Economist's View

Brad DeLong: The Democrats' Line in the Sand

Brad DeLong says it might be correct that the only way for Democrats "to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it." If so, then there's a line that Democrats cannot cross:

The Democrats' line in the Sand, by J. Bradford DeLong, Project Syndicate: ...[I]f an economy as a whole is under-saving and under-investing, the government ought to help to correct this problem by running surpluses, not make it worse by running deficits that drain the pool of private savings available to fund investment. This is why most economists are deficit hawks.

Of course, governments need to run deficits in depressions in order to stimulate demand and stem rising unemployment. Moreover, a lot of emergency government spending on current items is really best seen as national savings and investment. ...

But the rule is that governments should run surpluses and not deficits, so various American presidents’ economic advisers have been advocates of aiming for budget surpluses except in times of slack demand and threatening depression. This was certainly true of Eisenhower’s, Nixon’s, and Ford’s economic advisors, and of George H.W. Bush’s and Bill Clinton’s economic advisers.

It was true of Reagan’s economic advisers as well. Some of Reagan’s advisers sincerely did not believe that the tax cuts of the early 1980’s would generate the large deficits that they did (Beryl Sprinkel and Lawrence Kudlow come to mind). Others, like Martin Feldstein and Murray Weidenbaum, understood the consequences of the Reagan tax cuts and were bitter bureaucratic opponents, even if they did not speak out publicly.

In fact, since WWII, only George W. Bush’s economic advisers have broken with this consensus. A few have done so because they are making careers as party-line Republicans, so their priority is to tell Republican politicians what they want to hear (Josh Bolton and Mitch Daniels come to mind here). As for the rest, their reasons for supporting the Bush administration’s savings-draining policies remain mysterious. It is not as though they were angling for lifetime White House cafeteria privileges, or that having said “yes” to George W. Bush will open any doors for them in the future.

But their failings do pose a dilemma for Democratic deficit-hawk economists trying to determine ... economic policies ... should Barack Obama become president. Those of us who served in the Clinton administration and worked hard to ... turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America’s income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be “normal” again? That’s a hard question, and I don’t know the answer.

There is, however, one fiscal principle that must be respected. Fiscal deficits so large that they put the debt-to-GDP ratio on an explosive upward trend do not merely act as a drag on long-term economic growth; they also create the possibility that at any moment the economy might face an immediate macroeconomic and financial disaster. A more hawkish fiscal stance may no longer be possible in future Democratic administrations, and might not be good policy if it were, given the likely complexion of successor administrations. Stabilizing the debt-to-GDP ratio is thus the line in the sand that must not be crossed.

"The Income-Inequality Denialists"

Speaking of "the George W. Bush administration ... quest to win the class war by making America’s income distribution more unequal," Justin Fox finds out what happens if you say the inequality in the U.S. has been increasing. I've been down this road:

The strange fantasy world of the income-inequality denialists, by Justin Fox: One of the more interesting developments in the U.S. economy over the past few decades has been the dramatic rise in incomes at the very top of the scale. There's all sorts of anecdotal evidence for this... But the most exhaustive empirical evidence for this income explosion at the top has come from the work of economists Thomas Piketty and Emanuel Saez...

Certain elements among the right-wing economic chattering classes ... have honed an interesting response to this rise in income inequality: They deny that it exists. My economic policy cover story of a while back, which cited Piketty and Saez, seems to be drawing these denialists out of the woodwork. Gary North is one, and now David Gitlitz joins in at National Review Online:

On income inequality, Fox accepts as fact the findings of economists Thomas Piketty and Emanuel Saez that “75% of all income gains from 2002 to ’06 went to the top 1% — households making more than $382,600 a year.” But as Piketty and Saez have acknowledged, these results are significantly skewed by the fact that their data only includes income reported on individual tax returns.

Following cuts in individual tax rates in 1986 (under Ronald Reagan) and 2003 (under George W. Bush), many of the businesses that had been reporting income under the corporate tax switched to the lower individual rate. In 1986, business income accounted for only 11 percent of the income reported by the top 1 percent of earners. By 2005 that share jumped to more than 29 percent. Clearly, much of the reported gain of the top 1 percent is accounted for in this bookkeeping shift.

