Economist's View

Molly Ivins: Big Brother Bush

A year ago today on January 31, 2007, Molly Ivins passed away. I grabbed this column pretty much at random from the archive (here too) but it seems to be fairly representative  of what we have lost -- and timely given the recent debate over FISA:

Big Brother Bush, by Molly Ivins, AlterNet, December 29, 2005:  The first time as tragedy, the second time as farce. Thirty-five years ago, Richard Milhous Nixon, who was crazy as a bullbat, and J. Edgar Hoover, who wore women's underwear, decided some Americans had unacceptable political opinions. So they set our government to spying on its own citizens, basically those who were deemed insufficiently like Crazy Richard Milhous.

For those of you who have forgotten just what a stonewall paranoid Nixon was, the poor man used to stalk around the White House demanding that his political enemies be killed. Many still believe there was a certain Richard III grandeur to Nixon's collapse because he was also a man of notable talents. There is neither grandeur nor tragedy in watching this president, the Testy Kid, violate his oath to uphold the laws and Constitution of our country.

The Testy Kid wants to do what he wants to do when he wants to do it because he is the president, and he considers that sufficient justification for whatever he wants. He even finds lawyers like John Yoo, who tell him that whatever he wants to do is legal.

A Change in the Social Contract?

The intro to this article says that "A sea change may be afoot in how American business views its role in society":

A gentler capitalism, by David Callahan, Commentary, LA Times: Every few decades, America's business leaders change their minds about what obligations corporations and the wealthy have to society. This happened 100 years ago, when ex-robber barons like Andrew Carnegie invented modern philanthropy to address social ills, and in the mid-20th century, when leading executives stopped fighting unions and backed more generous wages and benefits. It also happened in the 1970s, when big business rejected that compact with labor, leading to the harsher free-market ethos of the 1980s and 1990s.

Now, corporate leaders are shifting their thinking once more, calling for a gentler form of capitalism.

The latest evidence came last week from two titans of business, H. Lee Scott Jr., chief executive of Wal-Mart, and Bill Gates, the retiring chairman of Microsoft. At an annual meeting of thousands of Wal-Mart employees and suppliers on Jan. 23, Scott pledged that the company ... would promote energy-efficient products and improve labor conditions in its supply chain. Scott even said that Wal-Mart stores might one day generate electricity with windmills and solar panels. The very next day, Gates ... used a speech at the World Economic Forum in Davos, Switzerland, to call for a new "creative capitalism" in which "more people can make a profit, or gain recognition, doing work that eases the world's inequities."

Signs have long been mounting that corporate leaders are looking beyond the bottom line. Last year, nearly two dozen top U.S. companies ... joined to call for faster action on climate change. ... Scores of chief executives have hired "corporate responsibility officers" -- a position that didn't exist a few years ago -- to monitor their companies' records on environmental, labor and diversity issues.

It is easy to be skeptical of such moves and talk. ... Still, there's good reason to think that we are at another historic pivot point. Corporations, and the people who lead them, do not exist in isolation. When society adopts new values, as Americans broadly have on issues such as climate change and sweatshop labor, executives tend to go along. Sometimes the coercive pressure of unions or government forces their hand; other times (as may be the case today with Wal-Mart) they may fear falling out of step with consumers, tarnishing their brand and gradually losing market share. ...

A sea change like this among the far-upper class doesn't happen often. Such a shift, if truly underway today, will have enormous political consequences... If the consensus in the executive suites is that economic inequality has risen too much, or that too many social needs like healthcare are going unmet, or that the polar ice caps might really melt, the next president and Congress will have more success tackling these problems. ...

The very mission of corporations could change. If a focus on social responsibility begins to nudge aside the bottom-line orthodoxy, we can expect voluntary steps to raise wages, improve health benefits (as Wal-Mart has promised) and adopt environmentally sustainable practices.

None of these outcomes is a given. Global competition is fierce, making it harder than ever for business leaders to think beyond their balance sheets. But as more corporate leaders proclaim their commitment to social responsibility, and as politicians, unions and activists demand that they live up to this rhetoric, a new era of a gentler capitalism may truly begin.

To the extent that there is a big change happening, it seems to me that the shifts in the past described above were driven in large part by economics, e.g. corporations giving in or promoting particular legislation to avoid solutions that would be much more costly to them. Thus, it really was concern about the bottom line that was the driving force behind the change. In that respect, you have to wonder how much of today's corporate and philanthropic concern over global warming and and other such issues is really an attempt by corporations to avoid potentially more costly solutions being imposed upon them, or an attempt by the wealthy to avoid a political backlash that would result in much higher tax rates. But, maybe I'm too cynical and there really is a different type of corporation or powerful individual beginning to emerge in response to a shift in social values. In the end, though, count me as skeptical. I'll be happy to be wrong, but I'll believe it when I see it as a general phenomena rather than just through a few high profile cases.

Sovereign Wealth Rules?

I'm haven't been too concerned about sovereign wealth funds, except to the extent that they present political difficulties that might trigger a harmful protectionist backlash, but Larry Summers says there are reasons to ask questions about their "multiple motives." However, he says, it's nothing a set of voluntary guidelines can't fix:

Different money, different rules, by Lawrence H. Summers, Commentary, International Herald Tribune: Along with the prominent emergence of sovereign wealth funds on the global scene, some key questions arise.

The first revolves around the issue of "multiple motives." What is the primus of capitalism? It is that people invest ... in order to maximize their value. If you think about national ownership of a ... business..., or even a direct investment made by a public pension fund in the United States, the same issue arises: There can be motives other than highest rate of return.

For example, perhaps a state-owned fund wants an airline to fly to its country. Perhaps it wants a bank to do extensive business in its country. Perhaps it wants suppliers from its country to be sourced. Perhaps it wants to disable an industry that competes with its nation's national champion. These other motives distort the whole notion of capitalism that value maximization is the chief objective.

Another concern is general politicization. Suppose a country ran an active trading operation and found itself in an investment much like George Soros's short position in the British pound in 1992. Would we be comfortable with the concept that nation X found that the fixed exchange rate of nation Y was untenable and wanted to launch a speculative attack against it? That is not conducive to successful relations between nations. There should be some kind of understanding that this is not going to happen.

Suppose the sovereign wealth fund in one country makes an investment in a major bank in another country. Then the bank gets in big trouble. There is no question as to whether investors are going to be bailed out. But is there any country in the world that can assert confidently that, with billions of dollars on the line, their head of state and foreign minister are not going to become involved in the negotiation of that transaction? Do we think that kind of thing is healthy for modern markets?

The question is not whether we should have sovereign wealth funds. They are terrific. Should we be against them simply because they are foreign? No. That's terrible. The question is: If we believe in market economies, and we work very hard to create open markets..., shouldn't we establish some set of standards that address the kinds of concerns ... that arise because of ... cross-border nationalization?

One suggestion is that the sovereign wealth funds themselves should get together and put an end to all this worry and discussion by agreeing to a number of principles to which they will abide - for example that under no circumstances are they going to speculate in currencies, they are always going to be long term investors and they are never going to use sovereign wealth funds to pursue any national political objective.

If sovereign wealth funds were to say they agree to these rules, that they have never done otherwise and never intend to, it would allay all the fears out there. It is the unwillingness to agree to such standards openly that is not wholly reassuring.

Hoisted by My Own Comment

knzn says I'm wrong about monetary policy losing its effectiveness before the federal funds rate hits zero:

When does monetary policy become ineffective?, by knzn: Mark Thoma* leaves a succinct comment on my previous post:

Where we differ is the point at which monetary policy loses its effectiveness - I think that happens way before i-rates hit zero.

It’s an interesting point, because it is a position that many economists (including Keynes himself) seem to have held over the years, but one which, as far as I can tell, has never made much sense.**

I should be more specific: It may make sense if you measure monetary policy in certain ways, but not if you measure monetary policy in the way that is reasonable given how today’s central banks set policy. One might be (but in my opinion shouldn’t be) inclined to measure monetary policy in terms of the volume of open market operations, or some similar measure. In that case, it is quite true that a volume of operations that was effective when the interest rate was 5% is no longer likely to be effective when the interest rate is 1%. And certainly the people responsible for conducting those operations do need to be concerned with the volume. But for us, as economists and such, who can and should view monetary policy with some degree of abstraction, it makes little sense to concern ourselves with the volume of such operations. The transaction costs associated with open market operations are tiny (and not proportional to volume anyhow); the market for Treasury bills to be purchased is vast and quite liquid; the absolute size of an open market operation is of little importance, except inasmuch as it affects other variables, such as interest rates. Moreover, the same argument applies to other “quantitative” measures of monetary policy, such as changes in bank reserves and changes in monetary aggregates.

Since today’s central banks (and the Fed in particular) generally define their policy stance in terms of an interest rate, the reasonable way to measure that stance is in terms of an interest rate. Now one might argue (but again, I don’t think one should) that a proportional change in the interest rate that was effective when the interest rate was high will no longer be effective when the interest rate is low. For example, if the interest rate is 8% and you lop off one fourth of it, making the interest rate 6%, that could be quite an effective policy move; but if the interest rate is 1% and you lop off one fourth of that, making the interest rate 0.75%, that is not likely to be very effective at all by comparison. But central banks don’t measure interest rates proportionally, they measure them in…usually 25 basis point increments. And a 75 basis point cut by the Fed, for example, is considered a big move whether the interest rate starts at 8% or at 3%. The sensible question, it seems to me, is whether the effect of a given cut – defined in basis points – will be diminished when interest rates are already low.

If anything, I would argue, the exact opposite should be true. Monetary policy works largely by affecting the discounted value of expected returns on capital assets. When the Fed cuts interest rates, all other things being equal, stocks are worth more, houses are worth more, factories are worth more, machines are worth more, contemplated investment projects are worth more, and so on. The more the value of an asset rises relative to the cost of producing it, the more it becomes profitable to employ people in producing that asset. And theory says this effect should get stronger the lower are interest rates to begin with.

links for 2008-01-31

• Weak GDP report - Econbrowser
• Behind Weak GDP: Inventory Liquidation - WSJ Economics Blog
• Finding the door to a parallel universe - EurekAlert
• A Laughable Idea: More Bush Tax Cuts for the Rich - New York Times Blog
• Is the Fed Bailing Out the Economy or the Banks? - Dean Baker
• Greenspan: Central Banks Probably Can't Stop Recession - WSJ Econ Blog
• Federal Reserve Tries to Polish Tarnished Image - Caroline Baum
• Fed May Be Raising Rates Before Summer's Over - John M. Berry
• The Economy You Want - Boston Globe Cartoon
• America’s middle classes are no longer coping - Robert Reich
• French labour reforms: unseen pitfalls - Vox EU
• Signng Statement Frenzy - Kevin Drum
• Dawning of the age of the Anthropocene - Andrew Leonard
• Greg Mankiw is up to no good - Bluematter
• The Führer Myth: How Hitler Won Over the German People - Spiegel
• Blue-eyed humans have a single, common ancestor - EurekAlert
• Rebate Psychology - New York Times
• The ownership society - Paul Krugman Blog
• GDP its both better and worse than youve heard - Paul Krugman Blog
• Repatriation Measure Will Undermine the Corporate Income Tax - CBPP

How Naïve Are We About Our Economic Future?

Jon Faust says that "I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison..." How well does the Fed forecast economic conditions? It turns out that "naïve" forecasts of GDP do better than a wide range of more complex econometric models:

Whither macroeconomics? The surprising success of naïve GDP forecasts, by Jon Faust, Vox EU: Over the past ten days, the U.S. Federal Reserve has lowered its policy interest rate 125 basis points based largely on its assessment of the need to battle strong recessionary forces. This comes after a December 12 meeting at which the Fed lowered rates a mere 25 basis points, still hoping to “foster maximum sustainable growth and provide some additional insurance against risks.”[1] To some, this rapid change in sentiment might seem surprising. In my view, though, these events mainly serve to remind us of how extraordinarily challenging it is to forecast economic activity.

Economic forecasting challenges I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison: weather forecasters have immense advantages over economic forecasters.

When making a forecast, weather forecasters have access to data on the current and recent past conditions. In contrast, when the Fed made the forecast for the January Federal Open Market Committee (FOMC) meeting, the latest available GDP data were for the third quarter of the previous year. On January 30, we will get an advance release of fourth quarter GDP for the U.S., but this initial estimate will be highly speculative. Historically, the root mean square revision of the annualised quarterly growth rate in the advance release is about 1.5 percentage points--easily enough to spell the difference between slow growth and deep recession.[2]

Further, the GDP data will continue to be revised in important ways indefinitely. For example, the 1999 benchmark revision of GDP data raised measured average growth over 1997 and 1998 by more than one-half of a percentage point.[3] A significant piece of the much-discussed productivity boom of the late 1990s was not in the GDP data until the 1999 benchmark. The weather equivalent would be forecasting temperature without knowing the current temperature, having only a fuzzy estimate of temperature in the recent past, and knowing that, years after the fact, a hot spell might be revised into the data.

Given that we cannot even measure GDP without considerable hindsight, we cannot expect forecasts of real economic activity to be very precise. We can and should, however, ask whether Federal Reserve forecasts are as accurate as possible.

