Economist's View

What Tax Cut?

John Berry makes a point worth repeating. He says the administration's claim that it cut taxes is wrong:

Bush Makes Up for Tax Cuts With More Spending, by John M. Berry, Bloomberg: ...Over substantial Democratic opposition, Bush and a Republican-controlled Congress have cut taxes significantly over the past six years. The problem is that -- with plenty of cooperation from Democrats -- they have also greatly increased spending.

From fiscal 2001 to 2006, federal outlays shot up 42 percent, more than double the 19 percent increase over the previous five years.

In the short run, you can cut taxes and spend more. In the long run, as Nobel laureate economist Milton Friedman has potently argued, to spend is to tax.

Can "State-Business-Union Collaboration" Save the Middle Class?

In one of the comments in Martin Wolf's forum about Larry Summers commentary on the difficulties globalization is causing for the middle class worldwide, Robert Wade writes:

Robert Wade: Larry Summers says: "The economic logic of free, globalised, technologically sophisticated capitalism may well be to shift more wealth to the very richest and some of the very poorest in the world, while squeezing people in the middle." A new study by Peter Edward presents confirming evidence (... 2006, 'Examining Inequality: Who Really Benefits from Global Growth?', World Development...). Of the increase in world consumption between 1993 and 2001 between 50 and 60 per cent accrued to those in the top 10 per cent of world PPP income in 1993, of whom four-fifths lived in the (old) OECD and most of the rest in Latin America. ...

Most of the rest of the increase accrued to the burgeoning middle class of China. Hardly any accrued to those living on less than $1-a-day, though 'hardly any' in percentage terms may have been sufficient to push enough people up ...[so] that the number under $1-a-day fell while the number between $1 and 2-a-day rose.

So when Larry talks of the "global middle class" being squeezed he is talking about the vast majority of the world's population, and the even bigger majority of the world outside the OECD and China. This should qualify any easy assertion that "globalization works"...

Larry also says: "[W]ithout its [the global middle class'] support it is very doubtful that the existing global economic order can be maintained." ... Elites are likely to sponsor measures that lower inequality only when their legitimacy is seriously threatened. We see fluctuations in after-tax inequality over time in response to the degree of threat to the capitalist order or to the survival of particular states... But despite the ... constancy (not fall) of world income inequality (the fast rise of China and India notwithstanding), inequality has hardly [been] an issue [in] global or even national policy discussion. ...

Finally, Larry says that 'the combination of low wages, diffusible technology and the ability to access global product and financial markets has fuelled an economic explosion' in Asia, especially in China. The problem here is that low wage labour is available all over the place, not just in Asia, and diffusable technology is, from the supply side, diffusable all over the place. Asian economies have certainly benefitted from being able to access global product and financial markets... But they have adopted policy regimes that depart in major ways from the principles that Larry keenly promoted from the US Treasury, whose spirit is caught in his remark in this column, 'protectionism [note the 'ism', as though it is a creed, like communism] is counterproductive'.

The governments of the successful economies (think Japan, Taiwan, South Korea, Singapore for starters) have in practice adopted a variety of policy instruments to accelerate the national integration of the economy, as a complement to Larry's central interest in 'international integration'. In the first three, these policy instruments included managed trade regimes with substantial amounts of protection ... in line with a larger development strategy. Larry refers to 'middle-income countries without natural resources struggl[ing] to define an area of comparative advantage'. I suggest that the struggle to define and exploit areas of comparative advantage in the context of increasing competition in world markets may ... involve a more pro-active directional thrust from the state (the direction established through state-business-union collaboration) than Larry would be happy to endorse. ...

I don't think state-business-union collaboration is the answer to this problem. Do you? Martin Wolf also comments on the article.

Why Backdate Stock Options?

Here's a discussion of the option backdating controversy from James Surowiecki at The New Yorker:

The Dating Game, by James Surowiechi, The New Yorker: ..When news broke, earlier this year, that some companies had backdated stock-option grants ... in order to make them more valuable, it seemed like a problem that would come and go quickly... But the scandal has metastasized... What’s distinctive about this one is that the benefits companies got from backdating were so small. Never, you might say, have so many cheated so much to gain so little.

The most common stock options are known as “at the money” options, which let you buy the company’s stock at the price that it had on the day of the grant. They’re valuable only if the stock price rises after you get them. The companies involved in the recent scandal were backdating options to a time when the stock price was lower, making them immediately lucrative. As it happens, companies are perfectly free to issue options priced below the current market: those are called “in the money” options, and they’re worth something right when they’re issued. .. But there’s a rule that companies have to follow when they issue “in the money” options: they have to disclose it in their financial statements.

The backdating companies broke this rule: they reported how many options they were issuing, but conveniently omitted the fact that they had been backdated. In Washington, people say that it’s not the crime that gets you—it’s the coverup. In the case of backdating, the only crime was the coverup.

The question is why anyone bothered. ... [C]ompanies didn’t need backdating to lavish huge sums of money on their executives: they could have issued more at-the-money options to make up the difference, or they could have just handed out grants of stock. ... Why did they sneak around? One reason is public relations. Companies typically justify ... stock options by claiming that they’re an incentive for performance: the executives get rich only if they do a good job and the stock goes up. Unless executives can time-travel, though, it’s hard to make that case for backdated options.

The bigger reason for choosing to backdate is to get around some bothersome accounting regulations. Until recently, the regulations distinguished, for no good reason, between in-the-money and at-the-money options. In-the-money options—but not at-the-money options—had to be recorded as an expense, which drove down reported earnings. Backdating allowed companies to reward employees with in-the-money options while getting the favorable accounting treatment of at-the-money options. ...

Classifying the options properly would have lowered the number in the “earnings” box, and so C.E.O.s assumed that it would also drag down the company’s stock price. They played games with their accounting because they thought investors weren’t smart enough to look at the fundamentals. They were “managing earnings,” massaging the numbers, something that many (perhaps most) companies do in some form or other... Executives do it because they believe that if they don’t the stock market will punish them.

They’re wrong. As the investment strategist Michael Mauboussin puts it, “The market follows cash flows,” not earnings. As long as revenues and expenditures are reported honestly, [several studies show that] accounting legerdemain doesn’t fool the market. ...

A Turning Point?

Yesterday, we heard from a physicist about economics. It was not a generally positive review of our discipline. Today, Chemistry World brings us scientists who, though it appears less than enthusiastic in some cases, suddenly find economics useful:

Economist’s review marks turning point, Chemistry World: Scientists have welcomed an economist’s review into the costs of climate change, which warns of global recession if greenhouse gas emissions are not stabilised.

A proper economic analysis was long overdue, providing independent support for the views of scientists accused of hyping up climate change, Chris Reay, National Environment Research Council (Nerc) research fellow at Edinburgh University, UK, told Chemistry World. ‘If this is the tipping point, I don’t mind if it comes from an economist,’ he said.

Thanks. We don't mind your help either. The statement refers to the Stern Review on the potential costs of global warming:

The government-commissioned report, carried out by former World Bank chief economist Sir Nicholas Stern, warns that the global economy could shrink by up to 20 per cent unless action is taken now to reduce greenhouse gas emissions; Stern estimates an R&D investment of one per cent of global GDP is needed.

‘The Stern Review finally closes a chasm that has existed for 15 years between the precautionary concerns of scientists, and the cost–benefit views of many economists,’ commented Michael Grubb, professor of climate change and energy policy at Imperial College London and the University of Cambridge, UK. And, said Grubb, it was encouraging that although Stern saw the problem as massive and urgent, it could be solved...

NDN: Krugman's Remarks at the New America Foundation Economic Conference

James Crabtree from NDN reports on a speech given today by Paul Krugman:

Paul Krugman’s Remarks at New America Foundation Economic Conference: DISCLAIMER: These notes were taken by NDN’s James Crabtree from Paul Krugman’s opening address to the New America Foundation’s “Back to the Economy” conference on Monday October 30th 2006. They are notes only, not a written speech circulated by Mr. Krugman. Any quotes taken should make clear that this is not a verbatim or official transcript.

Tim Duy: Third Quarter GDP, Part II

Tim Duy weighs in on the controversy over the auto production figures in the latest GDP release:

Third Quarter GDP, Part II, by Tim Duy: A bit of a controversy is simmering with regards to the jump in auto production as reported in 3Q06 GDP report.  According to Bloomberg:

An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

The report, in part, leads David Altig to conclude that:

Even an optimist would have to admit that the fourth quarter begins with a few pretty big challenges.

While Nouriel Roubini takes a more aggressive stance:

This mismeasurement of motor vehicle production in Q3 is highly suspicious coming about ten days before the US mid-term elections. It is also highly suspicious as it is not clear how the Bureau of Economic Analysis (BEA) at the Department of Commerce could have made such a gross mistake when seeing an alleged 26% increase in auto production that was patently at odds with many facts. During Q3 all the major US automakers - Ford, GM, Chrysler - announced production cuts for both Q3 and Q4. So, how could the folks at BEA argue and estimate that production went up by a whopping 26%?.. We thus expect BEA to provide a rapid clear and open explanation of this gross mismeasurement.

Admittedly, I was surprised as well – but I quickly thought to myself “oh, so prices fell.”  Didn’t seem like a big deal, so I was caught off guard by the controversy. 

It is worth it to step in and help the BEA – this is not an issue of “gross mismeasurement.”  This is an issue of some confusion about the NIPA accounts themselves.

Truth be told, the BEA is not helping itself.  From the Guide to the NIPAs:

Gross domestic product (GDP) (1–34), the featured measure of U.S. output, is the market value of the goods and services produced by labor and property located in the United States.

From this definition, it is reasonable to conclude that GDP measures output.  But, as I explain every time I teach principles of macroeconomics, in practice the BEA does not measure output.  Instead, the BEA measures demand:

GDP is measured as the sum of personal consumption expenditures, gross private domestic investment (including change in private inventories and before deduction of charges for CFC), net exports of goods and services (exports less imports), and government consumption expenditures and gross investment. GDP excludes intermediate purchases of goods and services by business.

For instance:

Personal consumption expenditures (PCE) (1–15) measures goods and services purchased by U.S. residents. PCE consists mainly of purchases of new goods and of services by individuals from private business.

In the background, the BEA is making use of the “national income equals national output” identity:  If it was purchased, we must have had the income for it, which implies that we produced the output in the first place.  Still, in practice, I am careful about using GDP as a measure of output, simply because it is calculated by measuring demand (purchases), not supply.

The 3Q06 “mismeasurement” of auto production is a perfect example – the supposed automobile “production” component of PCE is a measure of final sales, not production:

Sales estimates (PCE and PFI) for new cars and trucks are prepared using unit sales, allocations by sector, and estimates of average expenditure per vehicle…

In converting from nominal to real, a decline in prices yields a positive increase in real sales, even if nominal sales stay constant (or even fell).  As a demand side concept, this is not a problem.  If the price of automobiles falls relative to other goods in my basket, I am unambiguously better off as my budget constraint increased.  The real quantity of aggregate goods and services I can consume is greater.  No mismeasurement.  One, however, has to be careful of the supply side interpretations.

In practice, I tend to think of GDP as a demand side indicator, particularly when examining quarterly data.  In any event, I find it disingenuous to accuse the BEA of manipulating the data for political purposes – the confusion is readily cleared up once you understand how the data are constructed.

Update (by MT): Brad DeLong responds.

Tim Duy responds to Brad:

Update (by Tim Duy): Sorry for the delay – I had to shift to household production to compensate for a sick child.

Brad DeLong responds:

Now I am confused. Real GDP is (a) real final demand, plus (b) the change in business inventories. If cars were sold more cheaply in Q3 than anybody expected--and thus if the same flow of money spent on auto purchases resulted in more cars sold--then the extra cars sold must have come out of inventories, right?

Auto companies didn't ramp up production in Q3, did they?

Which serves to remind me that swimming with the big fish means you risk getting bitten now and then. Fair enough – some clarity can’t hurt, especially since Brad is getting to an important point. Note that I never claimed US auto production increased. My point is simply that the reported rise in auto production in the GDP accounts – as measured by final sales – is not necessarily inconsistent with the reported decline in US auto production. And it certainly does not imply that the BEA is manipulating the data for political purposes.

Let’s disregard the price decline, and just switch to physical units. In the comments, spencer points out that auto and light truck sales rose from 16.17 to 16.63 million units in Q3. Did in fact those sales never really happen because the Big 3 cut domestic production? 

No – at least two channels can be operating. One, as Brad (and spencer) points out, is inventory depletion. Which gets to the point that although something may get counted as final sales in 3Q, that doesn’t mean it was actually produced in 3Q. It could have been counted as an inventory accumulation in a previous quarter, and is subtracted in the current quarter. If the BEA underestimated inventory draw for this quarter, they can fix it on a revision – nothing nefarious need be occurring.

