancing activity has doubled since last year, saving many homeowners from foreclosure and preventing further additions to the shadow inventory of homes for sale.
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In some parts of the country, lower home prices are bringing demand and supply into sync. In California, distressed sales have helped pull prices down to much more affordable levels in a relatively short time. After surging to nearly $600,000 during the boom, California's median home price fell below $250,000 in early 2009 (Chart 6). It then rose for five consecutive months through July 2009, a sign that the market has pulled out of its tailspin. Renewed demand at a lower price point pushed inventories to a 3.9-month supply, the lowest in three and a half years.
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In 2009, the Fed has continued to pursue policies aimed at breaking the adverse feedback loop. With the federal funds rate near zero, the Fed still tried to inject added buying power into the economy through quantitative easing, a seldom-used policy tool that seeks to spur bank lending by increasing the money supply through direct purchases of securities. On March 18, the Fed said it would buy $300 billion in Treasury securities to push their interest yields down, hoping to encourage banks to lend more freely.[12] Dangers Still Loom The Fed attacked the adverse feedback loop aggressively, using a broad range of innovative policies to break the downward momentum at several points. Toward the end of summer 2009, the pace of the economy's decline had slowed and positive signs were showing up in financial markets, housing and manufacturing.

These bits of good news are heartening, but dangers still lurk. The global financial system has taken an estimated $1.6 trillion in losses since the crisis erupted. Even so, a lot more bad debt remains on balance sheets, hindering ability and willingness to lend. Institutions have yet to absorb the traditional losses that flow from recession.

A majority of U.S. consumers responding to University of Michigan surveys have said they expect high unemployment to persist over the next several years, a mindset that could pose challenges for policymakers. The worries will continue to put downward pressure on consumer spending and company revenues. Struggling employers will be reluctant to add jobs and could even impose further cuts, which would continue to feed delinquencies and pressure home prices, making it more difficult to arrest the adverse feedback loop.

Housing's road to recovery may contain potholes. For example, loan modifications may simply forestall eventual foreclosures. Recent Boston Fed research found that nearly half of renegotiated mortgages fall delinquent again within six months.[13] No doubt, more foreclosures will increase the downward pressure on prices and add to the excess supply of homes on the market.

The unsold homes that clog bank balance sheets will hit the market at some point. Including the shadow inventory increases the supply of existing homes for sale from 9.4 months to 12 months as of July.[14]

High foreclosure rates perpetuate the adverse feedback loop, but they may be a necessary price to pay to unravel the housing market's excesses. By forcing home prices to more sustainable levels, foreclosures play an important role in clearing markets. Affordability is critical to a lasting recovery in the housing market and, by extension, the broader economy.

The strategy for arresting the adverse feedback loop is to interrupt the downward spiral at several points, not just in the housing and financial markets that started it all. The economy's recent trends are encouraging, but the potential dangers suggest it's too soon to conclude that the adverse feedback loop has been broken.
Notes

The authors wish to thank Harvey Rosenblum for valuable comments and David Luttrell for research assistance.

See the FOMC's minutes for Jan. 29–30, 2008, www.federalreserve.gov/monetarypolicy/fomcminutes20080130.htm.

Alternative-A, or Alt-A, mortgages—alternatives to A, or prime, mortgages—typically went to borrowers who had higher credit scores than subprime borrowers but had no proof of income, high debt-to-income ratios or excess loan-to-value ratios. See "Accounting for Changes in the Homeownership Rate," by Matthew Chambers, Carlos Garriga and Don E. Schlagenhauf, Federal Reserve Bank of Atlanta, Working Paper no. 2007-21, September 2007, www.frbatlanta.org/filelegacydocs/wp0721.pdf.

Borrowers weren't using ARMs due to historically high mortgage rates; instead, housing prices were high, and buyers couldn't afford homes without the loans' ultra-low teaser rates. Most subprime ARMs underwritten during the boom carried a two-year lock before resetting to higher rates.

See "2009 Small Business Credit Card Survey," National Small Business Association, www.nsba.biz/docs/09CCSurvey.pdf.

Effective unemployment, a Bureau of Labor Statistics measure known as the U-6, is calculated by adding total employed workers in the labor force, plus all marginally attached workers, plus workers who are employed part time for economic reasons, expressed as a percentage of the sum of the civilian labor force and all marginally attached workers. Marginally attached workers are those who are not in the labor force but have searched for work, are available for work and want a job now.

The figure is based on calculations by financial services firm Credit Suisse.

Data are from American Bankruptcy Institute statistics. For more on the subject, see "Bankruptcy Filings Return to Pre-Reform-Law Pace," by Martin Merzer, CreditCards.com, July 20, 2009, www.creditcards.com/credit-card-news/bankruptcy-filings-back-to-pre-reform-levels-1282.php.

This is the payback for consumer debt growing faster than GDP (or income) on a sustained basis. The readjustment to reality (or mean reversion), unless financed by the rest of the world, is likely to take several years. See "Credit Cards Are the Next Credit Crunch," by Meredith Whitney, Wall Street Journal, March 11, 2009.

See "Flood of Foreclosures: It's Worse Than You Think," by Les Christie, CNNMoney.com, Jan. 23, 2009.

For a full discussion of the commercial paper funding facility and other Federal Reserve policy tools, see "Fed Confronts Financial Crisis by Expanding Its Role as Lender of Last Resort," by John V. Duca, Danielle DiMartino and Jessica J. Renier, Federal Reserve Bank of Dallas Economic Letter, vol. 4, no. 2, 2009.

The Fed announced the TALF in November 2008, but the program didn't begin operations until March 2009.

The $300 billion commitment is minimal in the context of the $7.4 trillion in Treasury debt held by the public. The Fed has since indicated this program will wind up in October without breaching the $300 billion ceiling.

See "Why Don't Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures and Securitization," by Manuel Adelino, Kristopher Gerardi and Paul S. Willen, Federal Reserve Bank of Boston, Public Policy Discussion Papers no. 09-4, July 6, 2009, www.bos.frb.org/economic/ppdp/2009/ppdp0904.pdf.

Data are from the research report "Afternoon Tea with Dave: Market Musings & Data Deciphering," by David Rosenberg, Gluskin Sheff + Associates, Aug. 24, 2009.

Economic Letter is published by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

Articles may be reprinted on the condition that the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Dallas.

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"A Smarter (and Cost-Efficient) Way to Fight Crime"

Robert Frank says ideas from game theory and the economics of signaling behavior can be used to improve the enforcement of rules and regulations:

A Smarter (and Cost-Efficient) Way to Fight Crime, by Robert Frank, Commentary, NY Times: ...The evidence suggests that when hardened criminals are reasonably sure that they will be caught and punished swiftly, even mild sanctions deter them. ... One way to make apprehension and punishment more likely is to spend substantially more money on law enforcement. In a time of chronic budget shortfalls, however, that won't happen.

But [Mark Kleiman] suggests that smarter enforcement strategies can make existing budgets go further. The important step, he says, is to view enforcement as a dynamic game in which strategically chosen deterrence policies become self-reinforcing. If offense rates fall enough, a tipping point is reached. And once that happens, even modest enforcement resources can hold offenders in check.

Consider violent crimes committed by drug gangs. In many cities, such gangs are too numerous for police to watch them all closely. Knowing that they are unlikely to be caught and punished, members can violate the law with impunity. In such situations, Mr. Kleiman argues, the police can gain considerable leverage just by publicizing an enforcement priority list. It is an ingenious idea that borrows from game theory and the economics of signaling behavior.

To see how it works, suppose that all drug violence ... is committed by members of one of six hypothetical gangs — the Reds, Whites, Blues, Browns, Blacks and Greens — and that the authorities have enough staffing to arrest and prosecute offenders in only one gang at any one time. Mr. Kleiman proposes that the police publicly announce that their first priority henceforth will be offenders in one specific gang — say, the Reds (perhaps because its members committed the most serious crimes in the past).

This simple step quickly persuades members of that gang that further offenses will result in swift and sure punishment. And that is enough to deter them. With the Reds out of action, the police can shift their focus to the Whites. They, too, quickly learn that violent offenses result in swift and certain punishment. So they quiet down as well, freeing the police to focus on the Blues, and so on.

But why don't the Reds, seeing that the police have moved on, start committing violent offenses again? The reason is that they always remain atop the enforcement priority list. If they start offending again, police attention will again quickly focus entirely on them. After a few rounds, Mr. Kleiman argues, the Reds will get the point. In like manner, one gang after another is pacified, even though the police have no more resources than before.

Considerable evidence supports Mr. Kleiman's emphasis on the efficacy of immediate sanctions. ... Several notable law enforcement successes, like a crackdown on gang homicide in Boston and strategic drug market disruptions in High Point, N.C., and Hempstead, N.Y., provide further testimony to the effectiveness of focused deterrence. ...

Potential applications of dynamic deterrence extend well beyond street crime. For example, it could help rein in corporate scofflaws who now feel free to violate environmental and safety regulations because they know that regulators are stretched thin.

The strategy won't work in all situations. But when the circumstances are right, it's a revolutionary idea.

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Paul Romer: New Systems versus Evolution

Paul Romer responds to questions from Chris Blattman about his proposal to establish charter cities, in particular, how to construct dynamic rule sets that maximize the chance of success:

New Systems versus Evolution, by Paul Romer: At a recent talk in London, Chris Blattman asked if a charter city could fail in the same way that public housing failed in Chicago. After the seminar and in his follow up post, we started a discussion of the deeper issue: What kind of dynamics would be desirable in the space of rules?

To frame the discussion, it helps to have some vocabulary. A rule set is a large collection of rules that are tightly linked. Rule sets can improve through what I will call an evolutionary dynamic based on small, incremental changes or through a new-system dynamic in which an entirely new rule set enters and competes with an existing one.

Chris and I agree that an evolutionary dynamic can lead a vibrant neighborhood but that it can also lead to a dangerous slum with no roads, sewers, safe water, electricity or other utilities.

We also agree that there is a risk associated with new systems. Sometimes they don't work, as the public housing projects in Chicago demonstrate. Sometimes they work remarkably well. Architecturally similar high-rise buildings in Hong Kong and Singapore provided livable housing for large numbers of working poor in the 1960s and 1970s. ...

The challenge that Chris posed to me, one that several others have also suggested, but not as precisely, is how to assess the tradeoff between faster growth and higher risk that the new-system dynamic seems to offer. A related question is who bears that risk. These are important questions. Here are some provisional answers.

Start with the distinction between catch-up growth and frontier growth. Catch-up growth is based on copying existing ideas. Frontier growth involves the discovery and implementation of new ideas.

In catch-up growth, the new-system dynamic can be used to copy existing rule sets. This allows faster growth without the additional risk that comes from using the new-system dynamic at the frontier. ...

The concept of a charter city does rely on the new-system dynamic, but in the context of economic development, charter cities can adopt a new rule set made up of rules that are known to work well. It can accelerate catch-up growth with little of the risk associated with the development of new systems at the frontier.

A charter city could be also used, perhaps in the United States, to encourage innovation at the frontier of urban living. An entirely new city could introduce changes to transportation systems or energy systems that are improbable along an evolutionary path. ... But in this case, faster growth would involve more risk.

It is important to recognize that new systems typically need evolutionary improvement after they are introduced. As existing charter cities compete with each other, they will evolve in precisely this sense. ... A new city could still fail, just as Detroit is failing in the United States. The risk of a failure falls primarily on the owners of the fixed assets that can't leave, not on the labor income of workers who can leave. This seems like just the right allocation for incentives and risk sharing. If the development authority with administrative responsibility for the city owns the land and collects revenue as rent on long-term leases, it has a strong incentive to get the rules right early on and to help the rules evolve in the right direction thereafter. ...

An arrangement with many cities that compete with each other is present today in China. Many new or rapidly growing cities compete for residents and investors. Local officials receive a substantial portion of their revenue from gains in the value of land that they own. To my knowledge, none of the new or rapidly growing cities in China has failed to the degree that public housing failed in the United States.

Finally, it is worth noting that roughly 3 billion people will move to cities in the next 50 years. If this growth takes place by an evolutionary dynamic that expands existing cities, many of these cities will fail as badly as the public housing projects did in Chicago. In fact, particularly many of them already do.

The right question to ask is not whether the new-system dynamic, as applied by charter cities, is subject to some risk. Rather, it is whether the risk of failure in charter cities is any greater than along the status quo path. Because charter cities use the new-system dynamic to copy best practice and create strong competitive pressures for rapid evolutionary improvement after they are built, I'm convinced that they offer the prospect of both faster growth and less risk.

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links for 2009-10-02

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Economist's View - 6 new articles

2009-10-02T22:52:00.001-07:00

Do Regulators Have Distorted Incentives?: Beatrice Weder di Mauro Roundtable at Free Exchange

I'm participating in a roundtable discussion at Free Exchange. The lead article by Beatrice Weder di Mauro argues that regulators need better incentives:

The dog that didn't bark, by Beatrice Weder di Mauro

Here's my response:

Prioroties at the Top, by Mark Thoma

Here are other responses:

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"Another Bad Employment Report"

Brad DeLong on the discouraging employment report released today. As the three posts that follow this one attest, this was not a surprise. But as Brad notes, even though we could see this coming, we do not have the plans in place that are needed to respond to the continuing weakness in labor markets:

Another Bad Employment Report (I-Wish-We-Had-a-Ripcord-to-Pull Department), by Brad DeLong: The adult civilian employment-to-population ratio drops below 59% to 58.8%, down from a December 2006 peak of 63.4% (and am April 2000 peak of 64.7%) [graph]...

God! I really wish that I were not so smart!

Brad DeLong, March 25, 2009:

The Stimulus Package Looks a Lot Smaller Now...: We are going to need a bigger one in September, which means it has to be put into the budget resolution now...

Well, we didn't. And now when it would be very nice to have a very large state aid program ready to be dropped into the fall reconciliation bill--and when it would be very nice to have a government-paid health corps starting up now as part of health care reform--we don't. ...

More commentary:

What Larry Mishel said:

The... employment decline, down 263,000, is still far below the awful hemorrhaging in the winter months.... The revisions announced to last March's employment level—payroll employment was an astounding 824,000... shows the huge hole we have been thrown into. That, of course, can't be blamed on Obama!...

[T]he drop in the labor force of 571,000 is the only reason that unemployment didn't exceed 10.0% [last] month.... Also amazing is that the nation's labor force—those employed or seeking work-declined by 615,000, or 0.4% over the last twelve months when normally we would expect it to rise by at least 1%...

What Dean Baker said:

The loss of 263,000 payroll jobs, coupled with a 0.1 hour decline in the average workweek, pushed the index of aggregate hours to 98.5, slightly below the 98.6 level in December of 1998. Hours worked have now declined by 8.6 percent from the pre-recession peak. In the 1981-81 recession the decline from peak to trough was 5.8 percent. The loss of jobs also pushed the unemployment rate to 9.8 percent....

The government sector lost 53,000 jobs in September... at the state and local level... 47,000... lost jobs.... The construction sector continued its rapid pace of job loss, shedding 64,000 jobs in September.... Manufacturing lost another 51,000 jobs.... Wage growth continues to weaken with wages rising at just a 1.7 percent nominal rate over the last quarter, almost certainly less than the rate of inflation.

The Bureau of Labor Statistics (BLS) reported its preliminary benchmark revisions to the establishment survey data... employment in March of 2009 was 824,000 lower than originally reported with private sector employment 855,000 lower. This extraordinarily large downward revision is not surprising... the imputation for new firms not included in the survey was consistently larger than the imputation from the prior year when the economy was still growing.... [T]he economy has lost 8,029,000 [payroll] jobs in the downturn....

[A] turnaround in the labor market is not imminent. Continuing losses of jobs and declines in hours, coupled with stagnant or declining real wages, means that workers' purchasing power is still falling. There are no further tax breaks scheduled to boost demand and state and local governments are cutting back and raising taxes to address budget shortfalls. The future is not good.

Kristin Winkler Krapja:

New orders for manufactured goods declined 0.8% in August...

Alan Rappeport:

US unemployment rate hits 9.8%: The US unemployment rate climbed to a fresh 26-year high of 9.8 per cent in September, as the pain of recession continues to linger on the shoulders of American workers in spite of aggressive measures to stimulate the economy. Official figures on Friday showed that non-farm payrolls dropped by 263,000, making it the 21st consecutive month that the US economy has shed jobs. The data were worse than even the most grim expectations, as economists predicted a 175,000 drop in payrolls, and followed a decline of a revised 201,000 jobs in August when the unemployment rate was 9.7 per cent. "It is clear that the labour market is still very weak," said Paul Dales, US economist at Capital Economics. "The last time one in ten members of the labour force were out of work was in 1983."...

The US unemployment rate has more than doubled in the past two years and the number of people without jobs has risen by 7.6m to 15.1m since the recession began in December 2007.... In September, hourly earnings ticked up by a penny to $18.67, but the average work week, a closely watched measure that signals future hiring, slid back to 33 hours. This remains close to a record low and economists suggest that an expansion in working hours will have to come before new hiring begins. "Hourly earnings are soft, reinforcing a view that the short term problem is disinflation not inflation, and does not support a consumer spending rebound," said Alan Ruskin, a strategist at RBS Greenwich Capital.

The labour department figures come as analysts project that the US economy grew at an adjusted annual rate of 3 per cent in the just completed third quarter. Fears abound, however, over a "jobless recovery", where companies that have become acclimated to operating with fewer workers are slow to begin rehiring and where employment lags the rest of the economy. Ben Bernanke, chairman of the Federal Reserve, said on Thursday that even if the economy expands at a rate of 3 per cent, that will not be enough to chip away at the unemployment rate, which is expected to rise above 10 per cent before falling back next year. Mr Bernanke has pointed to rising levels of long-term unemployment – of six months or more – as another looming risk to the labour force, as workers begin to see their skills erode. In September, 5.4m Americans had been unemployed for more than six months, representing 35.6 per cent of those who were unemployed....

Other indicators have added to the argument that unemployment will remain stubbornly high. New jobless claims have been mounting at a clip of around 500,000 a week, the rebound in manufacturing activity appears to be sputtering and the latest Conference Board survey found that more people feel like jobs are hard to get...

The U-6 underemployment rate--"total unemployed, plus all marginally-attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally-attached workers--is 17.0%.

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Paul Krugman: Mission Not Accomplished

If we don't do more to promote recovery, the human and economic costs will be large:

Mission Not Accomplished, by Paul Krugman, Commentary, NY Times: Stocks are up. Ben Bernanke says that the recession is over. And I sense a growing willingness among movers and shakers to declare "Mission Accomplished" when it comes to fighting the slump. It's time, I keep hearing, to shift our focus from economic stimulus to the budget deficit.

No, it isn't. ... Yes, the Federal Reserve and the Obama administration have pulled us "back from the brink" — the title of a new paper by Christina Romer, who ... argues convincingly that expansionary policy saved us from a possible replay of the Great Depression.

But while not having another depression is a good thing, all indications are that unless the government does much more than is currently planned..., the job market ... will remain terrible for years to come. Indeed, the administration's own economic projection ... is that the unemployment rate ... will average 9.8 percent in 2010, 8.6 percent in 2011, and 7.7 percent in 2012.

This should not be considered an acceptable outlook. For one thing, it implies an enormous amount of suffering over the next few years. ... John Irons of the Economic Policy Institute ... points out that sustained unemployment on the scale now being predicted would lead to a huge rise in child poverty — and that there's overwhelming evidence that children who grow up in poverty are alarmingly likely to lead blighted lives.

These human costs should be our main concern, but the dollars and cents implications are also dire. Projections by the Congressional Budget Office, for example, imply that over the period from 2010 to 2013 — that is, not counting the losses we've already suffered — the ... difference between the amount the economy could have produced and the amount it actually produces, will be more than $2 trillion. That's trillions of dollars of productive potential going to waste.

Wait. It gets worse. A new report from the International Monetary Fund shows that the kind of recession we've had, a recession caused by a financial crisis, often leads to long-term damage to a country's growth prospects. ...

The same report, however, suggests that ... a temporary increase in government spending — "is significantly associated with smaller medium-term output losses."

So we should be doing much more than we are to promote economic recovery, not just because it would reduce our current pain, but also because it would improve our long-run prospects.

But can we afford to do more...? Yes, we can.

The conventional wisdom is that trying to help the economy now produces short-term gain at the expense of long-term pain. But as I've just pointed out,... that's not at all how it works. The slump is doing long-term damage to our economy and society, and mitigating that slump will lead to a better future.

What is true is that spending more on recovery ... would worsen the government's own fiscal position. But even there, conventional wisdom greatly overstates the case. The true fiscal costs of supporting the economy are surprisingly small.

You see, spending money now means a stronger economy, both in the short run and in the long run. And a stronger economy means more revenues... Back-of-the-envelope calculations suggest that the offset falls short of 100 percent, so that fiscal stimulus isn't a complete free lunch. But it costs far less than you'd think from listening to what passes for informed discussion.

Look, I know more stimulus is a hard sell politically. But it's urgently needed. The question shouldn't be whether we can afford to do more to promote recovery. It should be whether we can afford not to. And the answer is no.

