Economist's View

"Immigration, Wages, and Compositional Amenities"

Why do people oppose immigration? Here's the introduction and part of the conclusion to a recent paper on this topic by David Card, Christian Dustmann, and Ian Preston. The bottom line is that the effects of immigration on wages and taxes -- to the extent that such effects exist -- are of concern, but according to this research it is not the primary objection:

Immigration, Wages, and Compositional Amenities, by David Card, Christian Dustmann, and Ian Preston, NBER Working Paper No. 15521, November 2009 [Open Link]: Introduction Standard economic reasoning suggests that immigration, like trade, creates a surplus that in principle can be redistributed so all natives are better off (Mundell, 1957). In practice the redistributive mechanisms are incomplete so both policies tend to create winners and losers. Even so, public support for increased immigration is far weaker than for expanding trade.[1] While the two policies have symmetric effects on relative factor prices, immigration also changes the composition of the receiving country’s population, imposing externalities on the existing population. Previous studies have focused on the fiscal externalities created by redistributive taxes and benefits (e.g., MaCurdy, Nechyba, and Bhattacharya, 1998; Borjas, 1999, Hanson, Scheve and Slaughter, 2005). A wider class of externalities arise through the fact that people value the ‘compositional amenities’ associated with the characteristics of their neighbors and co-workers. Such preferences are central to understanding discrimination (Becker, 1957) and choices between neighborhoods and schools (e.g., Bayer, Ferreira, and McMillan, 2007) and arguably play an important role in mediating views about immigration.

This paper presents a new method for quantifying the relative importance of compositional amenities in shaping individual attitudes toward immigration. The key to our approach is a series of questions included in the 2002 European Social Survey (ESS) that elicited views on the effects of immigration on specific domains – including impacts on relative wages and the fiscal balance, and a country’s culture life – as well as on the importance of maintaining shared religious beliefs, language, and customs. ...

Our empirical analysis leads to three main conclusions. First, we find that attitudes to immigration – expressed by the answer to a question of whether more or fewer immigrants from certain source countries should be permitted to enter, for example – reflect a combination of concerns over compositional amenities and the direct economic impacts of immigration on wages and taxes. Second, we find that the strength of the concerns that people express over the two channels are positively correlated. This means that studies that focus exclusively on one factor or the other capture a reasonable share of the variation in attitudes for or against increased immigration.[2]

Our third conclusion is that concerns over compositional amenities are substantially more important than concerns over the impacts on wages and taxes.[3] Specifically, variation in concerns over compositional amenities explain 3-5 times more of the individual-specific variation in answers to the question of whether more or fewer immigrants should be permitted to enter than does variation in concerns over wages and taxes. Concerns over compositional amenities are even more important in understanding attitudes toward immigrant groups that are ethnically different, or come from poorer countries. Similarly, differences in concerns over compositional amenities account for about 70% of the gap between high- and low-education respondents over whether more immigrants should be permitted to enter the country.

Interestingly, concerns over the direct economic impacts of immigration explain a much larger share of variation in responses to a summary question of whether immigration is good or bad for the economy. The contrast suggests that respondents make a distinction between the wage and tax effects of immigration and the effects on the composition of the host country, and place substantial weight on the latter in forming overall views about immigration policies. ...

Differences in compositional concerns also explain most of the differences in attitudes between older and younger respondents. The age gap is a particular puzzle for models of immigration preferences that ignore compositional amenities, because many older people are retired, and face a much lower threat of labor market competition than young people.

While our inferences are based on purely observational data, and rely on a restrictive structural model, we present a number of robustness checks and extensions that support our general conclusions about the importance of compositional concerns. ...

"America's Broken Politics"

Jeffrey Sachs says government is broken:

America's broken politics, by Jeff Sachs, Project Syndicate: ...The difficulties that Barack Obama is having in passing his basic program, whether in healthcare, climate change, or financial reform, are hard to understand at first glance. After all, he is personally popular, and his Democratic party holds commanding majorities in both houses of Congress. Yet his agenda is stalled and the country's ideological divisions grow deeper.

Among Democrats, Obama's approval rating in early November was 84%, compared with just 18% among Republicans. ... Only 18% of Democrats supported sending 40,000 more troops to Afghanistan, while 57% of Republicans supported a troop buildup. ...

Part of the cause for these huge divergences ... is that America is an increasingly polarized society. Political divisions have widened between the rich and poor, among ethnic groups (non-Hispanic whites versus African Americans and Hispanics), across religious affiliations, between native-born and immigrants, and along other social fault lines. American politics has become venomous as the belief has grown, especially on the vocal far right, that government policy is a "zero-sum" struggle between different social groups and politics.

Moreover, the political process itself is broken. The Senate now operates on an informal rule that opponents will try to kill a legislative proposal through a "filibuster"... To overcome a filibuster, the proposal's supporters must muster 60 of 100 votes... This has proved impossible on controversial policies...

An equally deep crisis stems from the role of big money in politics. Backroom lobbying by powerful corporations now dominates policymaking... The biggest players, including Wall Street, the automobile companies, the healthcare industry, the armaments industry, and the real-estate sector, have done great damage to the US and world economy... Many observers regard the lobbying process as a kind of legalized corruption...

Finally, policy paralysis around the US federal budget may be playing the biggest role of all in America's incipient governance crisis. The US public is rabidly opposed to paying higher taxes, yet the trend level of taxation (at about 18% of national income) is not sufficient to pay for the core functions of government. ... Powerful resistance to higher taxes, coupled with a growing list of urgent unmet needs, has led to chronic under-performance by the US government and an increasingly dangerous level of ... government debt. ...

Obama so far seems unable to break this fiscal logjam. To win the 2008 election, he promised that he would not raise taxes on any household with income of less than $250,000 a year. That no-tax pledge, and the public attitudes that led Obama to make it, block reasonable policies. ... America, in fact, needs a value-added tax,... but Obama himself staunchly ruled out that kind of tax increase during his election campaign.

These paralyzing factors could intensify in the years ahead. ... A breakthrough will require a major change in direction. The US must leave Iraq and Afghanistan, thereby saving $150bn a year for other purposes and reducing the tensions caused by military occupation. The US will have to raise taxes in order to pay for new spending initiatives, especially in the areas of sustainable energy, climate change, education, and relief for the poor.

To avoid further polarization and paralysis of American politics, Obama must do more to ensure that Americans understand better the urgency of the changes... Only such changes – including lobbying reforms – can restore effective governance.

The opportunity cost of the spending on the war effort doesn't receive enough attention -- Democrats are still worried about the weak on defense label and that has allowed the right to dominate policy -- so it's nice to see the issue raised. But on another topic, I like the filibuster when George Bush is president (even though it wasn't enough to stop all of the right's damaging policies from being passed into law), but dislike it now (we did manage to get health care by the filibuster, but at what cost?). So, here's a question: Is it time for the filibuster to be reformed or eliminated entirely, or does it provide a useful check on the political process? I find myself hesitant to get rid of it, but I can't fully justify that position.

Existing Home Sales Rise 10.1%

At MoneyWatch, some brief comments (and links to other discussions by Calculated Risk, The Big Picture, and Free Exchange) on today's news that existing home sales rose 10.1 percent in October:

Existing Home Sales Rise 10.1%

Paul Krugman: The Phantom Menace

Why is the administration so fearful of doing more to help employment recover?:

The Phantom Menace, by Paul Krugman, Commentary, NY Times: A funny thing happened on the way to a new New Deal. ... Consider the contrast between what Mr. Obama’s advisers were saying on the eve of his inauguration, and what he himself is saying now.

In December 2008 Lawrence Summers ... called for decisive action. “Many experts,” he warned, “believe that unemployment could reach 10 percent by the end of next year.” In the face of that prospect, he continued, “doing too little poses a greater threat than doing too much.”

Ten months later unemployment reached 10.2 percent, suggesting that despite his warning the administration hadn’t done enough to create jobs. You might have expected, then, a determination to do more.

But in a recent interview..., the president sounded diffident and nervous about his economic policy. He spoke vaguely about possible tax incentives for job creation. But “it is important though to recognize,” he went on, “that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession.”

What? Huh?

Most economists I talk to believe that the big risk to recovery comes from the inadequacy of government efforts: the stimulus was too small, and it will fade out next year, while high unemployment is undermining both consumer and business confidence.

Now, it’s politically difficult for the Obama administration to enact a full-scale second stimulus. Still, he should be trying to push through as much aid to the economy as possible. ...

