Economist's View

Market Bailouts and the "Fed Put"

Some questions for William Poole, president of the FRB St. Louis. The answers are extracted from his speech Market Bailouts and the "Fed Put":

One of the arguments against the Fed taking action to reduce problems in financial markets is that this creates a moral hazard problem. Can you remind us what the concern is?

The concern over moral hazard is that monetary policy action to alleviate financial distress may complicate policy in the future, by encouraging risky investing in the securities markets.

Do we know much about financial turmoil of the type we are experiencing now?

There are so few instances of market turmoil similar to the current situation that I’ll broaden the analysis to include significant stock market declines. Doing so gives us a substantial sample to discuss.

What is the most important question to consider?

[W]hether Federal Reserve policy responses to financial market developments should be regarded as “bailing out” market participants and creating moral hazard by doing so.

Maybe an example of the types of questions we should ask would help.

The U.S. stock market, between its peak in 1929 and its trough in 1932, declined by 85 percent. Question 1: If the Fed had followed a more expansionary policy in 1930-32, sufficient to avoid the Great Depression, would the stock market have declined so much? Question 2: Assuming that a more expansionary monetary policy would have supported the stock market to some degree in 1930-32, would it be accurate to say that the Fed had “bailed out” equity investors and created moral hazard by doing so? I note that a more expansionary monetary policy in 1930-32 would, presumably, have supported not only the stock market but also the bond and mortgage markets and the banking system, by reducing the number of defaults created by business and household bankruptcies in subsequent years.

Now apply these questions to the current situation. Did the Fed “bail out” the markets with its policy adjustments starting in August of this year? Have we observed an example of what some observers have come to call the “Fed put,” typically named after the chairman in office, such as the “Greenspan put” or the “Bernanke put”? Why has no one, at least not recently to my knowledge, argued that a more expansionary Fed policy in 1930-32 would have “bailed out” the stock market at that time and, by implication, have been unwise?[1]

Some people aren't going to make it to the end of this discussion. Any chance you could give a summary of the bottom line?

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

For those who do want to hear the details, how are you going to answer these questions?

My approach will be to start by discussing bailouts and moral hazard in general. I will examine the record of stock market declines and Fed policy adjustments and then analyze how monetary policy changes the nature of risks in financial and goods markets. Finally, I’ll argue that the ways in which monetary policy alters risks in the markets yields benefits for the economy and does not create moral hazard.

Then let's get started. Maybe you could explain how bailouts work.

A traditional bailout involves governmental assistance to a particular firm, group of firms or group of individuals. For ease of exposition, I’ll concentrate on bailouts of firms, but the same issues apply to bailouts of households.

Fixing the New Keynesian Phillips Curve

If we start with a basic New Keynesian model, i.e. a model with monopolistically competitive firms where only a fraction of the firms are allowed to reset prices each period, we can obtain a New Keynesian Phillips Curve (NKPC) (the assumption of monopolistic competition allows firms to be price-setters rather than price-takers as they would be under pure competition - if they are price-takers then price rigidities arising from the behavior of individual firms are hard to model, and price rigidities allow monetary policy to impact the real economy in the short-run, without them or some other impediment to full and immediate adjustment to shocks money would be neutral). The basic NKPC can be represented as:

     π_t = βE_tπ_t+1 + κφ_t

where π_t is the inflation rate at time t, E_tπ_t+1 is the expected rate of inflation at time t+1 based upon information available at time t, φ_t is real marginal cost at time t expressed as a percentage deviation from its steady state value, and β and κ are parameters, with the parameter κ an increasing function of the number of firms who can adjust their price each period.

Unlike the traditional Phillips curve, the NKPC implies the inflation process is forward looking, i.e. that current inflation depends upon expected future inflation (the firm needs to worry about future inflation because its price may be fixed for several periods), and that the correct scale variable is marginal cost, not output (though marginal cost can be related to the output gap and substituted into the equation to produce a more traditional looking Phillips curve, there is some uncertainty about this relationship). Another difference from the traditional Phillips curve is that the curve is derived from explicit maximization behavior on behalf of price setters, conditional on the assumed economic structure (monopolistically competitive firms, constant elasticity demand curves, random price resetting through the Calvo price-setting mechanism, etc., though I should point out that some question whether assuming the Calvo mechanism rather than deriving it as part of the model is consistent with the claim that this model is derived from first principles, but it is certainly better than its predecessor on this score).

Why should you care about the NKPC? You should care "because much of our intuition for what constitutes good monetary policy has been built up using models in which the NKPC is central." For this reason, it's important to know how well this model fits actual data. If the model fits poorly, and there are reasons to believe that the basic version given above does have problems, then the policy prescriptions derived from the model will be suspect. Thus, this Economic Letter from the San Francisco Fed looks at what's wrong with the New Keynesian Phillips curve, and how to fix the problems we have discovered:

Fixing the New Keynesian Phillips Curve, by Richard Dennis, FRBSF Economic Letter: Price rigidity is a key mechanism through which monetary policy is thought to affect the economy. When some prices are hard to change, firms may respond to a monetary impetus by changing instead their production and employment levels. Economists often link price rigidity, inflation, and movements in the real economy using some form of Phillips curve, often the New Keynesian Phillips curve (NKPC), a model that relates inflation to factors like capacity utilization or production costs. Unfortunately, an array of papers have shown that the NKPC is unable to match the time series properties of aggregate inflation, failing to capture inflation's persistence, overstating the role of expectations in price-setting, and implying what many believe to be excessive price rigidity.

These inconsistencies between the model and the data are important, not least because much of our intuition for what constitutes good monetary policy has been built up using models in which the NKPC is central. A model that cannot satisfactorily explain why inflation is persistent is of doubtful value for forecasting. Moreover, a model that overstates the magnitude of price rigidity will also tend to overstate monetary policy's importance for determining real outcomes, potentially providing a distorted view of the role that monetary policy plays in macro-stabilization.

This Economic Letter looks at the problems with the NKPC and discusses some alternatives that are increasingly being used to think about inflation and the monetary policy transmission mechanism.

Paul Krugman: Mandates and Mudslinging

Barack Obama is using right-wing talking points to claim that his health plan is better than the plans of his rivals, but it isn't:

Mandates and Mudslinging, by Paul Krugman, Commentary, NY Times: From the beginning, advocates of universal health care were troubled by ... Barack Obama’s plan, which ... wouldn’t cover everyone. But they were willing to cut Mr. Obama slack..., assuming that in the end he would do the right thing. ...

The central question is whether there should be a health insurance “mandate” — a requirement that everyone sign up for health insurance... The Edwards and Clinton plans have mandates; the Obama plan has one for children, but not for adults. ...

[U]nder the Obama plan, ... healthy people could choose not to buy insurance — then sign up for it if they developed health problems later. Insurance companies couldn’t turn them away, because Mr. Obama’s plan ... requires that insurers offer the same policy to everyone.

As a result, people who did the right thing and bought insurance when they were healthy would end up subsidizing those who didn’t sign up for insurance until or unless they needed medical care. ...

The fundamental weakness of the Obama plan was apparent from the beginning. ... But ... Mr. Obama, who just two weeks ago was telling audiences that his plan was essentially identical to the Edwards and Clinton plans, is attacking his rivals and claiming that his plan is superior. It isn’t — and his attacks amount to cheap shots.

First, Mr. Obama claims that his plan does much more to control costs than his rivals’ plans. In fact, all three plans include impressive cost control measures.

Second, Mr. Obama claims that mandates won’t work, pointing out that many people don’t have car insurance despite state requirements that all drivers be insured. Um, is he saying that states shouldn’t require that drivers have insurance? If not, what’s his point?

Look, law enforcement is sometimes imperfect. That doesn’t mean we shouldn’t have laws.

Third, and most troubling, Mr. Obama accuses his rivals of not explaining how they would enforce mandates, and suggests that the mandate would require ... nasty, punitive enforcement: “Their essential argument,” he says, “is the only way to get everybody covered is if the government forces you to buy health insurance. If you don’t..., then you’ll be penalized in some way.”

Well, John Edwards has just called Mr. Obama’s bluff, by proposing that individuals be required to show proof of insurance when filing income taxes or receiving health care. If they don’t have insurance, they won’t be penalized — they’ll be automatically enrolled in an insurance plan.

That’s actually a terrific idea — not only would it prevent people from gaming the system, it would have the side benefit of enrolling people who qualify for S-chip and other government programs, but don’t know it.

Mr. Obama, then, is wrong on policy. Worse yet, the words he uses ... make him sound like Rudy Giuliani inveighing against “socialized medicine”: he doesn’t want the government to “force” people to have insurance, to “penalize” people who don’t participate.

I recently castigated Mr. Obama for adopting right-wing talking points about a Social Security “crisis.” Now he’s echoing right-wing talking points on health care.

What seems to have happened is that Mr. Obama’s caution, his reluctance to stake out a clearly partisan position, led him to propose a relatively weak, incomplete health care plan. Although he declared, in his speech announcing the plan, that “my plan begins by covering every American,” it didn’t — and he shied away from doing what was necessary to make his claim true.

Now, in the effort to defend his plan’s weakness, he’s attacking his Democratic opponents from the right — and in so doing giving aid and comfort to the enemies of reform.

A Plan to Freeze Subprime Rates

Treasury Secretary Paulson is pushing a plan to freeze interest rates for some subprime borrowers:

U.S., Banks Near A Plan to Freeze Subprime Rates, by Deborah Solomon and Michael M. Phillips, WSJ: The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans...

An accord could reassure investors and strapped homeowners ... on more than two million adjustable mortgages are scheduled to jump over the next two years. ...

The plan is being negotiated between regulators including the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc., Wells Fargo & Co., Washington Mutual Inc. and Countrywide Financial Corp. ...

Details of the plan, which could be announced as early as next week, are still being worked out. In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase.

Many subprime loans carry a low "teaser" interest rate for the first two or three years, then reset to a higher rate for the remainder of the term, which is typically 30 years in total. In a typical case, the rate would rise to around 9.5% to 11% from 7% or 8%. That would boost an average borrower's payment by several hundred dollars a month.

Exactly which borrowers will qualify for the freeze and how long the freeze would last are yet to be determined. ... The parties are developing standard criteria that would determine eligibility. The criteria should be finalized by the end of year. ...

The mortgage servicers in the coalition represent 84% of the overall subprime market. The coalition also includes lenders, investors and mortgage counselors. ...

While the government can't force the industry to modify loans, Mr. Paulson and other administration officials have been using moral suasion to push for workouts...

Among the holdouts have been investors, who typically hold securities backed by mortgages. If interest rates are frozen, they would lose the potential benefit of higher payments. But investors have cautiously moved toward cooperation, likely on the grounds that it's better to get some interest than none at all. ...

Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can't afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help. The creditors are likely to look at whether the borrowers have equity in their homes, despite falling house prices, and whether their incomes are holding steady.

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications... But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off." ...

Officials in Washington have been cautious about steps that would be seen as rescuing borrowers, lenders and investors from the consequences of their own bad decisions. That is why few are suggesting direct support for borrowers who can't afford their loans. Mr. Paulson has decided his best option is to prod the markets to sort matters out themselves, as long as companies bear in mind the public interest in keeping people in their homes. ...

"If I ever saw a role for government, it is...to bring the private sector together when innovation has really outrun our ability to deal with it," Mr. Paulson said. ...

Will this be enough to make a difference?

links for 2007-11-30

• Low-income families face 3 barriers to health care - EurekAlert
• EU-India free trade agreement? - Vox EU
• Subprime Series, part 3 - Vox EU
• National and regional economic overview - FRB: Bernanke
• Democrats' health plans echo Nixon's failed GOP proposal - McClatchy
• The Fed’s Communication Strategy - FRB: Mishkin,
• Fed Chief Offers New Hint on a Rate Cut - New York Times
• Racism and Republicans - Hullabaloo
• Capital, Once Derided by Citi, Saves the Day - John M. Berry
• Karl Marx: Blogger or prophet? - Blog - Salon.com

Nicholas Stern: Climate Change, Ethics and the Economics of the Global Deal

Sir Nicholas Stern says "targets and trading must be at the heart of a global agreement to reduce greenhouse gas emissions." This is from his public lecture before the Royal Economic Society in anticipation of next week’s world summit on climate change in Bali:

Climate Change, ethics and the economics of the global deal, by Sir Nicholas Stern, Vox EU: The problem of climate change involves a fundamental failure of markets: those who damage others by emitting greenhouse gases generally do not pay. Climate change is a result of the greatest market failure the world has seen. The evidence on the seriousness of the risks from inaction or delayed action is now overwhelming. We risk damages on a scale larger than the two world wars of the last century. The problem is global and the response must be a collaboration on a global scale.

Rich countries must lead the way in taking action. That means adopting ambitious emissions reduction targets; encouraging effective market mechanisms; supporting programmes to combat deforestation; promoting rapid technological progress to mitigate the effects of climate change; and honouring their aid commitments to the developing world.