Moreover, just because a car is counted as a final sale in the US in 3Q does not mean it was PRODUCED in the US at all, in any quarter. In this case, the value is subtracted from GDP in the imports category. Note the large negative contribution due to rising imports (although I can’t say this was due to autos). Aggregate data can sometimes mask sectoral shifts unless you are looking for the shifts. It is not the BEA’s fault that Detroit chooses to make cars Americans are less interested in purchasing.

Getting back to the price decline, a decline in prices causes a statistical increase in real output. No big surprise – this is the way the data is computed. There may be an issue of whether the seasonal variations in prices have been accounted for properly. I have mused on this with other data. But I try to remember that the BEA has very qualified economists who spend hours studying the minutiae of these data, including the seasonal effects.

Paul Krugman: Bursting Bubble Blues

Paul Krugman on the economic and political consequences of the slumping housing market:

Bursting Bubble Blues, by Paul Krugman, Housing Bust, Commentary, NY Times: Here are the five stages of housing grief:

1. Housing bubble? What housing bubble? “A national severe price distortion [in housing] seems most unlikely in the United States.” (Alan Greenspan, October 2004)

2. “There’s a little froth in this market,” but “we don’t perceive that there is a national bubble.” (Alan Greenspan, May 2005)

3. Housing is slumping, but “despite what you hear from some of the Eeyores in the analytical community, a recession is not visible on the horizon.” (Richard Fisher, president of the Federal Reserve Bank of Dallas, August 2006)

4. Well, that was a lousy quarter, but “I feel good about the U.S. economy, I really do.” (Henry Paulson, the Treasury secretary, last Friday)

5. Insert expletive here.

We’ve now reached stage 4. Will we move on to stage 5?

Over the last few years, ... the housing boom became a bubble, fueled by a surge of irresponsible bank lending, which continues even now. ... The question now is how much pain the bursting bubble will inflict.

Last week’s report on G.D.P. showed the first signs of serious economic damage. According to the “advance” estimates (which are often subject to major revisions), growth in the third quarter of 2006 slowed to its worst level since early 2003. A plunge in spending on residential construction, which fell at an annual rate of 17 percent, was the main culprit. ...

Some say the worst is already over. Mr. Greenspan, who’s been an optimist all the way, now argues that the latest data on new-home sales and mortgage applications suggest that housing has already bottomed out. Business investment is still growing briskly, and so far consumers haven’t cut their spending. So maybe this is as bad as it gets.

But I think the pessimists have a stronger case. There’s a lot of evidence that home prices, although they’ve started to decline, are still way out of line. Spending on home construction remains abnormally high as a percentage of G.D.P., because banks are still lending freely in spite of rapidly rising foreclosure rates.

This means that home sales probably still have a long way to fall. ... Moreover, much of the good news in the latest economic report is unsustainable at best, suspect at worst. Almost half of last quarter’s estimated growth was the result of a reported surge in automobile output, which some observers think was a statistical illusion... So this is probably just the beginning. ...

In case you’re wondering, I don’t blame the Bush administration for the latest bad economic numbers. If anyone is to blame for the current situation, it’s Mr. Greenspan, who pooh-poohed warnings about an emerging bubble and did nothing to crack down on irresponsible lending.

Still, the bad news will have political consequences. The Bush administration has been trying to shift attention away from the disaster in Iraq to an allegedly booming economy. That strategy wasn’t working too well even when the headline numbers were good, because it never felt like a boom to most Americans. But now even the headline numbers have turned lousy.

And if that hurts the G.O.P. in next week’s election, well, there’s a certain poetic justice involved. The administration tried to claim undeserved credit for the positive effects of the housing boom, so why shouldn’t it receive some blame for the negative effects of the housing bust?

_________________________
Previous (10/27) column: Paul Krugman: The Arithmetic of Failure
Next (11/3) column: Paul Krugman: As Bechtel Goes

Neoclassical Theory under Fire from the Sciences

This is Philip Ball, "consultant editor of Nature and the author of Critical Mass," with a criticism of neoclassical theory:

Baroque fantasies of a most peculiar science, by Philip Ball, Commentary, Financial Times (free): It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that ... it is ... rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas ... may determine ... how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.

Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.

The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But ... the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.

This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.

It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

One can go through economic theory systematically demolishing all the cherished principles that students learn... [I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.

There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”

The author seems to believe he has a better theory of aggregate fluctuations:

[I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

That's fine, but when he says "The theory has not foreseen a single stock market crash" as his argument against neoclassical theory, he should first realize macroeconomists don't focus on predicting the stock market, and then he ought to put his theory to the same test. Can he predict stock market crashes? If he can predict the stock market's random walk behavior, will he then go on to show he can provide improved forecasts of the things macroeconomists care about? More generally, can physicists predict earthquakes, etc.? If I ask, why is there gravity, will physicists be able to tell me? Should I accept string theory as evidence of their success and superiority? The existing paradigm in physics doesn't work and the new one, string theory, doesn't produce testable implications and may be little more than mathematically sophisticated philosophic musings - is that where we want to head?

I don't mind the criticism, it's good for us and there are truths in what is said. But I always resent the arrogance of scientists from other fields thinking they can mosey on over to economics for a few minutes, diagnose our ills, and solve all our problems. I'd suggest they solve the problems in their own discipline first, or show a bit more humility when giving advice to others, especially when, as above, they are clearly unaware of vast swaths of literature such as the published work on corruption. And along those lines, and for the record, we're well aware of and have models for the list of things he mentions in his "abundantly clear" theory of market fluctuations. If he actually tried to build these models rather than simply casting aspersions at the existing paradigm, he'd find it isn't as clear as he thinks.

Update: I'd characterize this as a typical response to this post - Thoma was off the mark, but interesting discussion!:

Economics vs physics chez Thoma, by Felix Salmon: Mark Thoma's readers are certainly busy on weekends! A post of his on the general subject of physics vs economics went up on Sunday, and already it's got 52 comments and counting.

The impetus for the blog entry is a piece by Philip Ball in the FT, wherein a hard scientist attacks the soft scientists in the economic realm for their dogmatism and lack of falsifiability.

Thoma initially takes a slightly dubious tack in response, complaining that physicists can't predict earthquakes (they never claimed that they could) and that "the existing paradigm in physics doesn't work" (it does). But things rapidly get more subtle and interesting in the comments: a prime example of the blog format really enriching the debate.

Let me join in and also trumpet the quality of the comments I get here, and say thanks while I'm at it.

Summers: The Global Middle Cries Out for Reassurance

Because of the problems globalization and technological change have created for middle class workers, Larry Summers believes that the advancement of global integration will depend upon "what can be done for the great global middle" through policies enacted by the "best parts of the progressive tradition." He has in mind progressives who "do not oppose the market system," instead "they improve on the outcomes it naturally produces":

The global middle cries out for reassurance, by Larry Summers, Commentary, Financial Times (free): ...Neither the after-effects of September 11 2001 nor a tripling in oil prices has prevented the world’s economy from growing faster in the past five years than in any five-year period in recorded economic history. Given this recent performance and the ... optimistic outlook, one might have expected this to be a moment of particularly great enthusiasm for the market system and for global integration.

Yet in many corners of the globe there is growing disillusionment. From the failure to complete the Doha trade round to pervasive Wal-Mart-bashing, from massive renationalisation in Russia to the success of populists in Latin America and eastern Europe, we see a [growing] degree of anxiety about the market system...

Why is there such disillusionment? Some anti-globalisation sentiment can be seen as ... arising from the Bush administration’s foreign policy misadventures. But there is a much more troubling source: the growing recognition that the vast global middle is not sharing the benefits... – and that its share of the pie may even be shrinking.

The Democratic Policy Agenda

After listing some of the items on the Democrat's policy agenda, Jonathan Chait explains why Republicans are attempting to deflect the political conversation away from the content and merit of the Democrat's proposals during the election campaign using their usual trick of aggressively defining the Democrat's position as extreme, and then running against it:

Running against the boogeyman: Party of ideas? Not the GOP, by Jonathan Chait: ...Democrats running for the House of Representatives actually have an agenda. ... If you're like most people, you probably have no idea what that agenda is. Let me list it:

• Put new rules in place to break the link between lobbyists and legislation.
• Enact all the recommendations made by the 9/11 commission.
• Raise the federal minimum wage to $7.25 an hour.
• Cut the interest rate on federally supported student loans in half.
• Allow the government to negotiate directly with pharmaceutical companies for lower drug prices for Medicare patients.
• Broaden the types of stem cell research allowed with federal funds.
• Impose pay-as-you-go budget rules, requiring that new entitlement spending or tax cuts be offset with entitlement spending cuts or tax hikes.

Republicans disagree with all these items. Indeed, the reason these items are on the Democratic agenda is that Republicans in Congress have blocked them from coming up for a vote. So where's the Republican rebuttal? ...

My point is, we're not even getting a debate about a caricature of the Democratic position, let alone the actual one. Instead, we're getting things like this: GOP Rep. John Hostettler of Indiana is running an ad warning that if Democrats take power and California Democrat Nancy Pelosi becomes House speaker, she "will then put in motion her radical plan to advance the homosexual agenda..."

What is the homosexual agenda? The ad does not say. (Apparently it involves raising the minimum wage and cutting the interest rate on government-backed student loans. I can just see it if the Democrats win — all those gay Wal-Mart employees, cackling with glee as they use their fat $7.25-an-hour salaries to pay off their suddenly puny college debts.)

Which is my point. Republicans don't want an actual choice election, they want to run against a mythological Democratic Party so frightening that the voters overlook all the GOP's failures. ... They raise the specter of a radical Democratic agenda, but they refuse to say what they don't like about that agenda. And there's a good reason for that: It's popular.

When will Democrats stop allowing the other side to define them? I'm not sure why this has been such a problem in recent elections, but it's been frustrating to watch it happen again and again. Perhaps this will improve next election if, as looks likely even with the ongoing problem of defining themselves to the public, Democrats are able to regain some degree of power. Control of the House gives Democrats the opportunity to propose policies that define and publicize their policy agenda and, if they propose the right policies, this puts them in a much better position to present a well-known and well-defined policy agenda to the public during the campaign.

The Relative Value of Sports and Academics

John Whitehead at Hypothetical Bias on the relative value of sports and academics in higher education:

Perfect substitutes: At halftime of the ASU-Furman game..., the ASU Chancellor (i.e., President) stated that holding the NCAA I-AA championship football trophy felt just as good as having a Nobel Prize winner on the faculty...

The Cost of Doing Nothing

According to this report, acting now to avoid the negative consequences of global warming will require 1% of GDP, while waiting until later will cost between 5-20% of GDP:

Economist: Global warming will be costly, by Thomas Wagner,  The Associated Press: A comprehensive report on the global economic cost of climate change, to be released by the British government Monday, is expected to be the world's most serious effort to quantify the long-term effect of doing nothing.

The Independent newspaper reported Friday that the long-awaited review would say global warming could cost the world's economies up to 20 percent of their gross domestic product if urgent action is not taken to stop floods, storms and natural catastrophes.

Author Sir Nicholas Stern met privately with Prime Minister Tony Blair and his Cabinet ministers Thursday to brief them about his findings. Stern, a government adviser on climate change, is a former chief economist of the World Bank.

Quoting unidentified officials at the briefing, The Independent said Stern warned the world would have to pay 1 percent of its annual gross domestic product now to avert catastrophe but that doing nothing could later cost five to 20 times that amount.

"Business as usual will derail growth," the paper quoted Stern as saying as he briefed the government on his 700-page report, covering a period up to the year 2100.

The report was mandated by Blair's treasury chief, Gordon Brown, who is expected to replace Blair when he steps down as prime minister next year. Brown recently said he would use the report to alert governments around the world that they have been too slow to recognize — let alone fight — the threat of climate change. ...

Black-White Test Scores: Neighborhoods Matter

From the NBER Digest, research on the "persistently large black-white differences in standardized test scores":

Black-White Test Scores: Neighborhoods, Not Schools, Matter Most, by David R. Francis, NBER Digest: The large gap in student achievement, particularly between blacks and whites, has long troubled Americans. Fifty years after the Brown v. Board of Education decision, persistently large black-white differences in standardized test scores remain central to education policy.

In Racial Segregation and the Black-White Test Score Gap (NBER Working Paper No. 12078 [open link]), NBER researchers David Card and Jesse Rothstein cast some fresh and perhaps surprising light on this issue. Using data from SAT records for roughly one third of test takers in the 1998-2001 high school graduation classes, they find that the black-white achievement gap is clearly linked to racial segregation.

Suskind: The President Knows More Than He Lets On

Here's part of an interview with terrorism expert Ron Suskind. This isn't about economics, but I thought you should know that capturing and threatening "grievous injury" to young children is one of our interrogation methods:

"The President Knows More Than He Lets On", Spiegel Online: One hundred suspected terrorists from all over the world are still being held in secret American prisons. In an interview with Spiegel Online, CIA expert Ron Suskind accuses Washington of "running like a headless chicken" in its war against al-Qaida. He reserves special criticism for the CIA's torture methods, which he argues are unproductive.