Ricardo Hausmann: Stop Behaving as Whiner of First Resort

If Ricardo Hausmann was chair of the Fed, or in charge of fiscal policy, things would be different. He says consumption has been above its natural, sustainable rate and needs to adjust downward. Thus, monetary and fiscal policies designed to increase consumption and avoid a slowdown only delay the inevitable adjustment of consumption back to its natural rate:

Stop behaving as whiner of first resort, by Ricardo Hausmann, Commentary, Financial Times: The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US to deal with the so-called subprime crisis. Interest rates should be slashed quickly and $150bn put into taxpayers’ pockets...

The goal seems to be to avoid a 2008 recession at all costs. As Larry Summers ... put it, failure to act would make Main Street pay for the sins of Wall Street.

It is easy to lose sight of the overall picture. Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. ... Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions.

The adjustment of private consumption to sustainable levels is necessary, but is likely to have a negative influence in the short run on the growth of aggregate demand... It is hard for this adjustment to take place without bringing down the rate of growth of gross domestic product, possibly to negative numbers. ...

Returning to a sustainable path is good for the US and the world economy over any horizon that assigns some value to what happens after 2008. Sustainable growth is not the consequence of an unsustainable consumption boom but of the progress and diffusion of science, technology and innovation – which show no sign of slowing down.

An efficient adjustment to the US over-consumption imbalance (and Chinese under-consumption) in a way that does not hurt longer-term growth should be based on compensating for the decline of US consumption with an increase in domestic investment and in consumption abroad. It should not be based on giving the US consumer more rope with which to hang himself.

Hence, macroeconomic policy should not be based on a panicky attempt to avoid a 2008 recession at all costs but on a forward-looking strategy that achieves the needed reduction in consumption at the lowest cost in terms of the stable growth. This is not achieved by giving US households a $1,000 cheque by April, a trick that no macro­economic textbook would argue is particularly effective. If there is fiscal room – a big if, given the weak structural position of the US government and its likely cyclical worsening – it would be better spent in accelerating investments in plant and equipment via accelerated depreciation schemes, to improve the capacity of the economy to keep on growing after the crisis.

The logic behind monetary easing is also suspect. ... It is understandable that politicians facing a November election and bankers with a lot of their money at stake should feel that this is the worst crisis ever and have an obvious interest in exaggerating the consequences for Main Street.

They all assume that if banks lose capital, they will stop lending. This is what happens in developing countries because of incomplete financial markets, but is not what one would expect in the world’s most sophisticated capital market. In fact, bank capital has already been lost and the solution is not to put more air into the bubble but to put more capital into banks. This is already happening: Citibank, UBS, Merrill Lynch and Morgan Stanley have raised more than $100bn from foreign investors and sovereign wealth funds. Authorities might use their moral suasion to accelerate this process.

The US should face its need for adjustment with courage and reason, not fear. It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession. Many poorer countries with weaker markets and institutions have survived and benefited from an adjustment that involves a year of negative growth. Faster bank recapitalisation, fiscal investment stimulus and international co-ordination should be first on the policy agenda.

Even with effective monetary and fiscal stimulus, all adjustment costs can't be avoided - some people will incur losses no matter what monetary and fiscal authorities do. Some already have and adjustments are underway. The question, as noted above, is how to get to the long-run sustainable path for consumption and investment at the smallest possible cost.

This comes partly from using a different analytical framework, one oriented in the New Keynesian rather than in the Real Business Cycle tradition, but for me minimizing adjustment costs means avoiding the chance of sharp, abrupt, severe, self-reinforcing downturns where consumption initially falls way below its long-run sustainable path only to crawl back up to the long-run equilibrium later. Thus, I prefer supporting aggregate demand in the short-run so that it falls slowly to the long-run equilibrium rather than doing little or nothing and taking a chance that it falls precipitously, even if this means it will take longer for the adjustment process to be completed.

The Fed Cuts the Target Rate by Half a Percent

Here's the press release:

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

So the vote wasn't unanimous (9-1 as there are two open seats), Richard Fisher from the Dallas Fed dissented, and nine of the twelve district banks asked for a change in the discount rate consistent with the 50 bps rate cut. The other three banks, Dallas, Minneapolis, and Richmond, either did not agree with a 50 bps rate cut prior to the meeting, and/or they wanted to alter the spread between the discount rate and the federal funds rate.

While noting inflation concerns, the Committee also appears to be ready to cut rates further should incoming data suggest further cuts are necessary. Hopefully, though, we can now all catch our breaths for a little while and get a better assessment of exactly where we are.

Update: Fed cuts rates by 50 basis points (Financial Times), Fed Cuts Rates by Half Point (WSJ), Fed Lowers Rate Half Percentage Point to 3%, Says `Downside Risks' Remain (Bloomberg), Fed Cuts Rate for Second Time in 8 Days (NY Times).

Update: The Lone Dissenter: Dallas’s Fisher (WSJ Economics Blog),50 Bps and a Song... (Barry Ritholtz), Fed Cuts Fed Funds Rate 50bps (Calculated Risk), Another 50 basis points (William Polley), 50bp, Right on Schedule (Felix Salmon), Half Point Cut (Jeffrey Cane), Fed rate cut (Jim Hamilton)

"Expansionary Aggregate Demand Policies are Likely to Bring about a Period of Stagflation"

Guillermo Calvo responds to Larry Summers call to to move beyond monetary and fiscal stimulus and begin repairing the underlying problems in the financial system. While he agrees that the financial system needs to be strengthened, he does not have much faith in monetary and fiscal policy and believes their use will result in stagflation:

Guillermo Calvo, Economic Forum: I agree that we need “consistent, determined approaches” which will probably take us far beyond conventional monetary and fiscal policy. The main problem, however, is that we don’t seem to have a consistent macro view that is widely agreed upon and is itself consistent with the stylized facts of the current crisis. Thus, for example, policy has strongly relied on lowering the reference interest rate, a policy that is typically justified in models that abstract from credit market difficulties. The same applies to fiscal expansion. This lack of intellectual consistency is bound to create further confusion. Thus, I would encourage Larry and the other high-profile commentators to give a simple but clear view of their underlying assumptions.

To be consistent with my preaching, let me say that I am of the view that the current subprime crisis is starting to look more and more like those in emerging markets. The big but somewhat superficial difference, however, is that initially the problem did not entail a whole country but a sector (and, incidentally, since a sector does not print its own money, its situation is similar to that in emerging markets which suffer from Liability Dollarization, or Original Sin). Since the subprime sector hit the global financial market, it had the potential to damage other sectors through contagion, much like it happened in emerging markets after the Russian August 1998 crisis. Thus, we are witnessing the effects of a “supply” shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve “stocks,” while transitory fiscal policy involves “flows.” Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry's thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.

"Why Don't Chimpanzees Like to Barter Commodities?"

Chimpanzees are reluctant to trade "a very good commodity (apple slices)" for "an even more preferred commodity (grapes)." This research attempts to explain why and in the process learn something about how barter might have arisen among humans:

Why don't chimpanzees like to barter commodities?, EurekAlert: For thousands of years, human beings have relied on commodity barter as an essential aspect of their lives. It is the behavior that allows specialized professions, as one individual gives up some of what he has reaped to exchange with another for something different. In this way, both individuals end up better off. Despite the importance of this behavior, little is known about how barter evolved and developed.

This study (published in PLoS ONE on January 30) is the first to examine the circumstances under which chimpanzees, our closest relatives, will exchange one inherently valuable commodity (an apple slice) for another (a grape), which is what early humans must have somehow learned to do. Economists believe that commodity barter is one of the most basic precursors to economic specialization, which we observe in humans but not in other primate species. First of all, the researchers found that chimpanzees often did not spontaneously barter food items, but needed to be trained to engage in commodity barter. Moreover, even after the chimpanzees had been trained to do barters with reliable human trading partners, they were reluctant to engage in extreme deals in which a very good commodity (apple slices) had to be sacrificed in order to get an even more preferred commodity (grapes).

Prior animal behavior studies have largely examined chimpanzees’ willingness to trade tokens for valuable commodities. Tokens do not exist in nature, and lack inherent value, so a chimpanzee’s willingness to trade a token for a valuable commodity, such as a grape, may say little about chimpanzee behavior outside the laboratory.

In a series of experiments, chimpanzees at two different facilities were given items of food and then offered the chance to exchange them for other food items. A collaboration of researchers ... found that the chimpanzees, once they were trained, were willing to barter food with humans, but if they could gain something significantly better – say, giving up carrots for much preferred grapes. Otherwise, they preferred to keep what they had.

The observed chimpanzee behavior could be reasonable because chimpanzees lack social systems to enforce deals and, as a society, punish an individual that cheats its trading partner by running off with both commodities. Also because of their lack of property ownership norms, chimpanzees in nature do not store property and thus would have little opportunity to trade commodities. Nevertheless, as prior research has demonstrated, they do possess highly active service economies. In their natural environment, only current possessions are “owned,” and the threat of losing what one has is very high, so chimpanzees frequently possess nothing to trade.

“This reluctance to trade appears to be deeply ingrained in the chimpanzee psyche,” said one of the lead authors, Sarah Brosnan ... at Georgia State University. “They’re perfectly capable of barter, but they don’t do so in a way which will maximize their outcomes.”

The other lead author, Professor Mark F. Grady, Director of UCLA’s Center for Law and Economics, commented: “I believe that chimpanzees are reluctant to barter commodities mainly because they lack effective ownership norms. These norms are especially costly to enforce, and for this species the game has evidently not been worth the candle. Fortunately, services can be protected without ownership norms, so chimpanzees can and do trade services with each other. As chimpanzee societies demonstrate, however, a service economy does not lead to the same degree of economic specialization that we observe among humans.”

The research could additionally shed light on the instances in which humans also don’t maximize their gains, Brosnan said.

links for 2008-01-30

• From the Berbers to Bach (Culture and Globalization) - Yo-Yo Ma
• The Economic State of the Union - Jared Bernstein
• The tenuous future of Africa-EU trade relations - Vox EU
• Farewell To Ben Stein - The Big Picture
• Killer wage regulations - Vox EU
• Bush misleads about tax cuts during the State of the Union. - Daniel Gross
• "Better Late Than Never" (Krugman/gov policy) - PIMCO - Bill Gross
• The Repeater (evolution) - Olivia Judson
• President’s Push to Make Tax Cuts Permanent is Irresponsible - CBPP

Eric Rauchway: The Party of Stinkin'

What's behind the Republican's "inability to govern"? Do Democrats overreach?:

The Party of Stinkin', by Eric Rauchway, TNR: If the mixed results in the early Republican primaries--a Huckabee here, a McCain or Romney there--portends a split between the GOP's religious, fiscally conservative, and security-state wings, it won't be the first time a national American political coalition has failed. But it will be the third time in a hundred years an apparently strong Republican majority cracked up due to the party's inability to govern. By contrast, Democratic coalitions have failed mostly because the party has overreached after governing successes.   

In the midst of an economic depression, the Republican Party assembled a presidential majority in 1896 for William McKinley and his conservative platform. McKinley won despite the revolt of many traditionally Republican western states, whose citizens believed the party's elite had grown too cozy with industrial and financial leaders, while leaving the stricken farmers of the heartland in the cold. ...

With McKinley, the Republican Party shifted away from its post-Civil War habit of bludgeoning the South, and McKinley ran as a candidate of sectional reconciliation. He wooed the South with symbolic gestures, like declaring that their soldiers had demonstrated "American valor" in battle... He wooed the West with promises of renewed prosperity under his tariff and monetary policies. And Roosevelt's subsequent presidency--he took 56% percent of the popular vote in 1904--appeared to show that the Republicans could campaign and govern as a truly national party.

But the seeming solidity of this coalition concealed real divisions, owing largely to the Republicans' unwillingness to give Westerners what they demanded. Out there in the new states, voters began agitating for and adopting democratic measures--women's suffrage; initiative, referendum, and recall; and ways to popularly elect Senators and presidential candidates. Mere national prosperity, unevenly spread as it was and almost never trickling down to farmers, wasn't going to satisfy them. They actually wanted to take part in the country's government and change it for themselves.

Roosevelt made the right noises in response to this stirring insurgency... But, since he was a Republican beholden to eastern industry, he could do little more than talk... As another student of Rooseveltiana more acutely mentioned, he was "the greatest concocter of 'weasel' paragraphs on record."

Roosevelt's successor, William Howard Taft, couldn't weasel charmingly enough for an electorate increasingly dissatisfied with Republican complacency. In 1910, the Democrats took the Congress.

Roosevelt tried to push his party back in his direction, and when that failed, he led a third-party movement in 1912 that put Woodrow Wilson into the White House, along with a Democratic House and Senate. [...continue reading...]

Update: Underbelly Buce comments.

"The Three Trillion Dollar War"

Good question:

Keynesian trillions, Editorial, LA Times: President Bush['s]... final State of the Union speech made clear that he intends ... to ... spend whatever it takes to secure Iraq and Afghanistan -- and his legacy.

While the president's speechwriters were tweaking his address Monday, the White House announced that Bush would ask for $70 billion more for the two wars this year. A Pentagon spokesman said combat operations were costing $12 billion a month, with $9.2 billion spent in Iraq. That's just for combat operations. Including replacing equipment that's being used up and providing medical care and disability benefits for the wounded, Iraq has already cost well over $1 trillion. Back in early 2006, when war spending was running about $5 billion a month, economists Joseph Stiglitz and Linda Bilmes were sharply criticized for a study that predicted the Iraq war would cost up to $2 trillion. Their sequel, to be released next month, is titled "The Three Trillion Dollar War."