Uh, no it's not. That purported problem, raised by Alan Reynolds, was swatted down pretty convincingly by Piketty and Saez:

Most of the scenarios described by Alan Reynolds, such as a shift from corporate income to individual income or from qualified stock-options to non-qualified stock options, would imply that high incomes used to receive capital gains instead of ordinary income. For example, a closely held C-corporation which does not distribute its profits increases in value and those accumulated profits would appear as realized capital gains on the owner individual tax return when the business is sold. Yet, our top 1% income share series including realized capital gains has also doubled from 10.0% in 1980 to 19.8% in 2004.

A fair description of the current state of knowledge on the income distribution is that members of the economics establishment (from right-wingers to left) more or less unanimously accept the Piketty and Saez data as a more or less accurate representation of reality. There are big debates about what it all means, and why it's happening, but the only major objections that I know of to the Piketty-Saez data itself have been those raised on the op-ed page of the Wall Street Journal by Reynolds, a senior fellow at the libertarian Cato Institute who doesn't appear to have an advanced degree in economics or in anything else.

It's a case where the scientific consensus says one thing, and this one guy says the opposite. I don't have an advanced degree in anything either, and I like to think that on occasion the scientific consensus will turn out to be wrong and the lone outsider right. But I'm pretty sure this isn't one of those cases.

Why not? First, there's all that anecdotal evidence of vast new fortunes being created.

Second, Piketty and Saez have pretty convincing answers to all of Reynolds' objections to their data.

Third, Piketty and Saez come across as data jockeys with no particular axe to grind, while Reynolds is an overt ideologue.

Finally, when Reynolds strays into an area that I actually know something about--the use of stock options in compensation--he is so clearly blowing smoke that it becomes difficult for me to trust anything else he says....

So here's where all that leaves me. I'm going to keep "accept[ing] as fact the findings of economists Thomas Piketty and Emanuel Saez." And anyone who says I shouldn't do so, without raising some major objections beyond the feeble array already trotted out by Reynolds, goes down in my book as something of a joker.

Paul Krugman: The Obama Agenda

If Obama wins, how much change will he bring about?:

The Obama Agenda, by Paul Krugman, Commentary, NY Times: It’s feeling a lot like 1992 right now. It’s also feeling a lot like 1980. But which parallel is closer? Is Barack Obama going to be a Ronald Reagan of the left, a president who fundamentally changes the country’s direction? Or will he be just another Bill Clinton? ...

Reagan, for better or worse — I’d say for worse... — brought a lot of change. He ran as an unabashed conservative, with a clear ideological agenda. And he had enormous success in getting that agenda implemented. ... America at the end of the Reagan years was not the same country it was when he took office.

Bill Clinton also ran as a candidate of change, but it was much less clear what kind of change he was offering. He portrayed himself as someone who transcended the traditional liberal-conservative divide, proposing “a government that offers more empowerment and less entitlement.” The economic plan he announced during the campaign was something of a hodgepodge: higher taxes on the rich, lower taxes for the middle class, public investment in things like high-speed rail, health care reform without specifics.

We all know what happened next. The Clinton administration achieved a number of significant successes... But the big picture is summed up by the title of a new book by the historian Sean Wilentz: “The Age of Reagan: A history, 1974-2008.”

So whom does Mr. Obama resemble more? At this point, he’s definitely looking Clintonesque.

Like Mr. Clinton, Mr. Obama portrays himself as transcending traditional divides. ... Mr. Obama’s economic plan also looks remarkably like the Clinton 1992 plan...

Sometimes the Clinton-Obama echoes are almost scary. During his speech accepting the nomination, Mr. Clinton led the audience in a chant of “We can do it!” Remind you of anything?

Just to be clear, we could — and still might — do a lot worse than a rerun of the Clinton years. But Mr. Obama’s most fervent supporters expect much more.

Progressive activists, in particular, overwhelmingly supported Mr. Obama during the Democratic primary even though his policy positions, particularly on health care, were often to the right of his rivals’. In effect, they convinced themselves that he was a transformational figure behind a centrist facade.

They may have had it backward.

Mr. Obama looks even more centrist now than he did before wrapping up the nomination. Most notably, he has outraged many progressives by supporting a wiretapping bill that, among other things, grants immunity to telecom companies for any illegal acts ... undertaken at the Bush administration’s behest.