Instead, however, Mr. Obama is lending his voice to those who say that we can’t create more jobs. And a report on Politico.com suggests that deficit reduction, not job creation, will be the centerpiece of his first State of the Union address. What happened?

It took me a while to puzzle this out. But the concerns Mr. Obama expressed become comprehensible if you suppose that he’s getting his views, directly or indirectly, from Wall Street.

Ever since the Great Recession began ... some (not all) major Wall Street firms have warned that efforts to fight the slump will produce even worse economic evils. In particular, they say, never mind the current ability of the U.S. government to borrow long term at remarkably low interest rates — any day now, budget deficits will lead to a collapse in investor confidence, and rates will soar.

And it’s this latter claim that Mr. Obama echoed in that ... interview. Is he right to be worried? ... A ... model ... is Japan in the 1990s, which ran persistent large budget deficits, but also had a persistently depressed economy — and saw long-term interest rates fall almost steadily. ...

And shouldn’t we consider the source? As far as I can tell, the analysts now warning about soaring interest rates tend to be the same people who insisted, months after the Great Recession began, that the biggest threat facing the economy was inflation. ...

Still, let’s grant that there is some risk that doing more about double-digit unemployment would undermine confidence in the bond markets. This risk must be set against the certainty of mass suffering if we don’t do more — and the possibility, as I said, of a collapse of confidence among ordinary workers and businesses.

And Mr. Summers was right the first time: in the face of the greatest economic catastrophe since the Great Depression, it’s much riskier to do too little than it is to do too much. It’s sad, and unfortunate, that the administration appears to have lost sight of that truth.

links for 2009-11-22

• A vaguely passive-aggressive post on commenters - Crooked Timber
• The Thing about the Fed Most Worth Knowing - Economic Principals
• African leaders advise Bono on reform of U2 - Bill Easterly
• Republican Deficit Hypocrisy - Bruce Bartlett
• Executives Stayed Wealthy as Their Firms Failed, Study Says - NYT
• A Chart That Should Keep Progressives Up at Night - Progressive Fix
• How much greenhouse gas emission abatement is enough? - voxeu.org
• Bankers' Pay Revisited - Models & Agents
• Macro and the Organizational Capital Model - Arnold Kling
• Fed’s Bullard: Asset Buying Efforts Should Remain Active - RTE
• The triumph of the powerless (Chech. in 1989) - Michael Meyers
• Could sovereign debt be the new subprime? - Gillian Tett
• Role reversal - Paul Krugman
• Paul Kedrosky - links
• Abnormal Returns - links
• Credit Writedowns - links
• Brad DeLong - links

"What if a Recovery Is All in Your Head?"

Robert Shiller wonders if the recovery is based upon a self-fulfilling prophecy:

What if a Recovery Is All in Your Head?, by Robert J. Shiller, Commentary, NY Times: Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy.

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned... but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession ... is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

Certainly, people did not always believe that there is a regular “business cycle” that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression... “Recession,” a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. ...

Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover... A depression came to be another matter entirely.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article ... titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase...

In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course.

For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means. ...

The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.

Barry Ritholtz responds [Note: Updated version posted at Barry's request]:

How Overrated is Sentiment in Economics?, by Barry Ritholtz: There is a small cadre of Economists — original thinkers, contrarians, out of the box theorists — whom  I respect a great deal. It is a modest list ranging from Richard Thaler to David Rosenberg to Robert Shiller, with lots of smart econ wonks in between.

This morning, however, I find myself somewhat disagreeing with one of the smarter of the economists, Professor Bob Shiller... Hence, it is with trepidation that I point out the flaws in Shiller’s discussion about the recovery, (titled “What if a Recovery Is All in Your Head?“). It is a thought provoking but unpersuasive argument... To be fair, he uses the column to incite a debate, rather than defend the position that the recovery is “mostly mental.”

I find numerous things worth challenging in the column... Let me offer 10 items..:

1. Time: The typical post-war Recession lasts 8 months, not “a couple of years”; We are now in month 23. If people started to spend because they sensed it was “late in the recession” or somehow intuited that it was time for the contraction to end, well then, based upon history, that would have been somewhere around August 2008.

2. Not Totally Irrational: One of my complaints about economics is it over-emphasizes people as rational, unemotional actors. However, when it comes to sentiment, economics seems to make the same mistake in the opposite direction — it assumes that people are foolish, unthinking creatures unable to engage in ANY rational thought whatsoever. All sentiment, no rationality at all.

The reality is quite different: Sometimes, people behave the way they do because they have figured out a problem and are responding to it intelligently.

Home Economicus does not really exist — but then again, neither does Homo Idiotus.

3. Healthy Fear of Job Loss: Employed people began to spend their money more carefully when they saw coworkers getting laid off in increasing numbers. That is a rational act in the face of an increasing possibility of a loss of income. This is unlikely to change in the near future, so long as large public layoffs remain a news item. Is this a Sentiment factor — or a rational response to changing conditions?

4. Asset Deflation: Consumers cut back their spending when they saw their biggest assets (Homes, Stocks) lose a significant value. Again, a rational response to a change in personal financial conditions, or bad sentiment?

5. False Belief System: Earlier this year, the Dow had dropped over 5,000 points in 6 months. One of the collective fallacies our culture operates under is the delusion that the market is some kind of astute forecasting machine. It is not — it represents the collective wisdom of 10 million panicked monkeys. That millions of slightly clever, pants wearing primates can combine their collective ignorance, their intellectual foibles, biases and false beliefs somehow into something resembling intelligence was one of the false beliefs of the era. Unfortunately, this is a condition the monkeys are prone towards (Witch burning, bloodletting, organized religion, etc.).

Note however that this does not reflect collective negative sentiment, but is actually the result of what happens when a faulty belief system dominates a society.

6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. ... Why did this group suddenly gain traction in 2008? Maybe it was because  the population is not nearly so stupid as the politicians believe. The masses saw with their own two eyes the decay in the economy. Suddenly, the warnings were not as far fetched as they previously seemed.

7. Reacting to Flat Income: Families have recognized their incomes have remained flat to negative over the past decade, while their expenses have increased. What should be the rational reaction to this realization? (Hint: a new car, a bigger house, a new vacation are not on the list of options).

8. Time to Exit the Bunkers: Ten months ago, people were betting the economic world was coming to an end. The economy was in freefall, consumers froze, dramatically reduced spending. But the freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) most of us will agree that the Great Recession ended sometime in Spring of ‘09.

The US consumer is no longer frozen like deer in headlights. Is that sentiment, of just the reality of the situation — what happens when the ice melted?

9. The Cheerleaders Now Look Like Fools: At the onset of a recession, we often see cheerleaders, OpEd writers, and money losing fund managers make the argument that there is no economic slowdown — that the weakness is only in people’s minds. I call these people the Pervasive Pollyannas of Prosperity. (Think Phil Gramm, Amity Shlaes, Don Luskin). Some are partisans, others are dumb, others still merely incompetent — a few are all three. Yet despite their best efforts of the cheerleaders, the economy still went into freefall.  Perhaps the public has learned (a teeny bit) who to listen to and who to ignore.

10. Deleveraging: We know why this recession was so deep and long — the wanton use of leverage by people and financial institutions. The deleveraging that is taking place is a long slow process. It is rational, it is intelligent, and it will be how families will restore their balance sheets — the paradox of thrift be damned . . .

I appreciate that Professor Shiller was not arguing in favor of “its all mental.” He sought to spark a debate; I hope this response rose to the challenge . . .

I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.

But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.

links for 2009-11-21

• Trading Our Way Out of Crisis - Pascal Lamy
• On Carry Traders and Long Term Interest Rates - Rajiv Sethi
• Defining the university curriculum - UnderstandingSociety
• Baselines, Counterfactuals and the Stimulus - Econbrowser
• Credit Writedowns - links
• Felix Salmon - links
• Ajay Shah - links
• Chris Blattman - links
• PSD - links
• The Stash - links
• Economix - links
• Money Supply - links
• Brad DeLong - links

Stabilities and Instabilities in the Macroeconomy

More on what's wrong with modern macro, this time from Axel Leijonhufvud:

Stabilities and instabilities in the macroeconomy, by Axel Leijonhufvud, Vox EU: Fifty-some years ago, students were taught that the private sector had no tendency to gravitate to full employment, that it was prone to undesirable fluctuations amplified by multiplier and accelerator effects, and that it was riddled with market failures of various sorts. But it was also believed that a benevolent, competent, democratic government could stabilize the macroeconomy and reduce the welfare consequences of most market failures to relative insignificance.