Current Account Adjustments and Economic Growth

The San Francisco Fed looks at the likely consequences of a sudden reversal in the current account and concludes that should a "sudden stop" occur, the risks of substantial disruption are low:

What Are the Risks to the United States of a Current Account Reversal?, by Diego Valderrama, FRBSF Economic Letter: The U.S. current account has been in deficit since the beginning of the 1980s, except for a brief period in 1991, and has grown to 6.6% of gross domestic product (GDP) in the second quarter of 2006. The growing deficit has clearly caught the attention of policymakers and analysts. As Fed Chairman Bernanke put it in a speech he gave while a Governor of the Federal Reserve Board, "the current pattern of international capital flows—should it persist—could prove counterproductive" (Bernanke 2005).

The current account measures the difference between domestic income and expenditures, and it is the mirror image of the funding needed to finance this difference. With the deficit in the current account at historic highs, there is a perceived risk that it could quickly reverse (become less negative) if, for any reason, the United States should lose access to the financing that covers the income-expenditures gap. For example, this could happen as a result of a reduction in the demand for U.S. assets if foreign central governments diversified their reserves.

Economic theory does not offer a robust prediction as to how a current account reversal impacts economic growth, asset prices, or the exchange rate. Indeed, in the simplest models of open economies, countries can run very large current account deficits without much impact at all, as long as they reduce those deficits eventually by repaying old loans. However, other models predict that current account reversals can have a negative impact on economic output, asset prices, and the exchange rate (Mendoza 2006, Obstfeld and Rogoff 2005). Still other models predict that adjustments leading to strong exports and current account surpluses can boost income. Given the lack of a theoretical consensus, this Letter turns to the recent empirical literature to learn more about the potential risks to the U.S. economy of a possible current account reversal and about the factors that are associated with more disruptive corrections.

Vibrating Filaments of Imagination

Some science. Brian Greene defends string theory against charges that it is of little use because it fails to deliver testable implications:

The Universe on a String, by Brian Greene, Commentary, NY Times: ...Einstein's belief that he'd one day complete the unified theory rarely faltered. Even on his deathbed he scribbled equations in the desperate but fading hope that the theory would finally materialize. It didn't.

In the decades since, the urgency of finding a unified theory has only increased. Scientists have realized that without such a theory, critical questions can't be addressed, such as how the universe began or what lies at the heart of a black hole. These unresolved issues have inspired much progress, with the most recent advances coming from an approach called string theory. Lately, however, string theory has come in for considerable criticism. And so, this is an auspicious moment to reflect on the state of the art. ...

Fed Watch: Soft GDP Report Anticipated by The Fed

Tim Duy with a Fed Watch following today's disappointing report on real GDP growth:

Soft GDP Report Anticipated by The Fed, by Tim Duy: Brad DeLong responds to the headline GDP number with some hand wringing:

Gork!

The BEA says:

GDP (Third Quarter 2006 (advance)): 1.6% [per year]

The odds of the Fed's cutting interest rates soon just went up.

More to follow...

I like the title – I can imagine Brad saying “gork” while settling down with his morning coffee. Unsurprisingly, Nouriel Roubini finds occasion to gloat:

The first estimate of Q3 GDP growth is a dismal 1.6%, sharply lower than the 5.6% of Q1 and the 2.6% of Q2. In July - when I first predicted a US recession in 2007 - I forecasted that Q3 GDP growth would be 1.5% at the time when the market consensus was 3.1%.

Of course, Nouriel can’t help himself but to take the opportunity to double down on his bet that the US is headed toward a recession:

The first leading indicator of economic activity for October – the Philly, Richmond and Chicago Fed reports – are all consistent with a further economic slowdown in Q4 relative to Q3. I thus keep my forecast that Q4 growth will be between 0% and 1% and that the economy will enter into an outright recession by Q1 of 2007 or, at the latest, Q2.

But more on Nouriel later. The spectrum of economists was well represented in the Wall Street Journal ($$$). Pick the economist that best fits with your trading strategy:

[T]he markets are already split between [inflation] rebound or further softness in the fourth quarter. We expect the latter, triggering a Fed ease [of interest rates] in March. -- Ian Shepherdson, High Frequency Economics

or

[T]he Fed got the moderation in growth that it was expecting and hoping for … However, any expectations of Fed easing at this point would be very premature, in our judgment, as demand growth was fairly solid outside of housing and, partly fueled by real income gains from lower energy prices … we continue to expect the next move from the Fed to be a rate hike, but we see such a move as being data dependent and not occurring until the January/March timeframe. -- John Ryding, Bear Stearns

The latter is a good place for me to take over. This GDP report was anticipated by the Fed, and by adding an explicit forecast into Wednesday’s FOMC statement: “Going forward, the economy seems likely to expand at a moderate pace.” This was a deliberate effort to get ahead of the data, and stave off expectations of a rate cut. Did it work? Given the rally in bonds and the comments of DeLong and Shepherdson, I would say “not really.” Nor am I surprised. The Fed is fighting against history here, as Kash reminds us.

The Fed will not lose much sleep over this GDP report. Yes, the headline number is low. But the devil is in the details, and the Fed will be drawn toward three in particular. The first is the 3.1% gain in consumption spending – the wealth effect from a declining housing market has yet to hit consumers in earnest. The second is the 8.6% gain in fixed investment, and the revival of equipment and software spending to a 6.4% rate. Outside housing, investment spending is slowing, not collapsing. The third point is the import surge. Underlying domestic demand must be pretty strong; we can’t remotely satisfy our consumptive desires on domestic productive capacities.

The Fed will also be drawn to the deceleration in core inflation; core-PCE rose at 2.3% annual rate, down from the 2.7% rate in the second quarter. Still, inflation remains too high, and Fed officials will remain vigilant.

In short, the GDP report is consistent with the Fed’s view on the economy: A slowdown in the housing sector, with minimal spillover into other parts of the economy, and moderating inflation numbers. For the Fed, these are “stay the course” numbers (for some reason, I just can’t get that phrase out of my head).

But the third quarter is now behind us, sunk cost, history. We are already one month into the fourth quarter, which is where the real action will happen. First, will the wealth effect bite in consumers? Nouriel (of course), thinks so:

This weakness in residential and non-residential construction will directly affect retail activity where employment has already started to fall. Expect in Q4 and 2007 actual fall in durable consumption (autos, housing related consumption such as furniture and home appliances and other big ticket items) as the housing slowdown, the fall in home prices and the negative wealth effects of falling prices and reset of ARMs take a toll on consumption, especially housing-related durable one.

I suppose somebody has to be the anti-Nouriel, if only to maintain a “fair and balanced” blogsphere. Note that Nouriel cleverly covers his back by limiting his analysis to the volatile durable goods component, limiting his exposure on his claim that consumer spending is about to collapse. Recall from Nouriel’s take on the 2Q06 GDP report:

Real private consumption (that is 70% of aggregate demand) was growing only 2.5% in Q2, with durable goods consumption actually falling 0.5% led by lower purchases of cars and of goods related to housing: as housing slumps consumers are buying less furniture, home appliances, etc.. Expect even worse consumption growth in H2, as a further slumping housing sector, higher oil prices and high interest rates are seriously shaking saving-less, debt-ridden consumers whose real wages are falling.

So far, consumption growth is accelerating, not deteriorating in H2. Why aren’t households listening to Nouriel? Don’t they get it? On a basic psychological level, it is always good to touch base with Keynes:

For a man’s habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual habit; or, if he does adjust his expenditures to changes in his income, he will over short periods do so imperfectly.

This phrase is both underlined AND starred in my copy of The General Theory, so it must be important. It serves to remind me that consumer behavior changes slowly, especially on the downside. Once you are accustomed to a certain standard of living, you tend to resist downsizing. Hence why consumer spending rarely shifts as quickly as economists think it should.

Will 4Q be the turning point for consumers? Not so far, according to the early data. The University of Michigan reading on consumer sentiment jumped in October, telling me that consumers are happy. And only one thing makes consumers happy – SPENDING. Plus, they still have their jobs; initial unemployment claims continue to hover around 300k. Nothing to lose sleep about on that point. Moreover, real incomes are rising: according the GDP report, real disposable personal income stands 3.9% higher than 3Q05.

Oh, and oil prices fell.

Turning toward investment, I believe this is where you need to push to generate a recession. Specifically, business investment. Calculated Risk argues that declining residential investment will be followed by declining nonres fixed investment. This is the risk factor I am watching, but so far not seeing. Note that the pace of new orders for nondefence, nonaircraft capital goods accelerated through the second quarter, rising 0.6%, 0.8%, and 1.1% for July, August, and September (watch – October they will drop). Unfilled orders continue to grow as well.

Also, there is a reasonable chance that investment spending is held back by the delayed launch of Windows Vista. And note this from Bloomberg:

Norfolk Southern Corp., the fourth-largest U.S. railroad, boosted freight rates, helping third-quarter profit increase 38 percent. Sales rose 11 percent.

''Overall, we don't see any drastic slowing of the entire economy,'' Norfolk Southern Chief Executive Officer Charles ``Wick'' Moorman said in an interview. ``We think that pricing power will stay with us for a while.''

I pay attention to what the rail barons say – they generally have a good sense of economic activity.

Turning toward the jump in imports leads me to this bizarre claim:

The housing sector and the growing trade deficit were the main culprits … subtract[ing] from growth 1.1% and 1.3%, respectively. Confounding naysayers, consumers and business investment continued to stave off the recession that the housing adjustment and the tide of imports could easily cause. -- Peter Morici, University of Maryland

A “tide in imports” is almost certainly NOT going to cause a recession. Yes, yes, it contributes negatively to GDP, but only because we are buying more stuff than we can produce domestically. Rising imports must indicate strong demand. A positive contribution from imports – import compression – would be more consistent with weak economic conditions. For example, imports contributed positively to growth in 2001 and 2002. Has everyone forgotten that little party called the Asian financial crisis? Serious import compression. I suspect that crowded port conditions are pushing the Holiday import binge earlier into the year, and the seasonals have not quite caught up. If so, import growth will not be so strong in Q4.

All right, I have rattled off enough for one blog. I believe the risk of a hard landing is not insignificant, but recent data does not point in that direction. We are not seeing the hallmarks of a hard landing such as collapsing core durable goods orders, rising jobless claims, or plummeting consumer confidence. Without those signals, the Fed will stick to the soft landing story. Consequently, the Fed is not likely to view 3Q06 report as disastrous; they will view as in line with their expectations. Will those expectations be correct? Time will tell.

GDP Growth Slows in Third Quarter

Free Exchange from The Economist reviews today's release of GDP data showing third quarter real GDP growth falling to 1.6% (advance estimate) and discusses some of the political implications:

Big, bad news for Mr Bush, by Economist.com: It is hard to contemplate the new US GDP figures without a mental image forming of Republican campaign strategists rolling around on the ground, gripping their bellies and moaning "It hurts! It hurts!" Second quarter GDP growth was a lacklustre 2.6% (annualised)... This morning ... the news came that America's economy had disappointed again, growing by just 1.6% in the third quarter... There has been a tepid attempt to bring up the Dow's record levels, but this has fallen rather flat: the record isn't a record if you adjust for inflation, and anyway, the Dow isn't a very good proxy for economic health, or even investor confidence. It has only thirty companies in it, and these are weighted by cost rather than market capitalisation, which means that it is easily blown about by outsized movements in the prices of a few stocks. The S&P 500, which is much more representative, is still well below its 2000 peak.

In the New York Times on Tuesday, Eduardo Porter wrote This Time, it's Not the Economy:

President Bush, in hopes of winning credit for his party’s stewardship of the economy, is spending two days this week campaigning on the theme that the economy is purring. “No question that a strong economy is going to help our candidates,” Mr. Bush said in a CNBC interview yesterday, “primarily because they have got something to run on, they can say our economy’s good because I voted for tax relief.”

But Republican candidates do not seem to be getting any traction from the glowing economic statistics with midterm elections just two weeks away.

We'd suggest that this is because the statistics, like GDP, are not actually glowing; in fact, they're barely emitting enough light to check your watch by. Even fantastic headline numbers, like 4.6% unemployment, disguise weak wage growth and sagging labour force participation. Perhaps even more problematically for the Republicans, what growth there is isn't being felt by the average voter. Companies are increasing compensation--but they're spending it on benefits like health insurance, which doesn't feel the same as a wage increase even if you're one of the unlucky few who gets a $100,000 cancer treatment out of it. And income growth is concentrated among the wealthy, who are too few to swing an election.

Ironically, this last may be helping the Republicans, a little, by fuelling surging tax revenues. These have reduced his administration's projected budget deficits to roughly 2% of GDP, which is practically parsimonious by historical standards. That makes Mr Bush's tax cuts, eagerly supported by Republicans, look a lot more affordable. Though probably we won't hear Mr Bush, or any other Republicans, thanking rising income inequality in any of their stump speeches.