Next week the world gathers at Bali for the meeting of the Conference of the Parties of the United Nations Framework Convention on Climate Change. In thinking about global action to reduce greenhouse gas emissions, we must invoke three basic criteria:

• Effectiveness: the scale must be commensurate with the challenge – which means setting a stability target (or its equivalent in terms of an emissions reduction path) that can keep the risks at acceptable levels.
• Efficiency: we must keep down the costs of emissions reduction, using prices or taxes wherever possible.
• Equity: the problem is deeply inequitable with the rich countries having caused the bulk of current stocks of greenhouse gases and the poor countries being hit earliest and hardest – which means that the rich countries must take the lead.

What should the main elements of a global deal look like, what sort of a deal should it be, and how should it be built and sustained? My proposal is for a six-point programme with two groups of elements, the first three concerning targets and trading:

GDP vs. GDI

With today's release of revised data showing that GDP grew faster than originally estimated in the third quarter of this year, Brian Blackstone of the WSJ Economics Blog reminds us that we can measure aggregate activity as GDP and as GDI (because income = expenditures), and notes the two measures are not telling the same story:

Gross Domestic Income Tells Different Story Than GDP, WSJ Economics Blog: According to the latest gross domestic product revision, the U.S. economy swelled at nearly a 5% clip last quarter, almost double the economy’s noninflationary limit. Or did it?

Gross domestic income – a lesser-known gauge that the Fed has highlighted in the past as perhaps a better alternative — increased less than 2% last quarter, well below the economy’s potential. The first estimate of GDI is released with the second GDP estimate because it incorporates data that isn’t available earlier.

GDP counts economic activity based on expenditures, while GDI bases it on income. In theory, they should add up the same, though the often diverge — albeit not as much as they did last quarter.

Earlier this year when the Fed was trying to reconcile slower GDP growth with still-strong labor markets, it noted that GDI “might better capture the pace of activity.” GDI was running hotter than GDP at the time. ...

The main difference between the two gauges last quarter was corporate profits, which GDI includes and GDP excludes. Corporate profits from current production fell last quarter. GDI also doesn’t explicitly include net exports and inventories, as GDP does. GDI, in contrast, relies more heavily on employee compensation data.

But when there are differences, Fed officials may lean towards GDI, especially when it comes to signaling economic downturns. Fed economist Jeremy Nalewaik wrote in a March paper that GDI “has done a substantially better job recognizing the start of the last several recessions than has real-time GDP.” ...

A penny saved...

...is a penny workers don't earn:

Penny Foolish, by Eric Schlosser, Commentary, NY Times: The migrant farm workers who harvest tomatoes in South Florida have one of the nation’s most backbreaking jobs. For 10 to 12 hours a day, they pick tomatoes by hand, earning a piece-rate of about 45 cents for every 32-pound bucket. During a typical day each migrant picks, carries and unloads two tons of tomatoes. For their efforts, this holiday season many of them are about to get a 40 percent pay cut.

Florida’s tomato growers have long faced pressure to reduce operating costs; one way to do that is to keep migrant wages as low as possible. ...

In 2005, Florida tomato pickers gained their first significant pay raise since the late 1970s when Taco Bell ended a consumer boycott by agreeing to pay an extra penny per pound for its tomatoes, with the extra cent going directly to the farm workers. Last April, McDonald’s agreed to a similar arrangement... But Burger King ... has adamantly refused to pay the extra penny — and its refusal has encouraged tomato growers to cancel the deals already struck with Taco Bell and McDonald’s.

This month the Florida Tomato Growers Exchange, representing 90 percent of the state’s growers, announced that it will not allow any of its members to collect the extra penny for farm workers. Reggie Brown, the executive vice president of the group, described the surcharge for poor migrants as “pretty much near un-American.”

Migrant farm laborers have long been among America’s most impoverished workers. Perhaps 80 percent of the migrants in Florida are illegal immigrants and thus especially vulnerable to abuse. During the past decade, the United States Justice Department has prosecuted half a dozen cases of slavery among farm workers in Florida. Migrants have been driven into debt, forced to work for nothing... The Coalition of Immokalee Workers — a farm worker alliance based in Immokalee, Fla. — has done a heroic job improving the lives of migrants in the state, investigating slavery cases and negotiating the penny-per-pound surcharge with fast food chains.

Now the Florida Tomato Growers Exchange has threatened a fine of $100,000 for any grower who accepts an extra penny per pound for migrant wages. ...

The prominent role that Burger King has played in rescinding the pay raise offers a spectacle of yuletide greed worthy of Charles Dickens. Burger King has justified its behavior by claiming that it has no control over the labor practices of its suppliers. “Florida growers have a right to run their businesses how they see fit,” a Burger King spokesman told The St. Petersburg Times.

Yet the company has adopted a far more activist approach when the issue is the well-being of livestock. In March, Burger King announced strict new rules on how its meatpacking suppliers should treat chickens and hogs. As for human rights abuses, Burger King has suggested that if the poor farm workers of southern Florida need more money, they should apply for jobs at its restaurants.

Three private equity firms — Bain Capital, the Texas Pacific Group and Goldman Sachs Capital Partners — control most of Burger King’s stock. ...

Telling Burger King to pay an extra penny for tomatoes and provide a decent wage to migrant workers would hardly bankrupt the company. Indeed, it would cost Burger King only $250,000 a year. At Goldman Sachs, that sort of money shouldn’t be too hard to find. In 2006, the bonuses of the top 12 Goldman Sachs executives exceeded $200 million — more than twice as much money as all of the roughly 10,000 tomato pickers in southern Florida earned that year. Now Mr. Blankfein should find a way to share some of his company’s good fortune with the workers at the bottom of the food chain.

"Marx's 'Das Kapital' Lives On"

An excerpt from a book on Karl Marx:

Marx's 'Das Kapital' Lives On in Capitalist Age, NPR
[Listen Now]: ...Excerpt: 'Marx's Das Kapital: A Biography' by Francis Wheen: Chapter 1: Gestation ... Marx's earliest ambitions were literary. As a law student at the University of Berlin he wrote a book of poetry, a verse drama and even a novel, Scorpion and Felix, which was dashed off in a fit of intoxicated whimsy while under the spell of Laurence Sterne's Tristram Shandy. After these experiments, he admitted defeat: 'Suddenly, as if by a magic touch - oh, the touch was at first a shattering blow - I caught sight of the distant realm of true poetry like a distant fairy palace, and all my creations crumbled into nothing… A curtain had fallen, my holy of holies was rent asunder, and new gods had to be installed.' Suffering some kind of breakdown, he was ordered by his doctor to retreat to the countryside for a long rest - whereupon he at last succumbed to the siren voice of G. W. F. ...

After gaining his doctorate [Marx] thought of becoming a philosophy lecturer, but then decided that daily proximity to professors would be intolerable. 'Who would want to have to talk always with intellectual skunks, with people who study only for the purpose of finding new dead ends in every corner of the world!' Besides, since leaving university Marx had been turning his thoughts from idealism to materialism, from the abstract to the actual. 'Since every true philosophy is the intellectual quintessence of its time,' he wrote in 1842, 'the time must come when philosophy not only internally by its content, but also externally through its form, comes into contact and interaction with the real world of its day.' That spring he began writing for a new liberal newspaper in Cologne, the Rheinische Zeitung; within six months he had been appointed editor.

Marx's journalism is characterized by a reckless belligerence which explains why he spent most of his adult life in exile and political isolation. His very first article for the Rheinische Zeitung was a lacerating assault on both the intolerance of Prussian absolutism and the feeble-mindedness of its liberal opponents. Not content with making enemies of the government and opposition simultaneously, he turned against his own comrades as well, denouncing the Young Hegelians for 'rowdiness and blackguardism'. Only two months after Marx's assumption of editorial responsibility, the provincial governor asked the censorship ministers in Berlin to prosecute him for 'impudent and disrespectful criticism'.

No less a figure than Tsar Nicholas of Russia also begged the Prussian king to suppress the Rheinische Zeitung, having taken umbrage at an anti-Russian diatribe. The paper was duly closed in March 1843: at the age of twenty-four, Marx was already wielding a pen that could terrify and infuriate the crowned heads of Europe. ...

Marx was a pretty effective blogger. Here is a page from an archive of his posts, with more here.

Update: Andrew Leonard has more.

links for 2007-11-29

• Grooming the next Ahmad Chalabi - Los Angeles Times
• Lies, damned lies and statistics (on Iraq) - Comment is free
• Illegal Immigrants Don't Overuse Health Care - Ezra Klein
• Is the sky falling on both Wall Street and Main Street? - Maverecon
• Opportunity and equality - Clive Crook
• Dreaded 'R' Word Starts Tripping Off the Tongue - Caroline Baum
• Does offshoring boost domestic productivity? Evidence from Italy - Vox EU
• Rulings on Endangered Species Are Reversed - New York Times
• Zombie ideas about income mobility - Paul Krugman Blog
• Size Limits for Cable Look Likely - New York Times
• New Findings Underscore an Earth-Venus Kinship - New York Times

The Ruth Marcus Obsession with the Social Security Crisis that Does not Exist

Ruth Marcus of the Washington Post is at it again, trying to portray Social Security as a system in need of immediate fixing. But, as these responses by Dean Baker, Kevin Drum, and Paul Krugman make clear, Marcus is doing her best to elevate a second-tier problem (if it's even that) to the crisis, first-tier level. It appears that having taken a position on Social Security that is wrong, i.e. that it is a system headed for "crisis," she is incapable of admitting her errors and instead continues to defend the indefensible. She says it's irresponsible not to attack the problem now in her guise as one of the "Very Serious People," but the irresponsibility is coming from those, like herself, who are promoting a crisis that doesn't exist.

Here's Dean Baker:

More Social Securty UFOs at the Post, by Dean Baker: Ruth Marcus is on the warpath again arguing that those who don't want to jump in line on the SS crisis train are being irresponsible. Read it and weep.

A couple of quick points are in order.

Economic Security for Middle Class Families

How secure are middle class families? According to this report, not very:

2 out of 3 middle class American families on shaky financial ground, according to new report Landmark study based on new 'Middle Class Security Index' developed by Demos and Brandeis University, EurekAlert: Fewer than one in three middle-class families in America is financially secure, and the remaining majority are either borderline or at high risk of falling out of the middle class altogether, according to a new study published this week by Demos and the Institute for Assets and Social Policy (IASP) at Brandeis University.

By a Thread: The New Experience of America’s Middle Class is the first comprehensive report to measure economic stability across the American middle class. Based on national government data, By a Thread is the first in a series of reports and briefing papers that will utilize the new “Middle Class Security Index” developed by the non-partisan policy center Demos and IASP/Brandeis.

This Index measures the financial security of the middle class by rating household stability across five core economic factors: assets, educational achievement, housing costs, budget and healthcare. Based on how a family ranked in each of these factors, they were defined as financially “secure”, “borderline” or “at risk”.

“Much like a common cholesterol test that shows whether someone’s cardiovascular health is at risk, the Middle Class Security Index shows that financial health eludes the majority of the American middle class,” said Thomas M. Shapiro, Director of the Institute on Assets and Social Policy at Brandeis and one of the co-authors of the report. “ It also points to specific areas—like lack of assets—that inhibit financial security,”

The Middle Class Security Index shows worrying trends:

• Only 31 percent of families who would be considered middle-class by income are financially secure.
• One in four middle-class families match the profile for being at high risk of slipping out of the middle class altogether.
• More than half of middle-class families have no net financial assets whatsoever.
• Middle-class families have median debt of $3,500 and at least half of them have no assets.
• Only 13 percent of middle-class families are secure in their asset levels—meaning that they have enough to cover most of their living expenses for nine months should their regular income cease; 79 percent are “at risk” in this category, meaning they could not cover the majority of their expenses for even three months. Another 9 percent are “borderline.”
• Twenty-one percent of middle-class families have less than $100 per week ($5,000 per year) remaining after meeting essential living expenses. These families are living from paycheck to paycheck with very little margin of security

The participants of a press conference to launch the report commented on these findings:

"If we look back at the public investments of the mid-twentieth century—the GI Bill, federal home loan guarantees, better funding for public education and college—we see that they were geared at two key benchmarks on the way to the middle-class: assets and education,” said Henry Cisneros, Chairman of CityView and former U.S. Secretary of Housing and Urban Development. “But the Middle Class Security Index provides a real measurement of where we are after years of seeing those investments whittled away. American families are at risk of falling out of the middle class and never getting back in, and many of those who were excluded from the initial public investment—Latinos and African Americans—are among those with the greatest vulnerability. It’s time for a new public investment to stabilize the household economy and build the future middle class.”

“The By a Thread report findings mirror a reality of today’s unstable economy: The nation’s mortgage lending crisis is threatening the fabric of the urban communities that we revitalized by providing economic opportunity for more than 30 years. The ramifications of foreclosures on property values, municipal costs, crime, and consumer credit extends beyond the middle class and the neighborhoods most widely impacted by irresponsible lending practices,” said Jean Pogge, Executive Vice President, Consumer and Community Banking for ShoreBank.

"Workers in America are suffering a now generation-long stagnation of wages and rising insecurity,” said Ron Blackwell, Chief Economist at AFL-CIO. “By a Thread provides a unique metric for the resulting stress on middle class living standards and outlines bold policies to create an economy that works for all."

The Middle Class Security Index findings reported in By a Thread spotlight the strengths and vulnerabilities of the middle class by identifying barriers to financial security and offering solutions that would enable the broad majority of American families to enjoy a stable middle-class life. The report recommends a set of policies that will help open access to, and strengthen, America’s middle class. Legislative proposals cover a range of important issues affecting American households, including asset building and debt reduction, making higher education more accessible and affordable, and addressing the healthcare crisis.