The candidate’s defenders argue that he’s just being pragmatic — that he needs to do whatever it takes to win, and win big, so that he has the power to effect major change. But critics argue that by engaging in the same “triangulation and poll-driven politics” he denounced during the primary, Mr. Obama actually hurts his election prospects, because voters prefer candidates who take firm stands.

In any case, what about after the election? The Reagan-Clinton comparison suggests that a candidate who runs on a clear agenda is more likely to achieve fundamental change than a candidate who runs on the promise of change but isn’t too clear about what that change would involve.

Of course, there’s always the possibility that Mr. Obama really is a centrist...

One thing is clear: for Democrats, winning this election should be the easy part. Everything is going their way: sky-high gas prices, a weak economy and a deeply unpopular president. The real question is whether they will take advantage of this once-in-a-generation chance to change the country’s direction. And that’s mainly up to Mr. Obama.

Social and Economic Ideologies

This diagram shows the "average economic and social ideology of adults within each state ... scaled so that negative numbers are liberal and positive are conservative...""

...In the graph below, each state is shown twice: the avg social and economic ideologies of Democrats in the state are shown in blue, the avgs for Republicans in red.

...the big thing we see from the graph immediately above is that Democrats are much more liberal than Republicans on the economic dimension: Democrats in the most conservative states are still much more liberal than Republicans in even the most liberal states. On social issues there is more overlap (although in any given state, the average Republican is more conservative than the average Democrat). ...

The graph is from Andrew Gelman and David Park. More graphs here.

Does the Death Penalty Have a Deterrent Effect?

Justin Wolfers and Cass Sunstein say members of the Supreme Court "misread the evidence" on the deterrent effect of the death penalty:

A Death Penalty Puzzle The Murky Evidence for and Against Deterrence, by Cass R. Sunstein and Justin Wolfers, Commentary, Washington Post:  ...Last month, capital punishment resumed after a seven-month moratorium. Rapid scheduling of executions followed the Supreme Court's ruling in Baze v. Rees, reaffirming the constitutionality of the death penalty in general and lethal injection in particular.

To support their competing conclusions on the legal issue, different members of the court invoked work by each of us on the deterrent effects of the death penalty. Unfortunately, they misread the evidence.

Justice John Paul Stevens cited recent research by Wolfers (with co-author John Donohue) to justify the claim that "there remains no reliable statistical evidence that capital punishment in fact deters potential offenders." Justice Antonin Scalia cited a suggestion by Sunstein (with co-author Adrian Vermeule) that "a significant body of recent evidence" shows "that capital punishment may well have a deterrent effect, possibly a quite powerful one."

What does the evidence actually say? ...

In short, the best reading of the accumulated data is that they do not establish a deterrent effect of the death penalty.

Why is the Supreme Court debating deterrence? A prominent line of reasoning, endorsed by several justices, holds that if capital punishment fails to deter crime, it serves no useful purpose and hence is cruel and unusual, violating the Eighth Amendment. This reasoning tracks public debate as well. While some favor the death penalty on retributive grounds, many others (including President Bush) argue that the only sound reason for capital punishment is to deter murder. ...

But what if the evidence is inconclusive? We are not sure how to answer that question. But as executions resume, the debates over the death penalty should not be distorted by a misunderstanding of what the evidence actually shows.

"McCain's Visit is Ill-Advised"

Don Pedro has a question:

Why is McCain Going to Colombia?, Economists for Obama: I just learned that McCain is going to Mexico and Colombia next week. Mexico, OK, but Colombia? Presumably, the idea is for him to highlight his support for the stalled U.S.-Colombia trade agreement. But do his advisers realize that Colombia is embroiled in a political crisis?