Fifty years later, around the beginning years of this century, students were taught that representative governments produce pointless fluctuations in prices and output but, if they can be constrained from doing so – by an independent central bank, for example – free markets are sure to produce full employment and, of course, many other blessings besides. Macroeconomic policy doctrine had shifted from stabilizing the private to constraining the public sector.

This long swing in our understanding of the economy spans a half-century of prolific technical accomplishments in economics (Blanchard 2008). But what the story shows is that, ontologically, economics has been completely at sea, drifting on the surface in currents of our own making. We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.

Fed Watch: The Fed in a Corner

Tim Duy:

The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.

The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.

Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.

To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.

The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.

Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.

Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?

Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.

What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:

It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”

But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.

Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.

I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

links for 2009-11-20

• Interest rates: the phantom menace - Paul Krugman
• A big Fed mess - Free exchange
• Relief for States and Families Boosts Employment - CBPP
• Stabilities and instabilities in the macroeconomy - voxeu.org
• Do elections in developing countries improve economic policy? - voxeu.org
• Tough Bank Amendment Passes With Room Nearly Empty - Ryan Grim
• Housing back in the news - macroblog
• Push to Add to Stimulus Package Draws Debate - NYTimes.com
• Prose Hack - Andy Harless
• What Geithner Got Right - David Brooks - NYTimes.com
• Reducing Financial Complexity: A Different Take on Trans. Taxes - EconoSpeak
• How to do a second stimulus - Clive Crook
• The Right Way To Regulate - Martha Coakley and Elizabeth Warren
• Brad DeLong - links
• Economists Forum - links
• New Deal 2.0 - links
• Abnormal Returns - links
• Credit Writedowns - links
• Marginal Revolution - links
• naked capitalism - links

What Causes Employment to Lag Output in Recoveries?

At MoneyWatch, I attempt to explain why employment lags output in recoveries, and why the lag has been increased after 1990:

What Causes Employment to Lag Output in Recoveries?

I give three reasons, and then use one of them to try to explain the increased lag since 1990.

What’s Wrong With the Dodd Proposal to Restructure the Fed

At MoneyWatch:

What’s Wrong With the Dodd Proposal to Restructure the Fed, by Mark Thoma: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal reserve system and politicize the selection process, both of which are the opposite of the where reform should take the system. ...[...continue reading...]...

Paul Krugman: The Big Squander

The economy needs more help from the government, but it's unlikely to get it:

The Big Squander, by Paul Krugman, Commentary, NYTimes: Earlier this week, the inspector general for the Troubled Asset Relief Program ... released his report on the 2008 rescue of the American International Group... The gist of the report is that government officials made no serious attempt to extract concessions from bankers, even though these bankers received huge benefits from the rescue. And more than money was lost. ...

Throughout the financial crisis key officials — most notably Timothy Geithner... — have shied away from doing anything that might rattle Wall Street. And ... this play-it-safe approach has ended up undermining prospects for economic recovery. For the job of fixing the broken economy is far from done — yet finishing the job has become nearly impossible now that the public has lost faith in the government’s efforts, viewing them as little more than handouts to the people who got us into this mess.

About the A.I.G. affair:... why protect bankers from the consequences of their errors? Well, by the time A.I.G.’s hollowness became apparent, the world financial system was on the edge of collapse and officials judged — probably correctly — that letting A.I.G. go bankrupt would push the financial system over that edge. So A.I.G. was effectively nationalized; its promises became taxpayer liabilities.

But was there any way to limit those liabilities? After all, banks would have suffered huge losses if A.I.G. had been allowed to fail. So it seemed only fair for them to bear part of the cost of the bailout... Indeed, the government asked them to do just that. But they said no — and that was the end of the story. Taxpayers ... ended up honoring foolish promises made by other people ... at 100 cents on the dollar.

Could things have been different? ... Major financial firms are a small club, with a shared interest in sustaining the system; ever since the days of J.P. Morgan, it has been common in times of crisis to call on the big players to forgo short-term profits for the industry’s common good. Back in 1998, it was a consortium of private bankers — not the government — that put up the funds to rescue the hedge fund Long Term Capital Management.

Furthermore, big financial firms ... can pay a price if they act selfishly in times of crisis. Bear Stearns ... earned itself a lot of ill will by refusing to participate in that 1998 rescue, and it’s widely believed that this ill will played a major factor in the demise of Bear Stearns itself, 10 years later.

So officials could have called on bankers to offer a better deal,... and simultaneously threatened to name and shame those who balked. It was their choice not to do that...

And, as I said, these seemingly safe choices have now placed the economy in grave danger.

For the economy is still in deep trouble and needs much more government help. Unemployment is in double-digits; we desperately need more government spending on job creation. Banks are still weak, and credit is still tight; we desperately need more government aid to the financial sector. But try to talk to an ordinary voter about this, and the response you’re likely to get is: “No way. All they’ll do is hand out more money to Wall Street.”

So here’s the real tragedy of the botched bailout: Government officials, perhaps influenced by spending too much time with bankers, forgot that if you want to govern effectively you have retain the trust of the people. And by treating the financial industry — which got us into this mess in the first place — with kid gloves, they have squandered that trust.

"Threatening the Fed's Independence"

I agree with this:

Threatening the Fed's independence, by By Alan S. Blinder, Commentary, Washington Post: The Federal Reserve's performance in this ... crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. ... But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.

In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.

But not in the political world. The Fed is extremely unpopular in Congress and is facing hostile and potentially detrimental actions from both sides of the aisle. ... Christopher Dodd ... would clip the Fed's regulatory wings substantially.

Worse, legislation that just proceeded through the House Financial Services Committee could imperil the Fed's ability to conduct an independent monetary policy. With more than two-thirds of the House co-sponsoring the so-called Paul bill, prospects for floor passage unfortunately look good.

The ... bill would subject the Fed's monetary policy decisions and its dealings with foreign central banks to audit by the Government Accountability Office (GAO) -- which normally acts on requests from Congress. Under current law, these aspects of Fed business have been explicitly ruled off-limits (though the rest is auditable).

Is this extension of the GAO's reach, and hence that of Congress, a good idea? If you believe we'd get better monetary policy with decisions made by Congress in open debate, or heavily influenced by congressional opinion, it certainly is. But how many actually believe that? Very, very few. ...

The ... GAO is already authorized to examine most aspects of Fed operations. It can audit the Fed's special financial arrangements for Bear Stearns, AIG, Citigroup and Bank of America -- to name the most prominent examples. ...

But a congressional audit of monetary policy -- remember, the GAO works for Congress -- could easily develop into something quite different. ... It is entirely predictable that some in Congress will be unhappy with the Fed's decisions... Would we welcome a critical GAO audit of monetary policy, which members of Congress could use to browbeat, perhaps even to intimidate, members of the Fed's rate-setting body, the Federal Open Market Committee? ... Would we like Congress to override the Fed's decisions and set monetary policy -- which is its constitutional right? I think and hope not.

An independent monetary policy ... is one of the great and enduring achievements of the Progressive Era. ... Passage of the Paul bill would be a step away from independent monetary policy and a step toward ending the Fed as we know it. That is a step we should not take.

links for 2009-11-19

• China, the Renminbi, and Global Imbalances View - Econbrowser
• On Rational Expectations and Equilibrium Paths - Rajiv Sethi
• Bills offer clear path to better health care - Peter Orszag
• U.S. Mortgage Delinquencies Reach a Record High - NYTimes.com
• Treasury to Auction Off Investments in 3 Banks - NYTimes.com
• What next for macroeconomics ? — Crooked Timber
• The Hard Fall of Hedge Funders -- New York Magazine
• Unrealism is Not the Problem - Twenty-Cent Paradigms
• Accounting and Economics; and Money - Nick Rowe
• How Much is Enough? - Robert Skidelsky
• The Incredible Vanishing Asset - Esther Dyson
• The Case for a Job-Creation Tax Credit - Economix
• Sachs worries about transgressing planet's boundaries - Michael Roberts
• A Conversation on the Existence of Time - Discover Magazine
• A Minskian roadmap to the next gold mania - FT Alphaville
• Texas' gay marriage ban may have banned all marriages - McClatchy
• The Stash - links
• New Deal 2.0 - links
• Felix Salmon - links
• Money Supply - links
• Economix - links
• Free Exchange - links
• Economists Forum - links
• FT Alphaville - links
• Marginal Revolution - links
• Abnormal Returns - links
• Credit Writedowns - links
• naked capitalism - links
• Brad DeLong - links

What Happened to the Public Option

Robert Reich refuses to give up on the public option:

Harry Reid, and What Happened to the Public Option, by Robert Reich: First there was Medicare for all 300 million of us. But that was a non-starter because private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it was too much like what they have up in Canada -- which, by the way, cost Canadians only 10 percent of their GDP and covers every Canadian. (Our current system of private for-profit insurers costs 16 percent of GDP and leaves out 45 million people.)