Update: Free Exchange has an update that tries to paint a rosier picture of the data based upon this (free) article on the GDP figures from The Economist. However, as noted, even if the current figures do provide some hope, and there is doubt about that, there is a "grimmer picture for the long-run."

Paul Krugman: The Arithmetic of Failure

Some unpleasant military arithmetic:

The Arithmetic of Failure, by Paul Krugman, Commentary, NY Times: Iraq is a lost cause. It’s just a matter of arithmetic: given the violence of the environment, with ethnic groups and rival militias at each other’s throats, American forces there are large enough to suffer terrible losses, but far too small to stabilize the country. ...

Afghanistan, on the other hand, is a war we haven’t yet lost, and it’s just possible that a new commitment of forces there might turn things around.

The moral is clear — we need to get out of Iraq, not because we want to cut and run, but because our continuing presence is doing nothing but wasting American lives. And if we do free up our forces ..., we might still be able to save Afghanistan.

The classic analysis of the arithmetic of insurgencies is a 1995 article by James T. Quinlivan, an analyst at the Rand Corporation. “Force Requirements in Stability Operations” ... looked at the number of troops that peacekeeping forces have historically needed to maintain order and cope with insurgencies.

Mr. Quinlivan’s comparisons suggested that ... in some cases it was possible to stabilize countries with between 4 and 10 troops per 1,000 inhabitants. But examples like the British campaign against communist guerrillas in Malaya and the fight against the Irish Republican Army in Northern Ireland indicated that ... a difficult environment could require about 20 troops per 1,000 inhabitants. The implication was clear: “Many countries are simply too big to be plausible candidates for stabilization by external forces,” Mr. Quinlivan wrote. ...

Iraq is a cauldron of violence, far worse than Malaya or Ulster ever was. And that means that stabilizing Iraq would require a force of at least 20 troops per 1,000 Iraqis — that is, 500,000 soldiers and marines.

We don’t have that kind of force. The combined strength of the U.S. Army and Marine Corps is less than 700,000 — and the combination of America’s other commitments plus the need to rotate units home for retraining means that only a fraction of those forces can be deployed for stability operations at any given time. Even maintaining the forces we now have deployed in Iraq ... is slowly breaking the Army.

Meanwhile, what about Afghanistan? ... If Afghanistan were in as bad shape as Iraq, stabilizing it would require at least 600,000 troops — an obvious impossibility.

However, things in Afghanistan aren’t yet as far gone as they are in Iraq, and it’s possible that a smaller force — one in that range of 4 to 10 per 1,000 ... — might be enough to stabilize the situation. But right now, the forces trying to stabilize Afghanistan are absurdly small: we’re trying to provide security to 30 million people with a force of only 32,000 Western troops and 77,000 Afghan national forces.

If we stopped trying to do the impossible in Iraq, ... we and the British ... might still do some good. But we have to do something soon: the commander of NATO forces in Afghanistan says that most of the population will switch its allegiance to a resurgent Taliban unless things get better by this time next year.

It’s hard to believe that the world’s only superpower is on the verge of losing not just one but two wars. But the arithmetic of stability operations suggests that unless we give up our futile efforts in Iraq, we’re on track to do just that.

_________________________
Previous (10/23) column: Paul Krugman: Don't Make Nice
Next (10/30) column: Paul Krugman: Bursting Bubble Blues

The *Real* Dow 12,000 Story

Daniel Gross on a new Republican talking point, "Dow 12,000":

How Now, Grown Dow?, by Daniel Gross, Slate: The Dow Jones industrial average first closed above 12,000 on Oct. 19, and has remained above that lofty benchmark ever since. ... Dow 12,000 quickly became a Republican talking point. ... Dick Cheney boasted that "we've got all-time record highs on the Dow Jones Industrials again today." ... White House flack Tony Fratto noted that "we're seeing record highs in some of the markets, and that tells us, and we think it tells Americans, that there is a great deal of confidence in our economic future."

So far, Republican candidates don't seem to be benefiting from the Dow record, which is less surprising than it seems. For starters, the Dow's success does not mean that stock-market investors in general are thriving, because the Dow does not well represent the whole market. The Dow has a long and distinguished history... But as an overall stock-market proxy and investment tool, it's an also-ran. The ... index only accounts for less than one-quarter of the market. And because of its weighting system, the performance of a few stocks can have a disproportionate impact. ...

The S&P 500, whose constituents represent 80 percent of the overall market, is a much more accurate gauge of general market performance. ... And when you look at the S&P 500, it's clear that the stock-market recovery is not as broad as the Republicans would like you to think. Though it has recovered substantially from its 2002 low, the index is still off nearly 10 percent from its 2000 peak. As for the tech-heavy Nasdaq 100, ... it would have to nearly triple in order to set a record high. So, the claim that "the stock market" is at an all-time high simply doesn't match most investors' experiences.

What's more, 12,000 doesn't really even represent a record high for the Dow. In absolute numbers, the Dow is higher than ever. But.... In real terms, the Dow is still nowhere near the peak it hit several years ago. ...

[S]ome of those who are trumpeting the high nominal value of the stock market are urging people to focus on the real, inflation-adjusted value of another asset that has been at record highs recently. Take a gander at George Will's absurd column last week. ... Will celebrates the record nominal high in stock prices but urges readers to focus on the real price of oil. By mixing and matching real and nominal, Will could just as easily have argued that oil is more expensive than it has ever been, while the Dow is barely at the level it reached in 1999. If Democrats controlled the levers of power, he'd be making precisely that argument.

The distinction between the performance of the Dow and that of the other market indices is a perfect metaphor for the economy under Bush. Assume the stock market represents America. The Dow components—the tiny minority of the richest—are putting up record numbers, while the masses are struggling to do as well as they did in the late 1990s.

International Capital Flows and U.S. Interest Rates

What affect, if any, do international capital flows have on long-term interest rates within the U.S.?:

International Capital Flows Alter U.S. Interest Rates, by Les Picker, NBER Digest: There is a burgeoning literature on the impact of international capital flows on emerging market economies. ... In contrast, much less is known about the impact of capital flows on the larger economies of the world. ...[U]ntil recently, many market participants held the view that capital flows could not possibly affect interest rates in the United States.

In International Capital Flows and U.S. Interest Rates (NBER Working Paper No. 12560), authors Francis Warnock and Veronica Warnock ... ascertain the extent to which foreign flows into U.S. government bond markets can help to explain movements in long-term Treasury yields.

The authors address this issue at an important time. ... Over the course of 2004, the Federal Reserve began a well advertised tightening that raised short rates while economic growth strengthened and inflation picked up. Many market observers predicted an increase in long-term U.S. interest rates that would result in substantial losses on bond positions. However, long-term interest rates remained quite low, puzzling market participants, financial economists, and policymakers.

The authors find that foreign flows have an economically large and statistically significant impact on long-term U.S. interest rates. Their work also suggests that large foreign purchases of U.S. government bonds have contributed importantly to the low levels of U.S. interest rates observed over the past few years. In the hypothetical case of zero foreign accumulation of U.S. government bonds over the course of an entire year, long rates would be almost 100 basis points higher. Were foreigners to reverse their flows and sell U.S. bonds in similar magnitudes, the estimated impact would be doubled. Further analysis indicates that roughly two-thirds of the impact comes directly from East Asian sources. In addition, some of the foreign flows owe to the recycling of petrodollars, suggesting a mitigating factor that might be reducing some of the bite of higher oil prices. ...

"Twin Deficits, Twenty Years Later"

A new paper from the New York Fed looks at the twin deficits debate. Here's the introduction explaining the debate, part of the conclusion, and a link to the paper:

Twin Deficits, Twenty Years Later, by Leonardo Bartolini and Amartya Lahiri, Current Issues in Economics and Finance, October 2006  Volume 12, Number 7: In recent years, the twin-deficit hypothesis—the argument that fiscal deficits fuel current account deficits—has returned to the forefront of the policy debate. The argument first emerged in the 1980s, when a significant deterioration in the U.S. current account balance accompanied a sharp rise in the federal budget deficit. Now, with the U.S. current account and fiscal balances plunging by 3 and 4 percent of GDP, respectively, from 2001 to 2005, the view that the two deficits might be closely linked has attracted new interest. Changes in U.S. fiscal policy have also been viewed as playing a key role in widening the nation’s current account deficit since the turn of the millennium and thus in determining whether global current accounts will be rebalanced over the next decade.

According to the twin-deficit hypothesis, when a government increases its fiscal deficit—for instance, by cutting taxes—domestic residents use some of the income windfall to boost consumption, causing total national (private and public) saving to decline. The decline in saving requires the country either to borrow from abroad or reduce its foreign lending, unless domestic investment decreases enough to offset the saving shortfall. Thus, a wider fiscal deficit typically should be accompanied by a wider current account deficit.

Casual observation suggests that the twin-deficit hypothesis accurately captures the U.S. experience in the 1980s and the first years of the new century. However, the hypothesis does not explain the U.S. record of the late 1990s, when a substantial current account deficit coexisted with a federal budget surplus. Nor does it accord with Japan’s experience during the 1990s, or the experience of many other countries undergoing sharp swings in fiscal policy over the past two decades. Many empirical studies have also failed to find a strong relationship between fiscal and current account deficits, perhaps because they have used data on a very limited number of countries or have focused on periods that were too short to yield reliable evidence in a variety of environments and over time.

This edition of Current Issues contributes to the debate on the twin-deficit hypothesis by analyzing the link between fiscal and current account deficits across a larger sample of countries and over a longer period than examined in earlier studies. Reviewing the international record over the past thirty years, we revisit both key components of the twin-deficit hypothesis: the relationship between fiscal policy and private saving, and the response of current account balances to fiscal policy changes. Our findings confirm the broad wisdom that private saving indeed tends to decline when fiscal policy loosens. However, this response may have weakened over time. Saving now tends to fall by about 35 cents in response to each extra dollar of fiscal deficit, down from the decline of 40 to 50 cents that researchers have reported for earlier periods. In addition, much of the decrease in national saving is matched by a drop in the current account, whose deficit rises by 30 cents for each extra dollar of fiscal deficit.

These results offer some support for the twin-deficit view. They suggest, however, that the effects of fiscal policy on saving and the current account balance are too weak for deficit reductions in the United States to play a central role in correcting the nation’s current account imbalance with the rest of the world.

...

Conclusion ...Our estimates suggest that even if the federal fiscal deficit—currently about 2 percent of GDP—were fully erased, the nation’s current account deficit would improve by only a fraction of its current 7 percent of GDP. For example, if the U.S. current account continues to respond to fiscal changes as it has, on average, in our sample of OECD countries—by 30 cents on the dollar—a full elimination of the federal fiscal deficit would improve the U.S. current account by only 0.6 percent of GDP, or less than one-tenth of its current level. While these calculations are based on historical correlations that could break down if circumstances change in unexpected ways, they are nonetheless suggestive of the likely magnitude of the effects at work.

Preventive Care, Patient Dumping, and Universal Health Coverage

A few hospitals are starting to recognize that offering free preventive care to some uninsured patients is cost effective because it avoids much higher costs later on. Others hospitals are, apparently, pursuing a different strategy to avoid the cost of caring for the uninsured:

Hospitals Try Free Basic Care for Uninsured, by Erik Eckholm, NY Times: Unable to afford health insurance, Dee Dee Dodd had for years been mixing occasional doctor visits with clumsy efforts to self-manage her insulin-dependent diabetes, getting sicker all the while.

In one 18-month period, Ms. Dodd, 38, was rushed almost monthly to the emergency room, spent weeks in the intensive care unit and accumulated more than $191,000 in unpaid bills. That is when nurses ... tagged her as a ... repeat visitor whose ailments — and expenses — might be curbed with more regular care. The hospital began offering her free primary care through its charity program.

With the number of uninsured people in the United States reaching a record 46.6 million last year, ... Seton is one of a small number of hospital systems around the country to have done the math and acted on it. Officials decided that for many patients with chronic diseases, it would be cheaper to provide free preventive care than to absorb the high cost of repeated emergencies. ... Over the last 18 months, Ms. Dodd’s health has improved, and her medical bills have been cut nearly in half.

Reaching out to uninsured patients, especially those with chronic conditions like diabetes, hypertension, congestive heart failure or asthma, is a recent tactic... These institutions are searching for ways to fend off disease and large debts by bringing uninsured visitors into continuing basic care. ...

Still, only a fraction of the uninsured ... are benefiting. “All these local efforts are commendable, but they are like sticking fingers in the dikes,” Ms. Davis of the Commonwealth Fund said, noting that the larger trend was hospitals’ seeking to avoid the uninsured. ...

Universal care is a solution to this problem and it would also save all the money and effort that is wasted "seeking to avoid the uninsured" by handing them off to someone else:

Police allege 5 patients were dumped on skid row by hospital, by Richard Winton and Cara Mia DiMassa, LA Times: The LAPD says it has opened its first criminal investigation into the dumping of homeless people on skid row after documenting five cases in which ambulances dropped off patients there... Police said the patients, who had been discharged from a Los Angeles hospital, told them they did not want to be taken downtown. ...