The interesting question is why the U.S. economy, beneficiary since 9/11 of the largest military spending binge in history, now requires $150 billion more in the form of a short-term stimulus package. Why hasn't the $1 trillion in defense spending, in addition to the 2001 and 2003 tax cuts, been sufficient to keep the economic boom going? ... Does that mean the fundamentals of our economy are weaker than we thought, and a deeper slump might have occurred without all that spending? ...

The economist John Maynard Keynes taught us in the 1930s that money spent on guns -- or butter, or even digging ditches and filling them up again -- had the same stimulative effects on a slumping economy. We've developed a more nuanced view of government spending since then, but it's still worth asking: What would Keynes say about a $3-trillion war?

Update: Paul Krugman:

An Iraq recession?, Paul Krugman Blog: One thing I get asked fairly often is whether the Iraq war is responsible for our economic difficulties. The answer (with slight qualifications) is no.

Just to be clear: I yield to nobody in my outrage over the way we were lied into a disastrous, unnecessary war. But economics isn’t a morality play, in which evil deeds are always punished and good deeds rewarded.

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we’re spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

There is one caveat: high oil prices are a drag on the economy, and the war has some — but probably not too much — responsibility for pricey oil. Mainly high-priced oil is the result of rising demand from China and other emerging economies, colliding with sluggish supply as the world gradually runs out of the stuff. But Iraq would be exporting more oil now if we hadn’t invaded — a million barrels a day? — and that would have kept prices down somewhat.

Overall, though, the story of America’s economic difficulties is about the bursting housing bubble, not the war.

The Myth of the Rational Politician?

Robert Reich is not a big fan of using accelerated depreciation as a means of stimulating a lagging economy. Who wants to invest in more plants and equipment when the economic slowdown means you aren't even using all the plants and equipment you have now? Suppose that, due to an economic downturn, a trucking company that usually runs 100 trucks now has 15 sitting in the yard idle with the drivers at home waiting for the phone to ring. Will a cut in interest rates or a change in the depreciation rate allowed on taxes cause the firm to run out and buy more trucks? I can imagine reasons why you might want to jump on a great deal in such a situation and store up for the future, but generally you'd expect the response to be fairly small:

The Real Recession Problem: Consumers Are at the End of Their Ropes, by Robert Reich: Perhaps the silliest part of an already silly stimulus bill is a provision giving corporations big tax deductions this year on the costs of new machinery, instead of spreading those deductions over several years, as is normally the case. The idea is to get businesses to invest in more machinery, which will stimulate the economy.

But accelerated depreciation, as it’s called, doesn’t work. Almost the same tax break was enacted in 2002 and studies show just about no increase in business investment as a result. Why? Because companies won’t invest in more machines when demand is dropping for the stuff the machines make. And right now, demand is dropping for just about everything.

This tax break exemplifies the illogic of what’s called supply-side economics. If you reduce the cost of investing, so the thinking goes, you’ll get more investment. What’s left out is the demand side of the equation. Without consumers who want to buy a product, there’s no point in making it, regardless of how many tax breaks go into it.

Which gets us to the real problem. Most consumers are at the end of their ropes and can’t buy more. Real incomes are no higher than they were in 2000... And home values are dropping... Supply-siders who want to cut taxes on corporations and the rich just don’t get it. Neither does most of official Washington. ...

The "political tax" on the stimulus bill, i.e. the things in the bill that make it less than fully effective but are necessary to ensure its passage, appears to be high due to the need to produce legislation quickly. I hope the less than optimal bill that has been produced does not come from politicians holding the stimulus package hostage and knowingly reducing its impact in order to pursue ideological goals. It could be that, but if it's not, then what is it?

Maybe it's "the myth of the rational politician", i.e. politicians who are so uninformed about economics that they truly believe the policies they are insisting be part of the stimulus package will help put people back to work. I know I care about this more than most, but that's why it's necessary to talk about things other than haircuts and laughs, why it's necessary to listen when a politician keeps insisting that tax cuts can pay for themselves, or spouts other such nonsense along the campaign trail or after they are in office.

There are times when it actually matters if politicians understand the basics of economics, and now could well be one of them. Yet most of what passes for information on this topic amounts to reporters asking questions, then nodding their heads at whatever answer the candidate gives - whether it makes sense or not - before moving on to the next question on the list. Sometimes I wonder if the reporters are even listening to the answer, and if they are, if they know enough themselves to follow up effectively.

We can reduce the "political tax" on fiscal policy, but it will require, for one, that the media let the public know when political games or ignorance of basic economics is causing the government to under perform and produce legislation that is less than fully effective. We've had enough government under performance in recent years, failures to serve people in need, but it hasn't always been like that, and it doesn't have to continue.

links for 2008-01-29

• Why doesnt Bush get economic credit? - Paul Krugman Blog
• They Found Your Brain's Spam Filter - Scientific American
• How the press played the race card - Clive Crook
• How the feds stopped the states from averting the lending mess. - Nicholas Bagley
• Things I Don’t Understand About Things (Glaeser/McCain) - The Bellows
• Publishing Central Bank Interest Rate Forecasts - FRBSF Economic Letter
• What to do with $57 billion? - Energy Externalities
• It's the stupid economy - Los Angeles Times
• The US economy, Pravda style - Dean baker
• What is the purpose of a fiscal stimulus? - Economics and...
• Do capital gains tax cuts increase revenues? - Justin Fox
• A Tiny Glimmer in the New Home Sales Figures - Richard Green

"A Helpful Suggestion for the Fed"

Willem Buiter:

A helpful suggestion for the Fed, by Willem Buiter: It is now clear beyond a reasonable doubt that the Fed wants to prevent sudden sharp drops in the stock market. ... I propose that the Fed put its money where its heart is by engaging in outright open market purchases of US stocks and shares.

By intervening through the purchase of the most broadly-based value-weighted index of US stocks, e.g. the Wilshire 5000 Total Market Index, any unlevelling of the playing field between listed stocks can be avoided. I would prefer the Fed to acquire only non-voting shares, or to put any shares it acquires in a blind trust... On January 25 the Wilshire 5000 index stood at 13,423.62. The 52-week peak was on October 7, 2007 at 15,806.69. Let's split the difference and request the Fed to put a floor below the Wilshire 5000 at, say, 14,500.00. ...

What I propose is effectively the same as the Fed attaching a free put option to every equity share in a US-registered and-listed enterprise. It would put paid forever to all those jokes about the Greenspan put and the Bernanke put.

Let's do it!

Barry Ritholtz also has a letter to Ben. My view hasn't changed and is similar to Mark Gertler's. Update: Another view:

Ben Bernanke under fire, Times Online: ...Robert Shiller ... told The Times yesterday that Paul Volcker, the Fed’s chairman during the Carter and Reagan administrations, would have made a better job of spotting the consequences of the housing recession and credit turmoil on the American economy than Mr Bernanke. ...

Paul Krugman: Lessons of 1992

There are lessons to be learned from Bill Clinton's 1992 presidential campaign and what happened after he was elected:

Lessons of 1992, by Paul Krugman, Commentary, NY Times: It’s starting to feel a bit like 1992 again. A Bush is in the White House, the economy is a mess, and there’s a candidate who, in the view of a number of observers, is running on a message of hope, of moving past partisan differences, that resembles Bill Clinton’s campaign 16 years ago.

Now, I’m not sure that’s a fair characterization of the 1992 Clinton campaign... Still, to the extent that Barack Obama 2008 does sound like Bill Clinton 1992, here’s my question: Has everyone forgotten what happened after the 1992 election?

Let’s review the sad tale...

Whatever hopes people ... had that Mr. Clinton would usher in a new era of national unity were quickly dashed. Within just a few months the country was wracked by the bitter partisanship Mr. Obama has decried...

No accusation was considered too outlandish: a group supported by Jerry Falwell put out a film suggesting that the Clintons had arranged for the murder of an associate, and The Wall Street Journal’s editorial page repeatedly hinted that Bill Clinton might have been in cahoots with a drug smuggler.

So what good did Mr. Clinton’s message of inclusiveness do him?

Meanwhile,... Mr. Clinton ... did avoid some conflict by being strategically vague about policy. In particular, he promised health care reform, but left the business of producing an actual plan until after the election.

This turned out to be a disaster... Mr. Clinton didn’t deliver legislation to Congress until Nov. 20, 1993 — by which time the momentum from his electoral victory had evaporated, and opponents had had plenty of time to organize against him.

The failure of health care reform, in turn, doomed the Clinton presidency to second-rank status. The government was well run (something we’ve learned to appreciate...), but — as Mr. Obama correctly says — there was no change in the country’s fundamental trajectory.

So what are the lessons for today’s Democrats? First, those who don’t want to nominate Hillary Clinton because they don’t want to return to the nastiness of the 1990s ... are deluding themselves. Any Democrat who makes it to the White House can expect the same treatment: an unending procession of wild charges and fake scandals, dutifully given credence by major media organizations...

The point is that while there are valid reasons one might support Mr. Obama over Mrs. Clinton, the desire to avoid unpleasantness isn’t one of them.

Second, the policy proposals candidates run on matter. I have colleagues who tell me that Mr. Obama’s rejection of health insurance mandates —...an essential element of any workable plan...— doesn’t really matter, because by the time health care reform gets through Congress it will be very different from the president’s initial proposal anyway. But this misses the lesson of the Clinton failure: if the next president doesn’t arrive with a plan that is broadly workable..., by the time the thing gets fixed the window of opportunity may well have passed.

My sense is that the fight for the Democratic nomination has gotten terribly off track. The blame is widely shared. Yes, Bill Clinton has been somewhat boorish (though I can’t make sense of the claims that he’s somehow breaking unwritten rules, which seem to have been newly created for the occasion). But many Obama supporters also seem far too ready to demonize their opponents.

What the Democrats should do is get back to talking about issues ... and about who is best prepared to push their agenda forward. Otherwise, even if a Democrat wins the general election, it will be 1992 all over again. And that would be a bad thing.

The New Laffer Curve Logic and the Lack of Evidence for It

After being shown again and again that tax cuts don't increase revenues, those who make the Laffer curve argument stopped making the claim generally and shifted the argument to say that while it may not be true across the board, there is evidence that it is true for the very top rates. Now, as Lane Kenworthy discusses below, the argument has shifted again. But even after all of this reformulation of the argument to try and make it work somehow, somewhere, the evidence is still pretty shaky:

The New Laffer Curve Logic, by Lane Kenworthy: “When you cut the highest tax rates on the highest-income earners, government gets more money from them.”

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled “The Tax Threat to Prosperity” (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original “Laffer curve” argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The “supply-side” problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the amount of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here. This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via “tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures.” When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households’ incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let’s consider them in turn.

Fed Watch: Sometimes It Is the Path, Not the Destination

Tim Duy tries to figure out what the Fed and the economy will do next. All I can say is good luck:

Sometimes It Is the Path, Not the Destination, by Tim Duy: I spent much time this weekend – as is often the case – considering the path of economic activity over the next year, as well as the Fed's role in defining that path.  The Fed has come under widespread criticism for a seemingly awkward communication strategy that culminated with last week's surprise rate cut.  I think the last rate cut had the unfortunate appearance of a panicked effort to prop up equity markets.  That said, I think the criticism is likely too severe – it is easier to be bitter with the Fed than to admit you just weren't reading the situation correctly.

Of course, it is likely the Fed was not reading the situation correctly as well.  But what part of the forecast was in error?  We have heard repeatedly of Fed expectations that the economic downturn would be largely limited to the first half of 2008, followed by a gradual reacceleration to trend growth, albeit the anemic trend of roughly 2.5%.  We do not yet know that this forecast is fundamentally in error.  Indeed, I have argued in the past that it is consistent with the story told by a one-year ahead forecast derived from the yield curve, specifically the 10-2 spread:

Looking at the more recent history more closely:

The depth of the inversion of the yield curve in November 2006 signaled a 50% percent chance of recession in November 2007 – remarkably accurate, in retrospect.  But this is where the path vs. the destination becomes important.  In December of 2006, I told a business group that the then current recession hysteria would be short lived, but would return at the end of 2007.  I, however, didn't fully know the path to that point – I said it would likely reflect the washing out of the housing market.  For that particular group, I don't think the path was particularly important.  For financial markets, both the destination and the path are important.  The permabears, who were aggressively predicting a recession in early 2007, largely had the path right (financial market meltdown stemming from a faltering housing market), but were a year ahead on the timing.

links for 2008-01-28

• Why has the Bush economy been so lousy? (part I) - Paul Krugman Blog
• History (of high bond yields) - Across the Curve
• Ben Stein Watch - Felix Salmon
• Ben Stein Tells Us It's All the Traders' Fault - naked capitalism
• White House: Program That Lowers Savings is a Growth Package - pgl
  
• David Leonhardt Needs His Own Weblog - Brad DeLong
• The Minsky Moment - The New Yorker

Lawrence Summers: Beyond Fiscal Stimulus

Larry Summers says now that we have the ball rolling on fiscal policy (if only barely so), and interest rate cuts are in place, the time has come to take the next steps and begin to repair the financial system, to begin containing the damage caused by the housing sector, and to begin work on global coordination of policy. This addresses the first of these steps, repairing the financial system:

Beyond fiscal stimulus, further action is needed, by Lawrence Summers, Commentary, Financial Times: Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession... The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty... It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further...