So the compromise was to give all Americans the option of buying into a "Medicare-like plan" that competed with private insurers. Who could be against freedom of choice? Fully 70 percent of Americans polled supported the idea. Open to all Americans, such a plan would have the scale and authority to negotiate low prices with drug companies and other providers, and force private insurers to provide better service at lower costs. But private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it would end up too much like what they have up in Canada.

So the compromise was to give the public option only to Americans who wouldn't be covered either by their employers or by Medicaid. And give them coverage pegged to Medicare rates. But private insurers and ... you know the rest.

So the compromise that ended up in the House bill is to have a mere public option, open only to the 6 million Americans not otherwise covered. The Congressional Budget Office warns this shrunken public option will have no real bargaining leverage and would attract mainly people who need lots of medical care to begin with. So it will actually cost more than it saves.

But even the House's shrunken and costly little public option is too much private insurers, Big Pharma, Republicans, and "centrists" in the Senate. So Harry Reid has proposed an even tinier public option, which states can decide not to offer their citizens. According to the CBO, it would attract no more than 4 million Americans.

It's a token public option... And yet Joe Lieberman and Ben Nelson mumble darkly that they may not even vote to allow debate on the floor of the Senate about the bill if it contains this paltry public option. And Republicans predict a "holy war."

But what more can possibly be compromised? ... Make it available to only twelve people?

Our private, for-profit health insurance system, designed to fatten the profits of private health insurers and Big Pharma, is about to be turned over to ... our private, for-profit health care system. Except that now private health insurers and Big Pharma will be getting some 30 million additional customers, paid for by the rest of us.

Upbeat policy wonks and political spinners ... will point out some good things: no pre-existing conditions, insurance exchanges, 30 million more Americans covered. But... Most of us will remain stuck with little or no choice -- dependent on private insurers who care only about the bottom line, who deny our claims, who charge us more and more for co-payments and deductibles, who bury us in forms, who don't take our calls.

I'm still not giving up. I want every Senator who's not in the pocket of the private insurers or Big Pharma to introduce and vote for a "Ted Kennedy Medicare for All" amendment to whatever bill Reid takes to the floor. And if this fails, a "Ted Kennedy Real Public Option for All" amendment. Let every Senate Democratic who doesn't have the guts to vote for either of them be known and counted.

I think it's important to have a public option in the bill in some form, even an unsatisfactory one, because it will be much easier to expand the option once it's in place than it would be to pass new legislation in the future that creates a public option.

"Transgressing Planetary Boundaries"

Jeff Sachs says that if world population doesn't stabilize relatively soon, we're headed for trouble:

Transgressing Planetary Boundaries, by Jeff Sachs, Scientific American: We are eating ourselves out of house and home. ... The green revolution that made grain production soar gave humanity some breathing space, but the continuing rise in population and demand for meat production is exhausting that buffer. ...

Food production accounts for a third of all greenhouse gas emissions... Through the clearing of forestland, food production is also responsible for much of the loss of biodiversity. Chemical fertilizers cause massive depositions of nitrogen and phosphorus, which now destroy estuaries in hundreds of river systems and threaten ocean chemistry. Roughly 70 percent of worldwide water use goes to food production, which is implicated in groundwater depletion and ecologically destructive freshwater consumption from California to the Indo-Gangetic Plain to Central Asia to northern China.

The green revolution, in short, has not negated the dangerous side effects of a burgeoning human population, which are bound to increase as the population exceeds seven billion around 2012 and continues to grow as forecast toward nine billion by 2046. ...

It is not enough to produce more food; we must also simultaneously stabilize the global population and reduce the ecological consequences of food production—a triple challenge. A rapid voluntary reduction in fertility rates in the poor countries, brought about by more access to family planning, higher child survival and education for girls, could stabilize the population at around eight billion by 2050.

Payments to poor communities to resist deforestation could save species habitats. No-till farming and other methods can preserve soils and biodiversity. More efficient fertilizer use can reduce the transport of excessive nitrogen and phosphorus. Better irrigation and seed varieties can conserve water and reduce other ecological pressures. And a diet shifted away from eating beef would conserve ecosystems while improving human health.

Those changes will require a tremendous public-private effort that is yet to be mobilized. ... The window of opportunity to achieve sustainable development is closing.

Top-Down versus Bottom-Up Macroeconomics

When Paul DeGrauwe presented this paper at the What's Wrong with Modern Macroeconomics conference (papers here), his argument that rational expectations models are the intellectual heirs of central planning seemed to ruffle a few feathers:

Top-down versus bottom-up macroeconomics, by Paul De Grauwe, Commentary, Vox EU: There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.

Evidence on rationality from other sciences

These developments in mainstream macroeconomics are surprising for other reasons. While macroeconomic theory enthusiastically embraced the view that some if not all agents fully understand the structure of the underlying models in which they operate, other sciences like psychology and neurology increasingly uncovered the cognitive limitations of individuals (see e.g. Kahneman 2002, Camerer et al. 2005, Kahneman and Thaler 2006, and Della Vigna 2007). We learn from these sciences that agents only understand small bits and pieces of the world in which they live, and instead of maximising continuously taking all available information into account, agents use simple rules (heuristics) in guiding their behaviour (Gigerenzer and Todd 1999). The recent financial crisis seems to support the view that agents have limited understanding of the big picture. If they had understood the full complexity of the financial system, they would have understood the lethal riskiness of the assets they piled into their portfolios.

Top-down and bottom-up models

In order to understand the nature of different macroeconomic models, it is useful to make a distinction between top-down and bottom-up systems.

• In its most general definition, a top-down system is one in which one or more agents fully understand the system. These agents are capable of representing the whole system in a blueprint that they can store in their mind. Depending on their position in the system, they can use this blueprint to take command or to optimise their own private welfare. An example of such a top-down system is a building that can be represented by a blueprint and fully understood by the architect.
• Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system. Most living systems follow this bottom-up logic (see the beautiful description of the growth of the embryo by Dawkins 2009).

The market system is also a bottom-up system. The best description made of this bottom-up system is still the one made by Hayek (1945).

Hayek argued that no individual is capable of understanding the full complexity of a market system. Instead, individuals only understand small bits of the total information. The main function of markets consists in aggregating this diverse information. If there were individuals capable of understanding the whole picture, we would not need markets. This was in fact Hayek’s criticism of the “socialist” economists who took the view that the central planner understood the whole picture and would therefore be able to compute the whole set of optimal prices, making the market system superfluous.

Rational expectations models as intellectual heirs of central planning

My contention is that the rational expectations models are the intellectual heirs of these central-planning models. Not in the sense that individuals in these rational expectations models aim at planning the whole, but in the sense that, as the central planner, they understand the whole picture. These individuals use this superior information to obtain the “optimum optimorum” for their own private welfare. In this sense, they are top-down models.

In a recent paper, I contrast the rational expectations top-down model with a bottom-up macroeconomic model (De Grauwe 2009). The latter is a model in which agents have cognitive limitations and do not understand the whole picture (the underlying model). Instead, they only understand small bits and pieces of the whole model and use simple rules to guide their behaviour. I introduce rationality in the model through a selection mechanism in which agents evaluate the performance of the rule they are following and decide to keep or change their rule depending on how well it performs relative to other rules. Thus agents in the bottom-up model learn about the world in a “trial and error” fashion.

These two types of models produce very different insights. I mention three differences here. First, the bottom-up model creates correlations in beliefs that in turn generate waves of optimism and pessimism. The latter produce endogenous business cycles which are akin to the Keynesian “animal spirits” (see Akerlof and Shiller 2009).

Second, the bottom-up model provides for a very different theory of the business cycle compared to the business cycle theory implicit in the rational expectations (DSGE) models. In the DSGE models, business cycle movements in output and prices arise because rational agents cannot adjust their optimal plans instantaneously after an exogenous disturbance. Price and wage stickiness prevent such instantaneous adjustment. As a result, these exogenous shocks (e.g. productivity shocks, or shocks in preferences) produce inertia and business cycle movements. Thus it can be said that the business cycle in DSGE models is exogenously driven. As an example, in the DSGE model, the financial crisis and the ensuing downturn in economic activity is the result of an exogenous and unpredictable increase in risk premia in August 2007.