“The Index is the launching point for a range of new work that will examine economic stability in America’s middle class,” said Jennifer Wheary, Senior Fellow at Demos and report co-author. “In the coming months we’ll be adding new reports that illuminate middle- class stability by age, race and income—several of the key demographic factors that will inform future public policy investments.”

The Middle Class Security Index will be updated biennially, with accompanying reports, as new national data become available.

[Link to report]

Debate on Climate Change

Here is a debate on "how cutting emissions of greenhouse gases would affect the global economy" among Bjorn Lomberg, Gary Yohe, and Sir Nicholas Stern.

links for 2007-11-28

• The tax cut ratchet - Paul Krugman Blog
• Subprime Series, part 2: - Vox EU
• Trust and European capital market integration - Vox EU
• Unions and inequality redux - Bluematter
• Fresh Pain for the Uninsured - BusinessWeek
• Grim View of Iraq Dangers in Survey of Journalists - New York Times
• Freebies from Lobbyists (local - Oregon) - Capitol Notebook
• In Study of Brain Evolution, Zeal and Bitter Debate - New York Times
• The Dance of Evolution, or How Art Got Its Start - New York Times
• Blame US finance deficit, not China's yuan rate -- Shanghai Daily
• China Rejects Europe’s Call for Currency to Rise Faster - New York Times
• A Loss for Privacy Rights - New York Times
• A Slowdown in Jobs Lost, and Created - New York Times
• Social Security Again - The Washington Monthly

NBER Recession Dating: Time for a Meeting?

Robert Hall says the NBER Business Cycle Dating Committee hasn't scheduled a meeting yet, but that could change. Justin Fox has the details:

Economist Robert Hall sees "dark clouds," but don't go expecting him to declare a recession anytime soon, Curious Capitalist: With all the recent talk of a looming recession, I figured I ought to check in with Stanford economist Robert Hall, chairman of the Business-Cycle Dating Committee of the National Bureau of Economic Research, the semi-official arbiter of when recessions start and end. I e-mailed:

When everybody starts talking recession, as is this case now, what do you folks on the Business-Cycle Dating Committee do? Schedule a meeting in Cancun? Set up a conference call? Start sending around lots of e-mails? Deputize somebody to keep an especially close eye on incoming economic data? (I just imagine there must be some form of heightened activity, and I’m curious as to what form it takes.)

He responded:

We all follow developments pretty closely. Now that Larry Summers has scooped us, all the more so.

The process begins with emails. We don't usually have a conference call until we are quite convinced that a turning point has occurred. Thus the subject of the call is not whether the recession has begun or ended, but rather when that event occurred. Consequently, the call occurs long after it is generally recognized that a turning point has occurred. There is usually a period of 6 months or so when the financial press excoriates us for tardy action.

We don't generally have a physical meeting, though we do if the time for action happens to coincide with the annual meetings of the American Economic Association at the beginning of January. So far there has been no suggestion of a meeting when that happens in 6 weeks, but things could change.

I can certainly add as an individual member, now not speaking as chair, that I see some dark clouds. The high levels of consumption seen in the past decade may decline to something closer to normal. The relation of the consumption bulge to the house-price boom is still unclear, but it would not be a surprise to see the two variables return to normal together.

The Business-Cycle Dating Committee ... was set up by ... Marty Feldstein after he took over as president of the NBER in 1977. Before that, veteran NBER staffer Geoffrey H. Moore (he'd been there since 1939) had more or less singlehandedly determined what was a recession and what was not. Feldstein decided such work was better done by a committee. ...

Justin's post has a little more on the dating procedure, and there's even more here along with a set of FAQs . Here is the list of past recession dates.

Are we talking ourselves into a recession?

Reich: No Immunity for the Telecoms

Robert Reich does not favor immunity for the telecoms. I don't either:

Why the Telecoms Shouldn't Get Immunity, by Robert Reich: I'm old enough to remember J. Edgar Hoover’s FBI and Nixon’s CIA, and the Federal Intelligence Surveillance Act of 1978. But anyone who's even halfway sentient ought to know there's a Fourth Amendment to the Constitution. So you'd think that executives at the nation’s biggest telecoms -- AT&T, Verizon, and so on -- would be alert to the possibility that government might illegally snoop on Americans. Yet these executives didn’t blink an eye when the NSA came knocking. You want records of domestic phone calls? Sure, help yourself! Emails? Yeah, we got tons. They’re yours!

When word of this leaked out and the companies got sued..., the telecoms went to Congress and complained... They deserved immunity from such lawsuits, they said, because they were only following orders. Now that Congress is back, it's about to decide whether the telecoms' argument makes sense. It doesn't.

Only following orders? ... Corporate executives have a duty to disobey government orders when they have reason to believe those orders are illegal or unconstitutional -- and make the government go to court to get what it wants. The duty to refuse is especially important when it comes to the nation’s telecoms, whose technological reach is extending deeper and deeper into our private lives.

Sure, there’s a delicate balance between fighting terrorism and protecting civil liberties. But that’s for courts to decide – not spy agencies and not telecom executives. If in doubt, the telecoms can go to the special courts set up precisely to oversee this balance, and get a declaratory judgment. The only way to keep pressure on them to do this and not become agents of our spy agencies is to continue to allow Americans to sue them for violating their legal rights.

"Cyber Scholars"

PZ Meyers reports:

Cyber Scholars?, by PZ Meyers: Those sneaky alumni organizations — they've always got new angles on how to get to you. The alumni magazine for the University of Oregon has a writeup on me and a current member of the UO faculty, Mark Thoma. Apparently, we are Cyber Scholars, professors who use the blogosphere to teach the world. I think we need some new academic robes to go with that designation — preferably something in silver fabrics, and with a jetpack.

Here's the write-up. This kind of thing - the picture, the story, etc. - makes me self-conscious, so please feel free to scroll on by (I should note that one or two of the statistics are a bit off, but not by much, and that I wasn't going to post this until convinced to do so by others):

Cyber Scholars, by Katie Campbell, UO Quarterly: Mark Thoma compares the problem with the national deficit to dieting.

“People eat more in anticipation of a diet, which makes the diet that much harder once the time comes,” the UO associate professor of economics explains. It’s with that type of everyday language that Thoma reaches beyond the walls of academia to explain complex economic issues to average folks. That’s what he does everyday—on his blog (short for web log).

Many view the blogosphere less as a scholarly realm and more as a perilous information wasteland where the average blowhard can present himself as an expert. But a growing number of people with Ph.D.s, such as Thoma, are using blogs to connect with colleagues beyond their university departments and with the greater nonacademic community.

"The Death of Distance Has been Greatly Exaggerated"

How much should service-sector workers in developed countries fear offshoring competition?:

Service offshoring: Same old trade with a new label?, by Keith Head, Thierry Mayer, and John Ries, Vox EU: Pundits regularly invoke the notion of a world economy that is either “shrinking” or becoming “flat.” Explanations of this alleged flattening include technological innovations in transportation and communication that have enabled goods and ideas to flow more freely. The offshoring of service jobs, particularly call centers and computer software in India, has grabbed recent media attention. In his bestseller The World is Flat, New York Times columnist Thomas Friedman (2005) wrote of how he had “interviewed Indian entrepreneurs who wanted to prepare my taxes from Bangalore, read my X-rays from Bangalore, trace my lost luggage from Bangalore and write my new software from Bangalore.”

Most economists, cognizant of the gains from trade, do not view a “flat” world as an alarming prospect. As the 2004 Economic Report of the President remarked sanguinely, “When a good or service is produced more cheaply abroad, it makes more sense to import it than to make or provide it domestically” (p. 229). In a press conference after the release of the report, the Chair of the Council of Economic Advisors at that time, Gregory Mankiw, elaborated on the remarks in the report saying, “Whether things of value, whether imports from abroad, come over the Internet or come on ships, the basic economic forces are the same.” As Mankiw and Swagel (2006) describe in their insider account, these seemingly innocuous remarks about outsourcing managed to arouse a controversy. This was partly because of election-year sentiments but also because the threat of service offshoring raises serious concerns for many onlookers. How will we maintain our standard of living, people wonder, when we have to compete with highly skilled foreigners who are willing to do our jobs for a fraction of our wages?

Just as mainstream trade theory identifies gains from trade, it also shows that real wages of some workers tend to fall as a consequence of freer trade. Mankiw and Swagel (2006) respond to these concerns by arguing that the accumulated statistical evidence on the offshoring of services demonstrates that the magnitudes remain quite small compared to the size of the labour market. This case for complacency recalls a debate between Leamer and Krugman over whether rising imports from low-wage manufacturers were responsible for rising wage inequality in the US. Leamer (2000) pointed out that prices are determined on the margin and the volume of trade is irrelevant for wage determination. Krugman (2000) argued that, on the contrary, trade volumes were crucial evidence on the changes in factor prices that can be attributed to trade. However, if recent growth of service imports continues unabated, the current trickle of offshoring could turn into a flood. Mankiw and Swagel’s argument would be more persuasive if there were strong reasons to believe that economic impediments to offshoring will curb its future growth.

Our research investigates whether geographic separation limits offshoring trade, thereby shielding domestic workers from direct competition with their foreign counterparts. We develop a model that envisions employers searching globally for the most suitable workers for any given task and posits that distance raises the costs of using foreign workers. These higher costs reflect travel, training, or translation time associated with using workers that reside far from where their services will be consumed. Firms choose workers that offer the lowest costs after adjusting wages for productivity and distance-based service delivery costs.

We use data on bilateral trade in services for a large sample of countries to infer the extent to which distance increases the relative costs of using remote workers. We focus on the service category called Other Commercial Services (OCS) that includes service categories that are subject to the offshoring debate—professional services and call centers. Distance effects are conventionally estimated by applying the “gravity equation” to bilateral trade. This method, which has been widely used to study goods trade, posits that exports from an origin country to a destination country are proportional to the economic sizes of each partner country and inversely related to the distance between them.

The scatter plot in Figure 1 of British imports of OCS (averaged over 2000–2004) provides intuition on how the gravity equation is used to estimate distance effects.

Globalization is "A Lot Less Important Than You Think"

Paul Krugman says international trade doesn't matter as much as you might think:

Cool the globalization rhetoric, Marketplace: ... Paul Krugman: I've been on the road a lot lately, talking to audiences about my hopes for a great revival of middle-class America, and I almost always get asked about whether such hopes make sense in an age of globalization. Is it really possible to make working Americans better off, when they have to compete with workers around the world?

Yes, it is. The truth, is that international trade is less important, for good or for evil, than most people suppose. [...continue reading...]

Measuring Pure Inflation

Here are Ricardo Reis and Mark Watson who will tell you what they have done and why it matters. This is interesting work:

Relative Goods' Prices and Pure Inflation, by Ricardo Reis and Mark W. Watson, NBER WP 13615, November 2007 [open link]: ABSTRACT This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three components: idiosyncratic relative-price changes, aggregate relative-price changes, and changes in the unit of account. The model identifies a measure of "pure" inflation: the common component in goods' inflation rates that has an equiproportional effect on all prices and is uncorrelated with relative price changes at all dates. The estimates of pure inflation and of the aggregate relative-price components allow us to re-examine three classic macro-correlations. First, we find that pure inflation accounts for 15-20% of the variability in overall inflation, so that most changes in inflation are associated with changes in goods' relative prices. Second, we find that the Phillips correlation between inflation and measures of real activity essentially disappears once we control for goods' relative-price changes. Third, we find that, at business-cycle frequencies, the correlation between inflation and money is close to zero, while the correlation with nominal interest rates is around 0.5, confirming previous findings on the link between monetary policy and inflation.

...

6. What have we done and why does it matter? In this paper, we ... used different estimation techniques and specifications to robustly estimate pure inflation, and proposed a simple method to compute macroeconomic correlations while controlling for goods’ relative price changes.

Our first finding was that pure inflation can differ markedly from other conventional measures of inflation, like the PCE deflator or its core version. It is smoother, less volatile, and in particular in the 1990s, its ups-and-downs are quite different from those in other measures of inflation. This should be useful to economic historians since it provides an alternative account of the movements in inflation in the last half-century. Relative to existing measure of inflation, pure inflation has the virtue of separating absolute from relative-price changes, which is a crucial distinction in economic theory. Moreover, pure inflation matches more closely the concept that many economists seem to have in mind when discussing aggregate movements in prices and monetary policy (typically based on intuition that comes from a one-good world).

"A Note on Economic Conditions in the United States"

From Michael Perelman at EconoSpeak, a quote from Keynes:

A note from a careful observer of US financial conditions, by Michael Perelman: [pg.] 569: "I fancy that the great New York (banking) institutions have more skeletons in their cupboards than anyone yet knows about for certain, and that their concealed anxieties cramp their action more than is admitted."