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macroeconomic stimulus..., there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives...

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan’s did in the 1990s. ...

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. ... A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. ...

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. ... It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. ...

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett’s recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

Normal economic performance will not return without a return to normality in the credit markets. The fear that pervades the markets will not abate of its own accord, nor is there a silver bullet. But consistent, determined approaches to doing what is needed to resolve each of the problems that arise will, in the end, re-establish confidence.

Martin Feldstein: The Stimulus Package is Not about Long-Term Growth

Martin Feldstein discusses the ability of monetary policy to impact the economy when there are problems in the financial and housing sectors, and the relationship between stimulus to aggregate demand and long-run growth (yesterday's post discussing Andrew Samwick's commentary comes to the same conclusion as Feldstein on whether aggregate demand changes can impact long-run growth):

Seven Questions: Martin Feldstein on the “R” Word, Foreign Policy: Foreign Policy: Everyone is anxiously discussing the possibility that the U.S. economy is in a recession or that it will be soon. You wrote in December that the probability of a recession in 2008 has now reached 50 percent. Where do you stand now?

Martin Feldstein: Well, I think it’s higher. ...

FP: And how bad do you think it could get?

MF: It could get worse than the typical recession because the usual channels for turning something like this around through monetary policy are going to be less effective now due to the problems of the credit markets. The housing decline is really very serious this time. You put those two together, and I think we could end up with something that’s deeper and longer than has traditionally been true. But it depends on the Fed, the White House, and Congress doing something to either prevent or dampen the magnitude of a downturn...

FP: U.S. President George W. Bush has proposed a roughly $140 billion stimulus package that centers on one-time tax rebates. But George Mason University economist Russell Roberts says the very idea of an economic stimulus package is “like taking a bucket of water from the deep end of a pool and dumping it into the shallow end.” As he put it, “If you can make the economy grow, why wait for bad times?” So, is the idea of a stimulus package just political theater, or do you expect it to really help?

MF: I do expect it to help, but let me be clear about why it’s not like moving water from one end of the pool to the other, or more accurately, why it is not a way of making the economy grow under all circumstances. If the economy is fully employed and growing at a normal pace, 3.5 percent, with unemployment under 5 percent and no expectation of a downturn, then aggregate demand is not the problem. Then, the only way to get the economy to grow more is to have more investment in capital equipment, people working harder, more innovation, and so on. And you can’t do that by simply giving money back to taxpayers to spend more. So, the “spend more” approach to increasing economic activity is not about long-term growth. What it’s about is offsetting the risk of an economic downturn. ...

Repeating from yesterday, which was in large part a follow-up to comments on the Landsburg article about fiscal policy:

I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. ... Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path... Stabilization policy ... changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help.

Restoring Confidence in Financial Markets

Robert Shiller says it's time to to update financial regulation to fit the modern financial world:

To Build Confidence, Try Better Bricks, by Robert Shiller, Economic View Commentary, NY Times: The key to maintaining economic stability is well-placed confidence in the markets. Bubbles, by contrast, result from misplaced confidence.

We are living in a post-bubble world, following the stock market bubble of the 1990s and the real estate bubble of the 2000s. ... We need to restore confidence in the markets’ basic ability to function, not in their presumed tendency to make us all rich by always going up...

One main response to the Depression that helped prevent another from occurring was a set of tools that improved confidence by truly improving market security. One of these was the Federal Deposit Insurance Corporation, in 1933, but there were also a large number of others, especially the Securities and Exchange Commission the next year.

These were not obvious innovations and, in fact, were highly controversial at the time. Indeed, it is never obvious how the government should foster well-functioning markets. The fundamental role of governments in promoting markets is clear, but the design of their instruments must make creative use of a great deal of information about financial theory, human psychology and existing institutions and practices. The successful markets we have are a result of considerable inventive effort.

The F.D.I.C. was controversial because it was established amid the ruins of various state-level deposit insurance plans that had just gone bankrupt. Critics at the time also argued that federal deposit insurance would encourage unsound banking. But it turns out that the F.D.I.C. was a very good idea. It restored confidence in the banking system during the Depression, and with hardly any cost.

The S.E.C. was similarly controversial. Critics said it would hamstring or straitjacket the markets. But it is now the model for securities regulation around the world.

We need ... to set up a national study commission and to pay for serious creative research on how to adapt important ideas, like deposit insurance and securities regulation, to a modern financial world. ...

The ... problems ... need urgent attention. The very fact that many people feel they can no longer rely on some of our financial institutions may bring a self-fulfilling prophecy, which could then fundamentally harm economic activity.

The mortgage market is suffering. ... The commercial paper market is suffering, too. ... Other credit markets are also having problems...

Confidence in our brokerage firms is suffering. With every announcement of major losses, some people start to wonder whether they can rely on these companies.

Improvements in the deposit insurance system... [are needed. The] very least we can do is to raise the F.D.I.C.’s limits on insured deposits. The limit of $5,000 in 1934 was 12 years’ worth of per capita personal income at the time. The limit was last raised in 1980, to $100,000, which was then 10 years’ income. But because of inflation and economic growth, that limit is less than three years’ income today. ... We have allowed deposit insurance to go three-quarters of the way to extinction.

The insurance limits of the Securities Investor Protection Corporation, which protects customers when brokerage firms fail, were also last raised in 1980 — to $100,000 in cash accounts and $500,000 in securities — and thus have suffered an equally drastic erosion in real value. Such erosion could suddenly matter if the crisis, or even just the psychology of the crisis, were to worsen.

But far beyond this, at a time when so many problems have arisen outside the limits of existing federal insurance programs, we need to do more than update the programs for inflation. We need to consider the fundamental principles on which they were based, stress-test them for today’s environment and consider extending them in creative ways.

Is Unity the Answer?

Ezra Klein on calls for unity:

Unity isn't all it's cracked up to be, by Ezra Klein, Commentary, LA Times: ...I've got unity fatigue. That seems to be one of the chief buzzwords of this election. Unity. Barack Obama invokes it more frequently than John Edwards mentions "mills." My in-box, meanwhile, has only recently recovered from the torrent of messages sent by "Unity '08,"...

What accounts for all this talk of unity and bipartisanship and non-ideological problem solving? ... The short answer is that the candidates have no other choice. Washington these days is rived by partisanship, but that's not necessarily anything new or even particularly worrisome. In Washington, partisanship is like the San Francisco fog; it rolls in, hangs out for a while, and everyone goes about their business. The problem is, in this case, it's created total, impenetrable gridlock.

So, though elections are usually about what is to be done, this campaign has been unusually focused on whether it is in fact possible to get anything done. ...

The problem is that hearing all these presidential hopefuls pledge to end gridlock is a bit like having a friend promise to fix my toilet by checking under the hood of my car. Analytically, it's misguided. Now, ... candidates have to over-promise, so let's grant that they may not believe all their own hype. But at the same time, we shouldn't ignore the essential incoherence at the heart of these arguments:

Gridlock is not something the president of the United States can solve. Political gridlock begins in the U.S. Senate, but we keep trying to end it in the White House. There is no potential executive in either party who would not like to manifest his or her agenda by sheer force of will. But in reality, ... you don't get a doctor's note exempting you from the legislative process just because you ran, or even govern, as an independent. If you don't believe me, ask Arnold Schwarzenegger, the classic post-partisan unifier who couldn't attract a single Republican vote for his centrist health plan when it went before the Assembly.

Gridlock isn't a mystery. ... It's a function of the rules of the Senate, where 40 senators can refuse to end debate on legislation and thus doom its chances of passage. ...

This is the power of the filibuster, and it used to be a rarely invoked power, as the culture of the Senate prized compromise and consensus. In the 1977-78 congressional term, for instance, there were only 13 filibusters. Ten years later, there were 43. Ten years after that, there were 53. The Democrats used the tactic plenty when they were in the opposition a couple of years ago, but now that they're in power, it is the Republicans who are having a filibuster party. If they maintain their current pace, they'll have filibustered a full 134 times this term, more than doubling any other year on record. It's obstructionism on a truly historic scale.

Add to that obstructionist minority a divided government (the White House controlled by one party, Congress by another), the tensions of an ongoing war and a lame-duck president with no chosen successor and thus little concern for his plummeting popularity, and you have a moment that laughs at legislative progress. That's why the presidential campaign has become so focused on "getting things done."

But it's not up to the president. There are a variety of fixes for a filibuster-happy minority. The media, for example, could start accurately reporting the cause of the gridlock, shaming the relevant senators and increasing political pressure to compromise. The voters could eject politicians who refuse to compromise, laying down an electorally enforced preference for a functioning government. The Senate majority could change the rules, essentially eliminating the filibuster. ...

But the president can't do this, not on his or her own. Unity means nothing in the face of obstructionism, and problems can't be solved if legislators refuse to solve them.

links for 2008-01-27

• Inflation-Gap Persistence in the U.S. - Cogley, Primiceri, Sargent
• Dispelling Confusion on Food Stamps and Tax Rebates ... - CBPP
• No more food stamps. You've eaten enough - Andrew Leonard
• A Better Way to Deal With Downturns - Vox Baby
• Automatic Savers - Robert J. Shiller - Project Syndicate

Andrew Samwick: A Better Way to Respond to Downturns

Here's Andrew Samwick on fiscal policy. I disagree with some of this, e.g. if you wait until you know if monetary policy works then it's too late for fiscal policy. Also, it's not clear that monetary policy works faster than fiscal policy. Monetary policy can be put into place faster than fiscal policy, but once in place it takes longer to impact the economy. When you put the implementation and effectiveness lags together, there is no necessary winner between the two types of policies.

In the post below this one on the same topic, I didn't do a very good job of separating the focus of the short-run stabilization policy (whether to try to change C, I, G, or NX) from its consequences (crowding out and crowding in), so let me try to clear that up here. I covered crowding out and crowding in the next post, so the focus here is on whether policy ought to be directed at C or I, or even G (G can be either consumption or investment; also, NX is harder to change, but policies can also be directed at NX, e.g. subsidizing exports).

Andrew recommends focusing on government investment when implementing stabilization policy. I have no problem with spending on infrastructure rather than giving tax rebates so long as such policies can be put into place quickly enough. Andrew's advance planning (see below) is supposed to make the policies easy to implement quickly, but I have some doubts about how well that would work, though I have also made the point that some of these projects are implementable on short-notice (and some, e.g. grants to state and local government, can prevent existing projects from being shut down and can be accomplished very quickly). I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. If you believe theory, which component is changed won't have much long-run impact on investment anyway. Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path (assuming government provides the supporting infrastructure, but that doesn't have to be done with stabilization policy). Stabilization policy simply changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help:

A Better Way to Deal With Downturns, by Andrew A. Samwick, Commentary, Washington Post: ...While politically expedient, the stimulus package is unjustified in the short run and harmful in the longer term. ...

The $150 billion agreement calls for tax rebates to low- and middle-income households as well as business incentives. Doubtless, this will boost economic activity. If you pull levers, you get movement. Personal consumption and business investment will increase relative to what they might otherwise have been. But there is no discussion of repaying the money through higher taxes in the near term. Let's drop the euphemism of "stimulus package" and call this agreement by its proper name: "deficit spending."

It is ironic that additional borrowing is prescribed as the remedy for a malady that arose from unwise borrowing. ... If we acknowledge that bad loans fueled the activity, why is it now a widely shared policy objective to maintain that level of activity?

The answer is a combination of three factors. The first is elected officials' fear that they will be punished in November for an economic downturn unless they do "something" to avoid it. Few things precipitate bipartisan agreement so quickly. Using the incomes of future taxpayers to purchase reelection today is irresponsible but common public policy.

The second factor is policymakers' fear that unless "something" is done, a temporary economic downturn could become more protracted. This fear, to the extent that it is justified, is better addressed by the Federal Reserve lowering short-term interest rates, which would stimulate the economy more quickly and comprehensively than would fiscal policy. The Fed did just this on Tuesday. Yet the fiscal-policy lever has been yanked before any data have indicated whether the Fed's stimulus has had its intended effect.

The third factor is the recognition that some households will bear a disproportionate burden of an economic downturn, combined with a belief that "something" should be done to help them. Government has a choice in whom it taxes to finance this relief -- other taxpayers today or all taxpayers in the future. That the agreement holds the former group harmless was also praised by Bush. This "stimulus bill" is really $150 billion worth of some future generation's resources appropriated to finance our own consumption. Why are we entitled to pass on this additional debt? ...

In political arguments, you can't beat something with nothing. But we can learn from this experience to have a better menu of fiscal policy options the next time around. Two changes to our budget policy would go a long way toward that goal.

First, we should rule out deficit spending to finance a consumption binge. As the economy slows, the deficit will widen even without changes in fiscal policy. But an honest budget policy would be calibrated to balance the budget over a complete business cycle. Years of cyclical deficits will be offset by years of cyclical surpluses. As a corollary, we must not waive pay-as-you-go rules that require spending that increases the current deficit to be offset later, when the economy is stronger.

Second, we can plan well in advance. The federal government has a critical role in maintaining and developing public infrastructure, whether in transportation, telecommunications or energy transmission projects. A sensible capital budget would include a prioritized list of projects that need attention. Some would be slated for this year, some for 2009 and so on, over the useful lives of the projects. When economic growth falters, the government would be in a position to move some of the projects from later years into the present year.