In contrast to the rational expectations model, the bottom-up model has agents who experience an informational problem. They do not fully understand the nature of the shock or its transmission. They use a trial-and-error learning process aimed at distilling information. This process leads to waves of optimism and pessimism, which in a self-fulfilling way create business cycle movements. Booms and busts reflect the difficulties of economic agents trying to understand economic reality. The business cycle has a large endogenous component. Thus, in this bottom-up model, the financial crisis and the ensuing economic downturn should be explained by the previous boom.

Finally, the bottom-up model confirms the insight obtained from mainstream macroeconomics (including the DSGE models) that a credible inflation targeting is necessary to stabilise the economy. However, it is not sufficient. In a world where waves of optimism and pessimism (animal spirits) can exert an independent influence on output and inflation, it is in the interest of the central banks not only to react to movements in inflation but also to movements in output and asset prices so as to reduce the booms and busts that free market systems produce quite naturally. ...

links for 2009-11-18

• At Failed Banks, Post-Mortems Disclose Excessive, Yet Obvious, Risk - NYT
• How credit conditions will shape the economic recovery - voxeu.org
• Dollar Diplomacy Flip-Flop is a Threat to Free Trade - CFR
• Explaining Time, the Universe, and All That - Discover
• Fiscal Expansion That Is Deficit Neutral in the Long Run - Brad DeLong
• Receiver operating characteristics curve - Econbrowser
• Senator Schumer's Blowhard Moment? - Realtime
• The IMF Needs Fresh Thinking on Capital Controls - Dani Rodrik
• Taming the Stock Option Game - Lucian Bebchuk and Jesse Fried
• Can The Free Market Save Small Businesses and Nonprofits? - Bruce Judson
• Will the recovery be "jobless"? - Creative Destruction
• A Tale of Two American Economies - Nouriel Roubini
• Liquidity, OTC Market and TBTF Banks - Rortybomb
• The Great Disconnect Between Stocks and Jobs - Robert Reich
• The AIG report - Paul Krugman
• The Stash - links
• The Big Picture - links
• New Deal 2.0 - links
• Marginal Revolution - links
• naked capitalism - links
• Credit Writedowns - links
• Money Supply - links
• FT Alphaville - links
• Abnormal Returns - links
• Brad DeLong - links

Obama's Wrong-Headed Thinking on the Deficit

Edward Harrison catches this quote from Obama:

The president is in Beijing as part of his tour through several Asian countries to address economic challenges. He spoke candidly about the precarious balancing act his administration is trying to perform. He wants to spend money to kick-start the economy, but at the same time is in danger of creating too much red ink.

Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate.

"There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett.

"I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular.

Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession).

These comments also make it sound like any jobs program, if we get one at all, will be limited to (right-wing approved) tax cuts which is, in my opinion, inferior to direct job creation strategies. Tax cuts can be part of the mix, but by themselves are unlikely to do enough to solve the employment problem.

"Obama's Vietnam Syndrome"?

Simple question. If George Bush was president instead of Barack Obama, would the discussion and criticism of the war in Afghanistan be different? Why has there been so little attention to this issue? This has been bugging me for quite awhile, people are dying everyday - many of them are innocent bystanders - yet we don't seem to be willing to bring this discussion out into the open and talk about whether this is the correct policy to pursue. Is it because Obama and most of the left is "thoroughly frightened by America’s right wing"? (This is supposed to be an economics blog, so I tossed in a graph):

Obama's Vietnam syndrome, by Jonathan Schell, Commentary, Project Syndicate: There can be no military resolution to the war in Afghanistan, only a political one. Writing that sentence almost makes me faint with boredom..., who wants to repeat a point that’s been made thousands of times? Is there anyone on earth who does not know that a guerrilla war cannot be won without winning the “hearts and minds” of the people? ...

Americans are accustomed to thinking that their country’s bitter experience in Vietnam taught certain lessons that became cautionary principles. But historical documents recently made available reveal... those lessons were in fact known -- though not publicly admitted -- before the U.S. escalated the war in Vietnam. That difference is important. If the Vietnam disaster was launched in full awareness of the “lessons,” why should those lessons be any more effective this time? ...

Why did President Lyndon Johnson’s administration steer the U.S. into a war that looked like a lost cause even to its own officials? One possible explanation is that Johnson was thoroughly frightened by America’s right wing. ... His national security adviser, McGeorge Bundy, fueled Johnson’s fears. In a 1964 memo, he wrote that “the political damage to Truman and Acheson from the fall of China arose because most Americans came to believe that we could and should have done more than we did to prevent it. This is exactly what would happen now if we should be seen to be the first to quit in Saigon.”...

Did Johnson’s advisers push the country into a disastrous war in order to win an election -- or, to be more exact, to avoid losing one? ...

What is uncanny about the current debate about Afghanistan is the degree to which it displays continuity with the Vietnam debates, and the Obama administration knows it. To most Americans, Vietnam taught one big lesson: “Don’t do it again!” But, to the U.S. military, Vietnam taught a host of little lessons, adding up to “Do it better!”

Indeed, the military has in effect militarized the arguments of the peace movement of the 1960s. If hearts and minds are the key, be nice to local people. If civilian casualties are a problem, cut them to a minimum. If corruption is losing the client government support, “pressure” it to be honest, as Obama did in recent comments following President Hamid Karzai’s fraud-ridden re-election.

The domestic political lessons of Vietnam have also been transmitted down to the present. George McGovern, the Democratic presidential candidate in 1972, proposed to end the war, which by then was unpopular, yet lost the election in a landslide. That electoral loss seemed to confirm Johnson’s earlier fears: Those who pull out of wars lose elections. That lesson instilled in the Democratic Party a bone-deep fear of “McGovernism” that continues to this day.

There is unmistakable continuity between Joseph McCarthy’s attacks on President Harry Truman’s administration for “losing” China, and for supposed “appeasement” and even “treason” and Dick Cheney’s and Karl Rove’s refrains assailing Obama for opposing the Iraq war... It is no secret that Obama’s support for the war in Afghanistan, which he has called “necessary for the defense of our people,” served as protection against charges of weakness over his policy of withdrawing from Iraq. So the politics of the Vietnam dilemma has been handed down to Obama virtually intact. Now as then, the issue is whether the U.S. is able to fail in a war without becoming unhinged.

Does the American body politic have a reverse gear? Does it know how to cut losses? Is it capable of learning from experience? Or must it plunge over every cliff that it approaches?

At the heart of these questions is another: Must liberals and moderates always bow down before the crazy right over national security? What is the source of this right-wing veto over presidents, congressmen and public opinion? Whoever can answer these questions will have discovered one of the keys to a half-century of American history -- and the forces that, even now, bear down on Obama over Afghanistan. ...

Housing Starts Fall

I just posted this at MoneyWatch:

Housing starts fell unexpectedly last month. The Census report gives the details:

Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000.

Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of 511,000. The October rate for units in buildings with five units or more was 48,000.

This graph shows the recent trend in housing starts:

As the graph shows, starts bottomed several months ago, and have been "moving sideways" ever since. What is causing housing starts to move sideways rather than recover? Calculated Risk, one of the best sites for analysis of the housing industry, gives this explanation (which I agree with):

Total housing starts were at ... the all time record low in April of 479 thousand (the lowest level since the Census Bureau began tracking housing starts in 1959). Starts had rebounded to 590 thousand in June, and have move sideways (or down) for five months.

Single-family starts were at 476 thousand (SAAR) in October... Just like for total starts, single-family starts have been at this level for five months.

As he notes, an important piece of the puzzle is that the percentage of vacant units has been climbing and is now at a record level (see this report):

It is very unlikely that there will be a strong rebound in housing starts with a record number of vacant housing units.

The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times.

It appears that ... starts are now moving sideways - and will probably stay near this level until the excess existing home inventory is reduced.