Colombia's president, Alvaro Uribe--the torch bearer for the trade agreement--was only able to run for the second term he's now serving because the Colombian legislature amended the constitution to permit re-election. The constitutional amendment passed by just one vote. Last week, the Colombian Supreme Court sentenced a former congresswoman for accepting favors in exchange for her vote. With that ruling, the Court questioned the legitimacy of Uribe's re-election, and asked the separate Constitutional Court to determine the validity of the amendment.

links for 2008-06-30

• Oily Speculations - James Surowiecki
• Genuine innovation: New drugs save lives - Vox EU
• The Other Meaning of Bill Gates - Economic Principals
• Mortgage Problems Have Changed/Are Changing - Capital Gains and Games
• Ben Stein Watch: June 29, 2008 - Felix Salmon
• Political Freelancers Use Web to Join the Attack - NYTimes.com
• It is good to be the king (of oil) - Brad Setser
• Bee by Bee - Op-Ed - NYTimes.com

Sachs: "Simplistic Free-Market Optimism is Misplaced"

Jeff Sachs says this time it's different:

Saving Resources to Save Growth, by Jeffrey D. Sachs, Project Syndicate: Reconciling global economic growth, especially in developing countries, with the intensifying constraints on global supplies of energy, food, land, and water is the great question of our time. Commodity prices are soaring worldwide ... because increased demand is pushing up against limited global supplies. Worldwide economic growth is already slowing under the pressures...

A new global growth strategy is needed to maintain global economic progress. The basic issue is that the world economy is now so large that it is hitting against limits never before experienced.  There are 6.7 billion people, and the population continues to rise by around 75 million per year, notably in the world’s poorest countries. ...

An Increase in Worldwide Demand for Oil

Another round on the oil market model, this time to show what happens when there is an increase in the world demand for oil due to some factor such as increased demand from developing economies. The point is to show that, in this simple model, the increase in demand would increase in the long-run equilibrium price, but it would not change the level of inventories in the long-run. There are also other results to note, e.g. the possibility of overshooting the new long-run equilibrium and mimicking a bubble.

Case 1: An Increase in the Expected Future Price of Oil

First, the continuous time version of an increase in the expected price. I did a discrete time-version of this yesterday, but the continuous time version of this case Paul Krugman did yesterday is much simpler, so let's use that. Here's a quick review of that case:

In this model, the initial equilibrium is at point a. Then, there is an increase in the expected future price or a drop in the interest rate that increases the stock demand, N^d, and the equilibrium moves to point b. At this point, the spot price is above the equilibrium value in the flow market shown on diagram on the right, and there is excess supply as indicated by the red line. This excess supply increases the stock so, as shown by the arrow, the stock supply curve begins shifting out. Eventually, the economy settles at the new equilibrium shown at point c.

Summarizing the results for an expected increase in the future price:

1. The spot price, p, rises in the short-run, but is unchanged in the long-run.
2. The stock of inventories, N, rises.
3. The long-run flow equilibrium is unaltered.
4. The change in inventories depends upon the horizontal shift in the stock demand curve. This can be related to the slope of the stock demand curve, but it is not necessarily the case that a steeper demand curve leads to a smaller horizontal shift.
5. Steeper flow supply and demand curves affect the size of the change in the spot price during the transition (and the slopes can affect the transition path for inventories), but this does not change the ultimate size of the inventory change since this depends only upon the size of the shift in the stock demand curve.

Case 2: An Increase in Worldwide Demand for Oil

Moving to the next case, what happens if there is an increase in the world demand for oil due to worldwide economic growth. This shifts the flow demand curve outward:

Starting at the equilibrium a, as the flow demand curve shifts out, this causes an excess demand for oil as shown by the red line on the diagram. This excess demand is met by reducing stocks, so the stock supply curve begins shifting left and the economy moves to point b. Thus, so far there is an increase in price, and a decline in inventories.

But this isn't the end of the story. Because the increase in flow demand is permanent, the increase in price is permanent, and this will increase the expected future price. The increase in the expected future price will shift the demand curve out as shown in the next diagram:

As the demand curve shifts out to reflect the higher expected future price, the price moves up to point c. At point c, the flow market has excess supply as shown by the orange line segment, and this pushes the stock supply curve outward as the excess flow supply is absorbed as new stocks. Eventually, the economy reaches point d which, compared to point a, reflects a higher price but no change at all in inventories. Notice that the spot price overshoots its long-run value as it moves from b to c, then back down to b.