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"The Truth About Jobs"

Robert Reich joins the call for the government to do more to promote recovery:

The Truth About Jobs That No One Wants To Tell You, by Robert Reich: Unemployment will almost certainly in double-digits next year -- and may remain there for some time. And for every person who shows up as unemployed in the Bureau of Labor Statistics' household survey, you can bet there's another either too discouraged to look for work or working part time who'd rather have a full-time job or else taking home less pay than before... And there's yet another person who's more fearful that he or she will be next to lose a job.

In other words, ten percent unemployment really means twenty percent underemployment or anxious employment. All of which translates directly into late payments on mortgages, credit cards, auto and student loans, and loss of health insurance. It also means sleeplessness for tens of millions of Americans. And, of course, fewer purchases...

Which brings us to the obvious question: Who's going to buy the stuff we make or the services we provide, and therefore bring jobs back? There's only one buyer left: The government. Let me say this as clearly and forcefully as I can: The federal government should be spending even more than it already is on roads and bridges and schools and parks and everything else we need. It should make up for cutbacks at the state level, and then some. This is the only way to put Americans back to work. We did it during the Depression. It was called the WPA. Yes, I know. Our government is already deep in debt. But let me tell you something: When one out of six Americans is unemployed or underemployed, this is no time to worry about the debt. When I was a small boy my father told me that I and my kids and my grand-kids would be paying down the debt created by Franklin D. Roosevelt during the Depression and World War II. ... My father was right about a lot of things, but he was wrong about this. America paid down FDR's debt in the 1950s, when Americans went back to work, when the economy was growing again... We paid taxes, and in a few years that FDR debt had shrunk to almost nothing. You see? The most important thing right now is getting the jobs back, and getting the economy growing again. People who now obsess about government debt have it backwards. The problem isn't the debt. The problem is just the opposite. It's that at a time like this, when consumers and businesses and exports can't do it, government has to spend more to get Americans back to work and recharge the economy. Then – after people are working and the economy is growing – we can pay down that debt. But if government doesn't spend more right now and get Americans back to work, we could be out of work for years. And the debt will be with us even longer. And politics could get much uglier.

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Fed Watch: Hawkishness Dominates

Continuing with the same theme, but with monetary rather than fiscal policy, Tim Duy is worried about unwarranted hawkishness:

Hawkishness Dominates, by Tim Duy: As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation. To be sure, Bernanke & Co. have shifted direction often during the past two years. But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high.

Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

While Warsh does note that weak economic conditions would defer tightening, the message is clear: we are looking to tighten, and will do so aggressively when economic activity firms. Moreover, we will do so preemptively, which means we are looking for opportunities prior to the emergence of very solid data.

Note one of the concerns identified by Warsh:

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade's debt bubble? Considering the question always draws me back to this chart, which for me epitomizes the difference between the 1990s and the 2000s:

The 1990s saw a remarkable period of sustained, high levels of investment in equipment and software. In contrast, a sustained period of very low interest rates during this decade was barely able to coerce firms to invest in the high single digits. That, in my mind, is a critical problem, reflecting low expected returns to capital investment. In effect, the policy error might not have been low rates. Indeed, rates do not look to have been low enough to stimulate sufficient investment demand to absorb the productive capacity of the nation, the classic Keynesian problem:

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate....

With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.

This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade. In fact, it would lend additional credence to reports that the Fed needs to do much, much more - a massive, unsterilized expansion of the balance sheet - should they even hope to stimulate sufficient investment demand to absorb underutilized labor. Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis. That, however, appears to me to confuse monetary with regulatory policy. The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.

Following the Warsh speech, Vice Chair Donald Kohn looked to tamp down expectations of an imminent rise in rates:

Although economic conditions have apparently begun to improve--partly in response to the extraordinary steps the Federal Reserve and other authorities have taken--resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery. For that reason, as the FOMC stated last week, exceptionally low interest rates are likely to be warranted for an extended period. Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging. Still, we need to be ready to take the necessary actions when the time comes, and we will be.

Still, like Warsh, Kohn looks determined to find an opportunity to remove accommodation. This despite expected high rates of unemployment. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said U.S. economic growth next year probably won't be strong enough to "substantially" bring down the jobless rate, which may remain above 9 percent at the end of 2010.

"Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate," Bernanke said in response to questions at a House Financial Services Committee hearing today in Washington. Growth of 3 percent means the rate would "still probably be above 9 percent by the end of 2010," Bernanke said.

Interesting how the Fed is encouraging expectations of policy withdrawal even though unemployment rates will remain unacceptably high through 2010. And, if above 9 percent at the end of next year, certainly unacceptably high during 2011 as well. Richmond Federal Reserve President Jeffrey Lacker even goes one step further in a Bloomberg interview:

The Federal Reserve will need to raise interest rates when the economic recovery is "firmly" in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.

"I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise," Lacker said today in a Bloomberg Radio interview. "I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions."

Seriously, raising rates even if unemployment is 10%? LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y! This redefines the term "hawk."

From where does this fear of inflation emanate? That brings us to perma-hawk Philadelphia Fed President Charles Plosser:

Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed's monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed's credibility to do so came in the form of the 1981-82 recession and was a steep one.

Consequently, just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. The issues of when and the pace at which we unwind the extraordinary measures taken during the financial crisis and recession are ones that are high on my list of priorities and are the subject of ongoing discussions within the Fed.

The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don't exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:

One could at least wait for significant - or any, for that matter - year over year gains in unit labor costs before declaring that we are at the doorstep of the 1970's. Moreover, the seeds of that inflation did not sprout overnight; the signs were evident but ignored in the late 1960's. Only in Plosser's mind exists the need for an imminent withdrawal of policy.

Bottom Line: The data this week has not been supportive of a rapid exit from accommodative policy. Indeed, the opposite could very well be the case. Despite this, Fed officials, albeit to varying degrees, are uniformly signaling that the actions to expand the balance sheet are only temporary and will be reversed absolutely as soon as possible, which only undermines the stimulative potential of those actions. This is definitely not quantitative easing, and uncomfortably harkens back to the fear of inflation that constrained policy at the Bank of Japan. It is interesting that Fed Chairman Ben Bernanke has worked so hard to avoid a repeat of that experience yet appears ready to risk repeating it nonetheless.

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links for 2009-10-01

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Economist's View - 6 new articles

2009-10-01T23:03:00.000-07:00

U.S. Recession Probabilities

My colleague Jeremy Piger calculated new US recession probabilities based upon July 2009 data that became available today (October 1), and he notes that , "For the first time in a while, there was some action in the results, with the July probability dropping to 53%. Not a clear signal of the end yet, but something...."

Historical U.S. Recession Probabilities

Notes: Recession probabilities for the United States are obtained from a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales. For additional details, including an analysis of the performance of this model for dating business cycles in real time, see Chauvet, M. and J. Piger, "A Comparison of the Real-Time Performance of Business Cycle Dating Methods," Journal of Business and Economic Statistics, 2008, 26, 42-49. All data was obtained on October 1, 2009. Shaded areas indicate NBER recession dating.

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"Multiplying Multipliers"

Paul Krugman responds to Robert Barro's claim that the government spending multiplier is much less than one, and he notes other research that comes to a different conclusion:

Multiplying multipliers, by Paul Krugman: Mark Thoma, Menzie Chinn, and The Economist all have posts on the question of the size of the fiscal multiplier.

Mark already provides links to my various commentaries on Barro. But let me repeat the gist. Barro makes a great deal of the fact that private spending fell during World War II, rather than rising the way it should in a classical Keynesian (oxymoron?) story.

What I and others immediately pointed out was that this tells us very little about what would happen under current conditions: during World War II there, um, was a war on: consumption goods were rationed, construction required special permits, and so on. The government was, in other words, deliberately suppressing private spending, through direct controls. So WWII is not a useful data point for determining what the multiplier is under other conditions.

Barro's response to this, as far as I can tell, was … nothing. I don't think he even acknowledged the nature of the complaint.

On a happier note, this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country's situation. The question for the United States is which estimate is most relevant.

I'd say it's the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn't drive up interest rates (capital flows in). We're in a similar position for a different reason: fiscal expansion doesn't drive up rates because we're at the zero bound.

Oh, we're also relatively closed.

The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying.

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Pre-Commitment to Austerity?

In a recent column, David Brooks says that our recent troubles are partly the result of moral decay, and that we need to return to "our tradition of Calvinist restraint, self-denial and frugal responsibility."

But haven't consumers started showing restraint? Aren't saving rates are rising? To this, Brooks replies:

Over the past few months, those debt levels have begun to come down. But that doesn't mean we've re-established standards of personal restraint. We've simply shifted from private debt to public debt.

Is Brooks right that the recent increase in public debt is evidence of moral decay, or is the increase in the deficit actually the wise and prudent thing to do? Even though Thomas Palley wrote this before David Brooks gave us his moral lesson, it's still a pretty good response to this part of his austerity message:

The Fiscal Austerity Trap, by Thomas Palley: I Déjà vu all over again The U.S. economy is still struggling to find a bottom in face of the deepest recession since the Great Depression of the 1930s. ... Yet, even as the recession rages, much of the economic policymaking community is already back to arguing ... [that] massive budget deficits ... threaten future financial stability.

Budget deficit alarmism has been a perennial feature of the Washington policy landscape for the past thirty years, and the return of budget deficit alarmism represents a case of "déjà vu all over again." The push for fiscal austerity was the agenda of Concord Coalition Republicans and Hamilton Project New Democrats long before the crisis, and these groups have now opportunistically seized on the crisis-induced spike in the budget deficit to revive that agenda. With economic policy largely controlled by former Hamilton Project personnel, there is a grave risk the Obama Administration could go along with this renewed alarmism.

The fiscal austerity program is rooted in wrong-headed economic analysis. It was the wrong economic agenda before the economic crisis, and it is even more wrong in light of the deep economic weaknesses the crisis has revealed.

Not only is fiscal austerity the wrong economic agenda, it is also the wrong political agenda. At a time when the nation is trying to recover from three decades of laissez-faire excess, the fiscal austerity agenda revives neo-liberal anti-government sentiment by presenting profligate government as the problem. The real problem is flawed market arrangements that have promoted income inequality and financial excess that has undermined shared prosperity and can no longer deliver growth.

The fiscal austerity message does triple damage. First, it makes reform of existing flawed market arrangements more difficult by misdirecting public understanding and saying government is the source of problem. Second, it uses budget deficits as a "Trojan Horse" for launching an assault on vital public programs - including Social Security, Medicare, and spending on education and public infrastructure. Third, it threatens to create a fiscal austerity trap in which fiscal austerity lowers growth, thereby lowering tax revenues and necessitating more austerity.

Fiscal conservatives claim that closing the budget deficit represents "fiscal responsibility." That claim is absolutely wrong. The reality is fiscal austerity under current circumstances would constitute "fiscal irresponsibility." The U.S. likely confronts an extended period of economic weakness in which budget deficits will be needed to ensure adequate aggregate demand (AD).

Budget deficits also have an important role to play in spurring growth. The old growth model, based on debt and asset price inflation, is broken. That calls for a new growth model in which deficit-financed public investment should be a central part.

The economic crisis has discredited neo-liberal economics. It should also have discredited the neo-liberal obsession with fiscal austerity. The fact that the fiscal austerity agenda has managed to regain traction so easily shows how deeply ingrained are the misunderstandings of neo-liberal economics, and how far there is to go to establish a new healthier economic conversation. ...

However, there will come a time when the deficit needs to be addressed:

Hurry Up and Wait, by Christopher Beam: When it comes to the national debt, says Paul Krugman, the best advice may come from St. Augustine: "Oh Lord, make me chaste and continent—but not yet." That was the rough consensus among the economists who convened Wednesday ... for a conference held by the Center for American Progress and the Center for Budget and Policy Priorities: We absolutely have to do something about this deficit. Just not right now.

Their advice is on the merits, but it just so happens to be politically convenient. We wanted to reduce the deficit ... Democrats can say, but the experts told us not to! ...

Before the economists gave the politicians permission not to act right away, however, they established the need to do something eventually. Right now, CBPP president Robert Greenstein said, the annual deficit is about 8 percent of gross domestic product, while the national debt—the sum of all past deficits—is about 70 percent of GDP... If current policy persists, the deficit will inflate to become 20 percent of GDP by 2050, with a total national debt of 300 percent of GDP. ...

If those numbers don't scare you, maybe the practical consequences will. Princeton Professor Alan Blinder explored the possibilities. Inflation? "I don't think we're going to see that in the United States," he said, even though it happens all the time in other countries when debt mounts. Skyrocketing interest rates? That's a "very obvious candidate." But the most likely risk, he said, is a weakening dollar: "If the economy cracks, it cracks on the dollar."...

Another possibility, said Blinder, is that the political system cracks first. He cited the New Deal as an example of a good political crackup. What a mountain of debt could mean for our political system, he said, "I wouldn't even begin to forecast." A questioner, however, did just that. Recall 1992, he said, when Ross Perot ran on a platform of deficit reduction. Perot didn't win, but his influence—he drew enough votes to allow Bill Clinton to become president—produced a bipartisan obsession with deficit reduction, which occupied much of Clinton's first term. "It's highly likely we're about to see that happen again," he said.

So if the stakes are so high and the future so dire, why wait? ... Because the economy is still fragile. ... As Berkeley economist Laura Tyson put it, "We have two risks: If we do something too precipitously fast, we undermine recovery … but if we don't do something," we risk the dystopian future described above.

The first deficit-reduction measure—health care reform—is already on the table. Health care spending is by far the biggest driver of the deficit, the panelists reminded the audience. "No path to a balanced budget doesn't go through health care," said Harvard professor David Cutler. Bend the curve ("Whoever is responsible for that phrase should be shot," said Krugman) and we're well on our way to digging out.

Aside from that, we should start thinking about getting ready to maybe soon reduce the deficit. The word Tyson used was "pre-commit." The idea: Pass deficit reduction legislation now that kicks in as soon as the economy stabilizes. That would reassure creditors now that we're serious about paying off our debt. ...

There's just one problem: Deficit reduction may be politically impossible, now or later. A surprise cameo by former Treasury Secretary Robert Rubin reinforced the point. Taking the mic, Rubin reminded the panel that in 1993, during his tenure, the Deficit Reduction Act passed by a single vote in the House and required the vice president to break a tie in the Senate. "Not exactly a dramatic rallying around with respect to fiscal discipline," he said. "So what would make you think that our political system is likely to respond more effectively today?" ...

How to get around this paradox is an open question. Greenstein suggested incrementalism: a bit of deficit reduction here, a bit there. Once members realize that voting for fiscal responsibility won't kill their electoral chances, the political calculus will change. "My hope is that people don't get punished," he said. Krugman strained for optimism: "What we have to hope is that 10 years from now we will have a much saner political landscape"...

I like the idea of pre-commitment, but since we cannot bind future legislators using this device, it is, at best, a means of establishing a default option that might be politically difficult for legislators of the future to move away from. A "saner political landscape" in the future is the best hope, but trends over the last few decades don't point in that direction.

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"Why the Lehman Failure Did Change Everything"

There's a lot of revisionism going on over the consequences of the Lehman's collapse. The standard view is that allowing Lehman to fail was a mistake, and hence government intervention could have lessened the severity of the crisis. Government intervention wouldn't have avoided problems altogether, but the problems wouldn't have been as bad as what we experienced.

However, a few people are now pushing the idea that the failure of Lehman wasn't a primary contributor to the problems that financial markets and the economy experienced. According to the revisionist view, government intervention would not have made any difference, the problems would have been just as bad either way. The notion that government intervention would not have helped is, of course, the main point that this group wishes to emphasize. However, the revisionist view does not hold up to closer examination:

Why the Lehman failure did change everything, by Richard Robb, Economists' Forum: For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations "the more they are removed from common sense," and so showing that the Lehman collapse was inconsequential has spawned a minor literature.

The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn't the main cause of last autumn's turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as "the rate at which banks can borrow unsecured for three months."

But a better definition of Libor under the circumstances was "the rate at which banks said they can borrow". Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor "remained in that range [of the previous year] through the rest of the week" after Lehman's demise. In fact, in the year prior to Lehman's collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)

The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores. ...

There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

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Government Spending Multipliers Once Again

Since the WSJ is, essentially, rerunning op-eds:

Stimulus Spending Doesn't Work, by Robert Barro and Charles Redlick

May as well rerun a few of the responses:

War and non-remembrance, by Paul Krugman

Spending in wartime, by Paul Krugman

Paul Krugman on Robert Barro, by Brad DeLong
Fiscal Policy and Economic Recovery, by Christina D. Romer

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links for 2009-09-30

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Economist's View - 5 new articles

2009-09-30T22:57:00.001-07:00

Government Spending Multipliers Once Again

Since the WSJ is, essentially, rerunning op-eds:

Stimulus Spending Doesn't Work, by Robert Barro and Charles Redlick

May as well rerun a few of the responses:

War and non-remembrance, by Paul Krugman

Spending in wartime, by Paul Krugman

Paul Krugman on Robert Barro, by Brad DeLong
Fiscal Policy and Economic Recovery, by Christina D. Romer

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"Monetary Policy, Fiscal Policy, Capital Markets Policy"

Brad DeLong places government policy into "three boxes," fiscal policy, monetary policy, and capital markets policy:

Monetary Policy, Fiscal Policy, Capital Markets Policy, by Brad DeLong: Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:

Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn't really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven't been paying attention.

Well, yes I'm aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed's balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn't willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it "should" be given, say, a Taylor rule.

Which means that the zero bound is still binding, which means that right now we're very much still in liquidity trap territory.

I would put it somewhat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.

If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

I would add risk management to the definitions (e.g., I have called the central bank the "risk absorber of last resort"). When the Fed (or any other government agency) trades T-Bills for risky private sector assets, it changes the overall level of risk in the private sector since the risk has been absorbed onto the Fed's balance sheet (this is not the only way to reduce risk, e.g. government provided insurance against losses would also have this effect, and most of these actions can also create moral hazard). The risk management function of policy is something Brad has talked about in the past as well, and I'm not sure if he'd identify risk management as a separate category, or whether it fits into the the capital markets policy categories he identifies (it would also operate on the wedge between safe and risky assets by reducing the risk premium, so I'd include it there). Either way, I think it's worth mentioning since these actions can also affect the level of economic activity. When markets are frozen with fear, reducing the chance that hidden losses will be discovered after a transaction is complete can help to restore these markets.

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W/P = MP?

Bankers are, apparently, being rewarded generously for their fine performance in recent years:

In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits.

If people were really compensated according to the value they create, wouldn't bank managers would owe us money?

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Does America Need "A Moral Revival"?

Andrew Leonard's bad day:

The brighter side of high unemployment, Andrew Leonard: ...BusinessWeek contributor Gene Marks ... gloats about how high unemployment is good for his business. I guess any publicity is good publicity... But he didn't pick a good day. Having already been irritated enough by David Brooks, I can't say I was exactly in the mood for an explanation of why high unemployment is great for small businesses because now there are so many "good, bright, educated people" who are "willing -- no, let's admit -- grateful to work for less money and longer hours."

Even better, the bad economy provides cover for getting rid of that "dead weight" that you were feeling too guilty to throw overboard. ... And the capper:

Because let's face it: The upside to the high unemployment rate is that it has helped us control our payroll costs. No one's asking for raises. No one's demanding more benefits. ...It's now easier and more politically correct to hire part-timers, subcontractors, and other outsourced help to fill the gaps. That's because when people are out of work, they'll do whatever they've got to do to bring in cash.

I understand that Gene Marks is ... a small business owner (he sells customer relationship management tools), who is attempting to speak to other small business owners, all of whom, presumably, are also delighted that the potential hiring pool is so chock full of talent desperate to be exploited right now.

But one wonders who exactly is supposed to purchase all those products and services from the small businesses of the world, if unemployment creeps up to the 10 percent mark or higher? High unemployment means low consumer demand. Which usually means small businesses end up going out of business, or at the very least, laying off more employees, who push the unemployment rate even higher. And so on. Low employment might mean it would be harder to find qualified employees, but it also means more customers with money burning a hole in their pockets. Which scenario, do you think, is better for society in general?

I have no problem with contrarian arguments. But a look back at the oeuvre of Gene Marks suggests that in his efforts to be routinely contrarian, he ends up coming off as, well, how can I be polite? What's the opposite of insightful?

Here's what set him off:

The decline and fall of David Brooks, by Andrew Leonard: America needs "a moral revival," declares David Brooks... We are drowning in a sea of debt, and this is because we have lost our moorings; we have abandoned our tradition of Calvinist restraint, self-denial and frugal responsibility. If we don't start living right, we run the risk of cultural failure, that time-honored historical pattern in which "affluence and luxury lead to decadence, corruption and decline."

My my my. I've seen some high horses in my day, but David Brooks is perched on a saddle so far aloft in the clouds of self-delusion that he can't even see the earth, much less reality. Let's examine his thesis more closely.