Keynes. 1930. "A Note on Economic Conditions in the United States: A Memorandum for the Economic Advisory Council." CW 20, pp. 561-94.

links for 2007-11-27

• The Greeks are introduced to the potato - Bluematter
• Stealing Christmas (Housing and Christmas Spending) - Dean Baker
• The Citigroup who stole Christmas - Salon.com
• Radical 'human-centric' map of the world - EurekAlert
• Financial Globalization and Monetary Policy - FRBSF Economic Letter
• Farewell to development's old divides - James D. Wolfensohn
• Meanwhile, on the dollar front - Paul Krugman Blog
• Thompson's latest supply-side claim - Brendan Nyhan
• Scientists Mystified by Jellyfish Attacks on Fish Farm - Spiegel
• Cancer-resistant mouse discovered - EurekAlert
• Builders of masterpieces - International Herald Tribune

"The Problem with Forecasting House Prices"

Richard Green, a professor of real estate, finance and economics at the George Washington University, explains the sensitivity of housing prices to assumptions about the rate of appreciation. Small changes in expected appreciation can bring about much larger swings in current housing prices:

The problem with forecasting house prices, by Richard Green: The value of a house should, in equilibrium, be its capitalized rents. Its capitalization rate is (roughly) the after-tax required rate of return, plus depreciation and expenses less expected appreciation. We may write this out as:

r + m - pi.

The r and the m are relatively easy to measure. Households in the conventional conforming market can borrow at an after-tax mortgage rate of about 5 percent right now, and with very little equity, they can borrow at around 6 percent (the cost of interest plus mortgage insurance). Let's add a risk premium and put the total around 7 percent (this is probably a bit high). Depreciation and expenses will run around 2 percent of house value. So the value of a house is the value of its rent divided by 9 percent less expected appreciation.

Now let's see what happens when we let expectations about future prices range from an increase of 5 percent in a year to a decrease of 5 percent in a year. If expected prices increase five percent, values are 25 times rent (rent/.04); if the decrease 5 percent in a year, values are about 7 times rent. So a ten percentage point decline in expectations could cause house prices to fall by two-thirds.

I think this is part of the current problem. On the one hand, after roughly 2002, prices in many markets shot up well past the 25 to 1 point (on a quality adjusted basis), in part because of very low interest rates, and in part because of unrealistic expectations. Now that prices are falling (as inevitably they would), expectations have reversed, although it is not yet clear by how much.

Some months ago, when others were writing that the bottom was coming, I wrote that I didn't know when the bottom of the housing market was coming, and neither did anyone else. I wish I had been wrong.

Also see Richard's follow up to this post, "Long run vs Short run," [update] and "Three principles for avoiding future subprime messes."

Social Security and UFOs

Having recently taken on an editorial on Social Security by Ruth Marcus, I was going to let the latest Washington Post "the sky is falling" piece on Social Security and how it is headed for crisis pass by without comment (other than in the title I gave it in the daily links of "The Washington Post Continues to Promote the Lie that Social Security is Headed for a Crisis"), but on second thought, let's review. Here's Brad DeLong:

Hoisted from Comments: Low-Tech Cyclist Writes:

Grasping Reality with Both Hands: Brad DeLong's Semi-Daily Journal: I know bringing up Fred Hiatt is like shooting fish in a barrel on this score, but the WaPo has a subset of its unsigned editorials where it comments on what it calls "the ideas primary."

Five of the last seven Ideas Primary editorials have been on the Social Security 'crisis.' There have been 15 editorials in this series. One has been on global warming - the greatest crisis of our era - and two have been on our greatest domestic crisis, the lack of universal health care and the upcoming crisis in the Medicare trust fund. None have been on Iraq and the power vacuum we've created in the center of the Middle East. Interesting set of priorities, huh?

The most recent piece in the Washington Post on the "crisis" isn't from their "Ideas Primary," but it's just as bad. Dean Baker has the description:

Main THE UFOs Are Back at the Post (literally), by Dean Baker: I praised the Post a couple of weeks ago for printing a coherent column by Robert Ball in support of protecting the current level of Social Security benefits. This was an extraordinary departure from its never-ending drumbeat of SS crisis news stories, columns, and editorials.

Since that day, the Post has run a strange column by Ruth Marcus, a former editor, that seemed to attack Paul Krugman for changing his mind on Social Security. In another forum, I quipped about this column that "the UFOs have landed," referring to a nutty effort to discredit Social Security by claiming that more young people believe in UFOs than they will receive a Social Security check.

Well, today the Post actually has the UFO story in its full glory. It appears in an oped column by Amity Shales which is apparently further payback for the Robert Ball column. It looks like we must pay a high price for this modest dissent from the Post's dogma on the SS crisis.

On the substance, I am not quite sure why the opponents of SS believe that the effectiveness of their lies is a basis for gutting the program. This would be comparable to claiming that tens of millions of people believe that Saddam was responsible for September 11th, therefore we should invade Iraq. The fact that the public has been so terribly misled on the financial condition of its most important social program (even if they don't actually believe in UFOs) is a strong argument for putting off any changes until the public can learn the true facts of the situation.

After all the basic issues about the SS program -- how much money it should provide in retirement, how much people should be taxed in their working years, and how late in life they should have to work -- are issues that should be decided democratically, not by people who control major media outlets. And the public cannot possibly make such decisions in an intelligent manner when they are being deliberately misinformed about the true financial status of the program.

Where did the misleading UFO story come from? Here's President Bush on February 10, 2005 giving what was a standard speech at the time:

THE PRESIDENT: ...Somebody was telling me the other day ... he read an interesting poll; he said that a lot of younger workers felt like they're more likely to see a UFO than get a Social Security check. (Laughter.) It's an interesting dynamic, isn't it, when you think about it? There are a lot of young people, when they analyze Social Security and think about it, that they just don't think the government can fulfill the promise, which is a powerful -- it's powerful leverage for members of Congress to listen to.

In other words, the dynamic has shifted. The reason people are comfortable about taking on the Social Security issue..., there's a lot of folks out there who are demanding change -- for their sake. They're saying, what are you going to do about saving the system for me? I'm coming up; I have a better chance of seeing a UFO than getting a check from the government. What are you and the government going to do to make sure I get my check? That's the dynamic that's happening.

And that's why I'm optimistic something is going to get done, because people are beginning to speak out. Younger Americans who understand the math and know the reality are beginning to say to those of us who have been elected, what are you going to do about it? You're up there in Washington, D.C. -- do more than just occupy the office, solve problems and do your job. (Applause.)

I think the last quote should be:

Younger Americans who understand the math and know the reality are beginning to say to those of us who have been elected, why are you lying to us about it? (Applause.)

Why is the Washington Post participating in this attempt to mislead people about the nature of the problem? Brad DeLong is right:

Without major personnel changes, I give the Washington Post five years.

Paul Krugman: Winter of Our Discontent

Why are people so unhappy with the economy?

Winter of Our Discontent, by Paul Krugman, Commentary, NY Times: “Americans’ Economic Pessimism Reaches Record High.” That’s the headline on a recent Gallup report, which shows a nation deeply unhappy with the state of the economy. Right now, ... “an extraordinary 78% of Americans now say the economy is getting worse, while a scant 13% say it is getting better.”

What’s really remarkable about this dismal outlook is that the economy isn’t (yet?) in recession, and consumers haven’t yet felt the full effects of $98 oil (wait until they see this winter’s heating bills) or the plunging dollar, which will raise the prices of imported goods.

The response of those who support the Bush administration’s economic policies is to ... rattle off statistics... Many of these statistics are misleading or irrelevant, but it’s true that the official unemployment rate is fairly low... So why are people so unhappy?

The answer from Bush supporters — who are, on this and other matters, a strikingly whiny bunch — is to blame the “liberal media” for failing to report the good news. But the real explanation ... is that whatever good economic news there is hasn’t translated into gains for most working Americans.

One way to drive this point home is to compare the situation for workers today with that in the late 1990s, when the country’s economic optimism was almost as remarkable as its pessimism today. ...

The unemployment rate in 1998 was only slightly lower than ... today. But for working Americans, everything else was different. Wages were rising, yet inflation was low, so the purchasing power of workers’ take-home pay was steadily improving. So, too, were job benefits, including the availability of health insurance. And homeownership was rising steadily.

It was, in other words, a time when Americans felt they were sharing in the country’s prosperity.

Today, by contrast, wage gains for most workers are being swallowed by inflation. ... Meanwhile, the percentage of Americans receiving health insurance from their employers ... is continuing its downward trend. And homeownership... — well, you know how that’s going.

In short, working Americans have very good reason to feel unhappy about the state of the economy. But what will it take to make their situation better?

The leading Republican candidates for president don’t even seem to realize that there’s a problem. A few months ago Rudy Giuliani, denouncing Hillary Clinton’s economic proposals, declared that “she wants to go back to the 1990s” — as if that would be a bad thing. ...

But simply putting another Clinton, or any Democrat, in the White House won’t ensure that the good times will roll again. President Clinton was a good economic manager, but much of the good news during the 1990s reflected events that won’t be repeated, including low oil prices and ... the temporary leveling off of health care spending ...

And there are good reasons to think that the negative effects of globalization on the wages of some Americans are larger than they were in the ’90s. That’s a hugely contentious issue within the progressive movement, with no easy resolution. ...

Despite these caveats, Democrats have every right to make a political issue out of the failure of the Bush economy to deliver gains to working Americans — especially because conservatives continue to insist that tax cuts for the affluent are the answer to all problems.

But Democrats shouldn’t kid themselves into believing that this will be easy. The next president won’t be able to deliver another era of good times unless he or she manages to tackle the longer-term trends that underlie today’s economic disappointment: a collapsing health care system and inexorably rising inequality.

Fed Watch: Long Run Forecast vs. Short Run Reality

Will the Fed cut rates further, or pause at the next meeting?:

Long Run Forecast Vs. Short Run Reality, by Tim Duy: Recent Fedspeak has, in my opinion, been very clear – current policy is balanced and the bar for another rate cut in December is set high. Only evidence that growth will be substantially below already low expectations would prompt a rate cut. The minutes of the last meeting, however, present a puzzle. There was apparently lengthy discussion of downside risks, yet the final decision was supposedly a “close call.” And despite these numerous downside risks, and a positive trajectory for inflation, the statement defined policy as roughly neutral. The mix of signals leaves perfectly reasonable people with completely opposing opinions about the Fed’s intentions for future policy. One can read the minutes and find reason for pause, but also find a risk management motivation for another cut.

How can we resolve recent Fedspeak, the minutes, and the growth forecasts? Thinking on that question occupied a good part of the long holiday weekend. It appears that the Fed is preparing market participants for a pause in rate cuts before the economy has bottomed out. They would like December to be an opportunity for a pause. But assuming the continuing instability in financial markets, I suspect they will not be willing to risk a pause just yet.

One purpose of increasing transparency via the enhanced forecasts is to minimize the fluctuations of policy. I doubt anyone believes that wide swings in policy – such as the drop to 1% and the subsequent rise to 5.25% - are conducive to economic stability in the long-run. The long run forecast, both for growth and inflation, are intended to create a policy anchor from which the Fed can tie the economy with a short tether.

The Fed’s long term forecast suggests they see the economy’s potential growth rate near 2.5%. This reflects a combination of slower productivity and labor force growth. The inflation forecasts reveal an inflation target of 1.6% to 1.9%, with a midpoint of 1.75%. Combined, this suggests a range of the neutral fund funds rate at roughly 4.0% to 4.5%, with the current rate at the top end of this range. Hence, given this estimate of neutral, the Fed can reasonably conclude that current policy will “promote moderate growth over time” and that the risks to growth and inflation are equally balanced.

You might argue that given we are at that high end of the range, policy remains a tad bit tight relative to neutral. True enough, although the Fed might have cause to expect that ongoing high headline inflation deserves extra attention. From the minutes:

links for 2007-11-26

• Greenspan Shrugged - Economic Principals
• Isn't it time for Britain to join the EU? - Maverecon
• F.C.C. Chief Seeks Votes to Tighten Cable Rules - New York Times
• Ben Stein Watch: November 25, 2007 - Portfolio.com - Felix Salmon
• France: The price of suspicion - Vox EU
• Subprime Series, part 1: Financial Crises Are Not Going Away - Vox EU
• Do firm-level productivity differences explain wage inequality? - Vox EU
• The Washington Post Continues to Promote the Lie that Social Security is Headed for a Crisis

Do We Need Another Rate Cut?

Larry Summers wonders what we are waiting for:

Wake up to the dangers of a deepening crisis, by Lawrence Summers, Commentary, Financial Times: Three months ago it was reasonable to expect that the subprime credit crisis would ... not ... threaten ... economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses..., moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. ... [I]t is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year...

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. ...

Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort.

In such an environment, economic policy needs to be governed by the clear and public recognition that restoring the normal functioning of the financial system and containing any damage its breakdown may do the real economy is the central macro-economic and financial challenge facing the US. ...

What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. .... The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit” ... has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually.

All of this may not be enough to avert a recession. But it is much more than is under way right now.

With respect to traditional stabilization policy, monetary and fiscal policy lags are fairly long. Because of that, past policy responses will govern our immediate future - it's too late to do much now - and anything done now to change monetary or fiscal policy won't be felt with any force until sometime in the future. Thus, given the growing uncertainty about the future course of economic growth, effective risk management points toward taking actions today to reduce the potential for a catastrophic outcome of a deep and prolonged recession at some point in the future.