Why does the demand curve go through the same point for inventories as before? Recall from Krugman's post that  N^d = N(i-(p^e-p)/p), where i is the interest rate, p is the spot price, and p^e is the expected future price. At the initial long-run equilibrium, it must be that p^e=p, otherwise there would be a tendency for something to change (and hence it wouldn't be a long-run equilibrium [Update: I should add that there is no mechanism in this model to force p^e=p, but adding this in is a simple fix, e.g. just add an equation that says dp^e/dt = f(p^e-p), f'<0, or go to a more complicated rational expectations set-up. In this model, the requirement that p^e=p arises from making the model internally consistent with the definition of a LR equilibrium]). Thus, at the long-run equilibrium, the stock demand is just N(i). That means that the long-run equilibrium for stocks is independent of the spot price and its expected future value. Thus, the inventory level will be the same as its initial value after the offsetting changes in p and p^e.

Summarizing the results for an increase in flow demand:

1. The long-run spot price rises.
2. In the short-run, the spot price can overshoot in the new long-run equilibrium. The model doesn't predict overshooting, the a-b-c-d progression shown in the diagram is just for exposition, the actual path can be different (e.g. there's no reason for the expected spot price to increase only after the economy reaches point b). But the model is consistent with overshooting, and therefore the change in the spot price can look like a bubble that is inflating, then deflating even though the change is driven purely by fundamentals, i.e. by a shift in world demand.
3. The level of inventories can change in the short-run, but is unchanged in the long-run. (However, in a more general model, there might be a change in, say, the interest rate or convenience yield and this would cause an additional shift in the stock demand curve and change inventory levels. But it's still possible for the variation in inventories to be small.)

Finally, this is just a "vintage" Branson-style exchange rate model applied to commodities, so if you are familiar with those models and the bells and whistles that can be added to them, or with alternative models, for the most part the results and intuition ought to carry through to this case.

Update: Paul Krugman in response to Tyler Cowen.

links for 2008-06-29

• Ben Stein Goes Wild at the NYT!!!!!!!!!!! - Dean Baker
• As Housing Bill Evolves, Crisis Grows Deeper - NYTimes.com
• Why the next president won't be able to cure ailing economy - Daniel Gross
• New Obama Economic Advisers - Economists for Obama
• Higher education and human capital - Information Processing
• The perils of honesty in politics - Los Angeles Times
• Court Backs Cable Competition - NYTimes.com
• Is Your Tank Half Empty or Half Full? - Op-Ed - NYTimes.com
• Saving Resources to Save Growth - Jeffrey D. Sachs

Do We Need Another Stimulus Package?

Robert Shiller says the stimulus checks don't provide enough insurance against the possibility of a recession, and much more is needed:

One Rebate Isn’t Enough, by Robert Shiller, Economic View, NY Times: Tax rebates ... will eventually put more than $100 billion into the hands of consumers. The hope is that by spending the money, they will lessen the risk of economic disaster from the subprime crisis.

Have the rebates, now mostly distributed, achieved their objective?

It’s not very likely. The rebates may be helping..., but the stimulus they are providing is certainly too small to make a real difference. More will be needed, perhaps much more, before the economy is truly on safe ground.

From the outset, government officials considered the tax rebates as a kind of insurance for the overall economy. ... Has the tax rebate substantially reduced the probability of a downward spiral?

It is too soon to tell, because the Treasury only started to send out rebate checks in late April. Retail sales did rise in May. But the dreaded serious recession still seems very much a possibility. The unemployment rate shot up to 5.5 percent in May, from 5 percent. The Reuters/University of Michigan consumer sentiment index has fallen below the lowest levels of the last two recessions.

The theory supporting tax rebates was originally devised by John Maynard Keynes... But people who have studied [Keynesian] models find that these repercussions aren’t powerful enough unless the initial stimulus is really large. ... Why aren’t they more powerful?

Another Iteration on the Speculation Model

Here's another iteration on the model of oil markets we've been developing. [Update: Paul Krugman comments on the model and provides a simple, continuous time version.]

"The Blame for High Gas prices"

Richard Serlin:

The blame for high gas prices rests on simple-minded Republican ideology not speculators, by Richard Serlin: In Paul Krugman's June 27th column he writes:

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas.

A perhaps even bigger reason why Republicans want to blame speculators for sky high gas costs is that they don't want the public to put the blame where it's really due – on them.