Americans ran up a lot of debt in the last few decades. There's no question about that. But one of the most striking developments of the last year has been how Americans have responded to the financial crisis at an individual level. We made a collective decision to start saving and stop spending. Is this because we woke up one morning last fall and suddenly became born-again Calvinists? No, it seems clear that we were responding rationally to economic incentives. The economy crashed, unemployment surged, home prices plummeted, and presto: We all started pinching pennies. Morality, insofar as expressed via our spending habits, is merely a reflection of the economy.

To his credit, Brooks acknowledges this point. But then he immediately dismisses it:

Over the past few months, those debt levels have begun to come down. But that doesn't mean we've re-established standards of personal restraint. We've simply shifted from private debt to public debt.

This, Brooks suggests, proves that "there clearly has been an erosion in the country's financial values." Elsewhere he suggests that our cultural decline began sometime around 1980.

Brooks displays a bizarre historical amnesia throughout his column. For example, he never even mentions the transition from the Roaring Twenties to the Great Depression. Maybe it's because the shift from decadence to thrift at that point was also obviously a response to economic incentives. Even worse, a moral revival didn't restore economic growth after the Crash -- government action and ultimately the fiscal stimulus provided by World War II did the trick.

But a far more pertinent point of reference comes much earlier. Has Brooks somehow forgotten that just nine years ago the U.S. operated under a balanced budget and enjoyed a budget surplus? The explosion of public debt since that point has very little to do with the moral failings of Americans, and everything to do with objective fact. George W. Bush cut taxes, but did not match those cuts with spending cuts. Instead, he ramped up spending dramatically, on two wars, healthcare, and finally, a huge bailout of Wall Street.

Bruce Bartlett has calculated that even without Obama stimulus-related spending increases, the current deficit for fiscal year 2009 would be about $1.3 trillion instead of $1.6 trillion. If you are a believer in Keynesian economics, you can make a pretty good case that Obama's additional spending is designed to get the economy growing again, so as to avoid even worse deficits in the future. Do nothing, and a shrinking economy means lower tax revenues and higher social spending. Morality has very little to do it -- the appropriate, responsible fiscal choice at this point is for government to spend, while the people save.

Obama would be in much better position to do what's appropriate, of course, if he hadn't been saddled with a trillion-dollar deficit when he walked in the door. But the responsibility for that does not belong with some widespread betrayal of America's founding puritan values. It belongs explicitly to the party in control over the last eight years.

Update: Paul Krugman:

Moral decay? Or deregulation?, by Paul Krugman: Andrew Leonard is unhappy with my colleague David Brooks for suggesting that rising debt in America reflects moral decay. Surprisingly, however, Leonard doesn't make what I thought was the most compelling critique.
David points out, correctly, that something changed around 1980 — that consumers started spending a larger share of national income and that debt began increasing. Although he doesn't point this out, this was also when the federal government first began running substantial deficits even in good years.
David would have you believe that what happened then was a decline in Calvinist virtue. But, um, didn't something else happen around 1980? Can't quite remember .. someone whose name begins with the letter "R"?
Yes, Reagan did it.
The turn to budget deficits was a direct result of the new, Irving-Kristol inspired political strategy of pushing tax cuts without worrying about the "accounting deficiencies of government."
Meanwhile, the surge in household debt can largely be attributed to financial deregulation.
So what happened? Did we lose our economic morality? No, we were the victims of politics.

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links for 2009-09-29

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Economist's View - 7 new articles

2009-09-29T22:52:00.001-07:00

"New Income Inequality Data: Surprising and Frightening"

Bruce Judson is worried about what the latest reports on economic inequality say about our future:

New Income Inequality Data: Surprising and Frightening, by Bruce Judson: The newest economic inequality numbers ... are frightening. Yesterday, the Associated Press released an article titled, US income gap widens as poor take hit in recession. The opening paragraph of the article, based on recent census data, reads:

The recession has hit middle-income and poor families hardest, widening the economic gap between the richest and poorest Americans as rippling job layoffs ravaged household budgets.

The article ... failed to mention that the Census Bureau considered the differences between 2007 and 2008, with regard to economic inequality, statistically insignificant. But, whether the Census Data shows a meaningful increase, or not is irrelevant. The Census Data reports that, contrary to the almost universal expectations of economists, economic inequality most likely did not decrease in 2008. Experts had anticipated that the declines in income of the rich would lead to a reversal in this groups ever–widening share of our national income. Instead, the Census reported that the 2008 income losses by the top 10% of Americans were offset by larger losses among middle class and poorer Americans. ...

Early next week, my new book It Could Happen Here will be released... The book is an in-depth look , based on a historical analysis, of the implications of our historically high levels of economic inequality for the nation's ultimate, long-term political stability. As economic inequality grows, nations invariably become increasingly politically unstable: Should we complacently believe that America will be different?

A central conclusion of the book is that once economic inequality reaches a self-reinforcing cycle it is halted only by inevitably controversial, hard-fought, bitterly opposed government action. ... In 1928, economic inequality was near today's levels. Franklin Roosevelt succeeded in reversing the trend toward the continuing concentration of wealth, but it was a turbulent battle. ...

In FDR's era and in our own, money brings power: both explicitly and implicitly, in hundreds of different ways, both large and small. Today, the wealthiest Americans, together with a number of financial and corporate interests that act on their behalf, protect their ever-increasing influence through activities that include, among others, lobbying, supplying expertise to the councils of government, casual conversation at dinner parties, the potential for jobs after government service, the power to run media advertisements that influence public opinion. Indeed, MIT economist Simon Johnston, writing in The Atlantic asserted that the U.S. is now run by an oligarchy...

The new inequality data suggests that the potential problems for the nation associated with the concentration of wealth and power are even more severe than previously recognized. Two weeks ago, I wrote that "Once income concentration becomes a reinforcing cycle of the kind we are witnessing, it is never stopped by pure market forces." This mechanism is now in full swing. ...

The great strength of American democracy has always been its capacity for self-correction. However, Robert Dahl, the eminent political scientist, recognized that political power fueled by wealth may ultimately neutralize this central aspect of our democracy. In his 2006 book, On Political Equality, Dahl wrote:

As numerous studies have shown, inequalities in income and wealth are likely to produce other inequalities..

The unequal accumulation of political resources points to an ominous possibility: political inequalities may be ratcheted up, so to speak, to a level from which they cannot be ratcheted down. The cumulative advantages in power, influence, and authority of the more privileged strata may become so great that even if less privileged Americans compose a majority of citizens they are simply unable, and perhaps even unwilling, to make the effort it would require to overcome the forces of inequality arrayed against them.

In the chapter following this quote, Dahl notes "that we should not assume this future is inevitable." He's right. But he was clearly concerned. ...

Many current Executive Branch initiatives deserve our support and praise: However, nothing proposed to date will effectively halt growing economic inequality, and its corrosive impact on our economy and the long-term future of the nation. ...

My analysis in It Could Happen Here concludes that without a vibrant middle class, the the American democracy as we know it, is not sustainable. Before the Great Recession, the middle class was in far worse shape than was generally acknowledged. In an economy with a record number of job seekers for every available job, the potential for nearly one-half of all home mortgages to be underwater, and increasing foreclosures, the collapse of the middle class will accelerate. With each job loss and each foreclosure, another family becomes a member of the former middle class.

America has never been a society sharply divided between have's and have not's. Unfortunately, this new data says to me we continue to head in that direction. Economists assumed that the Great Recession would be a circuit breaker that would halt this advance, at least temporarily. It did not. ...

Could our democracy survive a transformation into a nation composed principally of a privileged upper class and an underclass that struggles from paycheck to paycheck that lacks basic economic security. My analysis of a broad sweep of history, suggests it could not.

We will only stop the growth of economic inequality if the President and the Congress are ready to fight in the style of Franklin Roosevelt. FDR was a divider not a conciliator. Before World War II, he fought an all-out war at home. Today, "There's class warfare, all right," as Warren Buffett said, "but it's my class, the rich class, that's making war, and we're winning."

I fervently hoped that we have not passed the point of no return, described by Professor Dahl. The recent news shows we are one step further on this road. If we continue down it, our nation may be on the path to becoming a House divided against itself, which ultimately cannot stand.

Are you as concerned as he is? I don't know if we are headed down the path of no return or not, but the part that concerns me is that recent changes in inequality do not seem to be driven by market forces that properly evaluate and reward productive activity.

Republicans worry a lot about the effect that small changes in tax rates would have on economic activity (something there's not a lot of evidence to support) because taxes distort the relationship between effort and reward. But if the rewards have become generally separated from productive effort, particularly the large rewards at the very top of the income distribution where the Republicans argue these incentive effects are the strongest, then there are large distortions in the system that have nothing to do with taxes. That is what Republicans ought to be worried about if they are truly concerned with ensuring that the rewards people receive match their productive effort.

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Social Mobility

Andrew Leigh says this is a "a terrific piece on social mobility":

American dreams, by Peter Browne: When Barack Obama spoke to schoolchildren at Wakefield High School in Virginia last week, he drew on his own experiences to argue that all young Americans, regardless of their family's wealth and income – even kids who "goofed off" at high school, like he did – have the potential to rise to the top. ...

But how typical is [this]? ... The seductive idea that anyone can move up the income scale might mean that Americans are more tolerant of a degree of inequality that would cause much deeper unease in many other western countries. ...

[R]ecent research drawing on a series of studies from Europe, the United States and Australia ... has concluded ... that among comparable countries, the United States has an unusually rigid social system and limited possibilities for mobility. ...

President Obama is no doubt aware of this research, and has made oblique references to the problems facing low-income families and neighborhoods in speeches and interviews. But the mobility myth is so widely believed and so deep-seated that it's not surprising he hasn't tried to confront the problem head on. When the Economic Mobility Project [2] surveyed 2100 adults and ran ten focus groups earlier this year it found that respondents overwhelmingly believe that personal attributes – "like hard work and drive" – are the prime determinants of how economically successful an individual can be. A smaller majority also disagreed with the statement that "In the United States, a child's chances of achieving financial success is tied to the income of his or her parent."

As the studies show, that statement is true for ... a higher proportion of American children than in most comparable countries. Among the twelve countries analyzed by economist Anna Cristina d'Addio in a 2007 OECD report,... the United States was in a group of four – with France, Italy and Britain – where family background plays the greatest role in influencing adult income. Children born into a poor family in any of these countries had a much lower chance of breaking into a higher income group than in any of the other countries in the study. ...

Britain came out worst, with around 50 per cent of a person's income explained by his or her parents' income. ... Italy and the United States weren't far behind, at around 47 per cent. At the other end of the range were Denmark, Norway, Finland and Canada, where parental income explained less than 20 per cent of the child's eventual earnings. ...[I]t's those four countries, rather than the United States, that come closest to realizing the American Dream.

Some studies have found that mobility is not only limited in the United States but has worsened in recent decades. ...

Why do some countries fare so badly...? The OECD report offers the most comprehensive list of likely factors, but its conclusions are tentative. ... But looking at the factors that the OECD believes contribute "significantly" to differences in mobility, it isn't hard to see why the United States performs badly...

First, there's the problem of entrenched income inequality. "In general," says d'Addio..., "the countries with the most equal distributions of income at a given point in time exhibit the highest mobility across generations." Among the twelve countries examined in the report, the United States has the most unequal distribution of income. ...

Equally interesting is the role of immigration in pushing up mobility. Overall, immigrants tend to be more upwardly mobile than the broader population. ... Yet the United States doesn't seem to have gained the ... benefits from migration... This clearly has something to do with how well migrant students perform at school. ...

The other key factor identified indirectly by the OECD, and more explicitly in a new Economic Mobility Project [8] report, is a strikingly low level of mobility among black Americans. ... The author of the Project's report, New York University sociologist Patrick Sharkey, finds that growing up in a high-poverty neighborhood "increases the risk of experiencing downward mobility and explains a sizable portion of the black-white downward mobility gap."

These neighborhoods usually suffer from other warning signs for low mobility identified in the OECD report, including a high rate of male unemployment at the time of a child's birth and a high rate of relationship breakdown. ...

For Barack Obama, the ... reform that's causing him the most difficulty at the moment – healthcare – also has implications for economic mobility. Child birth-weight is a "significant" factor in explaining low mobility, and the child's mental health and parents' physical health are "significant and large" factors, according to the OECD. Like any measures designed to break down the rigidity that keeps many Americans poor, improvements in health will take some time to influence overall mobility. But a system of health insurance for all Americans would certainly have an impact in the long term.

Ironically, the remarkable rise of Barack Obama could make it harder for Americans to recognize the shaky foundations of the American Dream. And the fact that so many people continue to believe the myth could make the problem worse. As the American researcher Isabel Sawhill writes, "When those who are relatively poor believe that they or their children will rise in status over time, they are less likely to complain about the status quo and more likely to accept the prevailing system." ...

Is it true that we tolerate inequality because we believe we are highly mobile, and that merit rather than family background is the most important factor in determining social outcomes? Even if it were true that merit is the most determinant of social mobility, that is not enough. The opportunity must be present before those with merit can take advantage of it, and ensuring that everyone has a chance to succeed is an important step in fixing the mobility problem. Nothing will ever be completely equal, some people will always have more opportunity than others to get ahead, but we could do a whole lot better than we are doing now at creating the opportunity for people to reach their full potential.

I am not generally predisposed to redistributive policies, and the best solution to the mobility problem is to ensure everyone has an equal chance to succeed. But since equal opportunity is a long way from reality, I believe that redistribution that compensates for differences in opportunity is justified.

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"An Inside Look at How Goldman Sachs Lobbies the Senate"

I am not as negative toward naked short-selling as Matt Taibbi (feel free to convince me I'm wrong), but his insights into the lobbying effort against financial reform are useful, and I share his concerns about the distortions (e.g. regulatory capture) this brings to the reform process:

An Inside Look at How Goldman Sachs Lobbies the Senate, by Matt Taibbi: ...Later on this week I have a story coming out in Rolling Stone that looks at the history of the Bear Stearns and Lehman Brothers collapses. The story ends up being more about naked short-selling and the role it played in those incidents than I had originally planned..., but it turns out that there's no way to talk about Bear and Lehman without going into the weeds of naked short-selling...

It's the conspicuousness ... that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn't a better example of "regulatory capture" ... than this issue.

In that vein, starting tomorrow, the SEC is holding a public "round table" on the naked short-selling issue. What's interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called "pre-borrowing." Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It's been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement...

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts... Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss's office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman's fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman's performance that they both called me on the same day — and I don't have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman's lobbying efforts and concluded that it was one of the most shameless performances they'd ever seen from any group of lobbyists, and that the "fact sheet" ... was, to quote one person familiar with the situation, "disgraceful" and "hilarious." ...

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"The Side He Picked in Economics was an Odd One"

David Warsh on Irving Kristol:

The Straw That Stirred the Drink, by David Warsh: Irving Kristol, who died earlier this month at 89, meant many different things to many different people. One way to remember him is as the editor who, with his friend and City College of New York classmate Daniel Bell, founded The Public Interest in 1965, at just the moment the phenomenon known as "the counterculture" was beginning to grip the popular imagination of the West.

The first issue featured Robert Solow on "Technology and Unemployment," Daniel Patrick Moynihan on "The Professionalization of Reform," Nathan Glazer on "The Paradoxes of Poverty," Jacques Barzun on "Art – By Act-of-Congress," Daniel Greenberg on "The Myth of the Scientific Elite," Martin Diamond on "Conservatives, Liberals and the Constitution," and Daniel Bell on "The Study of the Future."

And for the next fifteen years, while the Americans lost their way in Vietnam, the Soviet economy stagnated, the Chinese people suffered Mao Tse Tung's Cultural Revolution, The Public Interest was the quarterly that kept its head, serving as a focal point for meliorists of all kinds. Magazines such as People, Money and Rolling Stone built huge audiences in those years; The Public Interest rarely sold more than 12,000 copies. But the people who read it would in due course take over the nation's politics.

An extraordinary galaxy wrote for Kristol in those days on nearly every social issue of the day (Bell, a professor of sociology at Harvard, cut back his participation after the two disagreed on the presidential election of 1972): Peter Drucker, Milton Friedman, Seymour Martin Lipset, James Coleman, Robert Nisbet, Henry Fairlie, Aaron Wildavsky, William Bennett, James Tobin, Richard Zeckhauser, Thomas Schelling, Herbert Stein, Gordon Crovitz, Anthony Downs, David Gordon, John Meyer, Jeffrey O'Connell, Paul Starr, Christopher Jencks, Charles Reich, Michael Novak, Charles Lindblom, Josiah Lee Auspitz. They were conservatives and liberals alike, but the quarterly's content steadily trended over the years towards the stance that in time would become known as "neoconservative." (A terrific full issue-by-issue archive can be found here.)

Kristol "was able to pick a side without losing his clarity," wrote David Brooks in his New York Times column last week.

The side he picked in economics was an odd one. A 1975 issue featured a pair of articles: "The Social Pork Barrel" launched the career of a young Michigan Congressman, David Stockman, who would become budget director for Ronald Reagan; and "The Mundell-Laffer Hypothesis – a New View of the World Economy," by Wall Street Journal editorial writer Jude Wanniski, introduced the world to economists Arthur Laffer and Robert Mundell, and their newly-invented brand of "supply side economics."

The striking thing about Wanniski's article was its anti-establishment tone, anti-Chicago as well as anti-Cambridge, Mass. The new hypothesis might be as transformative as the Copernican Revolution, he averred – or at least that of John Maynard Keynes. Mundell and Laffer's enthusiasms for a gold standard, fixed exchange rates, large tax cuts and tight money were picked up and greatly amplified by the editorial page of The Wall Street Journal. The Republican Party was divided – insouciant economic populists in one wing, sober technocrats in another.

In the neo-conservative firmament, the stars of ordinarily first-magnitude conservatives Milton Friedman and Martin Feldstein dimmed, while Laffer and Wanniski brightened. The success of The Way the World Works, Wanniski's 1979 book for editor Midge Decter, nearly ripped apart the boutique social science publisher Basic Books, where Kristol worked as an editor as well.

By then The Public Interest was losing its force. As James Q. Wilson wrote the other day in The Wall Street Journal, "It began to speak more in one voice and the number of liberals who wrote for it declined." Daniel Bell quietly resigned, in 1980. It didn't matter. The Republicans were in power; and Kristol was ready for a second act. He would become widely known as "the Godfather" of neo-conservatism, dispensing favors and advice as a political activist operating out of the American Enterprise Institute in Washington.

In its obituary last week, The Economist summed up this second act of Kristol's career: "American conservatism, before he began to shake it up, was dour, backward-looking, anti-intellectual and isolationist, especially when viewed from the east coast. By the time Mr. Kristol … had finished with it, it was modern and outward looking, plumped up with business-funded fellowships and think tanks and taking the lead in all policy debates."

Success profoundly changed the game. The Cold War ended. The discipline and sense of fair play seemed to go out of civic life. There hasn't been anything like The Public Interest since. But for fifteen crucial years in the late '60s and '70s, Kristol's editing was the straw that stirred the drink.

I'm running short on time, so I'll leave the commentary to all of you, but I will note this:

Irving Kristol explains where the economics articles he published in The Public Interest came from:

Among the core social scientists around The Public Interest there were no economists.... This explains my own rather cavalier attitude toward the budget deficit and other monetary or fiscal problems. The task, as I saw it, was to create a new majority, which evidently would mean a conservative majority, which came to mean, in turn, a Republican majority - so political effectiveness was the priority, not the accounting deficiencies of government...

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"Crunch Time: The Fight to Fix the Financial System"

Simon Johnson and James Qwak wonder how much political capital the administration is willing to use to meaningfully reform the financial system:

It's Crunch Time: The Fight to Fix the Financial System Comes Down to This, by Simon Johnson and James Kwak, Commentary, Washington Post: The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.

The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.

But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...

We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.

Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...

Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.

The initial bill needs to be as strong as possible, and I agree that the administration needs to do what it can to prevent the bill from being scaled back. However, the initial legislation won't be as strong as I'd like even if the administration does prevail. But I hope we aren't thinking that we'll take one stab at financial reform and then we'll be done with it. Like climate change and health care, it will require a series of bills to achieve effective reform.

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"Come Dine with Me: The Economics"

Chris Dillow says the British TV show Come Dine with Me "raises important issues about the nature of rationality and preferences":

Come Dine With Me: the economics, by Chris Dillow: It's insufficiently appreciated that Come Dine with Me raises some profound issues in economics. Here are three:

1. The importance of norms of fairness. The format of CDWM is simple. There are four people. Each hosts a dinner party for the other three. The guests score their host out of 10. The person with the highest score wins £1000.

In this game, the optimum strategy for a guest is to score their hosts zero. This would mean the maximum score one's rival hosts could make would be 20, which in a normal game would not usually be sufficient to win. So, if your three rivals play normally, scoring them zero greatly increases your chances of winning.

If everyone knows this, we end up in a Nash equilibrium in which everyone scores zero; this is a one-shot game with scores revealed only after all four dinner parties, so tit-fot-tat doesn't apply.

But this never happens. Even contestants who claim to want to win score their rivals reasonably. This suggests that norms of fairness overwhelm selfish optimization*.