This raises the question of whether the overall economy will echo this pattern of falling backwards after apparent improvement, i.e. of moving sideways for a period of time. This is something I don't think we can or should rule out as we think about the appropriate economic policies that we should have in place to help the economy recover from the recession.

links for 2009-11-17

• A Case in Antiquities for ‘Finders Keepers’ - NYTimes.com
• Obamas Economic Policies are Working (debate) - intelligencesquaredus.org
• Promise in a ‘Cash for Caulkers’ Program to Weatherize Homes - NYTimes.com
• Banking Fix Made Easy With Six Simple Steps - Roger Lowenstein
• An Urgent Call for Action to Stem the U.S. Jobs Crisis - EPI
• Inventing a Better Patent System - NYTimes.com
• 4 in 10 families lack money for essentials when unemployed - EurekAlert
• Production and Producer Price Data Release - Mark Thoma
• Uncertainty and the tale of two depressions - voxeu.org
• The effectiveness of fiscal and monetary stimulus in depressions - voxeu.org

"The Very Best Short Summary of Adam Smith's Life and Work"

Adam Smith, the "Newton of political economy," may not be quite the "advocate of ‘market forces’, the enemy of government regulation, and believer in something called the ‘invisible hand" as you've been led to believe:

The Very Best Short Summary of Adam Smith's Life and Work, by Gavin Kennedy: Chris Berry, Professor of Political Theory at University of Glasgow is a leading expert on the life and work of one of the University of Glasgow's most famous academics, Adam Smith. He has created a 10 minute talk ... that describes the making of the man, the global significance of his writing and explains why Smith's work still resonates with us today:

Adam Smith in 10 Minutes: Adam Smith was born in Kirkcaldy in 1723. He entered Glasgow University at the early - but for the time not unusual - age of fourteen. He studied logic, metaphysics, maths and later Newtonian physics and moral philosophy under some of the leading scholars of the day. In 1740 Smith was awarded a Snell Scholarship (which is still in existence today) to study at Balliol College, Oxford. Smith preferred Glasgow, however, because Oxford’s curriculum was antiquated and he thought the teachers were lazy since, in contrast to Glasgow, their salary did not depend on the number of students taught. ...

The seeds of Smith's two great books were sown in his professorial years. The Theory of Moral Sentiments appeared in 1759 and drew on his lectures. It went through six editions in his lifetime. ... Although his second great book the Wealth of Nations was published in 1776 we know that he had already considered many of its leading themes at Glasgow as he lectured on as he put it: 'those arts which contribute to subsistence, and to the accumulation of property, in producing correspondent movements or alterations in law and government'. ...

If Smith of popular repute is the ‘father of capitalism’, the advocate of ‘market forces’, the enemy of government regulation and believer in something called the ‘invisible hand’ to produce optimum economic outcomes then he would be a disappointed parent. All his work is deeply steeped in moral philosophy. Indeed the simple fact that the final edition of the Moral Sentiments containing extensive revisions appeared in 1790, the year of his death, tells us is that Smith’s commitment to the moral point of view endured alongside and beyond the publication of the Wealth of Nations.

The Moral Sentiments is a leading example of a particular approach to moral philosophy – one that regards it not as sets of rationally or Divine ordained prescriptions but as the interaction of human feelings, emotions or sentiments in the real settings of human life. In many ways it is a book of social and moral psychology. What we can call economic behaviour is necessarily situated in a moral context. But more than that the key theme of the book is an opposition to the view that all morality or virtue is reducible to self-interest. Indeed his opening sentence declares that everyday human experience proves that false, he writes:

"China and the American Jobs Machine"

Robert Reich says China won't be abandoning its currency policy anytime soon:

China and the American Jobs Machine, by Robert Reich, Commentary, WSJ: President Barack Obama says he wants to "rebalance" the economic relationship between China and the U.S. as part of his plan to restart the American jobs machine. "We cannot go back," he said in September, "to an era where the Chinese . . . just are selling everything to us, we're taking out a bunch of credit-card debt or home equity loans, but we're not selling anything to them." He hopes that hundreds of millions of Chinese consumers will make up for the inability of American consumers to return to debt-binge spending.

This is wishful thinking. True, the Chinese market is huge and growing fast. ... But in fact China is heading in the opposite direction of "rebalancing." Its productive capacity keeps soaring, but Chinese consumers are taking home a shrinking proportion of the total economy. Last year, personal consumption in China amounted to only 35% of the Chinese economy; 10 years ago consumption was almost 50%. Capital investment, by contrast, rose to 44% from 35% over the decade. ...

Chinese companies are plowing their rising profits back into more productive capacity—additional factories, more equipment, new technologies. China's massive $600 billion stimulus package has been directed at further enlarging China's productive capacity... So where will this productive capacity go if not to Chinese consumers? Net exports to other nations, especially the U.S. and Europe. ...

The Chinese government also wants to create more jobs in China, and it will continue to rely on exports. Each year, tens of millions of poor Chinese pour into large cities from the countryside in pursuit of better-paying work. If they don't find it, China risks riots and other upheaval. Massive disorder is one of the greatest risks facing China's governing elite. That elite would much rather create export jobs, even at the cost of subsidizing foreign buyers, than allow the yuan to rise and thereby risk job shortages at home.

To this extent, China's export policy is really a social policy, designed to maintain order. Despite the Obama administration's entreaties, China will continue to peg the yuan to the dollar... This is costly to China, of course, but for the purposes of industrial and social policy, China figures the cost is worth it. ...

While China's currency policy is certainly a worthy topic for discussion, lately we are spending a lot of time pointing our fingers at others and blaming them for our problems rather than engaging in the more difficult task of getting our own house in order. I'm not saying that we should ignore things that unfairly disadvantage us, whatever those might be, just that a continued focus on external factors provides a convenient excuse to avoid going through the difficult changes needed to reform our own economy, an excuse that can be exploited by powerful interest groups opposed to needed change (though Reich at least touches on the US side of the equation in a part I left out).

Yes, China needs to change its currency policy, and the fact that it won't or can't change will probably lead to further economic imbalances, perhaps to dangerous levels, and cause increased political tension in the future. But I hope we don't allow the financial industry and others wishing to deflect blame for the crisis and avoid stricter regulation to use the controversy over China's currency policy to divert our attention elsewhere and alter the narrative about how we got into this mess.

The Fed “Refused to Use its Considerable Leverage”

A report on the NY Fed's role in the AIG bailout is less than flattering:

Audit Faults New York Fed in A.I.G. Bailout, by Mary Williams Walsh, NY Times: The Federal Reserve Bank of New York gave up much of its power in high-pressure negotiations with the American International Group’s trading partners last year, according to a government report made public on Monday.

Just two days before the New York Fed paid A.I.G.’s partners 100 cents on the dollar to tear up their contracts with the insurance giant, one bank volunteered to take a modest haircut — but it never got the chance. UBS, of Switzerland, alone offered to give a break to the New York Fed... It would have accepted 98 cents on the dollar.

But UBS’s good-faith gesture was quickly drowned out by Goldman Sachs and the top French bank regulator. They argued, with others, that it would be improper and perhaps even criminal to force A.I.G.’s trading partners to bear losses outside of bankruptcy court.

The banks and the regulator were confident that the New York Fed was not willing to push A.I.G. into bankruptcy... The New York Fed, led then by Timothy F. Geithner, who is now the Treasury secretary, therefore had little leverage in the negotiations...

The Fed “refused to use its considerable leverage,” Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, wrote in a report to be officially released on Tuesday, examining the much-criticized decision to make A.I.G.’s trading partners whole when people and businesses were taking painful losses in the financial markets.

There have been suggestions that the Fed chose to negotiate weakly, Mr. Barofsky said, to give a “backdoor bailout” to A.I.G.’s banks. He said Mr. Geithner and the Fed’s lawyers had denied this, but added that “irrespective of their stated intent,” there was no doubt about the result: “Tens of billions of dollars of government money was funneled inexorably and directly to A.I.G.’s counterparties.” ...

Mr. Barofsky said the facts also undermined the Fed’s arguments that banking secrecy was an essential part of bank stability.

“The default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds,” he said.

For the other side, see Economics of Contempt's Geithner Vindicated in TARP Watchdog Report.

An Impossible Task

I don't think the Chamber of Commerce could possibly hire a "respected economist" because any economist working for this group would lose whatever respect they might have:

Health bill foes solicit funds for economic study, by Michael D. Shear, Washington Post: The U.S. Chamber of Commerce and an assortment of national business groups opposed to President Obama's health-care reform effort are collecting money to finance an economic study that could be used to portray the legislation as a job killer and threat to the nation's economy, according to an e-mail solicitation from a top Chamber official.

The e-mail ... proposes spending $50,000 to hire a "respected economist" to study the impact of health-care legislation ... would have on jobs and the economy.