For decades Republicans have constantly blocked Democratic attempts to increase fuel mileage and many other efficiency and conservation measures. They've also constantly blocked or cut spending on alternative energy, all the while mindlessly chanting "Free market". The economics community had proven long ago that there are many situations and ways where a government role can add greatly to efficiency, wealth, and welfare, but this is a party that long ago refused to think beyond slogans. They acted as though not being simple-minded was a vice, liberal and un-American, when in fact, thinking, and believing in science, evidence, and logic is one of the things that made this country great, and the richest and strongest in the world.

Now we're paying a big price for Republican ideology in energy and so many other things. Had the Democrats not been outvoted, filibustered, and vetoed from enacting their "big government" mileage, conservation, research, and other energy measures over the last almost three decades, gasoline might be less than half its price today...

And, of course, it wouldn't hurt that this would have starved the terrorists, and some of the worst authoritarian regimes in the world, of money, and greatly decreased the momentous risks of global warming,... benefits that aren't taken into account by the magical free markets. ...

It's the Only Thing

On the political front, what do you think of this argument?:

For Obama, winning is everything, by Michael Tomasky: So we've now plunged into the turbid waters of the age-old expediency versus principle debate. Three times now in the space of a week, Barack Obama has departed from what would seem to be liberal principle: his refusal to accept public financing for the general election, his decision to vote for a bill that gives American telecoms retroactive immunity from prosecution for cooperating with the Bush administration's surveillance initiatives and his statement siding with the supreme court's conservative minority that on Wednesday voted to permit the death penalty for child rapists. Denunciations are ringing across the blogosphere.

We'll go through the issues individually. But the larger question here is about how far a candidate for president can go to inoculate himself against likely attacks – attacks that have a proven track record of working – before he's no longer the candidate you believed in a year ago. ...

Liberals don't have to be happy about these decisions, and those who want to attack Obama and hold his feet to the fire and so forth should do so to their heart's content. But it's worth remembering that a presidential campaign is one of the worst contexts in which to expect or demand ideological consistency.

Obama has, in fact, taken a number of strong stands that might hurt him. He did back the supreme court on habeas corpus rights for non-citizen detainees – not a popular position. He's against offshore oil drilling while polls are showing that majorities support it. His is a position that could harm him in the crucial state of Florida, but he's taken it. He'll presumably continue to stand his ground on opposing the federal gas-tax repeal, a position John McCain might choose to revive at some point. And he will have to defend ... his support for increasing the capital gains tax by up to 10%, as he will assuredly be attacked for that. He supports a large cap-and-trade scheme on carbon emissions that will surely be attacked as a tax on business. And so on.

I've always objected to setting up principle as a value that's oppositional to winning. To me, winning is a principle. It's the highest principle there is. If you win the election, you can do at least some of the good things that will improve people's lives in the country and around the world. If you lose it, you can't do any of them.

People will naturally disagree on which compromises are necessary and which ones aren't. What people shouldn't disagree on is that some are. ...

Are we sure these are positions of convenience rather than what he actually believes?

links for 2008-06-28

• In Bear Bailout, Fed Says It Tried to Avert Contagion - NYTimes.com
• Senate Confirms Duke to Fed Board - Real Time Economics
• Oil splat - Marginal Revolution
• Why U.S. Consumer Spending is Overstated - Economics Unbound
• Does the Housing Bubble Have to Pop? - The American Prospect
• Wine economics and economical wine - Vox EU
• Oenometrics - Andrew Leigh
• Does the Fed’s mandate extend to Beijing, Moscow and Riyahd? - Brad Setser
• Evaluating journal publication performance - Vox EU
• 1000 years of urban history: rise and fall of European and Arab cities - Vox EU
• Dubious Cap-and-Trade Skepticism - Twenty-Cent Paradigms

FRBSF: Consumer Sentiment and Consumer Spending

Today, we learn that "The consumer sentiment index fell to ... the lowest since 1980 and the third-lowest reading in the 56-year history of the survey."