Though police have documented other cases of hospitals dropping off recently discharged patients in the district, "this is the most blatant effort yet by a hospital to dump their patients on skid row against their will," LAPD Capt. Andrew Smith said. ... Police said they were investigating whether the patients were falsely imprisoned during their transfer and also whether the hospital violated any laws regarding the treatment of patients. ...

[T]he city attorney is looking at whether hospitals that engage in dumping could be penalized for violating the federal Emergency Medical Transfer and Active Labor Act, which requires medical facilities to screen and stabilize all patients and penalizes them for releasing or transferring patients who are medically unstable.

The city attorney also is examining whether hospitals that dump homeless patients can be cited for violating a state law that deals with unfair business practices...

Happiness Is Not the Same As Welfare

Robert Frank says to be careful not to confuse happiness, which is relatively invariant to growth in the economy, and human welfare which increases as the economy grows:

Prospering May Not Make People Happier, but It May Make Them Healthier, by Robert H. Frank, Economic Scene, NY Times: ...The rapidly expanding literature on ... “subjective well-being” appears to suggest ... that when the incomes of everyone in a community grow over time, conventional measures of well-being show little change.

Many critics of economic growth interpret this finding to imply that continued economic growth should no longer be a policy goal in developed countries. They argue that ... it is relative, not absolute, income that matters. As incomes grow, people quickly adapt to their new circumstances, showing no enduring gains in measured happiness. Growth makes the poor happier in low-income countries, critics concede, but not in developed countries...

All true. But these statements do not imply that economic growth no longer matters in wealthy countries. The reason, in a nutshell, is that happiness and welfare, though related, are very different things. Growth enables us to expand medical research and other activities that clearly enhance human welfare but have little effect on measured happiness levels.

Debating CEO Pay

A recap of recent debate and commentary on CEO pay:

First, there was Incentives for the Dead (Krugman) on executive stock options followed by the response Mixed Reviews for Krugman Today (Samwick). This was followed in turn by Power, Changing Social Norms, and CEO Pay (Thoma) and CEO Compensation (DeLong).

This led to an email exchange. First Andrew Samwick asks:

I liked your post on power and social norms affecting CEO pay. You are right--norms have changed. I have as of late been thinking more about how consequential norms are in relation to incentives, and in some cases, how cheap to implement.

I couldn't tell from the link to my post whether you were disagreeing with my statement about average pay:

Apart from the (relatively minor) increase in expected compensation that must compensate the added risk exposure imposed by the pay-performance sensitivity, there is no justification presented for higher levels of pay unless the incentives work, the value of the firm rises, and the CEO's compensation rises via that pay-performance sensitivity.

I think this is consistent with what you quoted from the HBR article. Am I missing something?

To which I responded:

Good to hear from you. My interpretation is that the authors are saying that the level of pay was too low both because they weren't adequately compensated for risk and because of the "uninvited but influential guests at the managerial bargaining table." Thus, when these pressures were alleviated, compensation rose by more than a simple risk premium adjustment would imply.

The other factor is that even if you accept that wages were lower by only the risk premium component (and I still need to be convinced), that does not mean that that subsequent increases justified by the risk compensation argument were limited to this amount. Once the barn door was opened by the argument, given the problems with executive compensation committees, etc., compensation rose by more than the risk premium argument would suggest.

Andrew replies:

Thanks for your e-mail. I don't think we're disagreeing much--see my next post on this with respect to Brad's post. Based on your e-mail, I think we still disagree on the extent to which we believe that the recent history of option grants to senior management can be attributed to anything Jensen & Murphy wrote or would endorse.

And he ends with this response to DeLong: More on Executive Compensation (Samwick).

Fed Watch: Staying the Course

Tim Duy reviews today's rate decision:

Staying the Course, by Tim Duy: The FOMC delivered no big surprises at the conclusion of today’s FOMC meeting; policy is held constant with a bias toward further tightening. Fears of additional hawkishness proved to be unfounded. And Richmond Fed President Jeffery Lacker continues to dissent, uncomfortable with Chairman Ben Bernanke’s willingness to let core inflation ease slowly back below 2%. Lacker is concerned that the longer inflation is high, the more likely it becomes that inflation expectations will creep up to match. Not an unreasonable position, but one that is out of line with the rest of the FOMC.

Two changes in the statement caught my eye. The first was the return to an explicit forecast: “Going forward, the economy seems likely to expand at a moderate pace.” “Moderate” is code for “soft landing.” With resource utilization at a high level, moderate growth implies only a gradual easing of inflation. Without more a more rapid deceleration in underlying economic activity, expect rates to be on hold for a time. The Fed does.

The second change was to eliminate energy as both a cause of inflationary pressures and a reason to believe inflation would moderate. I criticized the last statement on this point. My criticism, however, likely did not sway the FOMC to drop energy as an inflationary factor. What did sway Bernanke & Co. is the obvious drop in retail gasoline prices, not to mention lower oil and natural gas prices. Watch oil – prices drops have disappointed in the past.

I expect the Fed to be on hold in December as well. The next opening for a policy change is in January. By that time we will have an idea if growth reaccelerated in Q4. Higher consumer confidence and lower gas price suggest a solid start to the quarter. Can it last in the face of an ongoing housing slowdown?

Fed Leaves Target Rate Unchanged at 5.25%

The Federal Open Market Committee voted today to keep the target federal funds rate at 5.25%. The key differences between today's Press Release and the Press Release from the previous meeting are:

The Rise and Fall of the Managerial Class

Robert Samuelson on the rise and fall of the managerial class:

The Next Capitalism, by Robert Samuelson, Newsweek [WP]: When he died in 1848, John Jacob Astor was America's richest man, leaving a fortune of $20 million that had been earned mainly from real estate and fur trading. Despite his riches, Astor's business was mainly a one-man show. He employed only a handful of workers, most of them clerks. This was typical of his time, when the farmer, the craftsman, the small partnership and the independent merchant ruled the economy. Only 50 years later, almost everything had changed. Giant industrial enterprises -- making steel, producing oil, refining sugar and much more -- had come to dominate.

The rise of big business is one of the seminal events in American history, and if you want to think about it intelligently, you consult historian Alfred D. Chandler Jr., its pre-eminent chronicler. ...

Until Chandler, the emergence of big business was all about titans. The Rockefellers, Carnegies and Fords were either "robber barons'' whose greed and ruthlessness allowed them to smother competitors and establish monopolistic empires. Or they were "captains of industry'' whose genius and ambition laid the industrial foundations for modern prosperity. But ... Chandler ... uncovered a more subtle story. New technologies (the railroad, telegraph and steam power) favored the creation of massive businesses that needed -- and, in turn, gave rise to -- superstructures of professional managers: engineers, accountants and supervisors.

It began with railroads. In 1830, getting from New York to Chicago took three weeks. By 1857, the trip was three days (and we think the Internet is a big deal). From 1850 to 1900, track mileage went from 9,000 to 200,000. But railroads required a vast administrative apparatus to ensure the maintenance of "locomotives, rolling stock, and track'' -- not to mention scheduling trains, billing and construction...

Elsewhere, the story was similar. ... No matter how efficient a plant might be, it would be hugely wasteful if raw materials did not arrive on time or if the output couldn't be quickly distributed and sold. Managers were essential; so were statistical controls. Coordination and organization mattered. Companies that surmounted these problems succeeded. ... The rise of big business involved more than tycoons. Its central feature was actually the creation of professional managers. ...

The trouble now is that the defining characteristics of Chandler's successful firms have changed. ... We can ... identify many of the forces reshaping business: new technologies, globalization and modern finance... But the very multitude of trends and pressures is precisely the problem. No one has yet synthesized them and given them larger meaning.

Just as John Jacob Astor defined a distinct stage of capitalism, we may now be at the end of what Chandler perceptively called "managerial capitalism.'' Managers, of course, won't disappear. But the new opportunities and pressures on them and their companies may have altered the way the system operates. ... Asked about how the corporation might evolve, [Chandler] confesses ignorance: "All I know is that the ... Internet is transforming the world.'' To fill that void, someone must do for capitalism's next stage what Chandler did for the last.

Though it's mentioned, I don't think this pays enough attention to the role of information technology in reducing the need for middle management and white collar workers. Much of what these workers did in the past to track financial information, manage inventory and raw materials, plan distribution and sales strategies, and so on can now be done with a few mouse clicks on a computer or, alternatively, digitally outsourced for cheaper processing elsewhere.

This is not fundamentally different from any other sort of productivity shock, workers get displaced by new technology regularly, except that in recent years there are more white collars in the mix of workers affected by the technological innovation, a trend that may continue as information technology continues to advance. The question is where these displaced workers (or those who would have replaced them in future years) end up after the transition. Will these workers be able to transform their skills and move up to higher paying occupations or at least maintain their current income, or will the displaced current and future workers mostly move down to lower skill, lower paying jobs?

Given the outcome so far, we need to devote more attention to finding policies that can help workers receive a larger share of the productivity gains as we move to an increasingly information-based, geographically fractured, low-skill abundant, highly specialized, and highly competitive global economy. I'm not sure what fancy name to give "the next capitalism" or if it really needs one, but if growing inequality continues to be one of its main features, calling it "the new gilded age" as many do already might just stick.

Shiller: The Rising Wealth of Nations

Robert Shiller has an optimistic outlook for worldwide GDP growth in coming decades:

The rising wealth of nations, by Robert J. Shiller, Project Syndicate: The new Penn World Table, Version 6.2, comparing standards of living across countries, has just been released. The ... numbers are valuable because they are of exceptional quality and they correct systematically for relative price differences across countries, which sometimes leads to surprising results.

Among the 82 countries for which 2004 data are now available, there is good news: Real per capita gross domestic product rose by an average of 18.9 percent between 2000 and 2004, or 4.4 percent per year. ... At that rate, real per capita GDP will double every 16 years. ...

One surprise is that there was relatively little change in the ranking of countries by real per capita GDP after 2000. Despite all the talk about the Chinese economic miracle, China's ranking rose only slightly, from 61st (out of 82 countries in 2000) to 60th in 2004 -- even though per capita real GDP grew by ... 9.6 percent a year, the highest of the major countries.

Fed Watch: Reappearing After a Long Absence

Tim Duy has a Fed Watch in anticipation of tomorrow's rate decision from the FOMC:

Reappearing After a Long Absence, by Tim Duy: I have been missing in action for the past few weeks, neglecting Fed watching as I pushed forward other personal and professional commitments. Moreover, as I alluded to the last time I wrote, events were unfolding in such a way that I had little too add. Bond market bulls were pushing yields to remarkably low levels on the back of “the Fed is about to ease” story. I found that story untenable then, but experience has taught me that sometimes it is better to stand aside than get in the way of a charging pack of bulls – or bears for that matter.

But I have been looking for a time to jump back into the water, and the start of the FOMC’s two day meeting is as good an opportunity as any.  Especially now that yields have rebounded, and expectations of a rate cut have been pushed out deeper into 2007. Of course, the outcome of this meeting is something of a foregone conclusion, with the Fed comfortable to sit on the sidelines for the time being. Incoming data still point to a slowdown in overall economic activity, but inflation remains well above any reasonable comfort level. As a group, the Fed still bets that the combination of slowing activity and moderating energy costs will be enough to bring core inflation down, albeit gradually.

I find myself pulled in the same direction as William Polley and David Altig regarding the odds of a soft landing – it appears that the housing and auto slowdowns are mostly sector specific event at this point. I find David’s comments interesting:

In my line of business I have the opportunity to hear from a lot of people who are, as they say, close to the ground -- folks actually making stuff, hiring people, extending loans, putting together deals. My thoroughly unscientific sense is that the distribution of beliefs out there suggests things are more likely to get better than get worse.

This is consistent with my recent experiences as well – more complaints about lack of labor than anything else. Of course, it is reasonable to respond that the housing slowdown hasn’t had time to filter through the rest of the economy just yet. In any event, I noticed a similar theme in the minutes from the September FOMC meeting:

Although some survey evidence suggested that some firms were trimming capital spending plans, participants reported that their business contacts generally were quite positive about the economic outlook and the strength of demand for their products.

Moreover, I am challenged to accept the hard landing story with initial unemployment claims still hovering near 300k and consumer confidence bouncing back, at least as reported in the UMich preliminary numbers. Note also the rebound in commodity prices reported many places, including econbrowser. Will oil be far behind?