Step two, according to the e-mail, appears to assume the outcome of the economic review: "The economist will then circulate a sign-on letter to hundreds of other economists saying that the bill will kill jobs and hurt the economy. We will then be able to use this open letter to produce advertisements, and as a powerful lobbying and grass-roots document." ... In the e-mail, Gelfand writes that the proposal was "suggested by our Congressional allies" but does not specify who those allies are. ...

Randy Johnson, the Chamber's senior vice president who handles health-care issues, called the e-mail "inartfully worded" and said the group never intended to suggest that the outcome of the study would be preordained.

"It's not saying that we would tell the economist how it should come out. Perhaps it wasn't artfully phrased," Johnson said. "It's based on what we think the economist will come out with. It doesn't mean we know what the economist will come out with." ... Asked whether the Chamber would release the study if it concluded that the health bill would increase jobs and improve the economy, he initially said, "We would cross that bridge if we came to it."

Moments later, he said, that on reflection, a positive finding from the economist would help to educate the business groups and would play a role in the position they take on the legislation. "If it was like, oh wow, well, it doesn't have the kind of adverse impact we thought, that would educate us," he said.

What are the odds that this is the first time the Chamber of Commerce has commissioned a "study" like this?

links for 2009-11-16

• Audit Faults New York Fed in A.I.G. Bailout - NYTimes.com
• Economic theory and the crisis - voxeu.org
• Assessing the Impact of Government Policy - Econbrowser
• Credit Constraints and the Persistence of Unemployment - NEP-DGE Blog
• Post-Crisis: What Should Be the Goal of a Fiscal Exit Strategy? - iMFdirect
• Economics and Politics - Paul Krugman
• The Dodd Bill: CoCo’s? Fine; Hobble the Fed? Don’t Do It. - Jeff Frankel
• Is dynamic inconsistency the problem with inflation targeting? - Michael Roberts
• Ben Bernanke’s Outlook for the Economy - Mark Thoma
• New Deal 2.0 - links
• FT Alphaville - links
• Money Supply - links
• Economists Forum - links
• The Stash - links
• Economix - links
• Credit Writedowns - links
• Brad DeLong - links
• naked capitalism - links

"Sudden Financial Arrest"

Ricardo Caballero says that when there is a sudden failure of the financial system, governments should not let "fuzzy moral hazard reasoning" stop them from providing "massive" amounts of "credible public insurance and guarantees to financial transactions and balance sheets." He argues that "it is neither credible nor desirable to refuse to assist the private sector":

Sudden financial arrest, by Ricardo Caballero, Vox EU: “Sudden cardiac arrest (SCA) is a condition in which the heart suddenly and unexpectedly stops beating. When this happens, blood stops flowing to the brain and other vital organs…. SCA usually causes death if it’s not treated within minutes….”  – US National Institute of Health

There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as a sudden cardiac arrest (SCA). By analogy, I refer to its financial counterpart as a sudden financial arrest (SFA).

When an economy enters an episode of SFA, panic takes over, trust breaks down, and investors and creditors withdraw from their normal financial transactions. These reactions trigger a chain of events and perverse feedback-loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis. In this article I draw on the parallels between SCA and SFA to characterize the latter and to argue that a pragmatic policy framework to address SFA requires a much larger component of systemic insurance than most policymakers and politicians currently support.

How to Prevent the Next Financial Crisis

At MoneyWatch:

How to Prevent the Next Financial Crisis, by Mark Thoma

Paul Krugman: World Out of Balance

Paul Krugman reiterates that China's currency policy must change:

World Out of Balance, by Paul Krugman, Commentary, NY Times: International travel by world leaders is mainly about making symbolic gestures. Nobody expects President Obama to come back from China with major new agreements, on economic policy or anything else.

But let’s hope that when the cameras aren’t rolling Mr. Obama and his hosts engage in some frank talk about currency policy. For the problem of international trade imbalances is about to get substantially worse. And there’s a potentially ugly confrontation looming unless China mends its ways. ...

Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities.

And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. ... China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters.

But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. ...

That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”

Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.

But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines.

So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I’d be really worried about that prospect.

Unfortunately, the Chinese don’t seem to get it: rather than face up to the need to change their currency policy, they’ve taken to lecturing the United States, telling us to raise interest rates and curb fiscal deficits — that is, to make our unemployment problem even worse.

And I’m not sure the Obama administration gets it, either. The administration’s statements on Chinese currency policy seem pro forma, lacking any sense of urgency.

That needs to change. I don’t begrudge Mr. Obama the banquets and the photo ops; they’re part of his job. But behind the scenes he better be warning the Chinese that they’re playing a dangerous game.

Fed Watch: Should the Fed Be Doing More?

Tim Duy:

Should the Fed Be Doing More?, by Tim Duy: Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.

It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could have be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.

The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.

A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero:

links for 2009-11-15

• How Washington Can Create Jobs - Alan Blinder
• How the tax code encourages debt - James Surowiecki
• Roubini: For unemployment "the worst is yet to come" - Credit Writedowns
• When All Else Has Failed, Why Not Try Job Creation? - Economic Perspectives
• The Great Wallop - NYTimes.com
• Sound Familiar? - Economic Principals
• Promising to keep nominal interest rates low for too long - Nick Rowe
• Economic lessons from the playground - The Boston Globe
• Climate change negotiations: Time to reconsider - Jean Tirole
• Commodity inflation - Econbrowser
• Why Compact, Contiguous Districts are Bad for the Democrats - Andrew Gelman
• Variation as a social fundamental - UnderstandingSociety
• The social construction of monetary policy - Nick Rowe
• American dream needs repair - Clive Crook
• Fiscal Challenges Facing Cities: Implications for Economic Recovery - Brookings
  
• MTEF - links
• Credit Writedowns - links
• Abnormal Returns - links
• Marginal Revolution - links

"Unlike the New Deal, Obama’s Plan does not put People on the Public Payroll"

I missed this when it first ran in the Washington Post:

Unlike the New Deal, Obama’s plan does not put people on the public payroll, by Alec MacGillis, For The Washington Post, The Register Guard: To hear President Obama tell it, he’s been busy creating jobs since taking office. The $787 billion stimulus package, he said last winter, would “save or create 3.5 million jobs.” The White House is touting reports from recipients of stimulus funds asserting that they have created or saved 640,000 jobs so far.

Yet the national unemployment rate has now hit 10.2 percent... Obama declared recently that more action is needed: “I can promise you that I won’t let up until the Americans who want to find work can find work.”

It was a strong vow, but it raises a question: Why has a White House that talks so much about boosting employment steered clear of the most direct strategy that could keep Americans on the job?

Since taking office, the Obama administration has studiously avoided paying people to go to work, which could be accomplished by subsidizing workers’ private-sector employment or by creating new government-paid jobs. ...

Instead Obama’s team has taken a more indirect approach, a prudence that critics on the left say is misplaced. ... Engaging in more forthright job creation could invite some political pitfalls (such as those constant accusations of socialism), but is double-digit unemployment any less a political risk?

The administration is “scared of (any plans) seeming like old-fashioned make-work, but that’s what it is: You’re giving (people) jobs because they have nothing left to do,” said Dean Baker... “Giving people a shot at a job has to be worth a little bad publicity … but as in a lot of areas, they proved more cautious.”

White House officials ... say they opted against direct jobs programs not for political reasons but because they thought such efforts would not produce long-term value.

“I think we got the Recovery Act right,” Larry Summers, the president’s chief economic adviser, said in an interview. “The primary objective of our policy is having more work done, more product produced and more people earning more income. It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as expanding the total amount of work.”

Two-thirds of the stimulus went toward tax cuts, fiscal aid to states, and expanded unemployment benefits and food stamps. These efforts helped cushion the recession’s blow, saved public jobs and, by injecting demand into the economy, bolstered employment indirectly.

The remaining third of the stimulus, however, was expected to be the real jobs generator: $250 billion for infrastructure — roads, transit, water treatment — and for investments in energy efficiency, broadband access and other areas. But it is becoming clear that much of that spending is not producing many new jobs. ...

Administration officials argue that these investments, if done right, will lay the groundwork for growth for years to come. And they say that given the depth of the recession, it’s hardly a bad thing for the stimulus to deliver some punch a year or two from now. ... Summers said. “We designed the Recovery Act to ramp up over time, through 2010, and to make sure that the investments we made were important for the country’s future.”