Will this impact consumer spending? Perhaps, as "Forecasts including the [Index of Consumer Sentiment] questions were more accurate when consumption growth was falling (as in the 2001 recession) or low (as in the sluggish recovery year of 2002) and when the economy was slowing (as in 2007). ... Thus, the forecasting contributions of consumer attitudes seem stronger when the economy is weaker, although, admittedly, the reasons for these results are not yet fully understood":

Consumer Sentiment and Consumer Spending, by , James A. Wilcox, FRBSF Economic Letter: In the U.S. economy, two-thirds of production and expenditures are devoted to consumer spending, or personal consumption expenditures (PCE), which include most of retail sales, as well as households' expenditures on such items as rent, utilities, and much of medical care. Because this is such a large sector of the economy, the forecast accuracy of PCE affects the forecast accuracy of some of the key variables that policymakers focus on, such as unemployment, incomes, inflation, and interest rates. A large body of research has documented that measures of income, wealth, and interest rates, which indicate consumers' ability to spend, do consistently help forecast future consumer spending. The research results are less consistent, however, for forecast models that also include measures of consumers' willingness to spend, such as the University of Michigan's Index of Consumer Sentiment (ICS). Nonetheless, at some times, measures of consumer attitudes do seem to provide additional information about households' future spending; one such example is the period near the 1990-1991 recession.

This Economic Letter describes how the ICS is constructed and reviews some past research on whether measures of consumer attitudes improve forecasts of consumer spending. It also reports on some new research, which found that using the answers to the individual component questions of the ICS, rather than the ICS itself, further improved forecasts of PCE and its components. Finally, it shows how much and when measures of consumer attitudes might have helped forecasts in recent years.

Paul Krugman: Fuels on the Hill

Blaming speculators for high oil prices is a way to avoid facing the reality that things will have to change:

Fuels on the Hill, by Paul Krugman, Commentary, NY Times: Congress has always had a soft spot for “experts” who tell members what they want to hear, whether it’s supply-side economists declaring that tax cuts increase revenue or climate-change skeptics insisting that global warming is a myth.

Right now, the welcome mat is out for analysts who claim that out-of-control speculators are responsible for $4-a-gallon gas.

Back in May, Michael Masters, a hedge fund manager, made a big splash when he told a Senate committee that speculation is the main cause of rising prices for oil and other raw materials. ...

Many economists scoffed: Mr. Masters was making the bizarre claim that betting on a higher price of oil ... is equivalent to actually burning the stuff.

But members of Congress liked what they heard, and ... much of Capitol Hill has jumped on the blame-the-speculators bandwagon.

Somewhat surprisingly, Republicans have been at least as willing as Democrats to denounce evil speculators. But it turns out that conservative faith in free markets somehow evaporates when it comes to oil. For example, National Review has been publishing articles blaming speculators for high oil prices for years...

And it was John McCain, not Barack Obama, who recently said this: “While a few reckless speculators are counting their paper profits, most Americans are coming up on the short end...”

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas.

Indeed, this past Monday Mr. Masters assured a House subcommittee that ..[i]f Congress passed legislation restricting speculation,... gasoline prices would fall almost 50 percent in a matter of weeks.

O.K., let’s talk about the reality.

Is speculation playing a role in high oil prices? It’s not out of the question... Whether that’s happening now is a subject of highly technical dispute. (Readers who want to wonk themselves out can go to my blog and follow the links.) Suffice it to say that some economists, myself included, make much of the fact that the usual telltale signs of a speculative price boom are missing. But other economists argue, in effect, that absence of evidence isn’t solid evidence of absence.

What about those who argue that speculative excess is the only way to explain the speed with which oil prices have risen? Well, I have two words for them: iron ore.

You see,... its price is set in direct deals between producers and consumers. So there’s no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story...

In any case, one thing is clear: the hyperventilation over oil-market speculation is distracting us from the real issues.

Regulating futures markets more tightly isn’t a bad idea, but it won’t bring back the days of cheap oil. Nothing will. Oil prices will fluctuate in the coming years ... but the long-term trend is surely up.

Most of the adjustment to higher oil prices will take place through private initiative, but the government can help the private sector in a variety of ways, such as helping develop alternative-energy technologies and new methods of conservation and expanding the availability of public transit.

But we won’t have even the beginnings of a rational energy policy if we listen to people who assure us that we can just wish high oil prices away.