This raises the question, though: why is CDWM so different from Golden Balls - which is a pure Prisoners' Dilemma game - where we often see the selfish defect-defect strategy?

The answer, I suspect, lies in the abundance effect. The difference between CDWM and Golden Balls is that in the latter money is much more salient. And research (pdf) shows that, the more people think about money, the more selfish they behave.

The lesson is that context - not just incentives - matter.

2. The trickiness of inter-personal comparisons of utility. Let's assume that games are scored purely according to perceptions of fairness. It doesn't follow that everyone has an equal chance.

Take, for example, two people. One is a gourmand, used to fine dining and the highest standards. The other has low expectations. Our gourmand might well score a fair-to-middling dinner much lower than the diner with low standards. On this account the gourmand would have more chance of winning than the other diner, even if both are cooks of equal ability.

One might question the justice of this. More importantly, it raises the question: why should expressed preferences carry so much weight when they can be heavily affected by factors which should perhaps be irrelevant?

3. The importance of ordering. The four people are strangers. This means the first host is in a different position to the last host. The first is likely to judged heavily on his food, as the guests barely know him. But later hosts are more likely to be judged on personality as well, as by then the four have gotten to know each other.

This can cause diners to regret their earlier scores. We saw this last night, when Rachel said that, had show known how big an arse Stuart - the first host - was, she would not have scored him so highly.

This poses a big problem for conventional rational choice economics. It typically takes preferences as given, and revealed by choice. However, CDWM shows that preferences are sensitive to the order in which options appear. For Rachel, the choice: "score Stuart, then score Josh" yielded a different result than "score Josh, then score Stuart" would have done. I suspect this is related to Allais's paradox.

So, CDWM raises important issues about the nature of rationality and preferences. Watched even in narrow economists' terms, it is much more interesting than politicians' waffle about the crisis.

* Or it could be that the producers just tell the contestants not to play silly buggers.

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links for 2009-09-28

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Economist's View - 5 new articles

2009-09-28T23:00:00.001-07:00

"Crowding In"

Paul Krugman on Crowding In:

I'm at two deficit conferences Wednesday ... on what to do about the deficit,...[and] why we need to run deficits now. I'm trying to organize my thoughts...

Why, exactly, do we think that budget deficits are a bad thing? The textbook answer identifies two reasons — two ways in which budget deficits now make us worse off in the future. They are:

(1) The fiscal burden: deficits now mean higher debt later, which will have to be serviced, and that means higher taxes and/or less spending on other, presumably desirable things.

(2) Crowding out: when it runs deficits, the government competes with the private sector for funds, so deficits crowd out private investment, which reduces potential growth

All this makes sense under normal conditions. But right now we're not living under normal conditions. We're in a situation in which the economy is deeply depressed, and monetary policy — the usual line of defense against recession — is hard up against the zero-interest-rate bound. This weakens argument (1) — and it actually reverses argument (2).

On argument (1): it's still true that an increase in government spending raises future debt. But not one for one: because higher spending raises GDP, it leads to higher revenue, which offsets a significant fraction of the initial outlay. A back-of-the-envelope calculation suggests something like a 40 percent offset is plausible, so fiscal stimulus only costs 60 percent of what it costs.

But the really dramatic difference is for argument (2). Under the kind of conditions we're now facing, the main determinant of business investment is the state of the economy, as evidenced by the plunge in investment shown in the figure. This, in turn, means that anything that improves the state of the economy, including fiscal stimulus, leads to more investment, and hence raises the economy's future potential.

That is, under current conditions deficit spending doesn't lead to crowding out — it leads to crowding in. In fact, you could argue that the worst thing we can do for future generations is NOT to run sufficiently large deficits right now.

Things won't always work this way. Eventually we'll emerge from the liquidity trap, and the normal rules of economic prudence will reassert themselves. But we are not there, or anywhere close to there, right now.

Let me also suggest: Crowding-Out and Crowding-In. Here's the bottom line:

...Let us summarize what we have learned ... about the crowding-out controversy.

• The basic argument of the crowding-out hypothesis is sound: Unless the economy produces enough additional saving, more government borrowing will force out some private borrowers, who are discouraged by the higher interest rates. This process will reduce investment spending and cancel out some of the expansionary effects of higher government spending.

• But crowding out is rarely strong enough to cancel out the entire expansionary thrust of government spending. Some net stimulus to the economy remains.

• If deficit spending induces substantial GOP growth, then the crowding-in effect will lead to more saving-perhaps so much more that private industry can borrow more than it did previously, despite the increase in government borrowing.

• The crowding-out effect is likely to dominate in the long run or when the economy is operating near full employment. The crowding-in effect is likely to dominate in the short run, especially when the economy has a great deal of slack.

• Surpluses have just the opposite effects. When slack exists, they are likely to slow growth by reducing aggregate demand. But in the long run, budget surpluses are likely to foster capital formation and speed up growth.

And finally, see also ZIRP Deficits cause Crowding In of Investment, by reducing Deflation.

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"The Public Option Lives On"

Robert Reich says of the public option for health care insurance, "yes we can," even if it means overriding the promises of the person identified with the phrase:

The Public Option Lives On, by Robert Reich: Tomorrow (Tuesday) is a critical day in the saga of the public option. Democrats Charles Schumer ... and Jay Rockefeller ... are introducing an amendment to include the public option in the bill to be reported out by the Senate Finance Committee -- the committee anointed by the White House as its favored vehicle for getting health care reform.

Before you read another word, call and email the Senate offices of Democrats Max Baucus (Montana), Tom Carper (Delaware), Robert Menendez (New Jersey), Kent Conrad (North Dakota), and Ben Nelson (Florida) -- telling them you want them to vote in favor of the public option amendment. And get everyone you know in these states to do the same. Hell, you might as well phone and email Republican Olympia Snowe (Maine) and make the same pitch.

Background: Every dollar squeezed out of Big Pharma and Big Insurance is a dollar less that you'll have to pay ... to cover healthcare costs. The two most direct ways to squeeze future profits are allowing Medicare to use its huge bargaining leverage to negotiate lower drug prices, and creating a public insurance option to compete with private insurers...

But last January, the White House made a Faustian bargain with Big Pharma and Big Insurance, essentially scuttling both of these profit-squeezing mechanisms in return for these industries' agreement not to oppose healthcare legislation with platoons of lobbyists and millions of dollars of TV ads, and Pharma's willingness to cut drug prices by some $80 billion over the next ten years. The White House promised these industries they'd come out way ahead -- getting tens of millions of new customers who'd be buying private health insurance policies and thereby paying for an almost endless supply of new drugs. Healthcare reform would be, in short, a bonanza.

Big Pharma and Big Insurance have so far delivered on their side of the deal. In fact, Big Pharma has shelled out $120 million in advertisements in favor of reform. Now the White House is delivering on its side.

Last Thursday, for example, the Senate Finance Committee rejected Ben Nelson's amendment to require Big Pharma to give some $160 billion in discounts to Medicare -- thereby reducing the bonanza Pharma would reap from the healthcare bill. Not surprisingly, all Republicans voted against the amendment. But it was defeated only because Dems Baucus, Carper, and Menendez voted with the Republicans.

Carper later explained ... why he voted with the Republicans. The amendment, he said, would "undermine our ability to pass" health care reform, because the White House had made a deal with Big Pharma ... and White House officials had told him "a deal is a deal." The Times described the vote as a "big victory" for the White House.

Schumer voted for the amendment. He said he was "not at the table" when the White House and Big Pharma made their deal so didn't feel bound by it. But even if he had been at the table, he wouldn't be bound. No member of the Senate is bound to a deal made between industry and the White House. Congress is a separate branch of government.

Big Pharma and big insurance hate the public insurance option even more than they hate big Medicare discounts. And although the President has sounded as if he would welcome it, political operatives in the White House have quietly reassured the industries that it won't be included in the final bill. ...

But the public option lives on, nonetheless. It's still in the Senate Health, Education, Labor, and Pension bill. It still headlines the House bills, and Speaker Nancy Pelosi says she's still committed to it. The latest Times/CBS poll shows 65 percent of the public in favor of it.

Now, Schumer and Rockefeller are introducing a public option amendment in the Senate Finance Committee. Carper, Menendez, Baucus, and other Dems on the Committee should vote for it, or be forced to pay a price if they don't.

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Paul Krugman: Cassandras of Climate

Why aren't people getting hot under the collar about climate change?:

Cassandras of Climate, by Paul Krugman, Commentary, NY Times: Every once in a while I feel despair over the fate of the planet. If you've been following climate science, you know what I mean: the sense that we're hurtling toward catastrophe but nobody wants to hear about it or do anything to avert it.

And here's the thing: I'm not engaging in hyperbole. These days, dire warnings aren't the delusional raving of cranks. They're what come out of the most widely respected climate models... The prognosis for the planet has gotten much, much worse in just the last few years.

What's driving this new pessimism? Partly it's the fact that some predicted changes, like a decline in Arctic Sea ice, are happening much faster than expected. Partly it's growing evidence that feedback loops amplifying the effects of man-made greenhouse gas emissions are stronger than previously realized. For example,... global warming will cause the tundra to thaw, releasing carbon dioxide, which will cause even more warming, but new research shows far more carbon dioxide locked in the permafrost than previously thought, which means a much bigger feedback effect.

The result of all this is that climate scientists have, en masse, become Cassandras — gifted with the ability to prophesy future disasters, but cursed with the inability to get anyone to believe them.

And we're not just talking about disasters in the distant future... The really big rise in global temperature probably won't take place until the second half of this century, but there will be plenty of damage long before then.

For example, one 2007 paper in the journal Science ... reports "a broad consensus among climate models" that a permanent drought, bringing Dust Bowl-type conditions, "will become the new climatology of the American Southwest within a time frame of years to decades." ...

In a rational world, then, the looming climate disaster would be our dominant political and policy concern. But it manifestly isn't. Why not?

Part of the answer is that it's hard to keep peoples' attention focused. Weather fluctuates..., any year with record heat is normally followed by a number of cooler years...

But the larger reason we're ignoring climate change is that Al Gore was right: This truth is just too inconvenient. Responding to climate change with the vigor that the threat deserves would not, contrary to legend, be devastating for the economy as a whole. But it would shuffle the economic deck, hurting some powerful vested interests even as it created new economic opportunities. And the industries of the past have armies of lobbyists in place...; the industries of the future don't.

Nor is it just a matter of vested interests. It's also a matter of vested ideas. For three decades the dominant political ideology in America has extolled private enterprise and denigrated government, but climate change ... can only be addressed through government action. And rather than concede the limits of their philosophy, many on the right have chosen to deny that the problem exists.

So here we are, with the greatest challenge facing mankind on the back burner, at best, as a policy issue. I'm not, by the way, saying that the Obama administration was wrong to push health care first. It was necessary to show voters a tangible achievement before next November. But climate change legislation had better be next.

And as I pointed out in my last column, we can afford to do this..., economic modelers have been reaching consensus ... that the costs of emission control are lower than many feared.

So the time for action is now. O.K., strictly speaking it's long past. But better late than never.

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Stiglitz Interview

James Surowiecki interviews Joseph Stiglitz about "the mishandling of the financial crisis, the relationship between government and markets, and the future of capitalism around the world."

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links for 2009-09-27

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Economist's View - 4 new articles

2009-09-27T22:52:00.001-07:00

When You Believe in Things That You Don't Understand...

Robert Shiller defends financial innovation:

In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...

But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children's education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.

Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... "continuous workout mortgages"...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...

Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.

Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.

Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...

Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.

Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.

As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.

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"Gold Buggery"

Barkley Rosser:

Washington Post Puffs Gold Buggery, by Barkley Rosser: The business section of today's Washington Post contains one of the most ridiculous news stories I have seen yet. I would not mind if this were a column, but "What's Making Gold a Hot Commodity" by Frank Ahrens is supposedly a news story, and as such it should not contain whoppingly erroneous statements without some correction. So, Ahrens himself says the following: "In the long term, with each new dollar introduced into the system, each dollar you hold becomes worth less. That's more than just inflation, which we think of as simply rising prices. That's debasement of not only our currency, but the globe's reserve currency." It may well be that nonsensical thinking such as has this pushed the price of gold back over $1,000 per ounce again, but why should a business section reporter repeat it without the slightest doubt. It is not even good monetarism, as monetarists only view money supply expansions beyond growth of real output and not offset by velocity changes as inflationary. A bit later, Ahrens uncritically quotes Peter Boockvar, an equities trader at Miller Tabak: "It amazes me that any self-respecting central banker is not alarmed that gold is over $1,000 an ounce and the dollar is trading at all-time record lows." All-time record lows? Only against gold. Currently the dollar is about 1.46 against the euro, while it hit 1.5990 in July 2008. It is around 92 against the yen, but in 1995 got as low as 79.95. It is a bit over 1.5 against the pound, but was at 1.98 last year (and further back in history was over 4.0). Utter drivel. I do recognize that later in the article Ahrens brings up some factors that might caution people a bit against buying gold too frenziedly, such as how much of it is held by central banks, and how little demand for it is due to industrial use (only about 10%). But he never mentions that it has already been above $1,000 twice before, only to fall back, and in the late 1970s was much higher in real terms, at well over $800, only to fall very far below that and stay well below that for decades. The warnings could have been a bit clearer, along with avoiding mindlessly repeating totally ridiculous non-facts spouted by wacko gold bugs.

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"250 Years of Clever Counting"

Stephen Ziliak emails:

Only moralists and economists know that Adam Smith's Theory of Moral Sentiments (1759) turned 250 years old this year.

However worthy an Adam Smith party, I thought you'd like to know about another party and sentiment, "Arthur's Day" - the Guinness Brewery's 250th birthday party - to be celebrated Thursday, September 24th, all over the world:

My article, "Great Lease, Arthur Guinness - Lovely Day for a Gosset!" (prepared for a special "Beeronomics" issue of the Journal of Wine Economics), shows how clever counting at Guinness did not stop two and a half centuries ago when Arthur signed a 9,000 year lease for the brewery, house, and land at St. James's Gate in exchange for 45 pounds a year (nominal, not inflation adjusted)!

"The great innovation in statistics in the era after Galton and Pearson was made in the private sector of the economy, between 1904 and 1937, at Guinness's Laboratory, to the end of improving, however gradually, production of a consistent beer at efficient economies of scale" (Ziliak 2009, p. 4).

Here's the article "Great Lease, Arthur Guinness—Lovely Day for a Gosset!":

Abstract: Small sample theory—the great innovation in statistical method in the period after Galton and Pearson—was ironically discovered by a brewer during routine work performed at a large brewery, Arthur Guinness, Son & Company, Ltd. For four decades William S. Gosset applied small sample experiments to the palpable end of improving, however gradually, the production and control of a consistent unpasteurized beer when packaged and sold at efficient economies of scale. Introducing, "Guinnessometrics." Annual output of stout at Guinness's Brewery may have topped 100 million gallons but Gosset's scientific knowledge was built one barleycorn at a time; in fact, the inventor of small sample theory worked closely with botanists and breeders. In the process, the brewer, William Sealy Gosset (1876-1937) aka "Student," an Oxford-trained chemist—though self-trained in statistics—solved a problem in the classical theory of errors which had eluded statisticians from Laplace to Pearson. In addition, though few have noticed, Gosset's exacting theory of errors, both random and real, marked a significant advance over ambiguous reports of plant life and fermentation asserted by chemists from Priestley and Lavoisier down to Pasteur and Johannsen, working at the Carlsberg Laboratory. Central to the Guinness brewer's success was his persistent economic interpretation of uncertainty, what Ziliak and McCloskey (2008) call the "size matters/how much" question of any series of experiments. An enlightened change in Guinness human resources policy gave an incentive structure that also seems to have nudged "Student," who rose in position to Head Brewer, to find a profit when the opportunity knocked. Beginning in 1893, Guinness vested "scientific brewers" such as Gosset with managerial authority. In fact Gosset was at times involved with price negotiations over hundreds of tons of barley and hops—perhaps hours or minutes before he ran (that is, calculated) a regression on related material. In brewing circles William Gosset is remembered less nowadays than he might be. He did not give two cents for arbitrary rules about statistical significance—at the 5% level or any level arbitrarily assumed. How the odds should be set depends on the importance of the issues at stake and the cost of getting new material, he said from 1904. Yet even in brewing journals, both academic and trade, and for the past 85 years, statistical significance at the 5% level continues to draw its arbitrary line segregating a meaningful from a non-meaningful result, a better barley from a worse.

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links for 2009-09-26

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Economist's View - 3 new articles

2009-09-26T22:47:00.001-07:00

"Auditing the Fed"

Bruce Bartlett and Barry Ritholtz on Ron Paul's call for the Fed to be audited:

Auditing the Fed, by Bruce Bartlett: Ron Paul finally got his wish yesterday and the House Financial Services Committee held a hearing on his legislation to audit the Federal Reserve. There were only two witnesses: the Fed's general counsel and Tom Woods, a historian from the Ludwig von Mises Institute. The testimony is available here.

I urge those curious about this issue to read both statements. I think it is abundantly clear that this is a crackpot idea. The Fed is already thoroughly audited in every area except two: monetary policy and dealings with foreign central banks. The only purpose of having additional audits of the Fed is to undermine its independence precisely with regard to these two areas. If Woods presents the best argument for doing so, the argument is very shallow indeed.

Whatever one thinks of the Fed's policies in recent years--and there certainly are grounds for criticism--there is no reason whatsoever to believe that undermining its independence and putting the Congress in control of monetary policy--Ron Paul's goal--would improve matters at all. Indeed, there is every reason to believe that full congressional control of monetary policy would be a disaster. Instead of getting Switzerland-like stability, as Paul foolishly imagines, the more likely result would be Zimbabwe-like hyperinflation.

In the end, I agree with Barry Ritholz that whatever the Fed's failings, those of Congress are vastly worse. As he put it in explaining why he didn't testify yesterday:

I was invited to testify this week to the House Financial Services Committee about reform and regulation.
I politely demurred.
While I have been critical of the Federal Reserve (especially the Greenspan years), my beef with them has been their judgment and decision-making process. Congress, on the other hand, is a whole different matter. Its not their judgment, but rather, the fact they are owned not by the American people, but by lobbyists, and corporate interests. They have become structurally deformed.
How weird is it for me, who spent so many pages blaming the Fed for a lot of the recent crisis, to find myself in a position of defending them from outside political pressure? The choice we face is the recent Fed regime of secrecy, nonfeasance, irresponsibility, and easy money — versus something possibly likely to be a whole lot worse. ...
If the Fed has been a major source of problems, Congress is much worse. They were the great enablers of the crisis, readily corruptible, bought and paid for by the banking industry. I find Congress to be the worse of two evils — lacking in objectivity, incapable of producing legitimate regulatory review. ...

As I've made clear in the past, I also think that auditing the Fed, or reducing its independence in other ways, is a bad idea. The strange marriage of the populists and libertarians on this issue has given it more momentum that I expected, but hopefully not enough to carry the day.

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"Barney Frank Talks Back"

Ezra Klein interviews Barney Frank about financial reform:

Barney Frank Talks Back, Washington Post: ...What's the most important part of financial regulation?

Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. ...

Do you worry that the banks that are "too big to fail" have gotten even bigger?

Banks do fail. Wachovia failed. The problem is not banks but non-banks. The answer is: We will be restricting their activities. They will not be as big, as they will need much more capital. And if they do get big, they will not be so leveraged. It's not the size of the institution that's the issue, it's the amount of leverage.

Sen. Dick Durbin recently said that the big banks "frankly own the place" after they killed "cramdown" bankruptcy legislation in the Senate. Won't banks brush off financial regulation reform?

No. The big banks have been somewhat discredited. That's why the credit card bill went in pretty easily over their objections. I believe reining in derivatives and reducing leverage at high levels will be somewhat easy to do.

What killed the primary-residence bankruptcy bill [cramdown] was not the big banks but the community banks and credit unions. They do have a lot of clout. And they have a legitimate grievance: They have not been behind the abuses. If we only had community banks and credit unions, we wouldn't be in this problem. And it's important to note that they're not just powerful because they have money, but because they're in everybody's district, and they're responsible and thoughtful citizens.

So you think the big banks really have lost their power on the Hill?

Look at the credit card bill. Small banks don't do credit cards. ...

Should the administration have started on financial regulation sooner?

No! They were busy. I understand the media always wants to have bad things to say. But they were working on undoing where we were. They were working to put liquidity back. The problem was that 2008 took longer to end than we thought it would. It didn't really end till April of 2009. The early months of the Obama administration were spent trying to dig out of the hole. Let me ask you a question. What harm came from waiting?

The argument is that you won't get as much regulation because the banks are stronger now.

That's nonsense. ...

Is executive compensation a big part of the problem?

Absolutely. The problem is not just the amount. Shareholders will deal with that. It's the incentive. People had incentives to take risks because they got paid off if the risk paid off and paid no penalty if the risk blew up. They were taking risks free of the consequences of failure. Heads they won, tails they broke even. ...

You became a YouTube celebrity a few weeks ago for snapping at a town hall protester who held up a picture of Barack Obama with a Hitler moustache. You said that arguing with her would be like debating a dining room table. Why don't more of your colleagues yell back?