In addition, public-works programs take longer to get started than people realize, officials say. ... None of this persuades the critics... [who] ... argue that there is plenty of direct job creation that could be done, short of heavy infrastructure, that could have lasting value. The liberal Economic Policy Institute has drafted a plan that, along with a new business tax credit for hiring that the White House is already considering, includes a pure public jobs proposal: giving money to states and cities to hire people to paint schools, board up vacant homes, staff child-care centers and reopen library branches. Workers would be paid the market wage. It would cost $35 billion for a year, not much more than the combined price tag for the homebuyers’ tax credit and the $250 checks that Obama has proposed sending to Social Security recipients. ...

Conservative economists stand steadfast against any movement toward direct job creation. ... Jobs programs “sound so good in theory, but it just doesn’t work that way,” said Larry Lindsey, director of the National Economic Council under President George W. Bush. It would be better to stick with safety-net benefits for those most in need and to enact new tax cuts, such as a suspension of the payroll tax to encourage hiring. ...

One confusion here is the strict demarcation between "growth policy" and "stabilization policy." Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers' remarks reflect this type of thinking.

But, as Stephen G Cecchetti, Piti Disyatat and Marion Kohler note, stabilization policy can also have first-order effects:

The primary objective of macroeconomic policy is to maximize welfare – measured typically as income per capita. In working to meet this goal, the first question is whether policymakers should be concerned with stabilizing the economy around its long-run growth path. Stabilization is secondary if it has little or no effect on the level of real growth; while fluctuations have distributional consequences, they are of little direct concern...

The current consensus – as embodied in a variety of New Keynesian models – is that volatility can lower the long-run level of growth; so, smoothing fluctuations has first-order effects on welfare. While this conclusion is not without dissenters – see, for example, Lucas and Sargent (1979) and Lucas (2003) – it is accepted among policymakers, as is clear from the explicit or implicit role that output smoothing plays in the objectives of many central banks.

Even so, as Summers makes clear, the administration shunned "make-work" type stabilization policy in favor of policies devoted to building (or rebuilding) infrastructure because they could defend these policies against political attacks by pointing to their growth enhancing capabilities (same for tax cuts, even though everyone knew they were intended mostly for stabilization). So called make-work programs were denounced as wasteful by the opponents of stabilization policy, in part because they completely ignore the potential multiplier effects of such spending, but also because they ignore the value to communities that comes from the types of "make work" activities such as, say, those listed above in the discussion of a proposal from the EPI, and because they forget that stabilization can affect long-run growth in modern models.

Letting people struggle when they could be helped is not an acceptable policy, but it seems to be the one we've adopted. Putting unemployed people to work doing things of value for their communities is not wasteful, and given the very poor state of the labor market, we need to do something, and we need to do it now.

Update: See Alan Blinder's comments.

links for 2009-11-14

• The job market will rebound sooner than you expect - Daniel Gross
• Coverage expansion and cost control in health-care reform - Lane Kenworthy
• Krugman: Inflation targeting is first best - Greed, Green and Grains
• At Swoopo.com, a Price for the Thrill of the Auction - NYTimes.com
• U.S. trade gap widens - washingtonpost.com
• Europe emerges from recession - washingtonpost.com
• Credit Writedowns - links
• Marginal Revolution - links
• Brad DeLong - links

"The Ghost in the Recovery Machine"

Robert Shiller:

The ghost in the recovery machine, by Robert J Shiller, Commentary, Project Syndicate: The International Monetary Fund’s October World Economic Outlook proclaimed that, “Strong public policies have fostered a rebound of industrial production, world trade, and retail sales”. The IMF, along with many national leaders, seem ready to give full credit to these policies for engineering what might be the end of the global economic recession.

National leaders and international organisations do deserve substantial credit... But one also suspects that world leaders have been too quick to claim so much credit for their policies. After all, recessions generally tend to come to an end on their own, even before there were government stabilisation policies. ...

Economic theorists long ago developed models that describe how recessions end on their own. ... Some of these factors, rather than just the actions taken by governments and multilateral organisations, plausibly played a role in the current economic improvement. Unpredictable human psychology also plays a role. Such factors, indeed, matter very much for the economic outlook, and for judging the success of the recovery programme.

One can start with the stock-market turnaround since March of this year, which has been stunning. ... Moreover, this same sharp turnaround occurred in many countries – and for many assets, including oil prices, gold, and, in some countries, residential real estate.

Any solid understanding of the causes of this turnaround is likely to prove elusive. ... A market boom, once started, can continue for a while as a sort of social epidemic, and can foster inspiring “new era” stories that are spread by news media and word of mouth. The stories themselves help magnify the boom, becoming part of the feedback that sustains it.

The agreements reached at recent G-20 meetings stand as one of these stories, for they suggest a new era of international co-operation and economic professionalism – a narrative that has probably been exaggerated in the psychology of recovery.

The G-20 story is particularly salient in the developing world, for the international recognition that the G-20’s expanded role has given to developing countries is highly resonant psychologically.

Beyond that, stories of highly profitable banks paying huge bonuses to their executives have also inspired people to think that things are not so bad in the business world. Anger at these profits and bonuses only tends to increase the contagion of the story.

But any such speculative boom is inherently unstable... It was, in fact, an excessive speculative boom in the stock market and the housing market that got us into this financial mess in the first place.

To be sure, governments and multilateral institutions made some reasonable attempts to restore confidence. But they did not “engineer” a recovery. They got lucky, and the G-20, as well as the governments that instituted stimulus packages, are currently in a honeymoon period of apparent success.

Where our still-ailing world economy goes from here is as uncertain as the speculative markets that played such an important role in both the financial crisis and the recovery. We can only wish that formulating economic policy were as clear-cut as, say, mechanical engineering. It is not: a host of poorly understood natural cyclical factors play a role, and so do the vagaries of human psychology.

He may not want to give much credit to policy, but I would not have wanted to go through this crisis without the aggressive monetary and fiscal policy measures that policymakers put into place (and given the state of the labor market, even more was and is needed).

"The Illusion of Improving Global Imbalances"

Richard Baldwin and Daria Taglioni warn that the recent improvement in trade balances brought about by the recession is likely to be temporary since the underlying forces generating global imbalances are still present, and " the recovery of trade flows – a recovery that seems to have started this summer – will almost surely return the US, Germany, China and others to their old paths."

Remember all the talk before the crisis about whether we'll have a hard landing or a soft landing when global imbalances unwind? That's still an important question, and the fact that we cannot rule out a hard landing (with the accompanying rise in interest rates, rise in inflation, fall of the dollar, and a recession) means we will need find a way to reduce these pressures without triggering another crisis A key factor will be how the US manages the budget deficit in the future (which is definitely not a call to begin balancing the budget now, that's a task for better times). If the recent increase in US savings rates persists, that will help as well:

The illusion of improving global imbalances, by Richard Baldwin and Daria Taglioni, Vox EU: They are blamed for the global crisis directly (Paulson 2008) or indirectly (Calvo 2009), G20 leaders are committed to ending them, and commentators have generated an ocean of html painting them as one of the world’s greatest banes. “They” are global imbalances – large trade surpluses and large trade deficits.

Good news then – global imbalances have been shrinking at a fabulous rate (Figure 1). The figure – which includes China, Germany, the US and all the other usual suspects in the global-imbalances saga – shows that trade gaps have closed remarkably quickly since late 2008. ...

This rapid improvement seems odd given how little reform has occurred. The renminbi has not appreciated against the dollar and Chinese consumption has not boomed; the dollar has depreciated modestly against European currencies and the US savings rate has risen gently, but neither seems large enough to account for the massive shifts already observed, to say nothing of the World Bank predictions for future improvements.

We argue here that these global imbalance improvements are mostly illusory – the transitory side effect of the greatest trade collapse the world has ever seen. Before making the argument, we lay out the basic facts.

links for 2009-11-13

• Employment Policy - Angry Bear
• Discretion and financial regulation - Interfluidity
• Economic theory and the crisis - voxeu.org
• Did financial globalisation make the US crisis worse? - voxeu.org
• The illusion of improving global imbalances - voxeu.org
• More Lessons from the Crisis - FRB New York
• More Deficit Idiocy: Politico Edition - Chris Hayes
• White House hits out at plan to strip Fed powers - FT.com
• "Asset Price Bubbles and Monetary policy" - FRB Chicago
• The definition of strong (dollar) - Antonio Fatas
• Yes, We Need Big Banks - Economics of Contempt
• The Big Picture - links
• New Deal 2.0 - links
• FT Alphaville - links
• Money Supply - links
• Economists Forum - links
• Credit Writedowns - links
• Abnormal Returns - links
• Economix - links
• PSD - links
• Free Exchange - links
• naked capitalism - links
• Brad DeLong - links