Regarding the outcome of this meeting, I think we are all looking to the statement for some guidance – I anticipate something very similar to the last statement (the one I wasn’t particularly happy with at the time). I cannot see that they are eager to pull back from the inflation fears; recent numbers just don’t support that move yet. No, I anticipate that the asymmetric bias will remain in place. I am very interested to see if Richmond Fed President Jeffery Lacker dissents for a third consecutive meeting.  I don’t see what would have changed his mind in the past few weeks, but the lack of a dissent would be interpreted by market participants as putting a rate cut in the near term back in play. They don’t want to send that message. I expect the message they want to send is “With inflation rate uncomfortably high, rates will be held steady for the foreseeable future, barring a clear, sharp deceleration in economic activity. For now, our foot continues to hover over the break, not the gas.”

Is Housing a Good Speculative Investment?

James Surowiecki says to be careful as you watch the housing market, particularly if you have entered the market speculatively - the swing in posted prices that you see may not fully accurately reflect changes in actual housing prices and there are questions about the long-term real returns in this market:

Safe as Houses?, by James Surowiecki, The New Yorker: In the past few months, it’s been almost all bad news for the housing market. ... Yet, through it all, one fact has continued to provide solace to anxious homeowners and real-estate brokers alike: housing prices have stayed remarkably stable.

The lesson we’re supposed to take from this is that a home remains as solid and safe an investment as ever. After all, we’re constantly told, you have to go back to the Great Depression to find a full year in which housing prices fell. Unfortunately, the numbers upon which these comforting conclusions depend—namely, median home prices for the country—are unreliable and misleading.

Positive or Negative?

Robert Reich disagrees with Paul Krugman's message in his column "Don't Make Nice":

What the Dems Must Do When They Regain Control, by Robert Reich: Assuming they win, should House Dems (and maybe Senate Dems as well, if they take control there) focus on exposing the malfeasance of the Bush Administration – who knew what and when with regard to WMD, torture, Katrina, payoffs to Abramoff, and all the other rot – OR focus on how to turn the country around?

Anyone who say Dems can do both is living on another planet. A fundamental strategic choice lies ahead: Either expose Bush or build the new agenda. Either will require a huge effort to marshal facts and focus public attention. Either will necessitate extensive public hearings and a concerted media strategy. Either will be competing with a cacophony of campaign personalities, more bad news from Iraq, and a likely slowing of the economy.

If both are tried simultaneously, the media will focus on the more sensational – which will be dirt on the Bushies. Kiss the new agenda goodbye.

But there’s no point digging up more dirt. Bush isn’t running again. John McCain, the Republican’s most likely choice for president, has nicely distanced himself from the White House. He wouldn’t be tarnished.

Besides, the public and the media already know much of what’s gone wrong – and they’re already suffering from outrage fatigue. And the Dems wouldn’t be credible, anyway. It will be easy for Republicans to dismiss their efforts as more of the same old partisan bickering.

The fact is, the public is sick and tired of mud-slinging. That’s one reason it holds Congress in such low esteem.

But the Dems do need the public to know they have real answers for some of the nation’s most pressing problems. It’s crucial to use the next two years to establish credible ideas for what the nation can and must do in future years – provide affordable health insurance, spread the benefits of economic growth, partition Iraq and get out, stop nuclear proliferation, prevent a nuclear bomb from falling into the hands of terrorists, and control global warming.

Either go negative or go positive -- that’s the Dem’s inevitable choice. Going negative would be easy but also futile. The nation needs a positive agenda that only the Dems can deliver.

I must be living on another planet. I think it's possible to do both should Democrats take control -- to deliver a positive agenda but still fully investigate "the origins of the Iraq war and the cronyism and corruption that undermined it." The press will focus on war related issues in any case and it's not clear how much Democrats can get done with the expected (and even hoped for by many) gridlock over the next two years, so Democrats won't be able to do much beyond using "the next two years to establish credible ideas." Standing up to the past and upholding their core principles rather than "cutting and running" from any investigation may be the means through which Democrats gain the strength and power to implement the positive agenda they've established and want to put into place.

Which Party is Good for the Stock Market?

With the elections approaching, the White House is trumpeting and taking credit for the news that:

The Dow Set Record Highs On Three Consecutive Days This Week

Setting aside the confusion between real and nominal stock prices inherent in this statement from the White House web site, are Republican administrations good for the stock market? Let's check in with Hal Varian in a column from 2003:

Which Party in the White House Means Good Times for Investors?, by Hal Varian, Economic Scene, NY Times, November, 2003: Does the stock market do better when a Republican is president or when a Democrat is?

The answer is: It's not even close. The stock market does far better under Democrats.

This perhaps surprising finding is examined by two finance professors at the University of California at Los Angeles, Pedro Santa-Clara and Rossen Valkanov, in an article titled "Political Cycles and the Stock Market," published in the October issue of The Journal of Finance.

Professors Santa-Clara and Valkanov look at the excess market return - the difference between a broad index of stock prices (basically the Standard & Poor's 500-stock index) and the three-month Treasury bill rate - between 1927 and 1998. The excess return measures how attractive stock investments are compared with completely safe investments like short-term T-bills.

Using this measure, they find that during those 72 years the stock market returned about 11 percent more a year under Democratic presidents and 2 percent more under Republicans - a striking difference. [chart]

Forecasting House Seats

Is Democratic control of the House a near certainty?:

Forecasting House Seats from Generic Congressional Polls, by Andrew Gelman: My colleagues Joe Bafumi, Bob Erikson, and Christopher Wlezian just completed their statistical analysis of seat and vote swings. They write:

Via computer simulation based on statistical analysis of historical data, we show how generic vote polls can be used to forecast the election outcome. We convert the results of generic vote polls into a projection of the actual national vote for Congress and ultimately into the partisan division of seats in the House of Representatives. Our model allows both a point forecast—our expectation of the seat division between Republicans and Democrats—and an estimate of the probability of partisan control. Based on current generic ballot polls, we forecast an expected Democratic gain of 32 seats with Democratic control (a gain of 18 seats or more) a near certainty.

...Here's the full paper. Compared to our paper on the topic, the paper by Bafumi et al. goes further by predicting the average district vote from the polls... The only criticism I'd make of this paper is that they might be understating the uncertainty in the seats-votes curve (that is, the mapping from votes to seats). ... I like this paper... It goes beyond what we did, and all of this is certainly a big step beyond the usual approach of just taking the polls, not knowing what to do with them, and giving up!

I want to believe . . . .

Power, Changing Social Norms, and CEO Pay

In Paul Krugman's recent column on stock options (Incentives for the Dead), he cited a 1990 paper by Jensen and Murphy as one of the reasons CEO compensation committees began offering stock options to CEOs. The idea in Jensen and Murphy is that if the pay of CEOs does not rise and fall sufficiently with company fortunes, then CEOs will have little incentive to manage the companies efficiently. Linking pay to performance through stock options and other means was intended to overcome this problem. As Krugman says:

They argued that a chief executive who expects to receive the same salary if his company is highly profitable that he will receive if it just muddles along won’t be willing to take risks and make hard decisions. “Corporate America,” declared an influential 1990 article by Michael Jensen of the Harvard Business School and Kevin Murphy of the University of Southern California, “pays its most important leaders like bureaucrats. Is it any wonder then that so many C.E.O.’s act like bureaucrats?”

The claim, then, was that executives had to be given more of a stake in their companies’ success. And so corporate boards began giving C.E.O.’s lots of stock options...

Of course, the stock option scandal is partly about the "bait and switch" that occurred - selling stock options as though they are linked to performance and therefore provide the right incentives to CEOs, then backdating the stock options to ensure that they paid off even if the company didn't perform especially well.

Krugman didn't mention it in his column, but the paper is worth reading for another reason, its explanation of why executives weren't given sufficient incentives. Jensen and Murphy say the reason was political pressure and social norms which prevented companies from paying executives as much as they should:

CEO Incentives—It's Not How Much You Pay, But How, by Michael C. Jensen and Kevin J. Murphy, Harvard Business Review: ...The arrival of spring means yet another round in the national debate over executive compensation. ... Political figures, union leaders, and consumer activists will issue now-familiar denunciations of executive salaries and urge that directors curb top-level pay in the interests of social equity and statesmanship. The critics have it wrong. There are serious problems with CEO compensation, but “excessive” pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem—how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance. ... Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets? ...

Compensation policy is one of the most important factors in an organization’s success. ... This is what makes the vocal protests over CEO pay so damaging. By aiming their protests at compensation levels, uninvited but influential guests at the managerial bargaining table (the business press, labor unions, political figures) intimidate board members and constrain the types of contracts that are written between managers and shareholders. As a result of public pressure, directors become reluctant to reward CEOs with substantial (and therefore highly visible) financial gains for superior performance. ... Are we arguing that CEOs are underpaid? If by this we mean “Would average levels of CEO pay be higher if the relation between pay and performance were stronger?” the answer is yes.

The point, then, is this: Those of us who say that the increase in inequality has a lot to do with power and changing norms are ridiculed - but back when people were arguing for a big increase in corporate pay (and they did say that their proposed changes would increase the average level of pay), it was considered perfectly sensible to say that power and norms were keeping CEO pay down.

Sachs: Stresses on the Physical Environment Threaten Security

Jeffrey Sachs says we are ignoring, to our detriment and future peril, the "unprecedented stresses on the physical environment" such as water shortages which are "becoming a major obstacle to economic development in many parts of the world" and a source of military conflict:

Water strategy over military strategy, by Jeffrey Sachs, Project Syndicate: ...Global economic growth and risiang populations are putting unprecedented stresses on the physical environment, and these stresses in turn are causing unprecedented challenges for our societies. Yet politicians are largely ignorant of these trends. Governments are not organized to meet them and crises that are fundamentally ecological in nature are managed by outdated strategies of war and diplomacy.

Paul Krugman: Don't Make Nice

Paul Krugman tells Democrats that, should they gain power in the upcoming election, it would be a mistake to give into calls for reconciliation and bipartisanship since that will not end the divisiveness that plagues the political process. Instead, Democrats need to stand strongly against any compromises to their core principles and values and fully investigate "the origins of the Iraq war and the cronyism and corruption that undermined it":

Don’t Make Nice, by Paul Krugman, If They Win..., Commentary, NY Times: Now that the Democrats are strongly favored to capture at least one house of Congress, they’re getting a lot of unsolicited advice, with many people urging them to walk and talk softly if they win.

I hope the Democrats don’t follow this advice — because it’s bad for their party and, more important, bad for the country. In the long run, it’s even bad for the cause of bipartisanship.

There are those who say that a confrontational stance will backfire politically on the Democrats. These are by and large the same people who told Democrats that attacking the Bush administration over Iraq would backfire in the midterm elections. Enough said.

Political considerations aside, American voters deserve to have their views represented in Congress. And according to opinion polls, ... the public wants politicians to stand up to corporate interests. ...[T]he latest Newsweek poll ... shows overwhelming public support for the agenda Nancy Pelosi has ... if she becomes House speaker. The strongest support is for her plan to have Medicare negotiate with drug companies for lower prices, which is supported by 74 percent of Americans — and by 70 percent of Republicans!

What the make-nice crowd wants most of all is for the Democrats to forswear any investigations into the origins of the Iraq war and the cronyism and corruption that undermined it. But it’s very much in the national interest to find out what led to the greatest strategic blunder in American history, so that it won’t happen again.

What’s more, the public wants to know. ...[A]ccording to the Newsweek poll, 58 percent of Americans believe that investigating contracting in Iraq isn’t just a good idea, but a high priority; 52 percent believe the same about investigating the origins of the war.

Why, then, should the Democrats hold back? Because, we’re told, the country needs less divisiveness. And I, too, would like to see a return to kinder, gentler politics. But that’s not something Democrats can achieve with a group hug and a chorus of “Kumbaya.” ...

As long as polarization is integral to the G.O.P.’s strategy, Democrats can’t do much, if anything, to narrow the partisan divide. Even if they try to act in a bipartisan fashion, their opponents will find a way to divide the nation — which is what happened to the great surge of national unity after 9/11. One thing we might learn from investigations is the extent to which the Iraq war itself was motivated by the desire to have another wedge issue.

There are those who believe that the partisan gap can be bridged if the Democrats nominate an attractive presidential candidate who speaks in uplifting generalities. But they must have been living under a rock these past 15 or so years. Whoever the Democrats nominate will feel the full force of the Republican slime machine...

The truth is that we won’t get a return to bipartisanship until or unless the G.O.P. decides that polarization doesn’t work as a political strategy. The last great era of bipartisanship began after the 1948 election, when Republicans, shocked by Harry Truman’s victory, decided to stop trying to undo the New Deal. And that example suggests that the best thing the Democrats can do, not just for their party and their country, but for the cause of bipartisanship, is what Truman did: stand up strongly for their principles.

_________________________
Previous (10/20) column: Paul Krugman: Incentives for the Dead
Next (10/27) column: Paul Krugman: The Arithmetic of Failure

"On the Road with the Taleban"

This report on the situation in Afghanistan is from the BBC News. It's not encouraging. From an economic standpoint, corruption is a major problem:

On the road with the Taleban, by David Loyn BBC News: NATO troops in Afghanistan have been facing a growing number of suicide bomb attacks. It was hoped the troops would be able to make peace, win friends and provide security for reconstruction projects, but now it seems the regime they removed is beginning to return.