Under this policy, inflation is a risk if the housing crisis does not bring down economic growth after all, but it is changes in expected inflation over the longer term rather than shorter-run changes in actual inflation that cause the most worry. Given that markets anticipate an economic slowdown and expect the Fed to act accordingly and cut rates, I don't think a further rate cut will cause long-run inflation expectations to change to any worrisome degree. However, if the Fed fails to reverse any additional easing quickly should the data begin to show there isn't as much to worry about as we thought, or if the Fed eases in spite of an improved outlook, then I think elevated inflation expectations become more of a worry.

I'm still hopeful the economy can weather this, but hope is no excuse for imprudence.

About the Government Budget Deficit...

First, Paul Krugman notes the decline in corporate profits recently, a key factor in recent revenue increases:

Red tide rising, by Paul Krugman: The fall in the federal deficit since 2003 has been widely used by conservatives — including the Bush administration and all the leading candidates for the GOP presidential nomination — as proof that tax cuts actually increase revenue.

So here’s a heads-up: the good times are about to stop rolling.

The key factor in rising revenue hasn’t been a growing economy — it has been a surge in corporate taxes as a share of GDP.

But now profits are falling. Revenue will follow — and the deficit is about to get bigger again.

Next, Menzie Chinn says not to expect a balanced budget anytime soon:

Budget Deficit Watch: Receipts Stabilize, Deficit Fails to Shrink, by Menzie Chinn: Reader CoRev, in commenting on this post, advises me to look at the actual data for October (instead of the CBO estimate) before declaring a trend deterioration in the budget balance. Well, the data are out.

Here's what the deficit looks like, using Treasury's Monthly Treasury Statement data for October, and historical data.

Figure 1: Twelve month moving average of budget balance divided by nominal GDP (blue, left scale) and in billions of nominal dollars (red, right scale). Budget balance (on balance sheet and off balance sheet), as recorded by Treasury (October statement), divided by GDP interpolated using quadratic match. October GDP assumes 5% nominal GDP growth, in line 1.4% real GDP growth and 3.6% inflation in 2007Q4 (see WSJ survey). NBER-defined recessions shaded gray. Sources: Treasury's Monthly Treasury Statement data for October, and historical data, BEA October 31 GDP release, NBER, and author's calculations.

It turns out that the $55.6 billion deficit is not that different from the CBO's estimate of $59 billion. But it is the trend that is of greatest interest to me.

In addition, nominal receipts are slowing their ascent, while as a share of GDP, they have clearly plateaued.

Figure 2: Twelve month moving average of receipts divided by nominal GDP (blue, left scale) and in billions of nominal dollars (red, right scale). Receipts (on balance sheet and off balance sheet), as recorded by Treasury (October statement), divided by GDP interpolated using quadratic match. October GDP assumes 5% nominal GDP growth, in line 1.4% real GDP growth and 3.6% inflation in 2007Q4 (see WSJ survey). NBER-defined recessions shaded gray. Sources: Treasury's Monthly Treasury Statement data for October, and historical data, BEA October 31 GDP release, NBER, and author's calculations.

Seems to me a fair bet that, given current estimates for a slowdown to around 1.4% GDP growth SAAR in 2007Q4 (see this post), receipts will fall as a share of GDP.

Hence, I stick with the conclusion from my previous post on this subject: A balanced budget is far off.

Some more things to keep in mind as you think about the budget deficit. This is from a report from by the CBO:

Box 2. The Effect of the Aging of the Population on Spending on Medicare and Medicaid In coming decades, the share of the population that is covered by Medicare will expand rapidly as members of the baby-boom generation become eligible for the program, and the share that uses long-term care services financed by Medicaid will also probably increase. Although the aging of the population is frequently cited as a major factor contributing to the large projected increase in federal spending on those two programs, it accounts for a modest fraction of the growth that the Congressional Budget Office (CBO) projects. The main factor is excess cost growth—or the extent to which the increase in health care spending for an average individual exceeds the growth in per capita gross domestic product (GDP). As shown in the figure, if the age distribution of the population were fixed—so that the average age did not increase over time—and there were no excess cost growth, spending on Medicare and Medicaid as a share of GDP would remain essentially constant. That scenario is represented by the bottom line in the figure. The next line shows projected spending on Medicare and Medicaid if the age distribution of the population changes as expected—so that the average age of the population increases—but excess cost growth remains at zero. The difference between that line and the bottom line captures the effect of the aging of the population on projected federal spending on Medicare and Medicaid. The top line in the figure shows CBO’s projection of spending on those programs, which includes the effects of the aging of the population and of excess cost growth. By itself, aging accounts for about one-quarter of the projected growth in federal Medicare and Medicaid spending through 2030. By 2050, that share has fallen to under 20 percent, and by 2082, to only about 10 percent.

And two more graphs from the report:

If revenues begin to fall and the budget deficit begins increasing, we will hear that we need to cut taxes even more to solve the problem, which I hope you realize is a silly suggestion, and that we'll need to cut back on social programs - Medicare, Medicaid, and Social Security in particular to reign in spending. But I hope these graphs make clear that Medicare and Medicaid are not the problem, nor are demographics. I also hope that by now you are also well aware that the problems with Social Security, which are minor,  can be fixed any number of ways none of which is prohibitively costly (or even nearly so). As the CBO report says, "The main factor is excess cost growth—or the extent to which the increase in health care spending for an average individual exceeds the growth in per capita gross domestic product (GDP)." If the deficit does begin to increase as expected, don't be fooled by the misleading rhetoric that is sure to come from those who see it as an opportunity to push their ideology. "Socialsecuritymedicareandmedicaid" is not the main problem.

links for 2007-11-25

• EU to press China over yuan - International Herald Tribune
• Far From Beijing’s Reach, Officials Bend Energy Rules - New York Times
• Nothing can stop the American holiday shopper. - Daniel Gross
• Broken Government - John W. Dean - Book Review - New York Times
• A Guide to Estimates of the Cost of the Iraq War - City Economist
• The Quantity Theory and the Constitution - Twenty-Cent Paradigms
• Payload: Taking Aim at Corporate Bribery - New York Times
• Dr. Drug Rep - New York Times
• The Next Clintonomics - David Ignatius - washingtonpost.com

Shiller: A Time for Bold Thinking on Housing

Robert Shiller has a list of options for regulating mortgage markets and for helping homeowners who are having difficulty keeping up with their mortgages:

A Time for Bold Thinking on Housing, by Robert Shiller, Economic View, NY Times: We have to consider the possibility that the housing price downturn will eventually be as big as that of ... 1925 to 1933, when prices fell by a total of 30 percent.

As of this August, domestic home prices were already down 5 percent from their peak 14 months earlier..., and prices were falling at a faster rate in the months leading up to August. ...

This crisis should be an occasion for some inspired thinking about fundamental changes in our real estate institutions. The actions that have already been taken are not impressive. The housing market is worsening, and more and more home owners are getting into trouble...

The public response to the housing downturn of 1925-33 provides an important lesson in what government and private institutions can accomplish.

Faithful to Science

I haven't had much time to think about this, but posts are getting stale amid the rush of the holiday weekend, so, staying in "echo mode":

Taking Science on Faith, by Paul Davies, Commentary, NY Times: Science, we are repeatedly told, is the most reliable form of knowledge about the world because it is based on testable hypotheses. Religion, by contrast, is based on faith. ...

The problem with this neat separation into “non-overlapping magisteria,” as Stephen Jay Gould described science and religion, is that science has its own faith-based belief system. All science proceeds on the assumption that nature is ordered in a rational and intelligible way. You couldn’t be a scientist if you thought the universe was a meaningless jumble of odds and ends haphazardly juxtaposed. ...

The most refined expression of the rational intelligibility of the cosmos is found in the laws of physics, the fundamental rules on which nature runs. The laws of gravitation and electromagnetism, the laws that regulate the world within the atom, the laws of motion — all are expressed as tidy mathematical relationships. But where do these laws come from? And why do they have the form that they do?

When I was a student, the laws of physics were regarded as completely off limits. The job of the scientist, we were told, is to discover the laws and apply them, not inquire into their provenance. The laws were treated as “given” — imprinted on the universe like a maker’s mark at the moment of cosmic birth — and fixed forevermore. Therefore, to be a scientist, you had to have faith that the universe is governed by dependable, immutable, absolute, universal, mathematical laws of an unspecified origin. You’ve got to believe that these laws won’t fail, that we won’t wake up tomorrow to find heat flowing from cold to hot, or the speed of light changing by the hour.

Over the years I have often asked my physicist colleagues why the laws of physics are what they are. The answers vary... The favorite reply is, “There is no reason they are what they are — they just are.” The idea that the laws exist reasonlessly is deeply anti-rational. After all, the very essence of a scientific explanation of some phenomenon is that the world is ordered logically and that there are reasons things are as they are. ...

Although scientists have long had an inclination to shrug aside such questions concerning the source of the laws of physics, the mood has now shifted considerably. Part of the reason ... that the laws of physics have now been brought within the scope of scientific inquiry is the realization that what we long regarded as absolute and universal laws might not be truly fundamental at all, but more like local bylaws. They could vary from place to place on a mega-cosmic scale. A God’s-eye view might reveal a vast patchwork quilt of universes, each with its own distinctive set of bylaws. ...

The multiverse theory is increasingly popular, but it doesn’t so much explain the laws of physics as dodge the whole issue. There has to be a physical mechanism to make all those universes and bestow bylaws on them. This process will require its own laws, or meta-laws. Where do they come from? The problem has simply been shifted up a level from the laws of the universe to the meta-laws of the multiverse.

Clearly, then, both religion and science are founded on faith — namely, on belief in the existence of something outside the universe, like an unexplained God or an unexplained set of physical laws... For that reason, both monotheistic religion and orthodox science fail to provide a complete account of physical existence. ...

It seems to me there is no hope of ever explaining why the physical universe is as it is so long as we are fixated on immutable laws or meta-laws that exist reasonlessly or are imposed by divine providence. The alternative is to regard the laws of physics and the universe they govern as part and parcel of a unitary system, and to be incorporated together within a common explanatory scheme.

In other words, the laws should have an explanation from within the universe and not involve appealing to an external agency. The specifics of that explanation are a matter for future research. But until science comes up with a testable theory of the laws of the universe, its claim to be free of faith is manifestly bogus.

Very quick (and probably wrong) reaction: I guess I don't see why falsifiability isn't enough to distinguish science from faith. The argument - I think- is that a statement like "this object is blue," which appears falsifiable isn't since if the laws of the universe change the object may be red instead of blue tomorrow. So I have to take it on "faith" that blue will stay blue forever. Fine, but as I look at the object it's either blue or it isn't. If it changes from blue to red someday, then that is an indication that either the hypothesis itself or one of the maintained hypotheses (i.e. that the laws of physics are constant, at least locally) is false. So I don't see why the scientific method fails us in this particular instance. But as I said, I didn't give this the thought it deserves, so feel free to explain why I've totally missed the point. It wouldn't be the first time that has happened.

links for 2007-11-24

• Still More Grim News from the Credit Market - Yves Smith
• Why Does a Salad Cost More Than a Big Mac? - Mathew Yglesias
• Just when things were looking up in Afghanistan - IHT
• August in November - Paul Krugman Blog
• Is Atomic Radiation as Dangerous as We Thought? - Spiegel
• Economy May Defy Past and Disregard Housing - New York Times
• Lost in a Flood of Debt - New York Times
• Polar Bears for the South Pole? - Spiegel

"Ultimately, Consumer and Business Confidence are Mostly Irrational"

Robert Shiller says images that ought to remind us of troublesome past episodes in financial and energy markets are largely absent today - we don't see long lines at gas pumps, financiers leaping from buildings, etc. - and this explains why consumer and business confidence have not, as of yet, declined substantially. But should those images begin to change, watch out:

Markets ail, yet people irrationally exuberant, by Robert Shiller, Project Syndicate: The world's oil and stock markets have been plunged into turmoil in recent months. Yet consumer confidence, capital expenditure, and hiring have yet to take a sharp hit. Why?

Ultimately, consumer and business confidence are mostly irrational.

The psychology of the markets is dominated by the public images that we have in mind from day to day, and that forms the basis of our imaginations and of the stories we tell each other.

Popular images of past disasters are part of our folklore, often buried in the dim reaches of our memory, but re-emerging to trouble us from time to time.

Like traditional myths, such graphic, shared images embody fears that are deeply entrenched in our psyche. The images that have accompanied past episodes of market turmoil are largely absent today.

Consider the oil crisis that began in November 1973, resulting in a world stock market crash and a sharp world recession. Vivid images have stuck in people's minds from that episode: long lines of cars at gas stations, people riding bicycles to work, gasless Sundays and other rationing schemes.

Today, the real price of oil is nearly twice as high as it was at the peak of that crisis, but we have seen nothing like the images from 1973-75. Mostly we are not even reminded of them. So our confidence is not shaken, yet.

Just before the October 19, 1987, stock market crash, the biggest one-day drop in history, the image on people's minds was the crash of 1929. Indeed, the Wall Street Journal ran a story about it on the morning of the 1987 crash. ...

Images of 1929 - of financiers leaping from buildings, unemployed men sleeping on park benches, long lines at soup kitchens, and impoverished boys selling apples on the street - are not on our minds now.

The 1929 crash just does not seem relevant to most people today, probably because we survived the 1987 and 2000 crashes with few ill effects, while 1929 seems not only the distant past, but another world. ...