This approach to counter-cyclical fiscal policy has several advantages. Perhaps most obvious is that it forces the government to establish priorities for capital projects. It reduces overall expenditures by doing more of the work in times of economic slack, when costs are lower. It also abides by pay-go rules, since projects moved up to 2008 need not be done in 2009. With a little forethought, short-term economic concerns and long-term budget goals need not be in conflict.

Landsburg: Why the Stimulus Shouldn't Stimulate You

Steven Landsburg on the stimulus package. My comments along the way:

Why the Stimulus Shouldn't Stimulate You, by Steven E. Landsburg, Commentary, Washington Post: As a general rule, economic policies command bipartisan support only when they're incoherent. Take, for example, the fiscal stimulus package now bulldozing its way through the legislative process. It's poorly conceived, it's unlikely to work, and it's sure to do a lot of collateral damage.

I agree - it's not the best plan.

The idea, we're told, is to stave off an all-out recession by stimulating both investment (through tax cuts for businesses) and consumption (through tax rebates to individuals). But hold it right there.

Investment and consumption are natural rivals.

Investment means converting resources into machines and factories; consumption means converting those same resources into TV sets and motorboats. In anything but the very short run, more of one means less of the other. ...

The reference here is to "crowding out" [Note: There is a follow-up on this point in the post above this one]. The idea that when the government  spends or cuts taxes and increases the deficit, it competes for financial assets driving interest rates up. The rise in interest rates then chokes of (crowds out) private consumption of durables and business investment so that, treating consumer durables as an investment good, the rise in government deficit causes investment to decline.

But a key part of the crowding out story is that interest rates rise in response to the increase in deficits. However, under globalization, this has not been happening. Foreigners have been very wiling to lend us money and that has kept interest rates down. So crowding out is not much of a worry.

And there is something else to consider. There is also a phenomena called "crowding in". This is, in essence, the increase in investment that comes from having a stronger economy, i.e. from increased output and employment. Because crowding out has been so small, one could plausibly argue that crowding in has dominated in recent years so that deficit spending that bolsters GDP out of a recession actually brings about an increase, not a decrease, in investment.

Fine, but what makes you think that this package will put anyone to work? The idea behind the stimulus deal is to give people tax cuts so they'll feel richer and spend more. But government can't make people richer on average; all it can do is shuffle wealth around. To pay Peter, you must tax Paul (or at least promise to tax Paul in the future, when your debts come due). Peter spends more, but Paul spends less.

Now maybe you can time things so Peter goes on a spending spree today but Paul doesn't tighten his belt until next month. (Then again, maybe you can't: Paul's no fool, and he's likely to start cutting back as soon as he sees higher taxes on the horizon.) But even if you manage to pull this trick off, sooner or later you must tax Paul. So today's fiscal stimulus comes at the expense of tomorrow's fiscal drag.

A couple of things here. He is referring to "Ricardian equivalence." This is the idea that people will understand that any increase in the deficit will mean higher taxes in the future. In fact, in a perfectly functioning market economy (and with other conditions on things such as the "connectedness" of generations) the present value of the future tax burden is equal to the increase in the deficit. If this is the case then, in aggregate, policies such as a tax rebate won't stimulate the economy because the rebate is exactly canceled by the present value of the expected increase in taxes in the future.

There are (at least) two reasons to doubt this works perfectly. First, pure Ricardian equivalence requires perfect capital markets, and there is evidence that this condition is not satisfied. Second, it it possible to give this generation a tax cut, then pass along the burden to future generations. But so long as this generation cares about the next generation, then this will not work - the present value of the taxes the next generation pays matters to us and offsets the rebate as before. However, generations are imperfectly connected so that the pass through is not 100%.

In any case, if you look at the voluminous evidence on this topic, it is somewhat mixed, but overall you will find that people think there is partial, but not full Ricardian equivalence. There is some offset to government spending or tax cuts/rebates because of the expected tax burden policies that increase the deficit bring about, but it is not 100% and fiscal policy is still sufficiently stimulatory.

Finally on this point, the idea that deficit spending now means we will have to raise taxes and lower GDP in the future is exactly right - that's the point of stabilization policy, to shave the peaks and fill the troughs. When the economy is having trouble, we deficit spend to bring up GDP, then when things are so good that the economy is beginning to overheat we run a surplus (raise taxes) to bring GDP down closer to trend. Since deviations from the long-run trend rate of growth are costly whether you are above or below trend, this type of stabilization raises economic welfare.

Continuing:

Moreover, even if you do somehow manage to increase spending, that doesn't mean you'll put Americans to work. More likely, you'll put Asians to work producing goods for the U.S. market.

This current plan is not necessarily the best way to do this, but it's pretty easy to make sure a stimulus plan only increases employment domestically. That's just a matter of targeting (tax cuts to cement companies are unlikely to result in any jobs being offshored, and if government hires people temporarily itself, it's also easy to make sure the jobs are domestic).

President Bush seems to have become confused on this key point because he misunderstands supply-side economics. He has vaguely remembered that tax cuts put people to work, but he's forgotten that only marginal tax cuts put people to work. Non-marginal tax cuts -- such as the ones in the stimulus package -- have exactly the opposite effect, when they have any effect at all.

The reason: When people feel richer, they're less eager to work. An unemployed laborer with a tax rebate in his pocket might well feel less urgency about getting retrained or finding a new job. (Not every unemployed laborer will react this way, but you can be sure that some will.) If Americans demand more but produce less, the difference has to come from abroad.

Here, then, is the great irony: To stimulate spending, tax cuts have to make people feel richer -- but the richer people feel, the slower they'll be to rejoin the workforce. The more effective the tax cuts, the longer they threaten to prolong the expected recession. ...

Yeah, I'm pretty sure giving people a few hundred extra bucks is going to stop them from looking for a job, they can live for months on that. Never mind that most of the people receiving the benefit are already employed. Now if we had extended the length of time for unemployment compensation, we'd have something to talk about - there is evidence on this point, lots and lots of it, but we didn't. Republicans would not allow one of the best means of stimulating the economy (e.g. see the rankings of programs at the CBO) to be part of the bill.

Now let's talk about why we shouldn't want it to [stimulate consumption]. ...

He simply makes the crowding out point again and concludes, wrongly as noted above, that:

If you care about your grandchildren, you should be encouraging everyone else not to consume, but to save.

But much of the stimulus package is designed to achieve exactly the opposite: It encourages consumption, not saving. Not that there's anything wrong with consumption; it's what makes life worth living. But my consumption benefits me, while my saving benefits you.

I've already got plenty of incentive to consume. What you should be worrying about is my incentive to save. To say it again: The more I consume, the poorer your grandchildren will be; the resources I use won't be available to build machines that make your grandchildren more productive. It's all well and good to worry about the people who are struggling today, but let's also remember the people who will be struggling in the future. The worst thing we can do for them is to encourage consumption.

My resources may not be available, but the immense savings in Asia and among oil producing nations are still there waiting to be borrowed at attractive rates.

And while we're thinking about our grandchildren, let's also think about our contemporaries. Over the course of a typical decade, millions of people lose their jobs one at a time. In a severe recession, millions lose their jobs all at once. But it's no more painful to be unemployed for five weeks in the middle of a recession than it is to be unemployed for five weeks at the height of a boom. In fact, it's arguably less painful: Isn't it better to be unemployed at a time when unemployment carries less stigma and when you've got unemployed friends to hang around with? (Ask those striking Hollywood writers.) So it's hard to argue that we should do more for displaced workers during a recession than we do at any other time -- especially when people who lost their jobs a few years ago, and others who will lose them a few years hence, are footing a good chunk of the bill. ...

Suppose that it takes longer to get a job in a recession, a reasonable assumption. Then extending the time period covered by unemployment benefits, increasing the resources available to programs that help to reemploy workers, hiring some of the excess workers into temporary government employment, using tax rebates to stimulate the economy and employment, and so on to compensate for the lowered probability of finding a job during a recession, i.e. implementing policies that make it equally likely that unemployed workers in recessions and unemployed workers during boom times will find a job is not preferential treatment.

Ultimately, the only solution to unemployment is for displaced workers to get retrained and find their way back into the workforce. The new stimulus package only delays that process by propping up dying industries for a while and postponing the day of reckoning. Ultimately, there will be just as much hardship because the stimulus package can't last forever. Why spend all this money trying -- and probably failing -- to delay the inevitable?

Uhm, because it's not inevitable?

links for 2008-01-26

• Where Continents Go to Die: New Look into Center of the Earth - Spiegel
• Who gets stimulated ? - Paul Krugman Blog
• Let's hear the voice of Kenyans, through a recount - Jeffrey Sachs
• Markets Force Fed to Make a Big, Risky Rate Cut -  John M. Berry
• Fewer people trashing U.S. roads, beaches - McClatchy
• Gertler: Fed Criticism "Way Overboard" - WSJ Economics Blog
• Blogs - The New York Review of Books
• Trends and trendiness at Davos - Project Syndicate

"A Criminal Idea"

Jamie Galbraith tells the war hawks advocating the use of nuclear force to prevent the spread of weapons of mass destruction to think carefully about what they are suggesting because "as Nuremberg showed, it is not force that prevails. In the final analysis, it is law":

A Criminal Idea, James Galbraith, Commentary, Comment is Free: Five former Nato generals, including the former chairman of the US Joint Chiefs of Staff, John Shalikashvili, have written a "radical manifesto" which states that "the West must be ready to resort to a pre-emptive nuclear attack to try to halt the 'imminent' spread of nuclear and other weapons of mass destruction."

In other words, the generals argue that "the west" - meaning the nuclear powers including the United States, France and Britain - should prepare to use nuclear weapons ... to prevent the acquisition of nuclear weapons by a non-nuclear state. And not only that, they should use them to prevent the acquisition of biological or chemical weapons by such a state.

Under this doctrine, the US could have used nuclear weapons in the invasion of Iraq in 2003, to destroy that country's presumed stockpiles of chemical and biological weapons - stockpiles that did not in fact exist. Under it, the US could have used nuclear weapons against North Korea in 2006. The doctrine would also have justified a nuclear attack on Pakistan at any time prior to that country's nuclear tests in 1998. Or on India, at any time prior to 1974.

The Nuremberg principles are the bedrock of international law on war crimes. Principle VI criminalises the "planning, preparation, initiation or waging of a war of aggression ..." and states that the following are war crimes:

"Welfare for Wall Street"

Thomas Palley says the recent emergency rate cut is "welfare, Federal Reserve-style":

Welfare for Wall Street, by Thomas I. Palley: The Federal Reserve’s recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.

The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let’s not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.

Paul Krugman: Stimulus Gone Bad

I'm getting pretty tired of Democrats caving in on important issues rather than standing up and fighting for their core principles:

Stimulus Gone Bad, by Paul Krugman, Commentary, NY Times: House Democrats and the White House have reached an agreement on an economic stimulus plan. Unfortunately, the plan — which essentially consists of nothing but tax cuts and gives most of those tax cuts to people in fairly good financial shape — looks like a lemon.

Specifically, the Democrats appear to have buckled in the face of the Bush administration’s ideological rigidity, dropping demands for provisions that would have helped those most in need. And those happen to be the same provisions that might actually have made the stimulus plan effective.

Those are harsh words, so let me explain... Aside from business tax breaks — which are an unhappy story for another column — the plan ... ensures that the bulk of the money would go to people who are doing O.K. financially — which misses the whole point.

The goal ... should be to support overall spending, so as to avert or limit the depth of a recession. If the money ... doesn’t get spent — if it just gets added to people’s bank accounts or used to pay off debts — the plan will have failed.

And sending checks to people in good financial shape does little or nothing to increase overall spending. ... Give such people a few hundred extra dollars, and they’ll just put it in the bank. In fact, that appears to be what mainly happened to the tax rebates affluent Americans received during the last recession in 2001.

On the other hand, money delivered to people who aren’t in good financial shape ... does double duty: it alleviates hardship and also pumps up consumer spending.

That’s why many of the stimulus proposals we were hearing just a few days ago focused ... on expanding programs that specifically help people who have fallen on hard times, especially unemployment insurance and food stamps. ...

There was also some talk among Democrats about providing temporary aid to state and local governments, whose finances are being pummeled by the weakening economy. Like help for the unemployed, this would have done double duty, averting hardship and heading off spending cuts that could worsen the downturn.

But the Bush administration has apparently succeeded in killing all of these ideas...

Why would the administration want to do this? It has nothing to do with economic efficacy... Instead, what seems to be happening is that the Bush administration refuses to sign on to anything that it can’t call a “tax cut.”

Behind that refusal, in turn, lies the administration’s commitment to slashing tax rates on the affluent while blocking aid for families in trouble — a commitment that requires maintaining the pretense that government spending is always bad. And the result is a plan that not only fails to deliver help where it’s most needed, but is likely to fail as an economic measure...

And the worst of it is that the Democrats, who should have been in a strong position — does this administration have any credibility left on economic policy? — appear to have caved in almost completely. ...[B]asically they allowed themselves to be bullied into doing things the Bush administration’s way.

And that could turn out to be a very bad thing.