So the question is, you're asking me, who yelled back, why other people don't yell back? ... I don't know. Ask them.

I hope he's right, but I expect the fight will be tougher than implied above. Just about everybody has a credit card, and lowering fees on the cards, etc., is an easy sell to legislators looking to gain or maintain votes. Other proposals may not enjoy the same broad based support and appeal, especially after lobbyists and others spin the legislation as opposed to the best interests of the very people the legislation is trying to protect.

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links for 2009-09-25

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Economist's View - 4 new articles

2009-09-25T22:55:00.001-07:00

"Fiscal Responsibility Requires Higher Taxes"

Bruce Bartlett reiterates his disappointment with Republican attitudes toward taxes and the deficit:

Fiscal Responsibility Requires Higher Taxes, by Bruce Bartlett, Commentary, Forbes: Throughout most of our nation's history,... everyone who thought of themselves as a conservative believed absolutely in the necessity of balancing the budget... Today, the notion seems quaint. Republicans pay lip service to balancing the budget, but only when Democrats are in office. ... [T]he now-universal view among conservatives [is] that ... taxes must never be raised to reduce deficits. That's a cure worse than the disease...

This reversal of the historical conservative position has had enormous implications for our national finances. ... The reason why conservatives supported a balanced budget in the first place wasn't so much about the economics as a belief that it was a constraint on spending and the growth of government. That deficits were inflationary, raised interest rates and led to crowding out in financial markets, which reduced economic growth, was really a secondary consideration.

A key reason why a balanced budget requirement constrained spending is that deficits led to higher taxes. Since people don't like paying taxes, they put a brake on spending that couldn't be financed out of current revenues. In the event that there was some new program that was widely deemed to be desirable,... it was commonly understood that new taxes dedicated just to these programs were an essential requirement for enactment.

Programs that couldn't be financed weren't seriously considered until the Bush 43 administration. Contrary to the experience of Social Security and Medicare, he offered no dedicated financing for the Medicare drug benefit. It simply added to the budget deficit and will add as much to it over the next decade as the February stimulus package that every Republican voted against.

And, of course, no effort was made to pay for tax cuts or pork barrel projects. In fact, Republicans jettisoned PAYGO (pay as you go) budget rules in 2002. ... When pressed about their abandonment of support for the balanced budget, Republicans say that supporting higher taxes to reduce deficits only made them tax collectors for the welfare state. ...

In the 1970s, conservatives talked themselves into believing that cutting taxes was a better way of restraining government's growth than supporting a balanced budget. Just take away Congress's credit card, Ronald Reagan used to say, and it will be forced to cut spending.

This reversal of the long-held conservative position proved to be extremely popular, politically, and had a lot to do with the Republican takeover of Congress in 1994. It is now Republican dogma that taxes must never be increased no matter how big the deficit. The last Republican to do that, Bush 41, got thrown out of the White House..., Republicans believe. ...

During Bill Clinton's administration, Democratic economists got religion on deficits. They believe that his 1993 tax increase sparked an economic boom. They also saw that ... the federal budget [go] from deficit to surplus... Clinton's big mistake was in not locking up the surpluses in some way. One idea would have been to use the surpluses to create private Social Security accounts that Republicans wouldn't have dared to touch any more than they would dare to cut Social Security benefits.

Instead, the surpluses were completely dissipated on temporary tax cuts and spending programs that bought reelection for Republicans in 2002 and 2004, but made no lasting contribution to the economy's growth. Even as the surpluses turned into deficits, Republicans' position didn't change--they were still for big tax cuts...

Indeed, back in February when Congress was debating the stimulus package and the Treasury was facing a deficit of $1.2 trillion this year, the Republican position was that tax cuts--and only tax cuts--would stave off a deep recession. How that would have helped when incomes were falling to such an extent that tax revenues were virtually collapsing on their own was never explained. Tax cuts were a mantra to be repeated endlessly whether they had any rational connection to the economy's problems or not.

Everyone knows that fiscal discipline must be restored eventually, or we will face truly horrifying consequences... Everyone also knows that this will involve a combination of higher revenues and lower spending. The idea that we can restore fiscal health only with spending cuts is childish, as I tried to explain last week.

What we face is a game of chicken. Republicans think if they wait until the last possible second to support the smallest possible tax increase necessary to make a budget deal work, they can get the largest possible spending cuts. The problem is that there is not one iota of historical evidence that this strategy will work. The budget deals of the 1980s and 1990s were all roughly 50-50: half tax increases, half spending cuts.

At some point, taxes have to be back on the table as the price that must be paid for profligate spending. Only then will the American people realize that they can't have their cake and eat it too, as Republicans have preached for the last decade. Only when the American people go back to believing that spending must be paid for will they stop demanding something for nothing and put the country back on the path to fiscal sanity.

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The Shape of Things to Come?

At CBS Money Watch, some reactions to recent data releases:

What the Unemployment Numbers Tell Us About the Economy, by Mark Thoma

And an update:

What the Latest Economic Reports Say about the Recovery, by Mark Thoma

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Paul Krugman: It's Easy Being Green

The Waxman-Markey cap-and-trade climate bill won't destroy economic growth:

It's Easy Being Green, by Paul Krugman:, Commentary, NY Times: So, have you enjoyed the debate over health care reform? Have you been impressed by the civility of the discussion and the intellectual honesty of reform opponents? If so, you'll love the next big debate: the fight over climate change.

The House has already passed a fairly strong cap-and-trade climate bill, the Waxman-Markey act, which if it becomes law would eventually lead to sharp reductions in greenhouse gas emissions. But on climate change, as on health care, the sticking point will be the Senate. And the usual suspects are doing their best to prevent action.

Some of them still claim that there's no such thing as global warming, or at least that the evidence isn't yet conclusive. But that argument is wearing thin — as thin as the Arctic pack ice... So the main argument against climate action probably won't be the claim that global warming is a myth. It will, instead, be the argument that doing anything to limit global warming would destroy the economy. ...

It's important, then, to understand that claims of immense economic damage from climate legislation are as bogus, in their own way, as climate-change denial. Saving the planet won't come free (although the early stages of conservation actually might). But it won't cost all that much either.

How do we know this? First, the evidence suggests that we're wasting a lot of energy right now...— a phenomenon known ... as the "energy-efficiency gap." The existence of this gap suggests that policies promoting energy conservation could, up to a point, actually make consumers richer.

Second, the best available economic analyses suggest that even deep cuts in greenhouse gas emissions would impose only modest costs on the average family. Earlier this month, the Congressional Budget Office released an analysis of the effects of Waxman-Markey, concluding that in 2020 the bill would cost the average family only $160 a year, or ... roughly the cost of a postage stamp a day.

By 2050, when the emissions limit would be much tighter, the burden would rise... But the budget office also predicts ... that G.D.P. per person will rise by about 80 percent. The cost of climate protection would barely make a dent in that growth. And all of this, of course, ignores the benefits of limiting global warming.

So where do the apocalyptic warnings about the cost of climate-change policy come from?

Are the opponents of cap-and-trade relying on different studies that reach fundamentally different conclusions? No, not really. ... Instead, the campaign against saving the planet rests mainly on lies.

Thus, last week Glenn Beck — who seems to be challenging Rush Limbaugh for the role of de facto leader of the G.O.P. — informed his audience of a "buried" Obama administration study showing that Waxman-Markey would actually cost the average family $1,787 per year. Needless to say, no such study exists.

But we shouldn't be too hard on Mr. Beck. Similar — and similarly false — claims about the cost of Waxman-Markey have been circulated by many supposed experts.

A year ago I would have been shocked by this behavior. But as we've already seen in the health care debate, the polarization of our political discourse has forced self-proclaimed "centrists" to choose sides — and many of them have apparently decided that partisan opposition to President Obama trumps any concerns about intellectual honesty.

So here's the bottom line: The claim that climate legislation will kill the economy deserves the same disdain as the claim that global warming is a hoax. The truth about the economics of climate change is that it's relatively easy being green.

[See also Can Countries Cut Carbon Emissions Without Hurting Economic Growth? by Robert Stavins.]

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links for 2009-09-24

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Economist's View - 5 new articles

2009-09-24T22:57:00.001-07:00

Fed Watch: Rushing to the Exits?

Tim Duy is worried that the inflation hawks on the FOMC are gaining too much influence:

Rushing to the Exits?, by Tim Duy: A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.
The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

Today's Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank's policy making committee who think the Fed is putting too much weight on the argument that the economy's substantial slack will drive down inflation.

Slack is the economy's productive capacity that doesn't get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there's a lot of slack, it puts downward pressure on prices in the short-run. It's one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time."

In previous recent statements, it hasn't mentioned inflation expectations. It focused mostly on slack. Here's how the Fed put it in August: "Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed's inflation view could change and tilt it toward a more hawkish stance.

The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of truth behind a rumor that was circulating earlier this month. From Across the Curve:

I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.

Given the FOMC's own forecast, any consideration of tightening seems silly:

While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011. Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:

On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases. Indeed, unit labor costs are giving you the exact opposite story:

And employment compensation for the private sector is likewise trending down:

Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through. That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:

Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world's largest energy-consuming nation.

Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That's more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.

"The market has a glut of crude oil and refined products right now," Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. "If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices."

And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do? The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth. From Goldman Sachs (no link):

In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.

The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.
So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making "a colossal policy error" leading to higher inflation if they don't withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

"When you talk to committee members you see a little bit more angst than you'd expect," Meyer said in an interview yesterday at the Kansas City Fed's monetary policy conference in Jackson Hole, Wyoming. "In public they say they're confident they'll get it right, they're confident they have the tools to get it right. But when you talk to them in private there's some concern there."

So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they're scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has "begun the process of exiting from some emergency programs," the chief of the government's $700 billion financial-rescue fund said separately.

Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.

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"The Baucus Free Rider Problem"

At CBS Money Watch:

The Baucus Free Rider Problem, by Mark Thoma

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"The Crisis of Public Management"

Jeffrey Sachs says our public management systems need an overhaul:

The Failing U.S. Government--The Crisis of Public Management, by Jeffrey D. Sachs, Scientific American: The crisis of American governance goes much deeper than political divisions and ideology. The U.S. is in a crisis of policy implementation. Not only are Americans deeply divided on what to do about health care, budget deficits, financial markets, climate change and more, but government is also failing to execute settled policies effectively. Management systems linking government, business and civil society need urgent repair. The recent systems failures are legion and notorious. The 9/11 attacks might well have been prevented if the FBI and the intelligence agencies had cooperated more effectively... Hurricane Katrina caused mass devastation and loss of life because recommendations to bolster the levees ... and other protective measures were neglected for decades despite urgent expert warnings, and because the federal emergency relief effort failed... The U.S. occupation of Iraq was marked by massive ... corruption, incompetence, and implementation failures by U.S. agencies. On the economic front, the current financial crisis is a remarkable systems failure. Government regulatory agencies completely dropped the ball... The list, alas, goes on and on. Military procurement systems are ... broken... Public construction systems are failing... Roads, bridges, rail, water and sewerage systems and many dams are in dangerous disrepair...

We need a better scientific understanding of these pervasive systems failures. It is wrong to think that they illustrate the inevitable failure of government. Other governments around the world more successfully manage infrastructure investments, health systems and environmental resources, apparently with greater flexibility, less corruption, lower costs and better outcomes. America should be learning from their experiences. Several factors are at play. A key one has been the flawed privatization of public-sector regulatory functions. ... A second has been the collapse of planning functions within the federal government. ... A third, and paradoxical, factor is the chronic underfunding of government itself. ... The public is wary of putting more funds into government having witnessed one public sector failure after another. Yet without investing more resources in skilled public managers in health care, energy systems, and national security, we are probably doomed to remain stuck in the hands of vested interests and lobbies. Fourth, today's challenges cut across technical specialties, government departments and public and private sectors. ... Yet our government agencies are not designed to take a holistic approach. In short, we have arrived at a point where the challenges of sustainable development —including public health, infrastructure, energy and national security—require changes not only to policy but also to basic public management systems. In many crucial areas, tinkering will no longer suffice: we need an overhaul to regain government control over regulatory processes, reduce lobbying, restore public planning and ensure the adequate financing of skilled public managers, and align public management systems with holistic strategies.

As evidenced by the response to the recent crisis, I'd add a fifth item to the list, opposition to the construction of the kinds of technocratic institutions that are needed to manage public systems:

Conservative Interventionism: The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930's Reconstruction Finance Corporation and the 1990's RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial ... economy ... without an overwhelming degree of corruption and rent seeking. The discretionary power of executives, in past crises, was curbed by new interventionist institutions constructed on the fly by legislative action.
That is how America's founders ... envisioned that things would work. They were suspicious of executive power, and thought that the president should have rather less discretionary power than the various King Georges of the time. ...
So I wonder: why didn't the US Congress follow the RFC/RTC model when authorizing George W. Bush's and Barack Obama's industrial and financial policies? Why haven't the technocratic institutions that we do have ... been given a broader role in this crisis?

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"Dark Age in Macroeconomics?"

This is Nick Rowe (it's in response to Paul Krugman and follows up on one of Nick's previous posts):

Dark Age in Macroeconomics? A History of Taught approach, by Nick Rowe: (Or maybe the title should be: "Notes from the Phelps/Lucas Administration"; or "Notes to supplement our fading memories of the late 1970's".)

Is this a Dark Age in macroeconomics? In other words, have we collectively forgotten some (important) stuff that we used to understand?

I want to approach this question by looking at what was taught in the past to economics graduate students, so we can compare what is left out now to what was left out then.

I have a sample of one: my own lecture notes from grad school. I began my MA at UWO in 1977, and continued into the PhD. I took everything in macro/money that was offered. At the time, UWO was arguably the top Canadian department in macro/money (OK, Western grads would argue for; Queens grads would argue against), and would hold up well against anywhere in the world.

Macro 1 (David Laidler). Required course. Review and critique of ISLM (lags, stocks flows and the government budget constraint, are the IS and AD curves really demand curves? [no], the missing AS curve). Crowding out debate. Non-Walrasian macro (Barro and Grossman). Say's Law. Phillips Curve (up to Phelps and Friedman). Consumption function (Friedman/Modigliani). Demand for money. Investment demand.

Macro 2 (Michael Parkin). Required for those continuing to the PhD. (I can't resist quoting from the first page of my notes here: "Economics [is] Understand + Explain Phenomena using Rational models. How could Rational Behaviour [lead to] Disaster? Market Failure."). Review and critique of Neoclassical model of labour market. Lucas and Rapping (from the Phelps volume), and why their model was logically incoherent (Michael Parkin was right on this point). Mortensen's (also from Phelps volume) search theory of unemployment. Theories of implicit wage contracts (sticky wages). Theories of price adjustment (proto New-Keynesian). ISLM plus Phillips Curve (distinction between proto New-Keynesian and New Classical interpretations of Phillips Curve). Adaptive vs. Rational expectations. Policy Irrelevance Proposition ("[deviations of output from y* are] just noise, but obviously false").

Money 1 (Don Patinkin/Peter Howitt). Optional. Hume. Fisher. Lavington. Wicksell. Keynes' Tract, Treatise, and General Theory. Patinkin's Money interest and Prices. Are money and bonds net wealth? Commodity money. Solow/Swan growth model. Money and growth. Optimal quantity of money. Transactions costs. Baumol/Tobin and Miller/Orr models of demand for money.

Money 2 (Joel Fried). Optional. Microfoundations of money, Menger, Ostroy, Jones. Money in general equilibrium theory. Clower constraints. Transactions costs. Financial markets. Tobin. CAPM. Efficient Markets. Modigliani/Miller theorem. Term structure of interest rates. Tobin portfolio choice. Friedman and Monetarism. International finance. Dornbusch overshooting. Exogenous vs endogenous money. Canadian monetary policy.

Advanced Macro (Peter Howitt). Optional. (Lovely quote from the first page: "We are Aristotelian monks, trying to solve anomolies to stop future generations wasting their time doing the same thing.". Non-Walrasian disequilibrium theory (Clower, Leijonhufvud, Barro/Grossman, Malinvaud, Benassy, etc.). Stability. Catastrophe theory(!). Price adjustment under oligopoly. Optimal control theory. Inventories. Phelps/Winter price setting with transient monopoly power (from the Phelps volume, proto New-Keynesian).

(I learned some more money/macro in David Laidler's History of Thought class. But I was the only graduate student in that class, so I'm not going to count it. My colleague Calum Carmichael, who took the same course as an undergraduate, estimates that about one quarter of the Honours economics students took that class.)

I make the follow observations:

1. The Phelps volume was clearly very influential in the late 1970's. This supports Paul Krugman's memory, and my own.

2. The beginnings of the split between New Classical and New Keynesian approaches was already apparent in the late 1970's. I saw several references to the distinction between Fisher and Phelps on the interpretation of the Phillips Curve. (Fisherian market-clearing with misperceptions vs Phelpsian disequilibrium price adjustment). This too supports Paul Krugman's memory.

3. We received a very broad education in short run macroeconomics and monetary theory. Probably much broader than today's students. That tends to support the Dark Age hypothesis.

4. But there is one glaring omission from our education: we did lots of short run business cycle theory but almost no long run growth theory. We briefly covered the Solow growth model, but only as a prelude to money and growth. There was no interest in growth theory per se! If growth theory is important, and it is, that directly contradicts the Dark Age hypothesis. We barely touched on half of macro! The late 1970's were the Dark Age, for growth theory.

Why did we ignore growth theory?

Growth theory wasn't on the agenda. It wasn't that growth was unimportant; just that there seemed to be nothing important to say about it. All the exciting policy debates were about inflation and unemployment, not long run growth. All the exciting theoretical developments were about inflation and unemployment, not long run growth. "Endogenous" growth theories (a stupid misnomer, because growth is endogenous in Solow too, just with an extremely simple functional relationship to the exogenous variables, namely g=n) came later.

Fiscal policy has been off the agenda for much the same reasons, until recently.

(5. We spent surprisingly little time on open economy macroeconomics as well, for a Canadian school.)

OK. Let's compare notes!

This is very similar to my own experience, we also did very little growth theory (nothing beyond Solow-Swan, also as a prelude to looking at whether money was "superneutral"), and I didn't take any international at all - it wasn't part of the macro sequence (the international economy was not considered very important for understanding business cycle fluctuations). The emphasis was on short-run stabilization policy, monetary policy in particular. However, my experience was a bit different in that by the time I got to graduate school in the early 1980s, the split between saltwater and freshwater economists was well underway.

Paul Krugman says:

But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?

The answer was that they split. One faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever." That faction became New Keynesian, saltwater economics.

The other faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can't." That faction became real business cycle, freshwater economics.

Here's what I said about this just under two and a half years ago (edited slightly). As you can see, even though this was written well before Krugman's statement, it basically agrees with his assertion that everyone knew the New Classical model was in trouble by 1980 or 1981 (the Mishkin paper noted below was published, I believe, in 1982, but given the long publication lags the results were well known long before then). It also agrees with his comments that one faction, the New Keynesians, built upon the old Keynesian structure by giving it rational agents and microfoundations who operated in an environment beset with rigidities of one type or another (these rigidities prevent agents from fully neutralizing nominal shocks such as changes in the money supply), and the other faction reemerged as the real business cycle school:

I entered graduate school in 1980. Though it started with a pretty traditional IS-LM framework with some AD-AS thrown in, most of our time was spent learning the New Classical model. Much of the research effort at that time, at least the effort I was made aware of, was to try and punch holes in the result that comes out of the New Classical framework that only unanticipated money can affect real variables like output and employment.

This assault came on both theoretical and empirical fronts. Mishkin, for example, had published an empirical paper in the early 1980s that challenged work by Barro and others from the later 1970s supporting the New Classical model and its implication that only surprise money matters. On the theoretical front, the old Keynesian model -- which had been criticized for, among other things, lacking microeconomic foundations and lacking rational expectations -- was being reconstructed into the New Keynesian model. This model would eventually overcome theoretical objections that plagued the older Keynesian model, and it would also do a better job than the New Classical model of explaining the magnitude and persistence of business cycles and other features of the macroeconomic data. We learned some about Real Business Cycle models - but for the most part that work went on elsewhere and would surface later with more force as an alternative to the New Keynesian framework. But we were certainly made aware of the real business cycle model, e.g. arguments about reverse causality to explain statistical money income correlations. I'd say the same about growth theory - we did the Solow-Swan basics, but very little beyond that. Stabilization policy was the main issue we worried about at the time.

Does money matter? I thought so, that's what my dissertation was all about, it gave theoretical and empirical reasons to doubt the New Classical result that expected money does not affect output, but the issue of whether money matters was not settled until later. We now accept, for the most part, that the Fed can affect real interest rates and also affect the real economy, but at that time there was a very strong split within the profession on this issue. It wasn't until later that a general belief that anticipated monetary policy was a potentially useful stabilization tool surfaced in the profession. It's sometimes surprising to me today how complete the conversion on that issue has been, though it's certainly not 100%.