The images that are uppermost in our minds are of a housing crisis. We imagine residential streets with one "for sale" sign after another. Worse, there are images of foreclosures, of families being evicted from their homes, their furniture and belongings on the street.

If home prices continue to decline in the United States and possibly elsewhere, there could be many more vivid images. You may yet be presented with the image of your child's playmate moving away because his parents were thrown out in a foreclosure. You may see a house down the street trashed by an angry owner who was foreclosed.

Such images become part of your sense of reality, and could disturb your sense of confidence and reduce your willingness to spend and support the economy. Could such changes in psychology be big enough to tip us into a world recession?

While it is far from clear that they will, it is a possibility. Psychology need only change enough to bring about a drop in consumption or investment growth of a percentage point or so of world GDP, and market repercussions can do the rest.

Paul Krugman: Banks Gone Wild

Because of the failure to reform corporate governance after the last set of scandals, the people responsible for the housing crisis aren't the ones paying for it:

Banks Gone Wild, by Paul Krugman, Commentary, New York Times: “What were they smoking?” asks the cover of the current issue of Fortune magazine. Underneath the headline are photos of recently deposed Wall Street titans, captioned with the staggering sums they managed to lose.

The answer, of course, is that they were high on the usual drug — greed. And they were encouraged to make socially destructive decisions by a system of executive compensation that should have been reformed after the Enron and WorldCom scandals, but wasn’t.

In a direct sense, the carnage on Wall Street is all about the great housing slump. This slump was both predictable and predicted... But even as the danger signs multiplied, Wall Street piled into bonds backed by dubious home mortgages... Now the bill is coming due, and almost everyone — that is, almost everyone except the people responsible — is having to pay.

The losses suffered by shareholders in Merrill, Citigroup, Bear Stearns and so on are the least of it. Far more important ... are the hundreds of thousands if not millions of American families lured into mortgage deals they didn’t understand, who now face sharp increases in their payments — and, in many cases, the loss of their houses — as their interest rates reset.

And then there’s the collateral damage to the economy. You still hear occasional claims that the subprime fiasco is no big deal... But bad housing investments are crippling financial institutions that play a crucial role in providing credit, by wiping out much of their capital. ... Goldman Sachs suggested ... losses could force banks and other players to cut lending by as much as $2 trillion — enough to trigger a nasty recession, if it happens quickly. Beyond that, there’s a pervasive loss of trust, which is like sand thrown in the gears of the financial system...

How did things go so wrong?

Part of the answer is that people who should have been alert to the dangers, and taken precautionary measures, instead blithely assured Americans that everything was fine, and even encouraged them to take out risky mortgages. Yes, Alan Greenspan, that means you.

But another part of the answer lies in what hasn’t happened to the men on that Fortune cover — namely, they haven’t been forced to give back any of the huge paychecks they received before the folly of their decisions became apparent...

Executives are lavishly rewarded if the companies they run seem successful: last year the chief executives of Merrill and Citigroup were paid $48 million and $25.6 million, respectively. But if the success turns out to have been an illusion — well, they still get to keep the money. Heads they win, tails we lose.

Not only is this grossly unfair, it encourages bad risk-taking, and sometimes fraud. If an executive can create the appearance of success, even for a couple of years, he will walk away immensely wealthy. Meanwhile, the subsequent revelation that appearances were deceiving is someone else’s problem.

If all this sounds familiar, it should. The huge rewards executives receive if they can fake success are what led to the great corporate scandals of a few years back. There’s no indication that any laws were broken this time — but the public’s trust was nonetheless betrayed, once again.

The point is that the subprime crisis and the credit crunch are, in an important sense, the result of our failure to effectively reform corporate governance after the last set of scandals.

John Edwards recently came out with a corporate reform plan, but it didn’t receive a lot of attention. Corporate governance still isn’t regarded as a major political issue. But it should be.

"Not (Yet) a 'Minsky Moment'"

Charles Calomiris argues that the decline in credit due to current problems in financial markets is unlikely to cause a recession:

The Subprime troubles caused a liquidity shock, but there is little reason to believe that a substantial decline in credit supply under the current circumstances will magnify the shocks and turn them into a recession. We have not (yet) arrived at a Minsky moment.

Note, however, that this is based upon current circumstances and is qualified with:

It is hard to know whether new financial shocks will occur (e.g., large housing price declines, or substantial increases in defaults on other consumer loans), or whether consumption demand will decline independent of financial system problems. ... Of course, if housing prices fell by 50% nationwide (as some have argued is "entirely possible") there is no question that the impact on consumers would be severe... A real estate collapse would not only cause a decline in consumption via a wealth effect, it could produce a major financial accelerator effect.

Here's his reasoning:

links for 2007-11-23

• Tattered Dream - Eugene Robinson - washingtonpost.com
• A new fashion in modelling - Economist.com
• Sweden Turns to a Promising Power Source, With Flaws - New York Times
• The Ice-Cream Scoop Taken Out of the Universe - Discover
• Is Atomic Radiation as Dangerous as We Thought? - Spiegel
• New Numbers on AIDS - New York Times
• A new design for healthcare delivery - Steven Spear and Donald M. Berwick

"How Much Inequity Can You Take in a System?"

On equity:

Money motivates -- especially when your colleague gets less, EurekAlert: The feelings an individual has on receiving his pay cheque depend critically on how much his colleague earns. Hard evidence for this comes from an experiment conducted by economists and brain scientists at the University of Bonn. They tested male subjects in pairs, asking them to perform a simple task and promising payment for success. ... Participants who got more money than their co-players showed much stronger activation in the brain's "reward centre" than occurred when both players received the same amount. Details of the study are ... in the renowned academic journal "Science". ...

In the experiment ... the participants had to lie down next to each other in parallel brain scanners. They were asked to perform the same task simultaneously. Dots appeared on a screen and they had to estimate the number being displayed. They were then told whether their answer was correct. If they had solved the task correctly, they received a financial reward, which might range from 30 to 120 euros. Each participant also learnt how his partner in the game had performed and how much he would pocket in return.

Throughout this procedure the tomograph monitored the changes in blood circulation in the different regions of the subject's brain. ... A total of 38 men took part in the experiment. "We registered enhanced activity in various parts of their brains during the test," explains the Bonn neuroscientist Dr. Bernd Weber. "One area in particular, the ventral striatum, is the region where part of what we call the 'reward system' is located."

The reward system is activated when an individual has an experience he considers worth aspiring to. "In this area we observed an activation when the player completed his task correctly," says Bernd Weber... By contrast, when the subject got his estimate wrong, activity in his ventral striatum would subside. For us, however, the exciting finding here was the role played by another factor: the performance of the player in the other scanner. Weber's colleague Dr. Klaus Fliessbach sums up the outcome, "Activation was at its highest for those players who got the right answer while their co-player got it wrong."

The researchers then took a closer look at those cases in which both players estimated the number of points correctly. If the participants received the same payment there was relatively moderate activation of the reward centre. But if player one was given, say, 120 euros, while his partner received only 60, the activation turned out to be much stronger for player one. For player two, on the other hand, the blood flow into the ventral striatum actually decreased - even though he had performed the task successfully and had been rewarded for his efforts.

"This result clearly contradicts traditional economic theory," explains Bonn-based economist Professor Dr. Armin Falk. "The theory assumes that the only important factor is the absolute size of the reward. The comparison with other people's rewards shouldn't really play any role in economic motivation." It is the first time that this hypothesis has been challenged using such an experimental approach. It does not mean, of course, that the absolute size of the reward has no impact on the "reward centre": more excitement was registered in response to 60 euros than 30. "But the interesting point to emerge from our study is that the relative size of one's earnings plays such a major role," Armin Falk insists. ...

And:

Monkeys Have Sense of Fairness, Study Finds, by Susan McMillan, Emory Wheel: Two researchers at the Yerkes National Primate Research Center have found that brown capuchin monkeys have a sense of fairness and will reject inequitable rewards, much as humans do.

Frans de Waal, C.H. Candler ... said his work with Georgia State University professor Sarah Brosnan was based on a study they did in 2003. In that experiment, monkeys responded negatively when a partner received a superior reward for completing the same task, retrieving a pebble and placing it the researcher’s hand.

“As soon as the partner’s getting something better, like grapes, they don’t want to do it any more,” de Waal said. “They throw the food out of the cage sometimes.”

Brosnan and de Waal conducted a follow-up study to rule out alternative explanations for why monkeys would reject slices of cucumber, a previously acceptable reward.

“The most important one was you could argue that the monkeys reject the cucumber pieces because they see grapes and they want grapes,” de Waal said. “We would show them grapes, but we would put them away, and showing them the grapes didn’t make a difference in our test. It had to do with what partner was getting.”

Brosnan and de Waal also varied the amount of effort required to complete the task to see its effect on the monkeys’ reactions.

They found that when monkeys had to expend more effort, they were more sensitive to inequity and less likely to accept cucumber slices when partners had received grapes for equal or less work. But both would accept grapes even if they completed tasks at different levels of difficulty, de Waal said.

“If you gave them grapes, they were not sensitive to effort,” he said. “The grape is such a good reward that they would do whatever to get the grape.” ...

According to de Waal, the research illustrates inequity aversion, a concept from the field of behavioral economics, which applies behavioral psychology to economic interactions. Like the monkeys in de Waal’s study, humans do not always act as rational profit maximizers and sometimes turn down good offers if someone else is getting a better deal.

“For a monkey to refuse a perfectly fine food like cucumber just because somebody else is getting something better is an irrational reaction,” de Waal said. “Profit maximizing requires that whenever you can get something you take it.”

Some scholars, however, argue that reactions like the monkeys’ make sense in a social context. The capuchins’ sense of fairness has “evolved within the context of cooperation,” de Waal said, because capuchins live in groups and sometimes hunt squirrels together.

“If you don’t get in accordance to your effort, you should be sensitive to that, or everyone will take advantage of you,” he said. “It’s actually a rational response to make sure you get the right rewards for the right amount of work.”

De Waal said reactions to inequity are important for researchers to study because of widening gaps between haves and have-nots.

“How much inequity can you take in a system?” he said.

Happy Thanksgiving

Dress Your Turkey with Tin Foil

"The Theory of Moral Neuroscience"

Adam Smith's Lost Legacy says this discussion of how neuroscience is confirming the role of empathy in human sociality and morality is "worth a look":

The Theory of Moral Neuroscience, by Ronald Bailey, Reason Online: "As we have no immediate experience of what other men feel, we can form no idea of the manner in which they are affected, but by conceiving what we ourselves should feel in the like situation," observed ... Adam Smith in the first chapter of ... The Theory of Moral Sentiments (1759). "Whatever is the passion which arises from any object in the person principally concerned, an analogous emotion springs up, at the thought of his situation, in the breast of every attentive spectator." Smith's argument is that our ability to empathize with others is at the root of our morality.

Recent discoveries in neuroscience are bolstering Smith's insights about the crucial role of empathy in human sociality and morality. For example, in the 1990s, Italian scientists researching motor neurons in macaque monkeys discovered mirror neurons. As the story goes, a monkey's brain had been wired up to detect the firing of his neurons... One researcher returned from lunch licking an ice cream cone. As the monkey watched the researcher, some of his neurons fired as though he were eating the ice cream... The monkey's neurons were "mirroring" the activity that the monkey was observing.

Neuroscientist Giacomo Rizzolatti and his colleagues ... reported their discovery of monkey mirror neurons in 1996. Researchers soon found evidence for mirror neurons in human beings. Just like monkeys, it turns out that when we see someone perform an action—picking up a glass of water or kicking a ball—our mirror neurons simulate that action in our brains. Researchers have suggested that mirror neurons are crucially involved in the distinctive human development of language, morality, and culture.

Research looking at the brains of autistic people highlights the role that some neuroscientists believe that mirror neurons play in empathy. ...[T]he symptoms of autism often involve a marked lack of awareness of the feelings of others and little or no social interaction or communications with others. In 2005, researchers at the University of California San Diego (UCSD) ...[found] "...results [that] support the hypothesis of a dysfunctional mirror neuron system in high-functioning individuals with ASD"... Mirror neurons are not absent from the brains of ASD people, but they are misfiring. ...

Mirror neurons are not the sole source of our moral sense. After all, ASD individuals are not notably immoral. However, they are an important part of it. Empathy, the ability to feel someone else's joy, pain, and gratitude, helps guide our pre-reflective moral values. So let's consider the limits of empathy for schooling us in morality. Harvard University psychologist Joshua Greene offers the case in which, while driving, you see a bleeding hiker lying by the roadside. You must decide between taking the man to the hospital or refuse to do so because the injured man would bleed all over your expensive upholstery.

Greene correctly observes, "Most people say that it would be seriously wrong to abandon this man out of concern for one's car seats" But what about the case in which you receive a letter from an international charity that promises to lift a poor family in Africa out of abject misery at the cost of a $200 contribution from you? "Most people say that it would not be wrong to refrain from making a donation in this case," writes Greene. What's the difference? ... Greene proposes an evolutionary answer. He points out that our ancestors evolved in an environment in which they could only choose to save people that they knew personally, not total strangers living continents away.