We don’t know for sure how deep the coming slump will be... But there’s a real chance not just that it will be a major downturn, but that the usual response to recession — interest rate cuts by the Federal Reserve — won’t be sufficient to turn the economy around...

And if that happens, we’ll deeply regret the fact that the Bush administration insisted on, and Democrats accepted, a so-called stimulus plan that just won’t do the job.

When Iceland was Ghana

Thorvaldur Gylfason "assesses African development prospects using Iceland’s economic ascent over the last century as a benchmark":

When Iceland was Ghana, by Thorvaldur Gylfason, Vox EU: Believe it or not: in 1901, Iceland’s per capita national output was about the same as that of Ghana today. Today, Iceland occupies first place in the United Nations’ ranking of material success according to the Human Development Index that reflects longevity, adult literacy, and schooling as well as the purchasing power of peoples’ incomes. Can Iceland’s rags-to-riches story be replicated in Africa and elsewhere in the developing world? If so, what would it take?

Grandmother-verifiable statistics

In 1901, my grandmother was twenty-four. She had six children, as was common in Iceland at the time, even if the average number of births per woman had decreased from almost six in the early 1850s to four around 1900, like in today’s Ghana. In fact, the number of births per woman in Iceland was four in 1960, so Iceland and Ghana are separated in this respect by a half-century or less. It took Ghana less than fifty years, from 1960 to date, to reduce the number of births per woman by three, from almost seven to four. It took Iceland a century and a half, from the late 1850s to date, to reduce the number of births per woman by three, from five to two (or 2.1 to be precise, the critical number that keeps the population unchanged in the absence of net immigration).

True, Ghana has made more rapid progress on the population front than many other African nations. The average number of births per woman in Sub-Saharan Africa has decreased from 6.7 in 1960, as in Ghana, to 5.3 in 2005. These averages, however, mask a wide dispersion in fertility across countries. Mauritius is down to two births per woman compared with almost six in 1960. Botswana is down to three, from seven in 1960. The women of Kenya, Tanzania, and Uganda now have five, six, and seven children each on average compared with eight, seven, and seven in 1960.[1]

Goodbye to short lives in large families

The point of this comparison of demographic statistics is that social indicators often provide a clearer view than economic indicators of important aspects of economic development. Moreover, several social indicators of health and education – fertility, life expectancy, literacy, and such – are readily available for most countries and in some cases reach farther back in time than many economic statistics. Fertility matters because most families with many children cannot afford to send them all to school and empower them to make the most of their lives. Families with fewer children – say, two or three – have a better shot at being able to offer a good education to every child, thus opening doors and windows that otherwise might remain shut. Reducing family size, therefore, is one of the keys to more and better education and higher standards of life. As Hans Rosling has pointed out very vividly, short lives in large families are no longer a common denominator in developing countries.[2]

Around the globe, including in many parts of Africa, there is a clear trend toward smaller families and longer lives. In Ghana, for example, life expectancy at birth has increased by more than three months per year since 1960, from 46 years in 1960 to 58 years in 2005. In Sub-Saharan Africa on average, all 48 countries included, life expectancy increased less rapidly, from 41 years in 1960 to 47 years in 2005. Average life expectancy is now on the rise again in Africa, having reached a peak of 50 years in the late 1980s and then decreased mostly on account of the HIV/AIDS epidemic.

Iceland’s economic history through African eyes

Let us now return to Iceland and briefly trace its economic history since 1901 through African eyes, as it were. In 1901, Iceland’s Gross Domestic Product (GDP) per capita was about the same as that of Ghana today, measured in international dollars at purchasing power parity. This observation, illustrated in Figure 1, follows from two simple facts:

links for 2008-01-25

• Trade and the great divergence - Dani Rodrik
• Betting on recession - Econbrowser
• I hate Google Network Solutions - Environmental Economics
• Were you able to function without www.env-econ.net? - env-econ.net
• Laurence Seidman on fiscal policy - Clive Crook
• Reported Stimulus Package Would Provide Little Immediate Boost - CBPP
• Stimulus disappointment - Paul Krugman Blog
• Why worry about a poor stimulus plan? - Paul Krugman Blog

I See What You Mean, It Is Broken

Lately, I've been hearing a lot about how recent events in financial markets show that capitalism is broken.

When regular old workers are thrown out of work and their lives are thrown into turmoil, we're told that's capitalism functioning as it should, creative destruction, dynamism, able to respond quickly to changes in conditions and all of that. It's a big shock to the workers who lose their jobs and their source of steady income, even more so for the large number who don't qualify for unemployment compensation that allows the unemployed to replace about half their lost income, at least for a time, but a necessary shock according to the creative destructionists.

However, when executives face the same dynamism and their income falls (so that they also face a reduction in their income, say from a million to half a million), global capitalism is broken and needs to be fixed (e.g. "Market Bloodbath Highlights Cracks in Capitalism," one of many along these lines).

So, when only workers are affected, it's capitalism doing what it does best. But when it's executives who are facing the turmoil, capitalism needs fixing. I actually agree that we could do more in terms of both preventative policy (better regulation of the financial sector for example) and stabilization policy (see the less than optimal current fiscal stimulus package) to help capitalism function better, it's just interesting how much louder the calls are to fix the system when it's the executive ox that's getting gored.

From the Inbox...

Mark,

Your kilt for Saturdays Burns' night festivities is in my office.

Slainte

Trouble Right Here in River City

One of you got me in trouble. I received a big packet in campus mail from a law firm a few days ago demanding that I remove a defamatory, libelous comment from a post or face a lawsuit.

Someone had copied an article and posted it in comments (this was fairly recent). Subsequently, the author retracted the original article, admitted statements in the article were false, apologized, and it was removed from their website. Given that, I didn't see that I had much room to protest, and the lawyers at TypePad told me I was responsible for everything posted on my site, including all comments.

I had until the 23rd to remove it according to their demands, i.e. until midnight yesterday. I waited until 11:59 last night, then a half minute longer, then a few seconds more, then finally removed it just before the 23rd ended (a little voice keeps telling me to repost it every so often so that it stays in Google's cache, but I'm trying not to listen). I really wanted to fight it. But, given that the author had retracted the original, this didn't seem like the right place to take a stand.

No big deal I guess (or is it?), but I feel like I gave in too easily. I just didn't see how to resist in this case.

"Bill Gates Issues Call For Kinder Capitalism"

The last few days have been full of surprises. Bill Gates has "has grown impatient with the shortcomings of capitalism":

Bill Gates Issues Call For Kinder Capitalism, by Robert A. Guth, WSJ (Free): ...Bill Gates ... will call for a revision of capitalism. In a speech at the World Economic Forum in Davos, Switzerland, the software tycoon plans to call for a "creative capitalism" that uses market forces to address poor-country needs that he feels are being ignored.

"We have to find a way to make the aspects of capitalism that serve wealthier people serve poorer people as well," Mr. Gates will tell ... the forum...

Mr. Gates isn't abandoning his belief in capitalism as the best economic system. But in an interview with the Journal last week..., Mr. Gates said that he has grown impatient with the shortcomings of capitalism. He said he has seen those failings first-hand on trips for Microsoft to places like the South African slum of Soweto...

In particular, he said, he's troubled that advances in technology, health care and education tend to help the rich and bypass the poor. "The rate of improvement for the third that is better off is pretty rapid," he said. "The part that's unsatisfactory is for the bottom third -- two billion of six billion."

Three weeks ago, on a flight home from a New Zealand vacation, Mr. Gates took out a yellow pad of paper and listed ideas about why capitalism, while so good for so many, is failing much of the world. He refined those thoughts into the speech he will give today...

Among the fixes he plans to call for: Companies should create businesses that focus on building products and services for the poor. "Such a system would have a twin mission: making profits and also improving lives for those who don't fully benefit from market forces," he plans to say. ... Mr. Gates sees a role for himself spurring companies into action...

But Mr. Gates's argument for the potential profitability of serving the poor is certain to raise skepticism. "There's a lot of people at the bottom of the pyramid but the size of the transactions is so small it is not worth it for private business most of the time," says William Easterly, a New York University professor...

Key to Mr. Gates's plan will be for businesses to dedicate their top people to poor issues -- an approach he feels is more powerful than traditional corporate donations and volunteer work. Governments should set policies and disburse funds to create financial incentives for businesses to improve the lives of the poor, he plans to say today. "If we can spend the early decades of the 21st century finding approaches that meet the needs of the poor in ways that generate profits for business, we will have found a sustainable way to reduce poverty in the world,"...

In the interview, Mr. Gates was emphatic that he's not calling for a fundamental change in how capitalism works. He cited Adam Smith, whose treatise, "The Wealth of Nations," lays out the rationale for the self-interest that drives capitalism and companies like Microsoft. That shouldn't change, "one iota," Mr. Gates said.

But there's more to Adam Smith, he added. "This was written before 'Wealth of Nations,'" Mr. Gates said, flipping through a copy of Adam Smith's 1759 book, "The Theory of Moral Sentiments." It argues that humans gain pleasure from taking an interest in the "fortunes of others." Mr. Gates will quote from that book in his speech today. ...

To a degree, Mr. Gates's speech is an answer to critics of rich-country efforts to help the poor. One perennial critic is Mr. Easterly, the New York University professor, whose 2006 book, "The White Man's Burden," found little evidence of benefit from the $2.3 trillion given in foreign aid over the past five decades.

Mr. Gates said he hated the book. His feelings surfaced in January 2007 during a Davos panel discussion with Mr. Easterly... To a packed room of Davos attendees, Mr. Easterly noted that all the aid given to Africa over the years has failed to stimulate economic growth on the continent. Mr. Gates, his voice rising, snapped back that there are measures of success other than economic growth -- such as rising literacy rates or lives saved through smallpox vaccines. "I don't promise that when a kid lives it will cause a GNP increase," he quipped. "I think life has value."

Brushing off Mr. Gates's comments, Mr. Easterly responds, "The vested interests in aid are so powerful they resist change and they ignore criticism. It is so good to try to help the poor but there is this feeling that [philanthropists] should be immune from criticism."

A core belief of Mr. Gates is that technology can erase problems that seem intractable. ... Describing himself as an "impatient optimist," Mr. Gates said he will ask each of his Davos listeners to take up a "creative capitalism" project in the coming year.

And he vows to keep prodding them. "I definitely see, once I'm full time at the foundation, reaching out to various industries -- going to cellphone companies, banks and more pharma companies -- and talking about how...they can do these things," he said. 
[Full, much longer article - free - here]

"The Costs of a Different World"

What will it take to meet the challenge posed by climate change? This research concludes that "massive changes are required":

What a different world. Costs and policy for a low carbon society, by Valentina Bosetti, Carlo Carraro, Emanuele Massetti, and Massimo Tavoni, Vox EU: No longer confined to the roundtables of politicians and scientists, the debate on climate change has become a mounting wave that doesn’t seem to be losing momentum. Both policy and research communities have focused on the need to stabilise atmospheric CO2 concentrations at about 550 ppm (parts per million, all greenhouse gases included). This is generally considered a very ambitious, hardly feasible target with drastic implications for our economies and lifestyles.

Given projected world population dynamics, this objective requires reducing per capita emissions in the second half of this century from about 2 tonnes carbon equivalent (tC) to about 0.3 tC per year. In other words, the world will have to cut emissions to the per capita average of India today – quite a significant reduction for most industrialised countries (US average per capita emissions are about 5tC) and for countries that aim at similar lifestyle standards. For example, 0.3 tC is the amount of greenhouse gases emitted by an individual flying – one way – from the EU to the US East coast!

Clearly, a world with 0.3 tC per capita per year will be a different world. What are the optimal strategies and the related economic costs of achieving this ambitious, but seemingly inevitable, target?

"Beyond Payday Loans"

Bill Clinton and Arnold Schwarzenegger want to increase the availability and awareness of financial products that serve the needs of low income households many of whom rely, unnecessarily, on high cost alternatives:

Beyond Payday Loans, by Bill Clinton and Arnold Schwarzenegger, Commentary, WSJ: The American dream is founded on the belief that people who work hard and play by the rules will be able to earn a good living, raise a family in comfort and retire with dignity.

But that dream is harder to achieve for millions of Americans because they spend too much of their hard-earned money on fees to cash their paychecks or pay off high-priced loans meant to carry them over until they get paid at work.

Here is one initiative that can ... help... the "unbanked" enter the financial mainstream by opening checking and savings accounts, and working collaboratively with financial institutions and community groups to develop and market products that work for this untapped market. ... And it won't cost taxpayers a dime.

Imagine the economic and social benefits of putting more than $8 billion in the hands of low- and middle-income Americans. That is the amount millions of people now spend each year at check-cashing outlets, payday lenders and pawnshops on basic financial services that most Americans receive for free -- or very little cost -- at their local bank or credit union. Over a lifetime, the average full-time, unbanked worker will spend more than $40,000 just to turn his or her salary into cash. ...

More than 20 million Americans cash more than $60 billion in checks each year at check-cashing businesses. Full-time workers without a checking account typically pay $40 on average to cash their paychecks. And payday lenders sell an additional $40 billion in expensive small-dollar loans each year that carry fees 30 times the average credit-card rate.

But these Americans can become bank customers if they have access to the right products at the right terms, and the support they need to make good, responsible financial decisions. ... The vast majority of people without bank accounts work, and they have an average household income of $27,000. Most are also married, have at least one child, and are employed by a small business. ...