So, it wasn't generally agreed that money mattered, i.e. that money was a useful policy tool for stabilizing the real economy. But the Keynesian economics I learned at the time, which was in the implicit and explicit labor contracting framework for the most part, did say that money mattered. In fact, since the point was to challenge the New Classical result that money did not matter, the focus was mostly on monetary policy. As for fiscal policy, the Keynesian model we talked about - beyond the simple IS-LM version we learned at first - paid very little attention to fiscal policy, though papers such as Barro's "Are Bonds Net Wealth" were part of the conversation. Thus, when I went to graduate school - and this was partly due to who was teaching the courses - the primary focus was on whether and how changes in monetary policy affected the real economy.

In any case, even though it was a few years later than Nick's experience, we also spent considerable time on the ideas that Krugman notes have since been lost as we entered our recent "Dark Ages."

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links for 2009-09-23

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Economist's View - 8 new articles

2009-09-23T22:49:00.000-07:00

"Dark Age in Macroeconomics?"

This is Nick Rowe (it's in response to Paul Krugman and follows up on one of Nick's previous posts):

Dark Age in Macroeconomics? A History of Taught approach, by Nick Rowe: (Or maybe the title should be: "Notes from the Phelps/Lucas Administration"; or "Notes to supplement our fading memories of the late 1970's".)

Is this a Dark Age in macroeconomics? In other words, have we collectively forgotten some (important) stuff that we used to understand?

I want to approach this question by looking at what was taught in the past to economics graduate students, so we can compare what is left out now to what was left out then.

I have a sample of one: my own lecture notes from grad school. I began my MA at UWO in 1977, and continued into the PhD. I took everything in macro/money that was offered. At the time, UWO was arguably the top Canadian department in macro/money (OK, Western grads would argue for; Queens grads would argue against), and would hold up well against anywhere in the world.

Macro 1 (David Laidler). Required course. Review and critique of ISLM (lags, stocks flows and the government budget constraint, are the IS and AD curves really demand curves? [no], the missing AS curve). Crowding out debate. Non-Walrasian macro (Barro and Grossman). Say's Law. Phillips Curve (up to Phelps and Friedman). Consumption function (Friedman/Modigliani). Demand for money. Investment demand.

Macro 2 (Michael Parkin). Required for those continuing to the PhD. (I can't resist quoting from the first page of my notes here: "Economics [is] Understand + Explain Phenomena using Rational models. How could Rational Behaviour [lead to] Disaster? Market Failure."). Review and critique of Neoclassical model of labour market. Lucas and Rapping (from the Phelps volume), and why their model was logically incoherent (Michael Parkin was right on this point). Mortensen's (also from Phelps volume) search theory of unemployment. Theories of implicit wage contracts (sticky wages). Theories of price adjustment (proto New-Keynesian). ISLM plus Phillips Curve (distinction between proto New-Keynesian and New Classical interpretations of Phillips Curve). Adaptive vs. Rational expectations. Policy Irrelevance Proposition ("[deviations of output from y* are] just noise, but obviously false").

Money 1 (Don Patinkin/Peter Howitt). Optional. Hume. Fisher. Lavington. Wicksell. Keynes' Tract, Treatise, and General Theory. Patinkin's Money interest and Prices. Are money and bonds net wealth? Commodity money. Solow/Swan growth model. Money and growth. Optimal quantity of money. Transactions costs. Baumol/Tobin and Miller/Orr models of demand for money.

Money 2 (Joel Fried). Optional. Microfoundations of money, Menger, Ostroy, Jones. Money in general equilibrium theory. Clower constraints. Transactions costs. Financial markets. Tobin. CAPM. Efficient Markets. Modigliani/Miller theorem. Term structure of interest rates. Tobin portfolio choice. Friedman and Monetarism. International finance. Dornbusch overshooting. Exogenous vs endogenous money. Canadian monetary policy.

Advanced Macro (Peter Howitt). Optional. (Lovely quote from the first page: "We are Aristotelian monks, trying to solve anomolies to stop future generations wasting their time doing the same thing.". Non-Walrasian disequilibrium theory (Clower, Leijonhufvud, Barro/Grossman, Malinvaud, Benassy, etc.). Stability. Catastrophe theory(!). Price adjustment under oligopoly. Optimal control theory. Inventories. Phelps/Winter price setting with transient monopoly power (from the Phelps volume, proto New-Keynesian).

(I learned some more money/macro in David Laidler's History of Thought class. But I was the only graduate student in that class, so I'm not going to count it. My colleague Calum Carmichael, who took the same course as an undergraduate, estimates that about one quarter of the Honours economics students took that class.)

I make the follow observations:

1. The Phelps volume was clearly very influential in the late 1970's. This supports Paul Krugman's memory, and my own.

2. The beginnings of the split between New Classical and New Keynesian approaches was already apparent in the late 1970's. I saw several references to the distinction between Fisher and Phelps on the interpretation of the Phillips Curve. (Fisherian market-clearing with misperceptions vs Phelpsian disequilibrium price adjustment). This too supports Paul Krugman's memory.

3. We received a very broad education in short run macroeconomics and monetary theory. Probably much broader than today's students. That tends to support the Dark Age hypothesis.

4. But there is one glaring omission from our education: we did lots of short run business cycle theory but almost no long run growth theory. We briefly covered the Solow growth model, but only as a prelude to money and growth. There was no interest in growth theory per se! If growth theory is important, and it is, that directly contradicts the Dark Age hypothesis. We barely touched on half of macro! The late 1970's were the Dark Age, for growth theory.

Why did we ignore growth theory?

Growth theory wasn't on the agenda. It wasn't that growth was unimportant; just that there seemed to be nothing important to say about it. All the exciting policy debates were about inflation and unemployment, not long run growth. All the exciting theoretical developments were about inflation and unemployment, not long run growth. "Endogenous" growth theories (a stupid misnomer, because growth is endogenous in Solow too, just with an extremely simple functional relationship to the exogenous variables, namely g=n) came later.

Fiscal policy has been off the agenda for much the same reasons, until recently.

(5. We spent surprisingly little time on open economy macroeconomics as well, for a Canadian school.)

OK. Let's compare notes!

Paul Krugman says:

But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?

The answer was that they split. One faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever." That faction became New Keynesian, saltwater economics.

The other faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can't." That faction became real business cycle, freshwater economics.

I entered graduate school in 1980. Though it started with a pretty traditional IS-LM framework with some AD-AS thrown in, most of our time was spent learning the New Classical model. Much of the research effort at that time, at least the effort I was made aware of, was to try and punch holes in the result that comes out of the New Classical framework that only unanticipated money can affect real variables like output and employment.

This assault came on both theoretical and empirical fronts. Mishkin, for example, had published an empirical paper in the early 1980s that challenged work by Barro and others from the later 1970s supporting the New Classical model and its implication that only surprise money matters. On the theoretical front, the old Keynesian model -- which had been criticized for, among other things, lacking microeconomic foundations and lacking rational expectations -- was being reconstructed into the New Keynesian model. This model would eventually overcome theoretical objections that plagued the older Keynesian model, and it would also do a better job than the New Classical model of explaining the magnitude and persistence of business cycles and other features of the macroeconomic data. We learned some about Real Business Cycle models - but for the most part that work went on elsewhere and would surface later with more force as an alternative to the New Keynesian framework. But we were certainly made aware of the real business cycle model, e.g. arguments about reverse causality to explain statistical money income correlations. I'd say the same about growth theory - we did the Solow-Swan basics, but very little beyond that. Stabilization policy was the main issue we worried about at the time.

Does money matter? I thought so, that's what my dissertation was all about, it gave theoretical and empirical reasons to doubt the New Classical result that expected money does not affect output, but the issue of whether money matters was not settled until later. We now accept, for the most part, that the Fed can affect real interest rates and also affect the real economy, but at that time there was a very strong split within the profession on this issue. It wasn't until later that a general belief that anticipated monetary policy was a potentially useful stabilization tool surfaced in the profession. It's sometimes surprising to me today how complete the conversion on that issue has been, though it's certainly not 100%.

So, it wasn't generally agreed that money mattered, i.e. that money was a useful policy tool for stabilizing the real economy. But the Keynesian economics I learned at the time, which was in the implicit and explicit labor contracting framework for the most part, did say that money mattered. In fact, since the point was to challenge the New Classical result that money did not matter, the focus was mostly on monetary policy. As for fiscal policy, the Keynesian model we talked about - beyond the simple IS-LM version we learned at first - paid very little attention to fiscal policy, though papers such as Barro's "Are Bonds Net Wealth" were part of the conversation. Thus, when I went to graduate school - and this was partly due to who was teaching the courses - the primary focus was on whether and how changes in monetary policy affected the real economy.

In any case, even though it was a few years later than Nick's experience, we also spent considerable time on the ideas that Krugman notes have since been lost as we entered our recent "Dark Ages."

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What's an Apology Worth?

I'm sorry, I really am. Here's the economics of apologies:

Saying sorry really does cost nothing, EurekAlert: Economists have finally proved what most of us have suspected for a long time – when it comes to apologizing, talk is cheap.

According to new research, firms that simply say sorry to disgruntled customers fare better than those that offer financial compensation. The ploy works even though the recipient of the apology seldom gets it from the person who made it necessary in the first place.

The ... Nottingham School of Economics' Centre for Decision Research and Experimental Economics ... set out to show whether customers who have been let down continue to do business after being offered an apology. They found people are more than twice as likely to forgive a company that says sorry than one that instead offers them cash. ...

[C]o-author Dr Johannes Abeler said the results proved apologies were both powerful and cheap. He said: "We know firms often employ professional apologists whose job is to say sorry to customers who have a grievance.

"You might think that if the apology is costless then customers would ignore it as nothing but cheap talk - which is what it is. But this research shows apologies really do influence customers' behavior – surprisingly, much more so than a cash sweetener.

"People don't seem to realize they're dealing with an expert apologist rather than an individual who feels genuine shame.

"It might be that saying sorry triggers in the customer an instinct to forgive – an instinct that's hard to overcome rationally."

Researchers worked with a firm responsible for around 10,000 sales a month on eBay, controlling its reaction to neutral or negative feedback. Some customers were offered an apology in return for withdrawing their comments, while others were offered €2.5 or €5.

The simple apology blamed the manufacturer for a delay in delivery, adding: "We are very sorry and want to apologize for this." Customers offered money were told: "As a goodwill gesture, we can offer you €5 if you would consider withdrawing your evaluation."

Because customers had no idea they were taking part in the experiment, their behavior was completely natural and unaffected. Some 45% of participants withdrew their evaluation in light of the apology, while only 23% agreed in return for compensation.

The study also discovered that a higher purchase price further reduced the number of customers willing to forgive for cash. Yet the size of the initial outlay had no effect on the willingness of participants to settle for simply reading the magic words: "I'm sorry."

Dr Abeler, an expert in behavioral economics, said: "It's interesting to note our setting should have made it hard for an apology to work.

"The apology was delivered by a large, anonymous firm and wasn't face-to-face, and the firm had a clear incentive to apologize.

"All of this meant the apology should have been regarded by the customers as calculated, insincere and just cheap talk. Yet it still yielded much better outcomes than offering cash compensation – and our results might even underestimate its effects."

Apparently, this also works for doctors:

Apology a tool to avoid malpractice suits, by Lindsey Tanner, Associated Press: ...Some malpractice-overhaul advocates say an apology can help doctors avoid getting sued, especially when combined with an upfront settlement offer.

The idea defies a long tradition in which doctors cultivated a Godlike image of infallibility and rarely owned up to their mistakes.

The softer approach, now appearing in some medical school courses and hospital policies, is drawing interest as national attention has turned to reducing both medical errors and the high cost of malpractice insurance...

The hospitals in the University of Michigan Health System have been encouraging doctors since 2002 to apologize for mistakes. The system's annual attorney fees have since dropped from $3 million to $1 million, and malpractice lawsuits and notices of intent to sue have fallen from 262 filed in 2001 to about 130 per year...

Dr. Michael Woods, a surgeon in Colorado ... said his research has shown that being upset with a doctor's behavior often plays a bigger role than the error itself in patients' decisions to sue. ...

Accountants have also figured this out.

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"An Economics of Magical Thinking"

Roman Frydman and Michael Goldberg argue that the behavioral assumptions used to motivate agents in economic models need to change:

An economics of magical thinking, by Roman Frydman and Michael D. Goldberg, Commentary, Economist's Forum: Confidence seems to be returning to markets almost everywhere, but the debates about what caused the worst crisis since the Great Depression show no sign of letting up. Instead, the spotlight has shifted from bankers, financial engineers and regulators to economists and their theories. This is not a moment too soon. These theories continue to shape the debate about fiscal stimulus, financial reform, and, more broadly, the future of capitalism, which means that they remain a danger to all concerned.

Unfortunately, the assumptions that underpin these theories are largely inscrutable to those without a Ph.D. in economics. Indeed, the debate is full of terms that mean one thing to the uninitiated and quite another to economists.

Consider "rationality."

Webster's Dictionary defines it as "reasonableness." By contrast, for economists, a "rational individual" is not merely reasonable; he or she is someone who behaves in accordance with a mathematical model of individual decision-making that economists have agreed to call "rational."

The centerpiece of this standard of rationality, the so-called "Rational Expectations Hypothesis", presumes that economists can model exactly how rational individuals comprehend the future. In a bit of magical thinking, it supposes that each of the many models devised by economists provides the "true" account of how market outcomes, such as asset prices, will unfold over time.

The economics literature is full of different models, each one assuming that it adequately captures how all rational market participants make decisions. Although the free-market Chicago school, neo-Keynesianism, and behavioral finance are quite different in other respects, each assumes the same REH-based standard of rationality.

In other words, REH-based models ignore markets' very raison d'etre: no one, as Friedrich Hayek pointed out, can have access to the "totality" of knowledge and information dispersed throughout the economy. Similarly, as John Maynard Keynes and Karl Popper showed, we cannot rationally predict the future course of our knowledge. Today's models of rational decision-making ignore these well-known arguments.

The unreasonableness of this standard of rationality helps to explain why macroeconomists of all camps and finance theorists find it hard to account for swings in market outcomes. Even more pernicious, despite these difficulties, their models supposedly provide a "scientific" basis for judging the proper roles of the market and the state in a modern economy.

But incoherent premises lead to absurd conclusions - for example, that unfettered financial markets set asset prices nearly perfectly at their "true" fundamental value. If so, the state should drastically curtail its supervision of the financial system. Unfortunately, many officials came to believe this claim, known as the "efficient markets hypothesis," resulting in the widespread deregulation of the late 1990s and early 2000s. That made the crisis more likely, if not inevitable.

Public opinion has swung to the other extreme, as complacency about the need for financial regulation has been replaced by calls for greater oversight by the state to control the unstable behavior of financial markets.

Behavioral economists have uncovered much evidence that market participants do not act like conventional economists would predict "rational individuals" to act. But, instead of jettisoning the bogus standard of rationality underlying those predictions, behavioral economists have clung to it. They interpret their empirical findings to mean that many market participants are irrational, prone to emotion, or ignore economic fundamentals for other reasons. Once these individuals dominate the "rational" participants, they push asset prices away from their "true" fundamental values.

The behavioral view suggests that swings in asset prices serve no useful social function. If the state could somehow eliminate them through a large intervention, or ban irrational players by imposing strong regulatory measures, the "rational" players could reassert their control and markets would return to their normal state of setting prices at their "true" values.

This is implausible, because an exact model of rational decision-making is beyond the capacity of economists - or anyone else - to formulate. Once economists recognize that they cannot explain exactly how reasonable individuals make decisions and how market outcomes unfold over time, we will no longer be stuck with two polar extremes concerning the relative roles of the market and the state.

For the most part, asset prices undergo swings because participants must cope with ever-imperfect knowledge about the fundamentals that drive prices in the first place. So long as these swings remain within reasonable bounds, the state should limit its involvement to ensuring transparency and eliminating market failures.

But sometimes price swings become excessive, as recent experience painfully shows. Even accepting that officials must cope with ever imperfect knowledge, they can implement measures - such as guidance ranges for asset prices and changes in capital and margin requirements that depend on whether these prices are too high or too low - to dampen excessive swings.

Such measures require policymakers to exercise discretion, rather than simply rely on fixed rules. That might not please most economists, but it would leave the market to allocate capital while holding out the possibility of reducing the social costs that arise when asset swings continue for too long and then end, as they inevitably do, in sharp reversals.

In an email conversation with Roman Frydman about this article, I said:

You two have done really good work and have interesting things to say about this whole debate over macroeconomic models, but somehow the ideas have had trouble bubbling into the mainstream, or so it seems – and to me that says something negative about the sociology of our profession. But maybe it's had more impact than I'm aware of and I just haven't been keeping up – sure hope so as it deserves a fair and thorough hearing.

For more on "Imperfect Knowledge Economics," see here, or even better, see "Macroeconomic Theory for a World of Imperfect Knowledge" and "Financial Markets and the State." [Here's an example of their recommendations for regulating ratings agencies within the imperfect knowledge framework, here's an example for exchange rates, and here's an example of their proposal to limit swings in asset markets, i.e. to "pop" bubbles.]

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As Expected, Fed Keeps Target Rate on Hold

[Money Watch link] After its rate setting meeting today, the Fed announced that it "will maintain the target range for the federal funds rate at 0 to 1/4 percent," and that it "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Very few analysts thought the Fed should raise the rate, calls for higher rates came from a few inflation hawks but that's about it, and nobody I know of expected the Fed to change its interest rate policy. So no surprises here.

Of more interest are the Fed's characterization of economic conditions, its plans for the special facilities and other non-standard monetary policy options it has put in place to deal with the crisis, and its exit strategy.

Here, the Fed seemed more positive about the economy than it has been in the past, and further indication of the Fed's positive outlook comes with its announcement that it will wind down the purchase of mortgage backed securities and stop doing so altogether early next year, and its reiteration of its plans to end the purchase of Treasury bonds.

But while the Fed sees positive signs and is beginning to execute an exit strategy, the fact that it is keeping the interest rate on hold indicates that it expects a slow, drawn out recovery. I also expect a slow recovery, particularly for labor markets, so I'm glad to see that the Fed is being cautious and wants to avoid the mistake of raising rates too soon. It's a delicate tradeoff, if the Fed waits too long to raise rates it could face inflation problems, but if it tightens too soon it could choke off the recovery. My view is that if the Fed is going to make a mistake, it ought to be in favor of employment, and it looks to me like the Fed has similar sentiments.

Here's the Press Release:

Press Release, Release Date: September 23, 2009: Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve's purchases of $300 billion of Treasury securities will be completed by the end of October 2009. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

[More from the WSJ, the Financial Times, and Bloomberg.]

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How Should Regulators be Chosen?

At CBS Money Watch:

How should regulators be chosen?, by Mark Thoma

I argue that most people do not feel like their interests are represented when policy decisions are made about regulation, bailouts, and other matters, including decisions by the Federal Reserve on setting the target interest rate, and that needs to change.

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Is Government Helping or Hurting Business?

There's not a populist bone in Robert Reich's body. Not a one:

Why the Dow is Hitting 10,000 Even When Consumers Can't Buy And Business Cries "Socialism", by Robert Reich: So how can the Dow Jones Industrial Average be flirting with 10,000 when consumers, who make up 70 percent of the economy, have had to cut way back on buying because they have no money? Jobs continue to disappear. One out of six Americans is either unemployed or underemployed. Homes can no longer function as piggy banks because they're worth almost a third less than they were two years ago. And for the first time in more than a decade, Americans are now having to pay down their debts and start to save. Even more curious, how can the Dow be so far up when every business and Wall Street executive I come across tells me government is crushing the economy with its huge deficits, and its supposed "takeover" of health care, autos, housing, energy, and finance? Their anguished cries of "socialism" are almost drowning out all their cheering over the surging Dow. The explanation is simple. The great consumer retreat from the market is being offset by government's advance into the market. Consumer debt is way down from its peak in 2006; government debt is way up. Consumer spending is down, government spending is up. Why have new housing starts begun? Because the Fed is buying up Fannie and Freddie's paper, and government-owned Fannie and Freddie are now just about the only mortgage games remaining in play. Why are health care stocks booming? Because the government is about to expand coverage to tens of millions more Americans, and the White House has assured Big Pharma and health insurers that their profits will soar. Why are auto sales up? Because the cash-for-clunkers program has been subsidizing new car sales. Why is the financial sector surging? Because the Fed is keeping interest rates near zero, and ... the government is still guaranteeing any bank too big to fail will be bailed out. Why are federal contractors doing so well? Because the stimulus has kicked in. In other words, the Dow is up despite the biggest consumer retreat from the market since the Great Depression because of the very thing so many executives are complaining about, which is government's expansion. And regardless of what you call it – Keynesianism, socialism, or just pragmatism – it's doing wonders for business, especially big business and Wall Street. Consumer spending is falling back to 60 to 65 percent of the economy, as government spending expands to fill the gap. The problem is, our newly expanded government isn't doing much for average working Americans who continue to lose their jobs and whose belts continue to tighten, and who are getting almost nothing out of the rising Dow because they own few if any shares of stock. Despite ... all their cries of "socialism" -- big business and Wall Street are more politically potent than ever.