"You destroyed our government and all because of just one guest in our country, Osama," said the man leading the war against the British. We sat late at night in what must have been the women's side of a house commandeered for just that night by a man who stays constantly on the move. ... Taleban soldiers ... filled the room ... as we talked.

Declining Family Value

Starting a family is riskier than it used to be. Increasingly, rather than providing insurance against economic difficulties, the family is the source of the problems. As Jacob Hacker says in this commentary from the Los Angeles Times, "The family used to be a refuge from risk. Today, it is the epicenter of risk. And, increasingly, families are a source of risk as well":

Till Debt Do Us Part?, by Jacob S. Hacker, Commentary, LA Times: ...It may seem unromantic, but marriage has always been a vital economic institution as well as a social one. A marriage is, among many things, a contract to secure the welfare of an economic unit that, in most cases, includes children. The tale of the last generation is how the value of that contract has declined, while its costs and risks have increased — and how the vaunted nuclear family has suffered as a result.

Consider personal bankruptcy... In 2001, married people with kids were twice as likely to file for bankruptcy as single adults or childless couples. ... Families also were more likely to lose their homes than were married couples without children or than single adults — during an era in which foreclosure rates have skyrocketed. They also were much more likely to be behind on their credit card bills. And they were drowning in debt, with ... a level of debt not seen among any other household type.

Clearly, something is financially amiss with the once rock-solid American family. But what? Why hasn't the rising number of two-earner families protected more Americans from the risks of financial disaster? The answer lies ultimately in a simple fact:

Supply-Side Economics: Used and Abused

Jonathan Chait has a question for the president. If it's true that tax cuts raise tax revenues as he claims, and if it's also true that he has restrained spending like he says he has in his speeches, then why do we still have such a large deficit?

Bush's Silly Budget Logic, by Jonathan Chait, Commentary, LA Times: Alan D Viard, a former Bush White House economist currently at the conservative American Enterprise Institute, recently told the Washington Post: "Federal revenue is lower today than it would have been without the tax cuts. There's really no dispute among economists about that."

He's right. There's no dispute among economists. Conservative, moderate or liberal, every credentialed economist agrees that the Bush tax cuts caused revenues to drop. There is, however, a dispute between economists and pseudo-economists. Supply-siders may be laughed at by real economists, but they still enjoy a strong following among politicians, including, alas, the president of the United States. Here is what President Bush said a week and a half ago:

"They said that we had to choose between cutting the deficit and keeping taxes low — or another way to put it, that in order to solve the deficit we had to raise taxes. I strongly disagree with those choices. Those are false choices. Tax relief fuels economic growth, and growth — when the economy grows, more tax revenues come to Washington. And that's what's happened. It makes sense, doesn't it?"

Well, no, it doesn't make any sense at all. Bush, of course, is correct that tax revenues have risen over the last few years. This is normal.

Except in certain extreme theoretical conditions, tax cuts cause revenues to fall, and tax hikes cause them to rise. The economy also can affect revenues. During an expansion, revenues can rise unusually fast, and during a recession, they can drop unusually fast. ...

In the same speech in which he claimed that his tax cuts have caused revenues to rise, Bush bragged that he's "restraining spending." So why do we still have a deficit? I mean, he says he's kept spending down, he's caused revenues to skyrocket and the economy is going great guns. Why are we still in the red?

And if Bush's own economists say his tax cuts caused revenue to drop — and Viard isn't the only one — then how can he continually get away with insisting the opposite?

As the evidence against the Laffer curve continues to accumulate, it's getting harder to sell the myth that tax cuts pay for themselves, or at least I hope it is. Because of that, tax-cut advocates will likely retreat to an efficiency argument to support their cause.

One note. Jonathan Chait says:

Supply-siders may be laughed at by real economists...

Not quite. There are real economists that are supply-side advocates. But supply-side economics has been misused and misrepresented to suit political ends and that has tarnished its reputation, something that could have been avoided if those "real economists" had voiced strong opposition to claims made on behalf of the theory that were clearly wrong or wishful thinking at best.

Supply-side economics in the right hands, those of qualified real business cycle theorists who are interested in how the world works rather than supporting an ideology or political party, has a lot to offer. For example, I read an interesting paper last week ("A Theory of Demand Shocks") that combines a real business cycle framework with a new classical style Lucas island model information structure, where the information extraction problem concerns productivity shocks. But that is just the tip of a large iceberg of very good research on real business cycles.

My view is that the debate over which view is correct - real business cycle stories of aggregate fluctuations or new Keynesian style microfounded friction models - is not all that productive. My objection comes when people dismiss the demand side entirely. I believe both supply and demand shocks are important sources of aggregate fluctuations and that models synthesizing New Keynesian - Real Business Cycle theoretical models by imposing rigidities or other frictions on a real business cycle structure (augmented with an enhanced demand side) is ultimately where we will end up.

Poor Choices

Are the poor "perfectly rational, just like everyone else" or should we "attribute the behaviors of the poor to a unique “culture of poverty,” rife with deviant values"? This research proposes a third view that lies between these two extremes where the poor, just like everyone else, are "neither perfectly calculating nor especially deviant":

Researchers seek to incorporate street psychology into economics by Chad Boutin, Princeton Weekly Bulletin: Adjusting his laptop, Eldar Shafir punches up a table of figures that represents the financial decisions of lower-income families in Trenton... In the neighborhoods Shafir visits, though working people have the option of going to a bank to manage their money, they also are surrounded by cashing services that process checks for much higher fees. On his computer screen are numbers comparing how many people visit each kind of institution.

“It’s astonishing. Most of the people we have met are willing to spend a lot more to cash their checks at a service, because they feel that banks are intimidating and unwelcoming,” says Shafir, a professor of psychology and public affairs. “These are people who are not earning high incomes, but still would rather spend more at a business where they are welcomed by a clerk who remembers their mother’s name.” ...

Shafir and his fellow behavioral scientists are trying to ... change the field of economics from within. Their goal is simple: to ensure that businesses and the government take into account the way people actually think and behave when making financial decisions. ...[S]tudents of economics ... have been trained to idealize consumers as completely rational and impervious to psychological factors... “It is commonly believed that people are responsible for most of their own behavior, but research demonstrates the substantial influence of situational factors on the way we think and act,” says Shafir...

FRBSF: Did Quantitative Easing by the Bank of Japan Work?

The San Francisco Fed has an Economic Letter assessing of the Bank of Japan's policy of quantitative easing from 2001 to 2006. Here's the introduction and conclusion to the study:

Did Quantitative Easing by the Bank of Japan "Work"?, by Mark M. Spiegel Vice, FRBSF Economic Letter: On March 19, 2001, the Bank of Japan (BOJ) embarked on an unprecedented monetary policy experiment, commonly referred to as "quantitative easing," in an attempt to stimulate the nation's stagnant economy.

The Cost of the War for Iraq

We've seen estimates of how much the Iraq war has cost the U.S., but what has been the cost to Iraqis?:

An Early Calculation of Iraq’s Cost of War, by Anna Bernasek, Economic View, NY Times: Here's a basic question: What has been the cost of the Iraq war for Iraq? ... Although several studies have dealt with the war’s cost to Americans, there has been no comparable work addressing the cost to Iraqis.

Of course, the loss of human life has always been evident. Recently, the United Nations estimated that 100 Iraqis were dying each day, on average, as a result of the war. .... A recent study in The Lancet, the British medical journal, placed the average daily figure at about 500...

The economic cost has been less visible. Published information on the subject is very limited, although one economist, Colin Rowat, has made some preliminary calculations... Professor Rowat, a specialist on the Iraqi economy at the University of Birmingham in Britain, relied mainly on data from the International Monetary Fund to estimate the war’s overall effect on the Iraqi economy. His calculations are a work in progress, but what he has found so far is sobering: the cost amounts to a cut of at least 40 percent in Iraq’s national income. ...

Econometricians Are *Not* Saintly Automatons

Not too long ago, I posted this graph showing a (not so) curious gap in t-statistics just below the 5% significance level in published work in political science, and a similarly surprising amount just above the 5% cutoff. This implies “scholars “tweak” regression specifications and samples to move barely insignificant results above conventional thresholds” using data mining and other techniques to manipulate the results. Edward Glaeser discusses this and other issues associated with empirical research and gives ten recommendations for "a more economic approach to empirical methods" and "paths for methodological progress." Here's the introduction to the paper:

Researcher Incentives and Empirical Methods, by Edward L. Glaeser, NBER Technical WP 329. October 2006 [open link]: I. Introduction A central theme of economics is respect for the power of incentives. Economists explain behavior by pointing towards the financial gains that follow from that behavior, and we predict that a behavior will increase when the returns to that behavior rise. Our discipline has long emphasized the remarkable things – from great inventions to petty crimes – that human beings can do when they face the right incentives.

But while economists assiduously apply incentive theory to the outside world, we use research methods that rely on the assumption that social scientists are saintly automatons. No economist would ever write down a model using the assumptions about individual selflessness that lie behind our statistical methods.

Blaming the Poor for Their Poverty

Recent news that the U.S. population has surpassed 300 million along with the discussions of welfare policy associated with the ten year anniversary of welfare reform legislation brings up thoughts of Thomas Malthus. In Malthus' famous population theory, population grows geometrically while food supply increases at the slower arithmetic rate. Because of this, the size of the population will eventually exceed the available food supply necessary to support it.

Malthus believes there are two solutions to the inevitable overpopulation problem. First, there are preventive checks on population which reduce the birth rate. Preventive checks consist of moral restraint such as abstinence which Malthus believes to be virtuous, and vice such as prostitution and birth control which is not.

Second, there are positive checks on the population that increase the death rate - famine, misery, plague, and war - which, in Malthus' view, are unavoidable natural laws. They are unfortunate, but necessary to limit population. In his view, these positive checks represent punishment for those who are unable to limit population growth through moral restraint.

Malthus does not believe that positive checks can be avoided. If they are, then people will starve for lack of food. Thus, if we abhor starvation, we are foolish to try and prevent the positive checks to population:

It is an evident truth that, whatever may be the rate of increase in the means of subsistence, the increase of population must be limited by it, at least after the food has once been divided into the smallest shares that will support life. All the children born, beyond what would be required to keep up the population to this level, must necessarily perish, unless room be made for them by the deaths of grown persons. ... To act consistently therefore, we should facilitate, instead of foolishly and vainly endeavouring to impede, the operations of nature in producing this mortality; and if we dread the too frequent visitation of the horrid form of famine, we should sedulously encourage the other forms of destruction, which we compel nature to use. Instead of recommending cleanliness to the poor, we should encourage contrary habits. In our towns we should make the streets narrower, crowd more people into the houses, and court the return of the plague. In the country, we should build our villages near stagnant pools, and particularly encourage settlements in all marshy and unwholesome situations. But above all, we should reprobate specific remedies for ravaging diseases; and those benevolent, but much mistaken men, who have thought they were doing a service to mankind by projecting schemes for the total extirpation of particular disorders. If by these and similar means the annual mortality were increased ... we might probably every one of us marry at the age of puberty, and yet few be absolutely starved. [source]

Where does this thinking lead? To the idea that there must be no government relief for the poor:

A man who is born into a world already possessed, if he cannot get subsistence from his parents on whom he has a just demand, and if the society do not want his labour, has no claim of right to the smallest portion of food, and, in fact, has no business to be where he is. At nature’s mighty feast there is no vacant cover for him. She tells him to be gone, and will quickly execute her own orders, if he does not work upon the compassion of some of her guests. If these guests get up and make room for him, other intruders immediately appear demanding the same favour. ... The order and harmony of the feast is disturbed, the plenty that before reigned is changed into scarcity; and the happiness of the guests is destroyed by the spectacle of misery and dependence in every part of the hall, and by the clamorous importunity of those, who are justly enraged at not finding the provision which they had been taught to expect. The guests learn too late their error, in counter-acting those strict orders to all intruders, issued by the great mistress of the feast, who, wishing that all guests should have plenty, and knowing she could not provide for unlimited numbers, humanely refused to admit fresh comers when her table was already full. [source]

This statement was tempered in later editions of the Essay, but the message that helping the poor would only serve to increase their numbers and hence increase aggregate misery remained. The result of this was the Poor Law Amendment of 1834. From Brue:

Some of Malthus's ideas were adopted in the harsh Poor Law Amendment of 1834. The law abolished all relief for able-bodied people outside workhouses. A man applying for relief had to pawn all his possessions and then enter a workhouse before assistance was granted; his wife and children either entered a workhouse or were sent to work in the cotton mills. In either case the family was broken up and treated harshly in order to discourage it from becoming a public charge. The work house was invested with a social stigma, and entering it imposed high psychological costs. The law aimed at making public assistance so unbearable that most people would rather starve quietly than submit to its indignities. This system was to be the basis of English poor law policy until early in the twentieth century. Malthus, who died four months after the Poor Law Amendment was passed, must have regarded it as a vindication of his idea that there is not room enough at nature's feast for every one.