This year, California will become the first state in the nation to launch an effort to help unbanked residents open starter accounts... Approximately 11% of California households, including 25% of Latino and African-American households, do not have a checking account. And nearly half of households in the state don't have a savings account.

In coordination with the Federal Deposit Insurance Corporation, we will partner with financial institutions to increase the supply of starter accounts that work for unbanked consumers and banks. We will form regional ... groups to market accounts and help the unbanked build financial literacy. And we will build on work already being done in San Francisco, where city officials, working with banks and credit unions, have already signed up 11,000 individuals who previously had no checking or savings account. ...

links for 2008-01-24

• Does the Fed have enough ammunition? - Paul Krugman Blog
• Fiscal Stimulus on the Way - Robert's Stochastic thoughts
• Devil's Advocate (on fiscal stimulus) - Economic Investigations
• Could Someone Tell Rudy About the Balanced Budget Multiplier? - PGL
• The Monster is Back, and Its Hopeful - Olivia Judson
• Maybe Too Little, Always Too Late - New York Times
• Budget and economic outlook - CBO Director’s Blog
• Global Forces and Monetary Policy Effectiveness - Boivin and Giannoni
• Critique Mounts against Biofuels - Spiegel

Quasi-Experimental Evidence on the Neutrality of Money

Arindrajit Dube of the Institute for Research on Labor and Employment at UC Berkeley looks at how recession probabilities on Intrade changed immediately following the Fed's announcement of an emergency rate cut:

Market based evidence on the non-neutrality of monetary policy, by Arindrajit Dube: Ahem… we have for the first time used quasi-experimental evidence to estimate the impact of a large (and surprising) reduction in the federal funds rate on the probability of a recession.  Recent financial innovations allow us to use the market for “recession futures” to estimate impact of policy on implied probabilities in an event study framework.  Using hourly trading data from Intrade.com over a 48 hour period, we find that a 0.75 percentage point reduction in the federal funds rate on the morning of January 22 led almost instantaneously to a reduction in the implied probability of recession from 77% to 68%, and to around 70% after 24 hours of the announcement.

Please click here for larger version

We find the elasticity of recession odds to policy [d(probability of a recession)/ d(percentage point reduction in rate)]  to be between 9.3 and 12. This suggests that at best, a 400 basis point (4 percentage point) reduction in the federal funds rate can hope to reduce the odds of a looming recession by around 50%.  Our identification assumes that this was both unanticipated in terms of timing, and represents a net reduction in the medium term as compared to the forecasted path of the federal funds rate. If the surprise reduction in federal funds rate is partly substituting for a (now foregone) reduction in the future, the true effects of a medium-term reduction may be understated by our estimates. Overall, our results suggest that rational expectations are inconsistent with the theory of monetary policy neutrality.

"Capitalism's Enemies Within"

Robert Samuelson says there's something wrong with the markets that determine pay on Wall Street that causes pay to be too high and encourages excessive risk-taking:

Capitalism's Enemies Within, by Robert J. Samuelson, Commentary, Washington Post: Amid the mayhem on world financial markets, it is becoming clear that capitalism's most dangerous enemies are capitalists. No one can have watched the "subprime mortgage" debacle without noticing the absurd contrast between the magnitude of the failure and the lavish rewards heaped on those who presided over it. At Merrill Lynch and Citigroup, large losses on subprime securities cost chief executives their jobs -- and they left with multimillion-dollar pay packages. Stanley O'Neal, the ex-head of Merrill, received an estimated $161 million.

Everyday Americans will conclude (rightly) that this brand of capitalism is rigged in favor of the privileged few. ... If you leave your company a shambles -- with losses to be absorbed by lower-level employees, some of whom will be fired, and shareholders -- do you deserve a gold-plated send-off? Still, the more serious problem transcends the high pay itself and goes to the wider consequences for the economy.

Wall Street's pay practices perversely encourage extreme risk-taking that can destabilize the economy. Subprime mortgage losses may simply be chapter one. ... If banks and investment houses sustain more losses, the nation's credit system will be further wounded and so will the economy. ...

By "Wall Street," I mean all the commercial banks, investment banks, mutual funds, hedge funds and the like..., but particularly investment banks. Pay is eye-popping. In 2007, Lloyd Blankfein, chief executive of Goldman Sachs, received compensation estimated at $68 million. ... Just why investment bankers and traders out-earn, say, doctors or computer engineers is a question I've never heard convincingly answered. Are they smarter? Unlikely. Do they contribute more to the economy? Questionable. True, Wall Street often performs a vital function. ...

But Wall Street also frequently misallocates capital and credit. The "tech bubble" of the late 1990s was one episode. Now we have subprime mortgages. Why? Well, the herd mentality of financial crazes has a long history. But compensation practices skewed so heavily toward bonuses based on annual profits make matters worse. ...

To be fair, the real estate bubble had many causes, including low interest rates, the political popularity of homeownership and the (mistaken) belief that housing prices could never fall. This may explain why, so far, the backlash against Wall Street has been muted.

But if the subprime failure turns out to be a preamble to a larger financial breakdown, flowing from the creation of new securities that offered short-term trading possibilities but whose long-run risks were underestimated, then the mood could turn uglier. Indeed, many Americans may conclude that capitalism has run amok.

When I hear about inequality widening, the ultimatum game experiments where people are willing to do things that do not appear to be in their economic interest in order to punish unfairness sometimes come to mind. There is some tipping point - I don't know where it is - but there does come a point where the perception of unfairness causes people to demand change, and they may be willing to do things that appear to be economically irrational in order to bring that change about. Often, it is the threat of taking action, not the action itself, that promotes changes that reduce inequality. On a smaller scale, we see this when workers go out on strike and appear willing to pay a far higher cost than any gain they might eventually reap in order to ensure that pay is fair according to their perceptions of what fair means. And often the threat of a strike is enough to change the outcome of negotiations over who gets what share of the profits, the strike itself is not necessary.

Was the Great Depression such an event, a time where people came to believe that the system did not treat the typical household fairly, and thus demanded change? Some of the policies that came out of the Great Depression to alleviate inequality may have been an attempt to stave off more drastic change - it was either give in to the demand for a reduction in inequality within the capitalist system itself or, some feared anyway, face the possibility the capitalist system itself would be fundamentally altered or even replaced.

If we have a hard landing, a true hard landing where significant numbers of people are thrown out of work for a substantial period of time while those who were rewarded in recent years do not face similar hardship, will that trigger change? I think it might, though it's not exactly comfortable to think that something like universal health care has a better chance of being enacted if we have a severe recession that causes people to demand change, any change that benefits the working class, than if times remain relatively good. But hopefully I'm wrong about that and we'll get the needed change in healthcare and other areas without having to suffer through a long, deep, recession first.

Fed Watch: The Surprises Just Keep Coming

Tim Duy reevaluates after today's surprise move by the Fed:

The Surprises Just Keep Coming, by Tim Duy: One thing is clear – after six months of struggling to learn the policy objectives of the Federal Reserve under Chairman Ben Bernanke, I just am not going to catch a break. Ironically, I sent the following email to Mark Thoma last night, after I saw his lead-in to my last piece:

Funny guy...but truthful. The Fed's been kicking my a** lately. Still can't believe I got December right.

If I listen to Mishkin and his "medium term" outlook, I just know I am going to get burned again.

And there it is. Sigh – some days I wish that Mark had not convinced me to start doing the Fed Watch thing again.

I was referring of course to Federal Reserve Governor Frederick Mishkin’s recent comments:

I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting (Mishkin, 2007e). What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting. For these reasons, I hope the recent enhancements to the Federal Reserve’s communication strategy--especially the greater prominence of the macroeconomic projections of FOMC participants--will help shift attention toward our medium-term objectives and our approach in meeting these objectives.

I knew that Mishkin was throwing up a false signal, yet Fed policymakers just seem so sincere that they want to pursue greater transparency. Before I got lost in Miskin’s preamble, I had titled my last piece “Financial Freefall Put 75bp in Play.” Should have stuck with it.

Still, I am not so uncharitable as Wilhelm Butier and Felix Salmon, although I genuinely empathize with their frustration, both of whom express dismay over this “panic” move. Fundamentally, I tend more toward Jim Hamilton’s interpretation. But it was a panic move, no question about it. It stinks of the appearance of equity price targeting, and reeks of desperation - especially since each time the Fed cuts rates, they sent a message similar to that of the December 11 statement:

Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Such statements, and the supporting speeches, have pulled me in almost every time. I focused too much on Bernanke’s moves toward greater transparency, while neglecting his work on credit markets and, as Paul Krugman reminds us, the experience of the Bank of Japan at the zero-interest rate bound. The transparency/long term forecast story is essentially meaningless in the current environment, and the failure of the Fed to drop references to their long term forecasts earlier is, in my opinion, the most significant failure in the Fed’s communication strategy. Indeed, the Fed stepped up those efforts by publishing their forecasts! Thankfully, the most recent Fed statement neglects to include such a forecast.

Still, I am surprised that Fed policymakers are surprised with the flow of current data – they clearly believe they are far behind the curve. What did they expect to see if growth rates were decelerating from the superheated pace of the 3^rd quarter to something around 1%? The Fed’s own forecasts were bordering on near-recession territory in the near term. And did they honestly expect that the hundreds of billions of dollars that flowed out of housing would suddenly reappear in housing – or some other part of the US economy – within a few months of August’s meltdown?

But, here again, I missed something critical – Bernanke’s blasé attitude about global imbalances. From his September 11 speech:

links for 2008-01-23

• Size of the Pie, Distribution of the Pie - Lane Kenworthy
• The Fed’s emergency cut: There’s a new sheriff in town - Stephen Cecchetti
• The "Fed Put" in action - Interfluidity
• Make the Tax Cuts Work - New York Times
• Ratings Agency Reform - Richard Portes - Vox EU
• Comic Relief (Ben Stein Does it Again...) - EconoSpeak
• Can this be true? (McCain's Econ Adviser) - Paul Krugman Blog
• Is U.S. in Recession? Discussions Begin - WSJ Economics Blog
• The Politics of an Economic Nightmare - Robert Reich
• Economic stimulus…. - CBO Director’s Blog
• Did the Fed panic? - Clive Crook
• Panic at Davos! - Daniel Gross
• Pushing White House Memes On Social Security - Crooks and Liars
• How to insure against catastrophes - Vox EU
• The financial turmoil is like an elephant in a dark room - Martin Wolf
• Economists help climate scientists improve forecasts - EurekAlert
• When Bubbles Burst - IMF
• Democrats Want FHA Bill in Stimulus Plan, Frank Says - Bloomberg
• The GOP's Security Gap - Harold Meyerson
• Greenspan Put Is Dead. Long Live Greenspan Put - Caroline Baum
• Markets Force Fed to Make a Big, Risky Rate Cut - John M. Berry
• Capitalism's Enemies Within - Robert J. Samuelson
• Ralph Turvey on the Housing Component of CPI - Richard Green

Stiglitz: How to Stop the Downturn

Joseph Stiglitz outlines an optimal stimulus package:

How to Stop the Downturn, by Joseph Stiglitz, Commentary, NY Times: America's economy is headed for a major slowdown. Whether there is a recession ... is less important than the fact that the economy will operate well below its potential, and unemployment will grow. The country needs a stimulus, but anything we do will add to our soaring deficit, so it is important to get as much bang for the buck as possible. The optimal package would contain one fast-acting measure along with others that could lead to increased spending if and only if the economy goes into a steep downturn.

We should begin by strengthening the unemployment insurance system, because money received by the unemployed would be spent immediately.

The federal government should also provide some assistance to states and localities, which are already beginning to feel the pinch, as property values have fallen. Typically, they respond by cutting spending, and this acts as an automatic destabilizer. Federal assistance should come in the form of support for rebuilding crucial infrastructure.

More federal support for state education budgets would also strengthen the economy in the short run and promote growth in the long run, as would spending to promote energy conservation and lower emissions. It may take some time to put these kinds of well-designed expenditure programs into place, but this slowdown looks as if it will last longer than some of the other downturns in recent memory. ...

The Bush administration has long taken the view that tax cuts (especially permanent tax cuts for the rich) are the solution to every problem. This is wrong. ... A tax rebate aimed at lower- and middle-income households makes sense, especially since it would be fast-acting.

Something should be done about foreclosures, and appropriately designed legislation allowing those who have been victims of predatory lending to stay in their homes would stimulate the economy. But we should not spend too much on this. If we do, we’ll wind up bailing out investors, and they are not the ones who need help from taxpayers.

In 2001, the Bush administration used the impending recession as an excuse to cut taxes for upper-income Americans... The cuts were not intended to stimulate the economy, and they did so only to a limited extent. To keep the economy going, the Federal Reserve was forced to lower interest rates to an unprecedented extent and then look the other way as America engaged in reckless lending. The economy was sustained on borrowed money and borrowed time.

The day of reckoning has come. This time we need a stimulus that stimulates. The question is, will the president and Congress put aside politics to get the job done?

Economic and Social Differences by State and Party ID

From The Monkey Cage:

Economic and Social Differences by State and Party ID, by David Park: ...Here’s a graph from the 2000 National Annenberg Election Studies. Each state represents the mean economic and social estimates (red states indicate self-reported Republicans and blue self-reported Democrats). Positive is more Conservative and Negative more Liberal.