It would have been better if the effort to revive the economy had a stronger trickle up component, i.e. give the tax cuts or transfers to the people who need it rather than those who don't, they will spend the extra money, it will trickle up as profits to the owners of businesses as the money is spent and re-spent through the multiplier process, and the owners will use the profits to hire more workers and to make productive investments (and even if the money doesn't trickle up as expected, at least you've helped people in need, when tax cuts for the wealthy don't trickle down, the consolation prize isn't as attractive).

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Output, Productivity, Employment, Household Debt, Consumption, and Wealth

Two from the Antonio Fatás and Ilian Mihov Global Economy blog. First, Antonio Fatás notes cross-country differences in how productivity has evolved during the crisis, and he speculates that the difference may be due to differences in how much effort was devoted to reducing the impact of the recession on employment:

Output, employment and productivity during the crisis, by Antonio Fatás: While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.

In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.

Below is data on labor productivity measured as GDP per hour worked in four countries... In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.

Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.

Next, Ilian Mihov argues that consumer indebtedness might not be as bad as you've been led to believe:

Household debt, consumption and wealth, by Ilian Mihov: It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. ... Indeed,... debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy. 1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.

Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true). But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP). ... 2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line! ... There are ways in which this "neutrality of debt" may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.

In general, many other "imperfections" in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.

One quick comment. This is hinted at in the second to last paragraph, but to make it more explicit, the distribution of assets and liabilities can matter, and given the rise in inequality over much of this time period (it coincides with the rise in the green and red lines beginning in the 1970s evident in the diagram above) along with the stagnant wages of the working class, there may well have been important distributional effects.

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links for 2009-09-22

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Economist's View - 6 new articles

2009-09-22T23:01:00.001-07:00

Cynics, not Whiners?

Bruce Judson says effective financial reform is essential to restoring trust in government:

Restoring Trust in Our Economic System and the Institutions of Our Democracy, by Bruce Judson: The Financial Crisis Inquiry Commission (FCIC), which started work last week, will have a significant impact on the health of our democracy. When the FCIC completes its efforts, we will either be stronger or weaker as a nation. There is no middle ground. ...

The work of the Commission is important for two reasons. First, by openly educating the public about the causes of the financial crisis it will pave the way for reform. Existing interests will inevitably resist change. Reform becomes far easier when its advocates can point to a roadmap of specific problems that must be addressed. ...

Second, America is becoming an angry nation, with diminished faith in its institutions. There is a growing sense among all but the wealthiest Americans that "the game is rigged" against them. The public perception of the work of the FCIC will inevitably affect, for better or worse, our basic level of trust in the nation's democratic system.

In Trust, Francis Fukuyama demonstrated that societies with high trust are vibrant and productive, because individuals trust their interests will be protected. In the absence of trust, rigid work rules, contracts, litigation, and a range of other costs are created as everyone in the economy attempts to protect him or herself. In 1972, Kenneth Arrow, the Nobel laureate wrote, "Virtually every commercial transaction has within itself an element of trust." ...

When trust disappears, people become increasingly cynical. As this cynicism grows, citizens become disengaged from the political process: There's no point in voting or working toward any civic-related goal if you cynically believe nothing will ever change. At the same time, government becomes increasing ineffective as people no longer believe elected officials will fulfill their responsibilities or promises. As a result, a cynical society can quickly become a paralyzed society.

Ultimately, cynicism can also play a role in shifting a paralyzed society toward actual political instability. One of the causes of the collapse of the Soviet Union was the extraordinarily high degree of cynicism toward the government. ...

Last week, I wrote an ... article that ... critiqued the data and conclusions of a front page Wall Street Journal article that inaccurately down-played the extent of economic inequality. The article attracted hundreds of comments across the Web. The vast majority of these comments effectively said: What else did you expect? I discovered that cynicism is the reigning sentiment.

We are not becoming a nation of whiners. Far worse, we are becoming a nation of cynics.

To date, the growing cynicism of the American public is sadly justified. No one on Wall Street has apologized. No one has accepted responsibility for causing the crisis. While jobless victims of this crisis face increasing foreclosures, many of the firms that caused the crisis are—with government assistance—returning to past habits. ...

The work of the FCIC represents both ... opportunity and a potential danger. By shining a bright light on the causes of this crisis, the FCIC has the chance to once again demonstrate that no one is approve reproach and to provide a clear map of the problems that successful reform must address. With these results, the FCIC can demonstrate that the American system continues to work, and enhance trust in our democratic system.

The danger is that the FCIC does not fulfill this critical mandate, and it is ultimately perceived as failing to have aggressively searched for the truth. If this happens, my hypothesis is the nation will almost inevitably slide further on the path toward paralyzing cynicism. What happens then?

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Have Plans Ready Next Time

I have another post at CBS Money Watch:

Why We Need Plans To Break Up Too-Big-to-Fail Banks, by Mark Thoma

This reiterates that we need to have plans ready to dissolve systemically important financial firms. What I didn't say is that we should also do our best to prevent firms from becoming a danger to the system due to their size of connectedness.

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Predicting Crises

David Levine "aggressively argues":

our models don't just fail to predict the timing of financial crises - they say that we cannot.

The San Francisco Fed's Bharat Trehan says:

simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances. ... [W]e have taken two simple indicators off the shelf and shown that both would have signaled impending trouble prior to the current crisis. That makes it harder to argue that financial crises are, by their nature, unpredictable. And it shows that such simple indicators can be useful ... as signals of rising levels of risk in the economy.

See here. Or here.

We ought to be able to say, at the very least, something like:

If you keep eating that junky credit instead of a healthier financial diet, your monetary circulatory system is likely to have severe problems at some point in the future.

Many people had a sense things were out of balance and that at some point it would cause us problems, but the indicators most people looked at pointed to a diagnosis involving exchange rate movements and an international unwinding. The discussion centered on issues such as whether we would have a hard or a soft landing as this process unfolded, there was little discussion of the type of crisis that actually occurred.

So we need two things. First, we need indicators such as those identified in the SF Fed article that can tell us when danger is building in the financial sector.

But that is not enough. Though many people had a sense from the indicators they looked at that things were out of balance, the indicators pointed to international financial issues rather than the true problem, and hence most of the analysis and policy discussions were devoted to guarding against problems related to international financial flows.

Thus, the second thing we have a need for is a set of indicators that do a better job of telling us where the problems are likely to occur. That is where we made the biggest mistake, misdiagnosing the type of crisis that was coming. Having indicators that can do a better job of identifying the type of financial crisis we are facing will allow us to design and implement effective policy responses rather than wasting time analyzing and planning for the wrong type of crisis.

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"On the G20 Agenda"

Tim Duy:

On the G20 Agenda, by Tim Duy: Simon Johnson at the Baseline Scenario has a nice piece bemoaning the US pursuit of a rebalancing agenda at the upcoming G20 meeting. I largely agree with Johnson's tone. Something that sounds nice, but that to which no parties, particularly China and the US, can make a credible commitment. It is, however, keeping some poor staffer at the US Treasury busy 24-7. Johnson's third point, however, misses some important points:

Where is the evidence that this kind of "imbalance" had even a tangential effect on the build up of vulnerabilities that led to the global financial crisis of 2008-09? I understand the theoretical argument that current account imbalances could play a role in a US-based/dollar crisis, but remember: interest rates were low 2002-2006 because of Alan Greenspan (who controlled short-term dollar interest rates); the international capital flows that sought out crazy investments came from Western Europe, which was not a significant net exporter of capital (i.e., a balanced current account is consistent with destabilizing gross flows of capital); and the crisis, when it came, was associated with appreciation – not depreciation – of the dollar.

I believe Johnson underestimates just how close we came to a destabilizing collapse of the Dollar in 2008. That avoidance of that near collapse was well documented by Brad Setser in his legendary "quiet bailout" series:

...The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.

So far that hasn't been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.

Later analysis can be found here. Had it not been for the supporting role that China and other central banks played in financing the US current account deficit, we would have seen a full blown currency crisis, well before the financial crisis of September 2008.

As an aside, the intervention to support the Dollar was also the key event that allowed the US recession to evolve in the pattern envisions by domestic-focused economists, as opposed to those seeped in the traditions of international finance. Brad Delong has a fantastic piece on this issue, including the key assumption failed the internationalists:

Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future…

...The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.

I have no doubt that the willingness of central banks to flood the global economy with month in an effort to hold currency pegs contributed greatly to the great commodity price bubble that ultimately sent US real consumption into a tail spin well before the events in the fall of 2008.

As to the G20 proposal itself - easier said than done. Back on the real side of the economy, I believe the US economy is very structurally misaligned, to a disturbing degree. We simply do not make many of the products we want to buy, and have the capacity to make many products - like expensive housing - that no one wants to buy. Moreover, these structural misalignments have been building for at least 15 years, at least partly the consequence of the US strong Dollar policy that gave license for wholesale currency manipulation to support mercantilistic policy objectives. Reversing 15 years of policy in which deep structural shifts occurred will not happen overnight.

Nor do I think the Chinese are interested in making that transition happen. Thomas Freidman has a point here:

China now understands that. It no longer believes it can pollute its way to prosperity because it would choke to death. That is the most important shift in the world in the last 18 months. China has decided that clean-tech is going to be the next great global industry and is now creating a massive domestic market for solar and wind, which will give it a great export platform….So, if you like importing oil from Saudi Arabia, you're going to love importing solar panels from China.

This restructuring, not so much the financial restructuring, is what I suspect the Administration really wants to address.

Good luck with that.

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"A Vision for Innovation, Growth, and Quality Jobs"

Larry Summers, blogging from the White House, says the administration's policies will create jobs and help to ensure that "the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy":

A Vision for Innovation, Growth, and Quality Jobs, by Lawrence H. Summers: President Obama laid out his vision for innovation, growth, and quality jobs earlier today at Hudson Valley Community College. The President's plan is grounded not only in the American tradition of entrepreneurship, but also in the traditions of robust economic thought.

During the past two years, the ideas propounded by John Maynard Keynes have assumed greater importance than most people would have thought in the previous generation. As Keynes famously observed, during those rare times of deep financial and economic crisis, when the "invisible hand" Adam Smith talked about has temporarily ceased to function, there is a more urgent need for government to play an active role in restoring markets to their healthy function.

The wisdom of Keynesian policies has been confirmed by the performance of the economy over the past year. After the collapse of Lehman Brothers last September, government policy moved in a strongly activist direction.

As a result of those policies, our outlook today has shifted from rescue to recovery, from worrying about the very real prospect of depression to thinking about what kind of an expansion we want to have.

An important aspect of any economic expansion is the role innovation plays as an engine of economic growth. In this regard, the most important economist of the twenty-first century might actually turn out to be not Smith or Keynes, but Joseph Schumpeter.

One of Schumpeter's most important contributions was the emphasis he placed on the tremendous power of innovation and entrepreneurial initiative to drive growth through a process he famously characterized as "creative destruction." His work captured not only an economic truth, but also the particular source of America's strength and dynamism.

One of the ways to view the trajectory of economic history is through the key technologies that have reverberated across the economy. In the nineteenth century, these included the transcontinental railroad, the telegraph, and the steam engine, among others. In the twentieth, the most powerful innovations included the automobile, the jet plane, and, over the last generation, information technology.

While we can't know exactly where the next great area of American innovation will be, we already see a number of prominent sectors where American entrepreneurs are unleashing explosive, innovative energy:

In information technology, where tremendous potential remains for a range of applications to increase for years to come;

In life-science technologies, where developments made at the National Institutes of Health and in research facilities around the country will have profound implications not just for human health, but also for the environment, agriculture, and a range of other areas that require technological creativity; and,

In energy, where the combination of environmental and geopolitical imperatives have created the context for an enormously productive period in developing energy technologies as well.

Looking across the breadth of the U.S. economy, the prospects for transformational innovation to occur are enormous. But to ensure that the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy in the twenty-first century requires a role for government as well: to create an environment that is conducive to generating those developments.

The President's program is directed at strengthening our economic ecology—an educated workforce, a fluid environment that stimulates entrepreneurship, and building blocks in key areas of the economy—that has long been central to America's prosperity. These were core design considerations in putting together over $100 billion of Recovery Act funds that support innovation and they will continue to be core concerns going forward. With steps like these, the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy in the twenty-first century.

I hope you'll take a few minutes to read the President remarks today or, to delve into more detail, into a new white paper prepared by the National Economic Council about the policies President Obama is implementing to create a broader, more inclusive, more prosperous America based on the ingenuity of our people.

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links for 2009-09-21

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Economist's View - 6 new articles

2009-09-21T23:09:00.001-07:00

"Economists Need to Study Bubbles"

Robert Shiller says economists and their models need to take bubbles seriously (compare Dani Rodrik's "Blame Economists, not Economics"):

Economists need to study bubbles, reinvent models, by Robert Shiller, Commentary, Project Syndicate: The widespread failure of economists to forecast the financial crisis ... has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come. ...

[T]he current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. ... You won't find the word "bubble," however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of "bubbles" even being mentioned. Indeed, the idea that bubbles exist has become so disreputable ... that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. ...

[E]conomists assume that people ... use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. ... They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed. ...

In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn't seem to be a mere repetition of a quantifiable past. ...

To be sure, the purely rational theory remains useful for many things. ... Economists have also been right to apply his theory to a range of microeconomic issues... The theory, however, has been overextended. For example, the "Dynamic Stochastic General Equilibrium Model of the Euro Area," developed by Frank Smets ... and Raf Wouters..., is very good at giving a precise list of external shocks that are presumed to drive the economy, but nowhere are bubbles modeled. The economy is assumed to do nothing more than respond in a completely rational way to these external shocks.

Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, showed that monetary-policy anomalies — a prime example of an external shock — were a significant factor in the Great Depression of the 1930s. ... To some, this revelation represented a culminating event for economic theory. The worst economic crisis of the 20th century was explained — and a way to correct it suggested — with a theory that does not rely on bubbles.

Yet events like the Great Depression, as well as the recent crisis, will never be fully understood without understanding bubbles. The fact that monetary policy mistakes were an important cause of the Great Depression does not mean that we completely understand that crisis, or that other crises fit that mold.

In fact, the failure of economists' models to forecast the current crisis will mark the beginning of their overhaul. This will happen as economists' redirect their research efforts by listening to scientists with different expertise. Only then will monetary authorities gain a better understanding of when and how bubbles can derail an economy and what can be done to prevent that outcome.

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Financial Reform: The Consolidation of Regulatory Authority

Here's something I wrote for CBS Money Watch:

Who Should Oversee the Financial System?, by Mark Thoma

I expect many of you will disagree.

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"The Costs of Economic Growth"

Lee Arnold says via email "this is interesting." It's an analysis of when and if economic growth should be maximized when technological progress involves risks as well as benefits:

The Costs of Economic Growth, by Charles I. Jones, Stanford GSB and NBER, August 18, 2009: 1. Introduction In October 1962, the Cuban missile crisis brought the world to the brink of a nuclear holocaust. President John F. Kennedy put the chance of nuclear war at "somewhere between one out of three and even." The historian Arthur Schlesinger, Jr., at the time an adviser of the President, later called this "the most dangerous moment in human history."¹ What if a substantial fraction of the world's population had been killed in a nuclear holocaust in the 1960s? In some sense, the overall cost of the technological innovations of the preceding 30 years would then seem to have outweighed the benefits.

While nuclear devastation represents a vivid example of the potential costs of technological change, it is by no means unique. The benefits from the internal combustion engine must be weighed against the costs associated with pollution and global warming. Biomedical advances have improved health substantially but made possible weaponized anthrax and lab-enhanced viruses. The potential benefits of nanotechnology stand beside the threat that a self-replicating machine could someday spin out of control. Experimental physics has brought us x-ray lithography techniques and superconductor technologies but also the remote possibility of devastating accidents as we smash particles together at ever higher energies. These and other technological dangers are detailed in a small but growing literature on so-called "existential risks"; Posner (2004) is likely the most familiar of these references, but see also Bostrom (2002), Joy (2000), Overbye (2008), and Rees (2003).

Technologies need not pose risks to the existence of humanity in order to have costs worth considering. New technologies come with risks as well as benefits. A new pesticide may turn out to be harmful to children. New drugs may have unforeseen side effects. Marie Curie's discovery of the new element radium led to many uses of the glow-in-the-dark material, including a medicinal additive to drinks and baths for supposed health benefits, wristwatches with luminous dials, and as makeup — at least until the dire health consequences of radioactivity were better understood. Other examples of new products that were initially thought to be safe or even healthy include thalidomide, lead paint, asbestos, and cigarettes.

The benefits of economic growth are truly amazing and have made enormous contributions to welfare. However, this does not mean there are not also costs. How does this recognition affect the theory of economic growth?

This paper explores what might be called a "Russian roulette" theory of economic growth. Suppose the overwhelming majority of new ideas are beneficial and lead to growth in consumption. However, there is a tiny chance that a new idea will be particularly dangerous and cause massive loss of life. Do discovery and economic growth continue forever in such a framework, or should society eventually decide that consumption is high enough and stop playing the game of Russian roulette? The answer turns out to depend on preferences. For a large class of conventional specifications, including log utility, safety eventually trumps economic growth. The optimal rate of growth may be substantially lower than what is feasible, in some cases falling all the way to zero.

This paper is most closely related to the literature on sustainable growth and the environment; for example, see Gradus and Smulders (1993), Stokey (1998), and Brock and Taylor (2005). Those papers show that when pollution and the environment directly enter utility or the production function, a "growth drag" may result. Here, the key concern —the loss of life associated with potentially dangerous technologies —is quite different. Nevertheless, there are interesting links with this literature that will be discussed later. ...

...8. Conclusion Technological progress involves risks as well as benefits. Considering the risks posed to life itself leads potentially to first-order changes in the theory of economic growth. This paper explores these possibilities, first in a simple "Russian roulette" style model and then in a richer model in which growth explicitly depends on the discovery of new ideas. The results depend somewhat on the details of the model and, crucially, on how rapidly the marginal utility of consumption declines. It may be optimal for growth to continue exponentially despite the presence of existential risks, or it may be optimal for growth to slow to zero, even potentially leading to a steady-state level of consumption.

The intuition for the possible end to exponential growth turns out to be straightforward. For a large class of standard preferences, safety is a luxury good. The marginal utility associated with more consumption on a given day runs into sharp diminishing returns, and ensuring additional days of life on which to consume is a natural, welfare enhancing response. When the value of life rises faster than consumption, economic growth leads to a disproportionate concern for safety. This concern can be so strong that it is desirable that growth slow down.

The framework studied here clearly omits other factors that may be important. Health technologies can help to extend life, possibly offsetting some of the concerns here. Even dangerous technologies like nuclear weapons could have a life-saving use—for example if they helped to divert an asteroid thatmight otherwise hit the earth.

This paper suggests a number of different directions for future research on the economics of safety. It would clearly be desirable to have precise estimates of the value of life and how this has changed over time; in particular, does it indeed rise faster than income and consumption? More empirical work on how safety standards have changed over time—and estimates of their impacts on economic growth—would also be valuable. Finally, the basic mechanism at work in this paper over time also applies across countries. Countries at different levels of income may have very different values of life and therefore different safety standards. This may have interesting implications for international trade, standards for pollution and global warming, and international relations more generally.

1For these quotations, see (Rees, 2003, p. 26).

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Paul Krugman: Reform or Bust

The administration needs to take a more forceful approach to financial sector reform, especially reform that places limits on how executives can be paid:

Reform or Bust, by Paul Krugman, Commentary, NY Times: In the grim period that followed Lehman's failure, it seemed inconceivable that bankers would, just a few months later, be going right back to the practices that brought the world's financial system to the edge of collapse. ...

But now that we've stepped back a few paces from the brink — thanks, let's not forget, to immense, taxpayer-financed rescue packages — the financial sector is rapidly returning to business as usual. Even as the rest of the nation continues to suffer from rising unemployment and severe hardship, Wall Street paychecks are heading back to pre-crisis levels. And the industry is deploying its political clout to block even the most minimal reforms.

The good news is that senior officials in the Obama administration and at the Federal Reserve seem to be losing patience with the industry's selfishness. The bad news is that it's not clear whether President Obama himself is ready, even now, to take on the bankers.

Credit where credit is due: I was delighted when Lawrence Summers ... lashed out at the campaign the U.S. Chamber of Commerce, in cooperation with financial-industry lobbyists, is running against the proposed ... agency to protect consumers against financial abuses... The chamber's ads, declared Mr. Summers, are "the financial-regulatory equivalent of the death-panel ads..."

Yet protecting consumers from financial abuse should be only the beginning of reform. If we really want to stop Wall Street from creating another bubble,... we need to change the industry's incentives — which means ... changing the way bankers are paid. ... In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren't correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking...

The Federal Reserve, now awakened from its Greenspan-era slumber,... is considering ... requiring that banks "claw back" bonuses in the face of losses and link pay to long-term rather than short-term performance. ... But the industry — supported by nearly all Republicans and some Democrats — will fight bitterly against these changes. And while the administration will support some kind of compensation reform, it's not clear whether it will fully support the Fed's efforts.