Greene's findings again buttress Adam Smith's insight from more than two centuries ago that empathy works to prompt us to help our neighbors but attenuates with social distance. "That we should be but little interested, therefore, in the fortune of those whom we can neither serve nor hurt, and who are in every respect so very remote from us, seems wisely ordered by Nature," writes Smith. ...

But we do not have to be the slaves of our evolved moral intuitions. By showing us the neural workings of our moral sense, neuroscience is giving us the tools to understand and improve our moral choices. As Greene concludes, "I am confident that the scientific study of human nature will have an increasingly important role in nature's grand experiment with moral animals." ...

Banking System Oversight

Robert Reich says the Fed already has all the tools it needs to regulate financial markets, but it hasn't used them effectively:

The Fed can already help subprime, Marketplace: ...As someone who was in charge of one of the biggest regulatory agencies in the federal government, I can tell you regulations themselves don't do squat. They have to be vigorously enforced. And that means setting clear rules, having enough inspectors, and knowing when vigilance is required.

So how to prevent another banking crisis that causes millions of families to lose their homes and investors to lose their shirts? The Federal Reserve already has the authority it needs to do this. The Federal Reserve Act of 1913, as amended, and the Bank Holding Company Act of 1956, give it power to monitor and regulate the entire banking system.

The problem here was it failed to use this authority. It wasn't even paying attention.

A few years back, when the Fed lowered short-term interest rates to 1 percent, money became so cheap the Fed should have known lenders would hand it out to almost any borrower who could stand up straight. Especially when lenders could immediately fob off the loans to middlemen who bundled them and sold them off again.

Big banks, hedge-fund managers, everyone looked the other way because the party was too much fun. And then when the Fed started raising rates, it should have known the party would be over -- and there'd be a mess to clean up.

But the Fed didn't -- and still doesn't -- pay enough attention to the effects of its rate settings on the practices of lenders and borrowers. It still doesn't have enough bank examiners who know what to look for. Still doesn't know how to oversee giant financial conglomerates whose deals are so complex even their own top executives don't understand them. Is even now disregarding the next banking crisis, which will be a wave of credit-card defaults.

Instead of pumping out new regulations, Congress should give the Fed the resources it needs to use the authority it already has. Confirm new Fed governors who will be vigilant in overseeing the banking system. And hold all Fed appointees accountable for doing the job they're supposed to do. ...

links for 2007-11-22

• Have we sealed the universe's fate by looking at it? - EurekAlert
• Who’s the Richest [Country] of Them All? - WSJ Economics Blog
• Dazzle Them with Demographics - James K. Galbraith - Texas Observer
• A thought about political discourse - Paul Krugman Blog
• The Laffer Curve of Leftist Economics? - YouNotSneaky!
• The Laffer curve is all wrong - Bluematter
• Intergenerational payoffs from mothers’ education - Vox EU
• The Market for Scientists and Engineers - NBER Reporter - Richard Freeman
• Moyers & FDR - The Nation

A Letter to Treasury Secretary Paulson

Calculated Risk says this is recommended reading:

Dear Mr. Paulson, by Tanta: I see you're coming around to a view of the housing and mortgage mess that has a clear reality bias. You're not there yet, but the trend is inspiring. I want you to know that I'm from The Blogs and I'm here to help you.

First things first: why have mortgage lenders worked out troubled loans ever since the dawn of mortgage lending? Because lenders do what lenders do: seek maximum profits. If a loan was supposed to earn you a dollar, but isn't earning you anything because the borrower is not paying, and you have the choice of restructuring, and getting, say, 90 cents, or foreclosing, and getting, say, 70 cents, you restructure. It is possible that, end of the day, you really get 91 cents instead of 90 cents if you cloak it in fine-sounding rhetoric about keeping The Dream Alive and helping borrowers stay in their homes and stuff. (It costs maybe a penny to write boilerplate PRs like that; you get two cents in benefits from Happy Regulators; it nets out.)

How does this get complicated?

Ruth Marcus Tries to Show Her Beltway Badge of Seriousness

Ruth Marcus shows two things in her commentary today, "Krugman vs. Krugman". First, she hasn't a clue about Social Security financing. Second, she has no problem at all presenting a distorted picture to rationalize her clueless position.

On the Social Security financing issue, the most recent pieces I've seen are by Dean Baker, "The crisis that isn't," and Paul Starr, "Hold that Tax," but there's been so much written that it's hard to believe that anyone who isn't being willfully ignorant could be unaware of the true magnitude of the problem - the system is not headed for disaster, for a crash, or anything like that.

Anyone interested in understanding the financing issues ought to read America's Senior Moment by Paul Krugman. I refer you to this particular piece, from the New York Review of Books and written in 2005, because Ruth Marcus uses quotes from Paul Krugman dated 2001 or earlier to try to show he has been inconsistent on the Social Security financing issue. The subtext is, or course, that he is being dishonest.

But had Ruth Marcus included this quote from Paul Krugman's 2005 piece in her editorial (or quotes from other pieces of the vast amount Krugman has written about Social Security after 2001), it would have changed the interpretation of the quotes she includes in her article. Here, Paul Krugman explains why the future of Social Security was at issue at that time:

Four years ago, I and many other economists urged policymakers to think about the future cost of Social Security benefits, not because we thought there was anything wrong with Social Security itself, but because we regarded the future costs as a compelling reason not to cut taxes even if the overall budget was in surplus.

Keep that quote in mind, i.e. that the worry was that the Bush tax cuts would eat away at the accumulated Social Security surplus, as they did, as you read Ruth Marcus' desperate attempt to justify her doom and gloom about the future of Social Security:

Krugman vs. Krugman, by Ruth Marcus, Commentary, Washington Post: In liberal Democratic circles, the debate over Social Security has taken a dangerous "don't worry, be happy" turn.

The argument has two equally dishonest components. The first is to deny that Social Security faces a daunting financing problem... The second is to mischaracterize the arguments of those who advocate responsible action, accusing them of hyping the system's woes.

One prominent practitioner of this misguided approach is New York Times columnist Paul Krugman. "Inside the Beltway, doomsaying about Social Security -- declaring that the program as we know it can't survive the onslaught of retiring baby boomers -- is regarded as a sort of badge of seriousness, a way of showing how statesmanlike and tough-minded you are," Krugman wrote last week. "In fact, the whole Beltway obsession with the fiscal burden of an aging population is misguided."

Somebody should introduce Paul Krugman to . . . Paul Krugman.

"[A] decade from now the population served by those programs [Social Security and Medicare] will explode. . . . Because of those facts, merely balancing the federal budget would be a deeply irresponsible policy -- because that would leave us unprepared for the demographic deluge, with no alternative once it arrives except to raise taxes and slash benefits." (July 11, 2001)

"Broadly speaking, the next administration . . . will face two big economic tests. One . . . is whether it can stick to a fiscal policy, including a policy toward Social Security, that prepares this country for the demographic deluge." (Nov. 12, 2000)  ...

You get the idea, a lot of the article is just quotes from Krugman from 2001 or earlier (she even reaches back to 1996 at one point) as she tries to turn his concern over the effect tax cuts would have on the surplus, and hence our ability to meet future obligations, into more general concern over a potential crisis in the Social Security program even though that isn't what he was saying (and note the first quote also includes Medicare). The article then discusses whether or not Krugman mischaracterized the positions of politicians and the Washington Post editorial board, and again selectively quotes Krugman and others to try to justify her argument, but that, of course, has nothing at all to do with whether there is a Social Security "crisis". If there is no crisis - and there isn't - then it is being over-hyped. She doesn't think it's being over-hyped, but that's because she misunderstands the nature of the problem.

Not much of an argument - all it does for the most part is compare quotes from Krugman then and now without putting them in context (and leaving out a whole bunch of other quotes between 2001 and now). Even if there weren't an obvious context to Krugman's prior remarks, what if he had changed his mind as the evidence became clearer. What's wrong with that? That is, showing that someone said one thing in the past, and now says something different as they have learned more about the problem does not imply that what is said now is wrong or dishonest. What matters is if the new position is justifiable, and if Ruth Marcus wants to debate Paul Krugman on the correctness of his current postion on Social Security, which is, by the way, consistent with his prior position, all I can say is good luck --  though even the best of luck won't be enough to overcome the reality that she is on the wrong side of this argument.

Update: Here is Paul Krugman's response.

Update: More from Paul Krugman:

A thought about political discourse, by Paul Krugman: A meta-thought inspired by the Social Security craziness:

Faced with a major public issue, such as the future of Social Security, one might think that the crucial thing would be to ascertain the facts. If I say “there is no crisis,” and you think there is, well, produce the evidence that shows that my arithmetic is wrong — not something I once said that you think proves that I’ve changed my mind. Making this a game of gotcha is just childish.

But here’s the thing: this childishness infects a lot of political discourse. Think about what passes for a “tough” question on the Sunday talk shows. It’s not “Senator Bomfog — you say X, but the statistics show that it’s actually Y. How can you explain this discrepancy?” In fact, I’ve never seen that happen. In political reporting, being wrong means, at most, that your claims are “in dispute.”

No, what actually passes for “tough” questioning is “Senator Bomfog, you say X but last year you said Y. Aren’t you flip-flopping?”

Like I said, it’s childish — and destructive.

The New Fed Forecasts

The Fed released its "new and expanded forecast":

Fed Forecasts Emphasize Risks, by Greg IP: Federal Reserve officials, in a new and expanded forecast, expect the nation's economy to grow sluggishly next year and see risks of an even worse performance.

They also expect food and energy prices to continue putting upward pressure on inflation, but say underlying inflation is now, and will remain, within the target range implied by their new forecast.

The enhanced forecasts by officials of the Fed's policy-setting Federal Open Market Committee underline the conflicting pressures on the central bank to cut interest rates to protect economic growth or to hold them steady to quell inflation. ...

The Fed appears to put the economy's "potential" growth rate -- what it can achieve given long-term growth in the work force and output per worker -- at a mere 2.5%, well below the average annual growth of 3.1% recorded over the past 12 years and the Congressional Budget Office's 2.9% estimate of potential growth. That means a growth rate that others consider substandard might be viewed as healthy, or even inflationary, by the Fed.

FOMC members expect overall inflation, measured by the price index for personal-consumption expenditures, of 1.8% to 2.1% next year, reflecting continued upward pressure from rising energy and food prices. They expect core inflation, which excludes those two factors, of 1.7% to 1.9%. With core inflation now 1.8% and expected to remain there, the Fed isn't under pressure to push it lower.

By 2010, the Fed official said they expect overall and core inflation between 1.6% and 1.9%. Given that Fed officials expect to be able to achieve their desired inflation rate within three years, this range is the Fed's de facto inflation target. The 1.75% midpoint of this range is higher than that of the 1% to 2% comfort zone popularized in 2002 by Ben Bernanke, then a Fed governor...

The minutes, and an accompanying study by staff economists David Reifschneider and Peter Tulip, emphasize that projections are subject to a lot of forecasting error, and those errors grow the further the forecast goes into the future. Based on the track record of forecasts, they say there's a 70% chance growth will be 1.3 percentage points higher or lower than the FOMC forecasts next year, and 1.4 points higher or lower in subsequent years.

See also (1) Dovish Fed vs. Hawkish Fed: More on the FOMC Minutes and Fed’s New Forecasts: What’s Surprising and What Isn’t for more from the WSJ; and (2) So now you know by Jim Hamilton who is surprised by the three year ahead forecasts for relatively low output growth, as well as the forecast for relatively low inflation.

What's Behind the Resource Curse?

Why do resource rich countries experience slower growth?:

Resource Abundance and Corporate Transparency, by Art Durnev and Sergei Guriev, Vox EU: High oil prices brought the issue of so-called “resource curse” back to the frontlines of public debate. It has long been noticed that resource abundance does not always help countries grow out of poverty; instead, they often fall victim of poor governance and internal conflicts. Moreover, among the developing countries which did close the gap with the rich countries in the recent decades, the majority have been resource-poor.

It is still not clear what exactly prevents resource-rich countries from making use of their resource endowments. The newly emerging consensus among economists is that resource abundance slows down, or may even revert, development of growth-enhancing institutions. This conjecture is no longer just an academic hypothesis. Recently, it has been widely discussed by policymakers and the media. In particular, the New York Times’ columnist Tom Friedman’s formulated it as the First Law of Petropolitics: high oil prices stifle the development of democracy and political and economic freedom in oil-rich countries. ...

Our work ... supports the emerging consensus that slower growth in resource-rich economies may be explained by the negative impact of resource endowments on the development of economic and political institutions, which in turn suppresses economic growth. We show that it is not an abstract theory; nor should the existing cross-country comparisons be disregarded as a coincidence or a spurious correlation. It turns out that resource curse is indeed a corporeal phenomenon. It affects – in a very tangible way – corporate transparency in actual corporations. This in turn results in material consequences for capital allocation and growth of these firms. ... [...continue reading...]

links for 2007-11-21

• Dollar Will Weather the Whines, Jeers and Jokes - John M. Berry
• Origins of the Southern Strategy - Matthew Yglesias
• Giant fossil sea scorpion bigger than man - EurekAlert
• How Dangerous Is America? - Spiegel
• 'Crunch' Time For the GOP - Robert J. Samuelson
• Fed’s New Forecasts: What’s Surprising and What Isn’t - WSJ Econ Blog
• Dovish Fed vs. Hawkish Fed: More on the FOMC Minutes - WSJ Econ Blog
• Who will pick up the thread after the great unwinding? - Martin Wolf
• Loan Crisis Entangles Freddie Mac - New York Times

Brad Setser: "A Little Too late"

Brad Setser on the dollar:

A little too late, by Brad Setser: China's premier, Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness. ... Wen certainly has reason to worry.  No one has made a bigger bet on the dollar that China's government. I personally suspect that China's state ... hold[s] around $1.2 trillion in fairly long-term dollar-denominated debt. ...