Ultimately, in Malthus view, the difference between the rich and the poor comes down to a difference in moral character. It is an attempt to convince us that poverty is inevitable, that it is the consequences of poor choices and the moral inferiority of the poor, and that there is little that can be done about it.

There is a long history of blaming the poor for being poor and downplaying other possible sources of inequality arising from differences in power, social position, institutional structure, and so on, followed by an argument that attempts to help the poor only serve to increase the incentive for immoral behavior. Increasingly, we appear to be heading down this road again. But before we do, we should remember where it leads.

Playing Games with Economics

A video game designed to teach the principles of microeconomics:

Aliens Teach University Economics Class, by Nell Boyce, NPR, All Things Considered: ...[S]tudents taking ECON 201 at the University of North Carolina at Greensboro ... don't even come to class, they just log in to the Internet. The entire microeconomics course is a video game that students play online to earn three college credits.

Watch Sarbonians Crash-Land on Earth and Grapple with Economics of Survival

...The Sarbonian aliens are named after economics professor Jeff Sarbaum. "This is a game in which the students are literally immersed in a story. And they take on the role of a character," he explains. "So all of the reading material, all of the content, all of the examinations and homework, if you will, are built inside the engine of the game."

The Sarbonians come from an alien world that knows no scarcity. After they crash-land on Earth, the students have to grapple with economic challenges like how to make and distribute goods, and how to trade with another group of aliens.

..."I believe we are the first ones to fully emerge students in a narrative story and treat the whole course as a game," Sarbaum says...

In his microeconomics game, a robot acts like a tutor. As the game goes on, the characters talk more and more like economists. ...

To gauge how well students are picking up on the concepts, they take multiple-choice tests as they move through the different levels of the game. ...

China's New Left

An email suggests this article on the New Left's struggle to build a social model in China that moves away from neoliberal ideas:

China's New Left calls for a social alternative, by Pankaj Mishra, The New York Times Magazine: One day earlier this year I met Wang Hui at the Thinker's Cafe near Tsinghua University in Beijing, where he teaches. ... Co-editor of China's leading intellectual journal, Dushu (Reading), and the author of a four-volume history of Chinese thought, Wang ... has emerged as a central figure among a group of writers and academics known collectively as the New Left.

New Left intellectuals advocate a "Chinese alternative" to the neoliberal market economy, one that will guarantee the welfare of the country's 800 million peasants left behind by recent changes. And unlike much of China's dissident class, which grew out of the protests in Tiananmen Square in 1989 ..., Wang and the New Left view the Communist leadership as a likely force for change.

Once Again, There is Too a Short-Run Phillip's Curve

One more time, There is Too a Short-Run Phillips Curve. This commentary disagrees with economists who claim there is a permanent inflation-unemployment tradeoff. However, it's been quite a long-time since anyone seriously suggested a permanent tradeoff between inflation and unemployment, particularly since Phelps, Friedman, Lucas and others came up with came up with the expectations augmented short-run Phillips curve to rebut this idea. Thus, the commentary below strikes at a position - a permanent tradeoff between inflation and output - that no economist that I know of holds. It is the nature of the short-run Phillip's curve that is at issue, how long the short-run tradeoff persists, the steepness of the tradeoff, whether hybrid versions of the Phillips curve are needed, etc., and contrary to what is stated in this commentary, the existence of a short-run Phillip's curve is well-accepted. I do agree with the commentary's suggestion that somebody doesn't understand this literature, but I doubt very much that it is Bernanke, Mishkin, and others at the Fed that are the ones missing key pieces of this line of research:

Time to Throw the Phillip's Curve, by Jerry Bowyer, NRO: Last week the Nobel committee announced that this year’s prize in economics would be going to Dr. Edmund Phelps... This is good news indeed for advocates of supply-side economics. Phelp’s principal academic achievement is his successful rebuttal of one of the central tenets of modern Keynesianism: the Phillips curve.

Someone should alert the board of governors at the Federal Reserve of Phelps vindication, since the minutes released from the Fed’s most recent meeting still contain the same old Keynesian gobbledygook...

The Phillips-curve perspective is flawed. Attempts to stimulate growth and employment by way of loose money inevitably fail... Phelps has disproved the Phillips curve, at least as a long-run economic planning tool. He argues persuasively that labor markets determine the unemployment rate over the long run. ...

Alan Greenspan, despite his better training, basically governed the central bank as a Keynesian... One wonders what the world would look like now if not for the pernicious doctrine that growth causes inflation. What if planners a half-century ago never adopted the Phillips curve and the ’50s.. Imagine the ’70s without stagflation? What if Greenspan hadn’t destroyed the telecomm sector in the late ’90s with his tight-money policy? ... How many people who are now middle class would be affluent? How much global poverty would have been alleviated if the U.S. economy had been even more powerful in recent decades, able to drag that much more of the globe out of the muck and into prosperity?

A Nobel Prize for Dr. Edmund Phelps is an opportunity for the Federal Reserve, Wall Street forecasters, and the financial press to bury forever the enormously destructive theoretical error that is the Phillips curve.

Saying that economists believe "growth causes inflation" mischaracterizes the issue. Nobody believes that growth is inflationary. Increases in productivity (i.e. growth in aggregate supply) puts downward pressure on prices. It is growth in demand relative to growth in supply that matters, and if demand growth outstrips supply growth, inflation will result.

Paul Krugman: Incentives for the Dead

Paul Krugman on "the growing scandal involving backdated stock options" as a reflection of our failure to "come to grips with the epidemic of corporate misgovernance":

Incentives for the Dead, by Paul Krugman, Stock Options Commentry, NY Times: I don’t know about you, but I need a break from political scandals. So let’s talk about private-sector scandals instead — specifically, the growing scandal involving backdated stock options...

To understand the issue, we need to go back to the original ideological justification for giant executive paychecks. In the 1960’s and 1970’s, C.E.O.’s of the largest firms were paid, on average, about 40 times as much as the average worker. But executives wanted more — and professors at business schools provided a theory that justified much higher pay.

They argued that a chief executive who expects to receive the same salary if his company is highly profitable that he will receive if it just muddles along won’t be willing to take risks and make hard decisions. ...

The claim, then, was that executives had to be given more of a stake in their companies’ success. And so corporate boards began giving C.E.O.’s lots of stock options... If the stock went up, these options would pay off; if the stock went down, they would lose their value. And so, the theory went, executives would have the incentive to do whatever it took to push the stock price up.

In the 1990’s, executive stock options proliferated — and executive pay soared, rising to 367 times the average worker’s pay by the early years of this decade. But the truth was that in many — perhaps most — cases, executive pay still had little to do with performance. For one thing, the great bull market of the 1990’s meant that even companies that didn’t do especially well saw their stock prices rise.

Then there were the tricks that companies used... For example, after a downward move in the stock price, ... the price at which the executive had the right to buy stocks would be reduced to the new market price. Heads the C.E.O. wins, tails he gets another chance to flip the coin.

What the backdating scandal reveals is that for many executives even that wasn’t enough. To ensure that executives profited from newly issued options, companies would pretend that the options had in fact been issued at an earlier date, when the stock price was lower. ...

What’s wrong with backdating stock options? There’s a tax evasion aspect, but the main point is the bait-and-switch. The public was told that gigantic executive paychecks were rewards for exceptional performance, but in practice executives were lavishly paid simply for showing up at the office.

And in some cases even that wasn’t required. Cablevision Systems gave options to a deceased executive (in other words, to his heirs), backdating them to make it appear that he had received them while still alive.

The moral of the story is that we still haven’t come to grips with the epidemic of corporate misgovernance revealed four years ago by the Enron and WorldCom scandals, then drowned out as a political issue by the clamor for war with Iraq. Even now, we’re still learning how deep the rot went.

And there’s no reason to believe that the problem has been solved. ...[E]xecutive compensation, which fell briefly after the Enron and WorldCom scandals, has shot right back up.

So we’re still waiting for serious corporate reform. And don’t tell me that everything must be O.K. because stocks have been rising lately. Remember, they rose even faster in the 1990’s — and the 1920’s.

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Previous (10/16) column: Paul Krugman: One Letter Politics
Next (10/23) column: Paul Krugman: Don't Make Nice

Does Culture Explain Urban Development?

This theory of urban development which puts a vague notion of culture at the center of the analysis is from The Manhattan Institute, a right-wing think tank that has William Kristol and Peggy Noonan, among others, on its Board of Trustees:

A Tale of Several Cities, by Julia Vitullo-Martin, Commentary, WSJ: ...Why does Boston prosper ... while Philadelphia languishes...? Why does much of Boston look like Hollywood's idea of a hip, fabulous place to live, while downtown Philadelphia seems to be a bleak postindustrial landscape...?

The answers are not to be found in conventional 20th-century analysis, which emphasized the ... decline of industrial jobs, the burdens of excessive taxation, the inevitability of racial tensions and the dominance of geography. After all, in traditional urban terms, Philadelphia and Boston are nearly twins, both founded by Protestant-Anglo stock in the 17th century, both blessed with prime locations, beautiful waterfronts, good vernacular housing, historic buildings, Olmsted parks, renowned museums and fine universities. And both are high-tax cities that have lost their industrial base. Yet one now thrives while the other declines.

At least part of the answer stems from their underlying cultures. In his "Puritan Boston and Quaker Philadelphia" (1979), E. Digby Baltzell argued that Boston Brahmins, with their belief in authority and leadership, embraced a sense of responsibility for civic life, while Philadelphia Gentlemen, with their inward but judgmental Quaker ways were deeply unconcerned about their city's welfare. Over the course of the 19th century and well into the 20th, they abdicated their role in government and watched indifferently as Philadelphia became, by the 1960s, the worst run city in the nation. The Brahmins ... cared about their city -- and so, subsequently, did the Irish politicians with whom they warred and the Italians who replaced the Irish.

Such cultural analysis -- long out of fashion as too soft (as as opposed to econometrics) or too racist (who is to say that one culture is better than another?) -- is due for a comeback. It starts to explain, in a way that mere fiscal analysis does not, why Miami has become the gateway to Latin America, why Los Angeles rules the Pacific Rim and why Chicago controls the Midwest. And it helps us to understand how New York City moved in 30 years from the humiliation of near bankruptcy to being the dominant city on earth.

The old answer of urban success was deterministic: taxes and geography. Cities with superb natural harbors, for example, become the natural capitals of trade... Yet as the historian Richard Wade has noted for years, against the tide of his field, this theory has its flaws: If the sheer excellence of a harbor truly determined a city's fate, then the greatest city in America would be Upper Sandusky, Ohio.

What flourishing cities often have in common, instead, are two crucial cultural characteristics: combativeness and cunning. New Yorkers, for example, fought back from their 1975 bankruptcy with every tool at their disposal, fair and unfair. ... New York armed itself with brilliant leadership, cut its bloated operating and capital budgets, cajoled ... federal loan guarantees from Congress, poured money into fixing up thousands of units of abandoned housing, fought crime and graffiti -- and emerged triumphant. ...

That same energy contributes to New York's cyclical boom-and-bust nature, regularly pushing speculation beyond the limits of an exuberant boom, thereby encouraging a bust. New Yorkers have done this for centuries while, for example, more temperate Chicagoans have not. Seemingly more stolid than New Yorkers, Chicagoans have transformed Carl Sandburg's brawling city of big shoulders into what is probably the most beautiful of postindustrial cities.

Chicagoans actually think about beauty in a way that New Yorkers do not, caring for their public gardens -- which go unvandalized though they are also unpoliced -- and embracing Mayor Daley's seemingly quixotic decision, 20 years ago, to put flowers wherever he could fit them, starting with highway barriers. (At the time, New York's parks commissioner, Gordon Davis, complained that he couldn't even get his own staff to plant flowers in front of his headquarters.) Cherishing their unparalleled lakefront -- originally a gift of businessman Montgomery Ward -- Chicagoans keep it free of invasive development...

Cunning and combativeness, however, often restore cities financially without making them many new friends ... But what makes cities successful -- or even just lovable -- can seldom be quantified. Even Baltzell, who admired the mind and achievements of Puritan Boston, said that his heart and loyalties were rooted in Quaker Philadelphia, which he criticized so harshly. As poet Phyllis McGinley wrote, perhaps in astonishment, "Some love Paris and some Purdue."

"The answers are not to be found in conventional 20th-century analysis." I think 21st-century analysis can explain more than this implies. For example, though these only scratch the surface, see Before Glaeser, "Urban Economics Was Dried Up" or The New York Paradox which "helps us to understand how New York City moved in 30 years from the humiliation of near bankruptcy to being the dominant city on earth." In any case, it will take a lot more than this to convince me that a theory of urban development that uses "cunning and combativeness" and the supremacy of particular cultures as its primary explanatory variables dominates or even augments existing theoretical explanations of urban success.