There is no overlap between Democrats and Republicans on the economic dimension but some overlap on the social dimension. Democrats appear to be more economically cohesive than Republicans. Socially, WV Democrats are more conservative than Republican VT, NY, MA, CT and RI. ...

Emergency Rate Cut

I can't say I expected this to happen today. So far so good, stock markets are recovering, at least for the moment, but the 75 basis point cut is aggressive and makes me wonder if there are things the Fed knows that we don't. In that sense, I hope this move calms markets rather than reinforcing their worries. First, the statement from the FOMC:

FOMC Statement: The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin. In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

Here's Greg Ip of the Wall Street Journal:

Fed Cuts Key Interest Rate As Recession Fears Well Up, by Greg Ip, WSJ:  Federal Reserve Chairman Ben Bernanke, putting caution aside, orchestrated a steep cut in interest rates just a week before a scheduled policy meeting in an effort to short-circuit a downward spiral of investor confidence and tightening credit.

The three-quarters of a percentage point cut in the Fed's short-term interest rate target -- to 3.5% -- could help restore confidence to investors and counter the threat of recession. But the reduction risks making the Fed look like it panicked in response to market developments.

The move is unlikely to be the last cut, the Fed indicated. "Appreciable downside risks to growth remain," it said, vowing to "act in a timely manner as needed to address those risks." ...

The immediate market response was positive. The Dow Jones Industrial Average, down as much as 464 points early in the morning, recovered much of those losses by midday. European markets, which were falling steeply, reversed course and closed higher on the Fed's action.

The Fed said it acted because of "weakening of the economic outlook and increasing downside risks to growth. Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets."

The Fed statement suggested a downshift in its worries about inflation. It said it expects "inflation to moderate in coming quarters" though it will "monitor inflation developments carefully."

The move would be "pointless" if it merely shifted a scheduled rate cut ahead by a week, said former Fed governor Laurence Meyer, now vice-chairman of consultants Macroeconomic Advisers LLC. "Instead, today's move was driven by a desire to get a larger cumulative change in the federal funds rate by the end of the month." He predicted a half-point cut next week. ...

The move was the first rate cut between scheduled meetings of Fed policymakers since the immediate aftermath of the Sept. 11, 2001 terrorist attacks...

The Fed last cut the target for the federal-funds rate, charged on overnight loans between banks, by as much in 1982, when it was lowered a full point. Prior to 1994, however, fed funds rate cuts weren't announced, and the Fed relied on the less-important discount rate, charged on direct Fed loans to banks, to signal its actions. It cut that rate a full percentage point in 1991. ...

The rate cut follows five months of gradualism in which the Fed has seen each of its last three rate cuts rapidly overtaken by events, as the credit crunch and housing collapse deepened. Mr. Bernanke had been balancing those risk against still-high inflation. But he signaled on Jan. 10 that he had shifted his focus principally to supporting growth as employment, retail sales and manufacturing activity all weakened sharply. While some Fed officials mulled the merit of an intermeeting cut then, Mr. Bernanke figured the speech would serve to recalibrate market expectations enough that he could wait until next week's meeting.

That game plan changed Monday in response to a double dose of bad market news: first, that several major bond insurers could lose their triple-A credit ratings, which would shift the risk of default on an additional billions of dollars of debt back onto banks, further constraining their lending; and then, on Monday, the global stock market rout, which cast into doubt the rest of the world's ability to ride out a U.S. recession. ...

And, Brad DeLong points to Rex Nutting:

Fed cuts rates 75 basis points in emergency move - MarketWatch: WASHINGTON (MarketWatch) -- Hoping to halt a market meltdown and prevent a recession, the Federal Reserve lowered its overnight lending rate by three quarters of a percentage point to 3.50% on Tuesday in a rare move between formal meetings.

The 75 basis-point surprise cut came after global financial markets sold off in dramatic fashion on Monday on fears that bad bets in credit markets could spread further and drive the U.S. economy into recession. See full story on London markets.

"The committee took this action in view of a weakening economic outlook and increasing downside risks to growth," the Federal Open Market Committee said in a statement. The Fed also lowered its discount rate by 75 basis points to 4%. It was the largest cut in the federal funds rate since 1982, after the FOMC had driven rates to 20% to kill inflation.

U.S. stocks opened with huge losses. The Dow Jones Industrial Average was down more than 450 points, or more than 3%. Treasurys rallied. "This move is not an instant fix," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics. "The economy is still staring recession in the face, but at least the Fed now gets it." With the move coming just eight days before the next scheduled meeting, "there can be no doubt that the timing of this morning's move is aimed at supporting global financial markets after yesterday's global equity meltdown," wrote Joshua Shapiro, economist for MFR Inc. Some traders said the Fed's move sniffed of panic. "I think that there's an element of thinking that, if the Fed is so worried that it is cutting rates, then that is feeding into fears that the U.S. economy is in really bad shape," said David Page, a strategist at Investec Securities in London.

After a conference call Monday evening among the 10 voting members of the Federal Open Market Committee, the FOMC released a statement early Tuesday saying downside risks to growth remain. One member of the committee, William Poole, president of the St. Louis Fed, voted against the move. One other, Fed Gov. Frederic Mishkin, was absent. "While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," the FOMC said. "Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets." "Appreciable downside risks to growth remain," the statement said. "The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks." The statement barely mentioned inflation, only saying that the FOMC expects inflation to moderate and will monitor inflation carefully...

I teach most of today and can't so much on this, so here's more from: Jim Hamilton, Paul Krugman, Andrew Samwick, WSJ Economics Blog (here and here too), Bloomberg, Financial Times, Felix Salmon, Wilhelm Buiter, and Barry Ritholtz. 

 

"Every Major U.S. Bank Was Profitable Last Year"

John Berry says we shouldn't feel too sorry for banks, or worry that credit is about to dry up and ruin the economy [Update: After today's events, I'll be curious to see if John Berry, who has been more bullish (or at least less bearish) than many other commentators, changes his tune at all.]:

Every Major U.S. Bank Was Profitable Last Year, by John M. Berry, Bloomberg: With all the large writedowns and losses announced for the fourth quarter, hardly any attention is being paid to just how profitable U.S. banks really are.

That inattention has raised unnecessary concerns that the banks may be so crippled by losses that they will cut lending to the point it might undermine the U.S. economy.

Some commentators have said the banks are in the worst shape since the Great Depression. That isn't close to being correct.

Other analysts have raised the specter of the stagnant Japanese economy of the 1990s, when banks there were crippled by huge losses when a real estate price bubble burst... This comparison also is off base.

Even Citigroup Inc., by far the hardest hit of the big U.S. banks by subprime-related problems, earned $3.62 billion last year. That was with a $9.83 billion fourth-quarter net loss and more than $22 billion in writedowns and additions to loan-loss reserves.

For JPMorgan Chase & Co., the third-biggest U.S. bank, the focus was on the 34 percent drop in fourth-quarter profits from a year earlier. Its full-year $15.4 billion profit, a record, was largely ignored. ...

Economist Robert E. Litan, a senior fellow at the Brookings Institution who has done numerous studies of the U.S. financial system, said the banks are in far better shape than the dire assessments suggest.

''Strip out the losses and Citi could make close to $10 billion a quarter,'' Litan said. Noting how quickly the bank has been able ... to replace the capital depleted by losses, he added, ''Why would anybody buy stock if they thought Citi was going down the tubes?''

''And this is nothing like the Japanese situation,'' Litan said. ... The story is largely the same at Merrill Lynch & Co., the world's largest brokerage, though the losses are greater relative to its size. ...

Credit isn't as readily available as it was for several reasons, including a less favorable economic outlook, tighter lending standards, particularly for mortgages, and a lack of a secondary market for some types of loans such as jumbo mortgages.

On the other hand, the interest rates many borrowers are paying have dropped. The bank prime rate, to which many loans are linked, is 7.25 percent, the lowest since January 2006.

As of Jan. 17, the average interest rate on 30-year fixed- rate mortgages dropped to 5.69 percent, the lowest level since June 2005.

In the two weeks ended Jan. 18, corporate borrowers sold $50 billion worth of investment-grade bonds at the lowest interest rates since April 2007.

The credit well hasn't run dry and it's not about to. And the nation's banks will be supplying a large share of it.

links for 2008-01-22

• More on Taxes at the Top - Lane Kenworthy
• Employment and confidence wonkery - Paul Krugman Blog
• Our feudal economy - Stumbling and Mumbling
• Aristotle's (modern) politics - The Daily Princetonian
• 3.2 Million Unemployed Apply For Opening At Ohio Bob Evans - The Onion
• Ben Bernanke Knows How to Run a Meeting - The Monkey Cage
• Black Pharaohs - National Geographic
• India on a roll, or the benefits of celluloid soft power - Project Syndicate
• Stimulating politics - Dean Baker

Tim Duy: Adding to the Fiscal Stimulus Discussion

While Tim was in central Oregon this weekend teaching the next generation of Fed Watchers where to go and hide after a bad call, he thought a bit about fiscal policy:

Adding to the Fiscal Stimulus Discussion, by Tim Duy: I rarely comment on fiscal policy. But tonight I feel somewhat adventurous, comfortably ensconced this holiday weekday in the snowy Central Cascades, watching the temperature dip toward zero. I was happy that I brought with me the print edition of the weekend Wall Street Journal, if nothing else for Bruce Bartlett’s op-ed piece and the cover story on fiscal policy. It, as well as Mark’s comments, prompted me to think about potential benefits offered by the proposed stimulus, concluding that there is an important international aspect to the stimulus that is often overlooked.

My initial read of Barlett’s piece was as an argument against temporary tax cuts, not for permanent cuts. And by in large, I agreed with Barlett. To be sure, there will be persons who do in fact spend virtually all of their tax rebate immediately, and those whose liquidity constraints are temporarily relieved. But, when all is said and done, the dollars being talked about are small relative to the size of the economy and temporary. We will see a flurry of press stories detailing the issuance of the checks, the ensuing stories of a spike in consumer spending, complete with the personal accounts of households and retailer. The personal income report will pop, and the GDP report will gain one percentage point over what it would have been otherwise, perhaps staving off a technical recession. Economists will have another data point to beat to death with econometrics, conclusively reaching multiple conclusions.

Reporters could write their stories now, fill in the details later. I have been here before, and will be here again.

This is not meant to imply that I am opposed to a stimulus package – if we can afford to spend $100+ billion in Iraq, we can afford to do it here. And if you want to get cash in the hands of spenders fast, putting checks in the mail is the way to do it. While I am very sympathetic to calls for infrastructure spending, we all know the money will trickle out over time, and thus have a fraction of the impact of $100 billion spent today. I would prefer rebates limited to those households earning less than $85,000, and expansions to a mix of temporary adjustment programs (unemployment insurance, etc.). I am wary of additional support for homeowners, but only because I am appalled that we as a society have created conditions such that households feel compelled to spend upwards of 50% of their income on housing.

Moreover, there is an additional mechanism by which the stimulus could be effective, even if the impacts on domestic consumption are relatively small and temporary – the stimulus may reduce the probability of a disorderly adjustment of the external accounts.

I generally do not view the current situation in a typical closed-economy Keynesian fashion. Keynes focused on situations where domestic consumption fell short of productive capacity due to an unwillingness to spend (excessive saving met with hesitant investment). Government spending – sustained, long term capital investment – could alleviate the imbalance by releasing the unused resources via issuance of debt.

In contrast, the US faces a resource constraint, not an unwillingness to spend. The existence of our sizable trade imbalance is evidence of that constraint. We have no problem spending money – we consume more than we produce in this country. Period. We rely on foreign savings and production (depending on what side of the international accounts you focus on) to support that consumption. Which is why I found this comment to be particularly prescient:

Foreign savers will no longer lend to citizens for consumption (by buying securitized mortgages and such), so the gov will temporarily borrow the money from foreign savers and give it to citizens to spend.

Correct – US consumers lost access to an important source of financing, and market participants are in a “run and hide” mood as they sort out the long term implications. What financial markets remain willing to absorb is US government debt. The fiscal stimulus we enact today can be viewed as an attempt to stabilize markets enough to lure foreign savers, or governments, back into supporting US domestic demand in excess of production capabilities without the US government as an intermediary. Note the desperate attempt of the financial community to recapitalize via foreign savings. And see Brad Setser.

Suppose that the transition away from foreign savings/production is underway – as suggested by the stabilization of the US current account deficit. There is a risk that this becomes disorderly, and the US government can smooth the transition by borrowing funds from abroad to offset a drop in capital inflows to private assets. The temporary stimulus has its impact not by “jump starting” the economy, but instead by preventing a disorderly adjustment as we transition to a new growth path. Then the stimulus was effective, even is “temporary.”

But the other side of the adjustment will not be days of wine and roses. Quite the contrary. Lessening our reliance on external production implies reduced rates of domestic demand growth on the other side of this downturn. It comes as little surprise to me that the Fed’s long term outlook appears looks consistent with potential growth near 2.5%.

Longer term, the potential downsides of stabilization policy emerge if we are not happy with the transition toward lower domestic demand growth rates. Then we will be increasingly using monetary and fiscal policy to foster a growth path that I suspect the rest of the world will be increasingly unwilling to support. As incomes rise across the globe, citizens of other nations will be increasing interested in producing for their own consumption, not ours. At that point, continued reliance on the rest of the world will prove difficult to maintain.