The capital loss on those dollars could be considerable.  ...[W]hat should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB.  After all, China's government has financed its dollar purchases by issuing RMB debt. ... Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars. ...

The majority of China's dollar exposure comes from intervention over the last three years. That puts Wen in a bit of a bind. His [recent] comments were no doubt intended to tell Washington that it needs to start paying more attention to the value of the dollar. Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar. ...

Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market. He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio.

But doing so would truly cause the dollar's value to tumble. It would dramatically reduce the value of China's existing dollar holdings. As importantly, it would -- absent a change in China's currency policy -- also push the RMB down and push up Chinese inflation.

No wonder Wen is unhappy. ...

The US slowdown has brought a lot of latent tensions to the surface -- in the Gulf ... as well as in China. Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. ...

And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever. What if the US turns out to be borrowing at what amounts to a low initial teaser rate? ...

[The] system where the Gulf, China and some other Asian economies intervene heavily in order to resist market pressure for appreciation ... is under a lot of strain. Both China and the Gulf are starting to worry about the all the (depreciating) dollars they now have to absorb to sustain the system, even if they haven't actually balked at buying those dollars.

It consequently really shouldn't be a surprise that a range of countries are now asking the US to take policy actions -- notably steps to defend the dollar -- that will reduce the strain that the system places on them. ...

In some sense, the current system seems poised at a knife's edge. ... There are a set of investors -- China's government, Japan's government, some large oil exporters and for that matter most domestic US investors -- that are significantly overweight in US financial assets. ... If those investors with lots of dollars decide that they already have to many and try to reduce their dollar holdings, watch out. ...

On the other hand, the dollar has already fallen rather substantially against most European currencies. ... At some point investors who are holding lots of euros or pounds might decide that the dollar is cheap. ...

I am not sure which outcome -- at attempt by those already over-weight dollars to lighten up, or a decision by others that the dollar already has fallen by too much against the euro -- is more likely. I can see the case for both, though the absence of any real signs of resurgent demand for US financial assets suggests, at least to me, that there is a slightly higher chance of even more dollar weakness. ...

Paul Krugman notes Brad Setser's question, "What if the US turns out to be borrowing at what amounts to a low initial teaser rate?", then says:

On the whole, I think people are worrying too much about the falling dollar. But it’s certainly true that Wile E. Coyote has looked down, and things will be very different from the way they were in the mid-00s.

Are Immigrants Good for Cities?

Giovanni Peri reviews research on how immigration impacts cities. The research shows that "the less-educated [are] relatively unaffected by immigration while highly-educated and houseowners gain from it":

Immigration and cities, by Giovanni Peri, Vox EU: Immigration is one of the new century’s ‘hot button’ issues. Whether it is Romanians in Milan or Mexicans in Los Angeles, the concern and the debate has intensified. Political campaigns are fought and won on the issue in several nations and it has shifted party politics in many others. Most of the concern and political backlash focuses on the large and increasing presence of immigrants in cities – especially low-education immigrants.

This is easy to understand from the facts. In the US and Europe, immigration is disproportionately directed to cities, especially large metropolitan areas. In the recent decade immigrant arrivals – currently around 1.25 million people per year – accounted for 40% of the US population growth and for 50-75% of the growth of its largest metropolitan areas. For instance, 27% of people residing in London are foreign-born, as well as 28% of people in New York and 17% in Paris, vis-à-vis much lower national averages (respectively equal to 9%, 12.1% and 10% for the UK, the US and France).

Percentage of Immigrants in Top US cities

	Population in millions	Percentage of foreign-born
Overall US	299.3	12.1
Top 17 metropolitan areas	105.1	26.9
New York	18.8	27
Los Angeles	12.9	35
Chicago	9.6	15
Dallas	6.0	17.4
Philadelphia	5.8	7.9
Houston	5.5	19.8
Miami	5.4	36
Washington, DC	5.3	21.3

Source: U.S. Bureau of Census, July, 2006.

What are the real effects of immigration on wages, rents and local prices faced by the natives? Does immigration drive out the native population? In theory it can work either way. In a static Walrasian world with homogeneous workers, an inflow of workers tends to depress wages, drive up rents and push out natives. However if variety of skills, complementarities in production and agglomeration economies are important, immigration could raise productivity of natives; immigration can drive urban growth which then makes the cities more economically attractive. The matter cannot be settled by logic. Facts are needed.

Recent research One recent strand of research uses data from US cities and states to explore issues such as the response of natives to immigrants and the impact of immigration on the local economy. Recent research by David Card[1] and others is identifying important regularities that point to a positive productivity effect of immigrants on natives overall, and to an increase of average housing value in high immigration cities. These average effects, however, are accompanied by an important distributional component. Highly educated natives enjoyed the largest benefits while the less educated did not gain (but did not lose much either) from immigration to their cities. In a series of recent papers coauthored with Gianmarco Ottaviano[2], I use US data to analyze the impact of immigration on wages, rents and local prices faced by native workers accounting also for the response of natives to immigrants in the form of relocation.

Crowding out natives? From a pure accounting perspective, immigrants were responsible for about 50% of the population growth of the top 100 US metropolitan areas during the 1990s. However, if the inflow of immigrants caused an outflow of native workers (towards areas with low immigration), it would simply change the composition of a city but would not produce net population growth. Analyzing the response of native population to immigrant population across cities, we find instead that large inflows of immigrants over the period 1970-2005 were not associated with any reduction of native population growth. In fact, in most cases, large immigration flows were associated to larger population and employment growth for natives as well. A part of this positive correlation is due to the fact that booming cities attracted natives and immigrants alike. However, we also isolated an immigrant-specific 'pull factor' in each city, in the form of enclaves of earlier immigrants that preferentially attracted co-nationals in period of large outmigration from the country of origin. Even these 'pull-driven' inflows of immigrants were not related at all to outflows of natives, which disproves the theory of crowding out.

Effects on wages and house prices A second result emerges from the cross-city analysis and it is similarly robust and significant. The average wage of native workers and the average housing price increased significantly more in cities with large immigration flows than in cities with low immigration flows over the period 1970-2005. While part of this effect is also explained by the 'booming city' theory, isolating the immigrant-specific pull-driven variation we still find that a 1% increase in the share of foreign-born increased the average native wages by around 0.3-0.4%, and the average house prices (and rents) by 1%. These positive average effects, however, are accompanied by distributional effects. Analyzing the impact by education group we find that native workers with no high school diploma experienced a small reduction in wages and small increase in their rents as a consequence of immigration, while those with college education experienced a significant wage and rent increase.

Click to enlarge

Our explanation of the positive wage effects relies on an important mechanism that seems to be operating in cities as well as in the US economy as a whole, and is based on the fact that the skill composition of immigrants is complementary to that of natives. Foreign-born individuals in the US are over-represented among workers with low skills (no degree) and among those with very high skills (graduate degrees particularly in science and technology). On the other hand, foreign-born are under-represented among workers with high-school and some college education. Most American workers, therefore (70% of which have high school or some college education), do not compete with immigrants for similar jobs but benefit from their complementary productive tasks. Moreover, even at similar levels of education native and immigrant workers tend to specialize in different occupations.

For instance, in related research[3] I found that among less educated workers, immigrants specialize in manual intensive tasks such as cooking, driving and building while natives specialize in language-intensive tasks such as dispatching, supervising and coordinating. The productivity of supervisors, clerks and accountants benefits from the productive services of construction workers, hand packers and janitors in their company. Similarly at high levels of education foreign-born specialize in analytical-mathematical tasks and natives in managerial-language intensive tasks. Again, lawyers’ productivity benefits from the competence of their computer and information technology assistants. Such skill differences translate into limited competition in the labour market and rather complementarities, inducing higher demand (and productivity) for native skills in economies where the supply of immigrants increases. As these complementarities work within as well as across education groups, there is a benefit for natives overall in producing in an economy with immigrants (the positive average wage effects). However the largest benefits are for those with intermediate and high education that do not compete at all for jobs with the large group of less educated immigrants.

On the other hand, this higher productivity of natives overall and the increased city population generates upward pressure on housing prices and rents. These effects, in the long run, induce more house building, so that their impact on house prices should not be large. This is true for housing of less educated workers who live in less desirable locations whose supply is very large. However, more educated individuals, who concentrate in highly desirable urban locations (e.g. Manhattan, Santa Monica or Downtown San Francisco), face a space constraint and experience increasing house values even in the long run.

Interestingly, our quantitative estimates imply an almost exact wash between the increase in average wages and that in average rents, at least on average, so that the real local wage, corrected for local prices is left essentially unchanged[4]. This can be interpreted as an effect of native’s mobility as they 'arbitrage away' real wage differences by moving across cities. The productive effect of immigrants ultimately accrues to house-owners who see the value of their houses increase.

Other effects The positive average wage effect combined with a somewhat adverse distributional effect and a positive house price effect (mostly for highly educated) leaves the less-educated relatively unaffected by immigration while highly-educated and houseowners gain from it. Where, therefore, does the vastly negative reaction to immigration come from? Two important channels, relative to local public good provision, are left out of our analysis. First, fiscal cost of immigrants at the local level may be relevant, especially if they use public goods (such as hospitals and schools) more than natives do and, because of their income, they contribute less in local taxes. Second, people seem to attribute positive value to living in ethnically homogeneous neighborhoods and to sending children to school with better-educated high-income families. Moreover, there may be important peer effects in education and learning. Opinion polls suggest that people may care significantly about these aspects of immigration.

Bottom line Our research shows that market-mediated economic effects of immigrations are mostly positive for natives. However, in order to affect policies it is also crucial to understand better the welfare-related effects and the peer effects that may explain most of the negative attitude towards immigrants.

Footnotes

1 David Card (2007) “How Immigration Affect U.S. Cities” CReAM Discussion paper #11/07, June 2007.
2 G.I.P. Ottaviano and G. Peri (2007) “The Effects of Immigration on U.S. wages and rents: a general equilibrium Approach” CEPR Discussion Paper # 6551; G.I.P. Ottaviano and G. Peri (2006) “The Economic Value of Cultural Diversity: Evidence from U.S. cities” Journal of Economic Geography, Vol. 6, Issue 1, Pages 9-44; and G.I.P. Ottaviano and G. Peri (2005) “Cities and Cultures” Journal of Urban Economics, Volume 58, Issue 2, Pages 304-307.
3 G. Peri and C. Sparber (2007) “Task Specialization, Comparative Advantages, and the Effects of Immigration on Wages” NBER Working Paper, # 13389, September 2007.
4 As reported above an increase in the share of immigrants by 1% increases rents by 1% and wages by 0.3-0.4%. As housing cost account for about 30% of total family expenditure the change in the local price index due to immigration is 0.3*1%=0.3% which is similar to the change in wages.

Growth Policy and Poverty Reduction

In his remarks on the East Asia crisis and the financial hypocrisy summarized in the post below this one, Joseph Stiglitz says:

The poor were among those who bore the biggest burden of the crisis, as wages plummeted and unemployment soared. As countries emerged, many placed a new emphasis on "harmony," in an effort to redress the growing divide between rich and poor, urban and rural.

They gave greater weight to investments in people, launching innovative initiatives to bring health care and access to finance to more of their citizens, and creating social funds to help develop local communities.

Dani Rodrik discusses whether "investing in people" is always the best growth strategy:

Pro-poor growth, social growth, or just growth?, by Dani Rodrik: Income per head in a landlocked African country stands at a fraction of levels it had reached in the 1970s, with only the last few years seeing some decent economic growth. What kind of a growth strategy should this country follow? A strategy that focuses on expanding employment opportunities in the rural areas where most of the poor live? Should it consist of expanding their capabilities, by investing directly in education and health? Or should it focus on wherever the economic activities that will provide sustainable sources of income growth into the future lie, even if these may be in mostly urban areas and likely to foster greater inequality in the short-run?

These are the unexpected questions which a meeting with the World Bank raised... When my colleagues and I pushed for a growth strategy that focused, well, on growth, the reaction from the World Bank staff present was skeptical. It was pro-poor growth they wanted. ... Growth should be social growth, which means investing in people...

Here is how I see it. Having a growth strategy that focuses on growth proper ... does not mean that you don't care about poverty or inequity. It just means that you recognize different targets require different strategies. I recognize that a growth policy may not necessarily achieve significant poverty reduction in the short-run. That is why there is always room for social policy. Growth policy is not social policy--at least not necessarily in the short to medium-run (although in the long-run it probably is the most effective social policy we can think of). But it is indispensable to generate a sustainable increase in the economy's resources and long-run living standards. ...

And by the same token, social policy (targeting the poor directly) should not be confused for a growth strategy. Trying to come up with "pro-poor growth strategies" may backfire if it shortchanges us on growth while distracting us from the need for proper social policies.