I was startled last week when Mr. Obama ... questioned the case for limiting financial-sector pay: "Why is it," he asked, "that we're going to cap executive compensation for Wall Street bankers but not Silicon Valley entrepreneurs or N.F.L. football players?"

That's an astonishing remark — and not just because the National Football League does, in fact, have pay caps. Tech firms don't crash the whole world's operating system when they go bankrupt; quarterbacks who make too many risky passes don't have to be rescued with hundred-billion-dollar bailouts. Banking is a special case — and the president is surely smart enough to know that.

All I can think is that this was another example of ... Mr. Obama's visceral reluctance to engage in anything that resembles populist rhetoric. And that's something he needs to get over.

It's not just that taking a populist stance on bankers' pay is good politics — although it is: the administration has suffered more than it seems to realize from the perception that it's giving taxpayers' hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.

Equally important, in this case populism is good economics. Indeed, you can make the case that reforming bankers' compensation is the single best thing we can do to prevent another financial crisis... It's time for the president to realize that sometimes populism, especially populism that makes bankers angry, is exactly what the economy needs.

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Fed Watch: Even With Growth, A Long, Hard Road

Tim Duy looks forward to the Federal Open Market Committee rate setting meeting later this week:

Even With Growth, A Long, Hard Road, by Tim Duy: The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.

Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:

In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:

All of that is well and good. The FOMC, however, will look at this data flow and ask "what's next?" An inventory correction in the wake of the 2001 recession provided little lasting support, leaving the economy struggling until the housing bubble gained force in 2003-04. The clunkers program and the homebuyers credit likely borrowed some spending from the future. And even if the homebuyers credit is extended, the marginal impact is likely to decline as it increasingly benefits those looking to buy anyway. Moreover, there is growing concern that this summer's buying binge - such that it is was - can be partly attributed to a slowing in foreclosure activity earlier this week. Now that the pace of foreclosures looks to be picking up, and the threat of the option-ARM lending comes more clearly into the view, the sustainability of this summer's housing gains comes into question. On top of all that housing concern, the possibility that the FHA might need a bailout indicates that the risk of loaning into an overpriced housing market has simply been shifted from the private sector to the taxpayer. Consequently, the FHA - the current housing lender of last resort -is poised to tighten credit standards. And even the surprisingly strong retail sales numbers are somewhat suspect, as they don't appear to comport with the anecdotal reports of retailers. A reasonable midpoint analysis, via the Wall Street Journal:

The July/August average for "core" retail sales is still not much stronger than the [second-quarter] average, but after a string of contractions, these data suggest that consumer demand is, at a minimum, stabilizing. Core retail sales may even be starting to firm slightly (up in 2 of the past 3 months), but we will need to see another month or two of positive data to have confidence in that view. –Stephen Stanley, RBS

In addition, financial markets remain glued up by many metrics. Importantly, consumer credit growth is still significantly restrained, as is bank lending for commercial and industrial loans:

Given the steady anecdotal buzz surrounding the deterioration of the commercial real estate market, it is difficult to expect a rapid reversal of these trends. In short, if you think credit markets are still under stress, as the Fed certainly does, and are worried about the availability of credit to support future spending, also among Fed concerns, then shifting rhetorically to signal a tighter policy stance irrational. Moreover, it would seem inconsistent with plans to continue expanding the balance sheet via purchases of mortgage backed securities and TALF assets.

Now, the above are among the reasons many expect a relatively tepid recovery to emerge in the years ahead. Suppose instead that you, logically, believe that the economy is set to come roaring back on the straightforward hypothesis that deep recessions are always followed by strong recoveries. James Grant makes just such an argument in this past weekend's Wall Street Journal:

"At the business trough in 1933," Mr. Darda points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.

One would have to wonder if Grant has ever seriously considered a different analysis of the path of the business cycle. After all, I have never heard it argued by the more pessimistic forecasters that the fundamentally reason for their concerns is that private enterprise is no longer practiced in the US. That this should be his line of argument seems silly. That aside, the post-1933 rebound is illustrated by the industrial production series:

What one could add to this story, however, is that despite the rapid growth of 1933-1937, unemployment remained unacceptably high and inflation remained sufficiently contained such that the price level never came close to regaining the ground lost during the depression:

And - critically for divining the path of policy - the growth in the 1933-1937 period was not sufficient to allow for policy tightening, as evidenced from the 1937 recession. One does not have to deny that the recession is over - and can even expect nontrivial growth - while still expecting a sufficiently weak outcome that prevents a significant reversal of the Fed's monetary stance. Or further fiscal stimulus, for that matter. Which is to say that those who see rapid growth as a reason for an imminent Fed reversal are looking in the wrong direction. Even rapid growth could leave the Fed on the sidelines for much, much longer than many anticipate - and they know it. Bernanke has schooled policymakers well on the lasting damage that typically follows the collapse of a debt-driven bubble.

Bottom Line: Economic activity is clearly on the upswing - but the durability and sustainability of the recovery remains in doubt. The FOMC statement will certainly take notice of strengthening economic data. But a resumption of growth is not the only issue that factors into policymaking. At this juncture, the focus to resource utilization - how long will persistently weak labor marks sustain downward pressure on wages and thus make a wage-price inflation spiral simply unattainable? For now, a seemingly long period of time. Indeed, I find it virtually impossible that Fed officials will dare shift from "sure, we can withdraw stimulus when needed" to "it is not necessary to aggressively withdraw stimulus" until the unemployment rate begins a sustained march downward. And for now, we are still waiting for the upward march to end.

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links for 2009-09-20

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Economist's View - 6 new articles

2009-09-20T22:48:00.001-07:00

Toxic Assets in the 18th Century

An example of a "toxic asset" from the past, the inconvertible bank note, that shows the need for the government to identify financial sector risks, and then provide the regulation necessary to keep the financial sector functioning normally:

Toxic assets in the 18th century, by Oren Levintal and Joseph Zeira, Vox EU: The global financial crisis has revived the old debate on optimal regulation in the money and credit markets. The current debate is centred on how to regulate highly sophisticated financial markets, yet the pros and cons are similar to those observed a few centuries ago, when paper money emerged and became the state of the art in the money market. Actually, problems of regulation appear whenever financial innovations change the ways capital markets operate. Looking at this history, e.g. the study of Davis (1896) on banking in Massachusetts, can help us understand the turbulent recent developments. In recent work, we touch on these issues by studying the evolution of paper money and its influence on economic efficiency and financial stability (Levintal and Zeira 2009).

Financial innovation in the 18th century

The evolution of money is, in some sense, a story of the development of financial technology. In the pre-banking era, gold and silver coins were the main media of exchange. Transactions were made with coins because purchases on credit were very risky (and barter was almost always impossible). When banks emerged during the medieval ages, they started to lend silver and gold. It was much cheaper to borrow money from a bank, which could exploit economies of scale to diversify the risk of default, than borrowing from a single risk-averse lender. Hence, the introduction of money lending by bankers reduced borrowing costs and facilitated trade.

The problem with lending silver or gold coins is the burden of reserves. Since lending and trade occur in different locations and different times, the bank must hold large reserves for loans. To see this, consider a simple model with a buyer, a seller, and a bank. At first, the buyer borrows silver from the bank. Then, he goes to the market to buy goods and pays the seller with his silver coins. The seller receives the silver and decides whether to hold it, deposit in the bank, or repay his bank loans. Note that silver flows into the bank only after the trade is executed (through deposits or loan repayments by sellers). Since the bank lends silver to buyers before trade, it faces a liquidity problem that imposes a reserve constraint on its lending. Namely, in order to be able to lend each morning, the bank has to carry silver reserves from the previous day, which is costly.

A better instrument of lending would be an asset that is available right at the moment of lending, without the need to hold it in advance. This type of asset emerged in the form of convertible notes or paper money. Convertible notes were issued by private banks and could be converted into silver or gold on demand. From the bank's point of view, lending notes was cheaper than lending silver, because silver had to be held in advance while notes could be issued by the bank at no cost. Actually, the bank still had to hold some reserves because the notes were not perfect substitutes for silver. Some note-holders continued to demand silver for various reasons. However, most of the notes were not converted because agents used them as a medium of exchange.

Convertible bank notes spread through the economy, as they enabled easier lending. This phenomenon happened toward the end of the middle ages and the beginning of the modern period. But that was not the end of the story. Banks realised that they could further reduce their lending costs by issuing inconvertible notes. If the notes were not convertible on demand, the bank did not have to hold reserves at all. We show in our paper that inconvertible banknotes emerge endogenously in a model of money and banking. The value of these notes is stable as long as there is competition with other forms of money, such as silver or notes issued by other banks. Competition imposes discipline on the issuing banks, because agents can always move to other forms of money. However, if some bank becomes the dominant issuer of notes (as was the case many times) and if silver is scarce, these notes face little competition. Thus, the issuing bank has incentive to over-issue notes, which might lead to inflation. This happened in several episodes of free banking and ultimately led to government intervention.

Inconvertible note crises

A very interesting example of inconvertible bank notes happened in Boston in 1740. In those days, the economy suffered from a chronic shortage of specie and a lack of appropriate substitutes. Several attempts were made to establish a bank that would supply an alternative medium of exchange. All of these schemes, described in detail by Davis (1896), proposed to issue notes that were not convertible into silver on demand, contradicting the practice of convertible notes prevailing in Europe. The intense debate and the greater scarcity of specie led to the establishment of two private corporations, the Land Bank and the Silver Bank. These banks issued notes that were not convertible on demand. The notes of the Land Bank could be redeemed only after twenty years into certain "manufactures" whose quality and value remained vague. The Silver Bank promised to redeem its notes within fifteen years into silver. The structure of the notes enabled the banks to operate without large reserves, because they were not obliged to convert on a daily basis. The notes circulated for less than two years. Many opposed their circulation, especially the Land Bank notes, but others favoured them. The operation of the banks was outlawed in 1741 by an Act of Parliament.

Another example of inconvertible notes was the famous "optional clause" in Scotland. The Scottish banking system in the 18th century comprised many private banks that issued convertible notes with an optional clause. The clause allowed the issuing bank to suspend payments of specie for six months and pay an additional interest of 2.5%. The exercise of the clause culminated in the years 1762-1765 where convertibility was practically abandoned, even beyond the six-month suspension. At some point, banks refrained from paying specie altogether, "confirming Scottish dependence upon paper" (Checkland 1975). The period was characterised by chronic inflation, exchange crises, and specie shortage. The public strongly protested against the option clause and the inability to receive specie, calling for government intervention. Eventually, in 1765, the option clause was outlawed and all the notes were required to be convertible on demand.

These examples demonstrate the endogenous development of inconvertible money issued by private banks, which served as a tool to minimise the stock of bank reserves. They also clarify why and how the government had to intervene. Evidently, all the free-banking episodes terminated with government regulation. Indeed, free and competitive money markets motivated the invention of new forms of money. Yet it also led to the emergence of a "toxic" asset (the inconvertible banknote) that had adverse effects on the economy and required government regulation. This story should sound familiar to the current observer, with banknotes replaced by asset-backed securities and toxic mortgages playing the role of the villain. The lesson is the same – free financial markets enhance financial innovation but can also have a somewhat shady side. The role of the government is to identify the risks and provide adequate regulation keeping the market on track.

References

Checkland, S. G. (1975), Scottish Banking: A History, 1695-1973, Glasgow: Collins, 1975.

Davis, A.M. (1896), "Currency Discussion in Massachusetts in the Eighteenth Century" The Quarterly Journal of Economics, Vol. 11, No. 1. (Oct., 1896), pp. 70-91.

Levintal, O. and J. Zeira (2009), "The Evolution of Paper Money", CEPR Discussion Paper 7362, July.

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"What the Economy Needs Now"

Lawrence Mishel of the Economic Policy Institute (link)

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The Response to Climate Change "Can Be Gradual—and Affordable"

When the topic of climate change legislation comes up, Republicans predictably respond with "but what about small business?," though the concerns generally extend to big business as well. Again and again we hear that any attempt to reduce carbon emissions will significantly reduce economic growth. For example, tomorrow's Wall Street Journal asks "Can Countries Cut Carbon Emissions Without Hurting Economic Growth?"

Taking the no we can't side of the debate, a side I disagree with, is Steven Hayward of the American Enterprise Institute. Taking the yes we can side is Robert Stavins of Harvard (see here too). He argues, persuasively in my opinion, that objections to climate change legislation based upon what it will do to business, small or large, and what it will do to the economic growth rate suffer from "basic errors":

Yes: The Transition Can Be Gradual—and Affordable, by Robert Stavins, WSJ [podcast of debate]: ...Critics argue that the legislation passed earlier this year by the U.S. House of Representatives—to cut U.S. emissions 80% below 2005 levels by 2050—will mean big, disruptive changes to our infrastructure and untold economic damage. But they make a couple of basic errors. For one thing, they seem to think we'd have to replace the entire infrastructure quickly, paying trillions of dollars to shift to cleaner power. They also seem to assume that we have to choose between much more expensive energy and no energy at all.

The move to greener power doesn't have to be completed immediately, and it doesn't have to be painful. ... How would this work? One way is via a combination of national and multinational cap-and-trade systems. ... The effect would be to send price signals through the market—making use of less carbon-intensive fuels more cost-competitive, providing incentives for energy efficiency and stimulating climate-friendly technological change, such as methods of capturing and storing carbon.

More Efficient

True, in the short term changing the energy mix will come at some cost, but this will hardly stop economic growth. ... Consider this: From 1990 to 2007, while world emissions rose 38%, world economic growth soared 75%—emissions per unit of economic activity fell by more than 20%. Critics argue we can't possibly increase efficiency enough to hit the 80% goal. In a very limited sense, that's true. Efficiency improvements alone ... won't get us where we need to go by 2050. But this plan doesn't rely solely on boosting efficiency. It brings together a host of other changes,... What's more, making gradual changes means we don't have to scrap still-productive power plants...

[click here for larger version]

As for how much this will cost, the best economic analyses—including studies from the U.S. Congressional Budget Office and the U.S. Energy Information Administration—say such a policy in the U.S. would cost considerably less than 1% of gross domestic product per year in the long term, or up to $175 per household in 2020. (That's the cost of one postage stamp per household per day.)

In the end, we would be delaying 2050's expected economic output by no more than a few months. And bear in mind that previous environmental actions, such as attacking smog-forming air pollution and cutting acid rain, have consistently turned out to be much cheaper than predicted.

Critics ... challenge the price estimates the experts have set out. ... In particular, they say, developing nations won't sign onto plans for curbing emissions, for fear of losing their economic momentum. Indeed, we do need a sensible international arrangement in place..., and the economic pain will be much greater if we don't set up an international carbon market. But it can be done. ...

Road to Cooperation

For instance, the U.S. and China have been involved in intense talks about climate policy. If the two nations come together in a bilateral agreement—a real possibility—they would have much more leverage to persuade other major nations to join. From there, developing nations could be brought on board by giving them targets that reduce emissions without stifling growth. Advanced nations might agree to more-severe emissions cuts and allow developing nations to make gradual cuts in the early decades as they rise toward the world's average per-capita emissions. With the right incentives, developing countries can and will move onto less carbon-intensive growth paths.

The longer we put off serious action, the more aggressive our future efforts will need to be... For every year of delay before moving to a sustainable emissions path, the global cost of taking necessary actions increases by hundreds of billions of dollars. ... [A]cting sooner ... will lower the ultimate costs of achieving the target, because there will be more time allowed for gradual transition—which is what keeps costs down. Perhaps most important, the costs of failing to take action—the damages of climate change—would be substantially greater. ...

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"New Models for a New Challenge"

Stephen Cecchetti, Piti Disyatat and Marion Kohler on "whether our macroeconomic models are still relevant," and if not, what needs to change:

Integrating financial stability: new models for a new challenge, by Stephen G Cecchetti, Piti Disyatat and Marion Kohler, September 2009: Introduction Reflecting on the financial crisis that is not yet over, it is natural to ask whether our macroeconomic models are still relevant. For all of their elegance and beauty, with their microeconomic foundations and complex endogenous dynamics, they provided the basis for monetary policy that delivered a quarter of a century of stability. The Great Moderation was great - inflation was low, growth was high, and both were stable. At least, that's what we thought. In retrospect, signs of smugness abounded. Academic journals are filled with papers explaining that this stability was, in large part, a result of good policy. And policymakers listened. The economy was inherently stable, with strong self-correcting forces. The financial crashes that were so common before the mid-20th century were banished by our deep and profound understanding that had been translated into mathematical models.
What a difference a year makes!

The models neither stopped the crisis from happening nor provided guidance on how policies could cushion its impact. They failed utterly in guiding our construction of an institutional framework capable of preventing systemic financial failure. Yes, there were warnings.¹ And yes, there were models that hinted at the sources of the difficulties we now face. And yes, the economic reasoning provides the lens through which we can start to understand what happened and why. But, in the end, we ignored the risks.

In this essay, we begin with a brief review of the pre-crisis consensus that provided the basis for stabilization policy as it has been conducted since around 1980. Our main conclusion is obvious: we need to build economic models that integrate the financial sector in a serious way, accounting for the role of intermediaries with all of their linkages, both with each other and with the real economy. And, most importantly, these models must be capable of endogenously creating financial stress that can build up until the pressure leads to a crisis - that is, models in which booms and busts are normal. ...
... 4. Conclusion For macroeconomics, the biggest lesson of the financial crisis is that our models need to find a more meaningful role for finance. Episodes of financial stress are too frequent, and seem too costly, to be treated just as events that are "bad luck" and therefore of little consequence to forward-looking stabilization policy, as suggested by Lucas (2009). Rather, we should ask whether policy can and should intervene to make financial stress less likely and less damaging when it inevitably comes.

While the New Keynesian workhorse models are built around a role for stabilization policies, they appear to have stopped too soon. Understanding how to deliver economic stability must include an understanding of how to avoid financial instability.

Modeling financial booms and busts requires a model where financial imbalances matter for the real economy. As we have suggested in this essay, this means questioning a number of fundamental assumptions of the current workhorse macroeconomic models, including whether capital markets function properly, whether individuals behave rationally, whether we can really rely on the fiction of a representative agent, and whether markets clear.

As daunting a task as this may seem, prospects for progress are encouraging. Not only is there a clear awareness of the challenge (Bean (2009)), but work is already under way: heterogeneous agent models are being solved, bounded-rationality and learning are being actively explored, agent-based models are being simulated, and incomplete financial markets as well as substantive financial frictions are being introduced.

It is our hope and expectation that successfully integrating financial imbalances into models of real fluctuations will yield a toolkit for policymakers. It will guide us in the creation of new stabilization tools as well in the improved use of old ones. It will help us understand how to measure financial stress in real time and allow for transparency and accountability of policymaking in the same way that price measurement is essential for holding inflation targeting central banks accountable. Getting there will not be easy, but then, the challenge to conventional monetary policymaking 50 years ago surely appeared daunting as well. Hopefully, this time it will not take as long to get things worked out.

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"The Essential Pillars of a New Climate Pact"

Sheila Olmstead and Robert Stavins argue that three essential elements must be present in the successor to the 1997 Kyoto Protocol:

The essential pillars of a new climate pact, by Sheila M. Olmstead and Robert N. Stavins, Commentary, Boston Globe: The climate change summit at the United Nations on Tuesday is aimed to build momentum for ... a successor to the 1997 Kyoto Protocol, which expires in 2012. To be successful, any feasible successor agreement must contain three essential elements: meaningful involvement by a broad set of key industrialized and developing nations; an emphasis on an extended time path of emissions targets; and ... policy approaches that work through the market, rather than against it.

Consider the need for broad participation. Industrialized countries have emitted most of the ... man-made carbon dioxide in our atmosphere, so shouldn't they reduce emissions before developing countries are asked to contribute? While this seems to make sense, here are four reasons why the new climate agreement must engage all major emitting countries - both industrialized and developing.

First, emissions from developing countries are significant and growing rapidly. ... Second, developing countries provide the best opportunities for low-cost emissions reduction... Third,... industrialized countries may not commit to significant emissions reductions without developing country participation. Fourth, if developing countries are excluded, up to one-third of carbon emissions reductions ... may migrate to non-participating economies through international trade, reducing environmental gains...

The second pillar of a successful post-2012 climate policy is an emphasis on the long run..., and major technological change is needed to bring down the costs of reducing CO2 emissions. The economically efficient solution will involve firm but moderate short-term targets to avoid rendering large parts of the capital stock prematurely obsolete, and flexible but more stringent long-term targets.

Third, a post-2012 global climate policy must work through the market rather than against it. ... One market-based approach, known as cap-and-trade, is emerging as the preferred approach ... among industrialized countries. ...

Cap-and-trade systems can be linked directly, which requires harmonization, or indirectly by linking with a common emissions-reduction credit system; indeed, this is what appears to be emerging... Kyoto's Clean Development Mechanism allows parties in wealthy countries to purchase emissions-reduction credits in developing countries by investing in emissions-reduction projects. These credits can be used to meet emissions commitments...

A new international climate agreement missing any of these three pillars may be too costly, and provide too little benefit, to represent a meaningful attempt to address the threat of global climate change.

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links for 2009-09-19

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