"Why the Stock Market Had a Terrible Day"

I think the Fed made the right move at its last rate setting meeting when the target rate was held constant, but Robert Reich doesn't share that view. He wants action on both the monetary and fiscal policy fronts to prevent a downturn, rebuild infrastructure, and implement green technologies. I don't think we need the threat of a recession to justify spending more on infrastructure and the environment, so I'd support that in any case:

Why the Stock Market Had a Terrible Day, by Robert Reich: The big surprise is why anyone should be surprised the stock market dropped 3 percent today. The immediate trigger was the price of oil moving above $140 a barrel for the first time. A secondary trigger was yesterday's decision by the Fed not to reduce interest rates. (Some conservatives maintain it was the Fed's failure to RAISE them that caused today's ruckus on Wall Street... They're wrong. The recession is the biggest worry for everyone...) Another was the implosion of the US autos sector, and additional writedowns by major Wall Street banks.

But behind all of this is the one fundamental fact that economic analysts would rather not dwell on: American consumers are at the end of their ropes. High energy prices have contributed to it, as have high food prices. Consumer confidence is plunging. Housing prices are still dropping, which means the piggy banks of home equity and refinancing are closing.

But without consumers, there's no one to buy all the goods and services we create. Sure, big American companies are doing fine abroad, but foreign sales can't sustain them. Nor can exports. Hence, bond defaults by companies are up. Earnings are down.

What to do? Two things. We need an expansive fiscal policy that stimulates the economy with infrastructure spending -- especially mass transit, levees, and bridges, as well as investments in green technologies.

We also need a more progressive tax system that puts more money into the hands of the middle class and working class -- which will spend it. ...

links for 2008-06-27

• Capital inflows to China - Economist.com
• Fed Lays Groundwork to Increase Rates, If Needed - John M. Berry
• Why the Irish said ‘no’- Vox EU
• Luskin’s Criticism of Obama’s Social Security Proposal Flunks - pgl
• I can't hear you (hands on ears) - Environmental Economics
• Roundtable: 'How to stop the next bubble' - Prospect Magazine
• Pay Dirt: Martian Soil Fit for Earthly Life - Scientific American
• How Lies Live and Grow in the Brain - Op-Ed - NYTimes.com
• New Flavors of Web Addresses Are On the Way - NYTimes.com
• Does anyone know how much oil there is in the world? - Yves Smith
• Pricking housing bubbles in a monetary union: taxes and regulation - Vox EU
• Toward a Transparent Financial System - WSJ.com

Fed Watch: This Is Not Good

Tim Duy says the Fed is in "something of an untenable position, to say the least":

This Is Not Good, by Tim Duy: Presidential candidate Barack Obama summed up the Fed’s dilemma today. From Bloomberg:

''The Fed is in a tough situation because it wants to control the inflation being caused by energy while at the same time trying to restore the economy,'' he said.

One tool, two objectives – something has got to give. The Fed is not blind to their dilemma, and today Fed Vice Chairman Donald Kohn said monetary policy has reached an impasse domestically, and implores emerging market economies to start doing the heavy lifting on inflation fighting. From the Wall Street Journal:

“The upward trend in prices of food and energy over the past several years…importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities,” Kohn told a monetary conference in Frankfurt.

And “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability,” he said.

Kohn’s analysis sounds remarkably close to my own – Dollar bloc nations are effectively tied to Fed policy, and that policy is simply too easy for the those economies. But not to easy for the US, which puts the Fed in something of an untenable position, to say the least. Kohn is making an obvious effort to shift the blame for rising commodity prices away from the Fed, because, as is well know, it is never the Fed’s fault, whatever the problem (actually, the US Treasury deserves some of the blame, for using the IMF like a club during the Asian Financial Crisis).

Kohn’s is urging the Dollar bloc nations to raise interest rates while the Fed holds steady. This appears to be at odds with dollar supportive Fedspeak, although I suspect that rhetoric is largely directed at the major currencies. Still, could the Fed really want a fresh bout of Dollar weakness? Indeed, some Asian nations are already selling dollars to support their own currencies, even before Kohn’s speech. Interestingly, I suspect this will put the Fed into another inflation bind. If the Fed is correct and the rise in commodity prices, and specifically oil, is predominately due to global demand, rather than the Dollar’s decline, then higher rates abroad could help soften the foreign currency prices of commodities. But it is not inconceivable that a fresh bout of Dollar weakness raises the dollar price of those commodities.

In other words, the US has benefited by the foreign willingness to accumulate Dollar assets; it allows the US to consume well beyond productive capacities without, until recently, inflationary consequences. If the rest of the world is implored to tighten policy and weaken the Dollar, then I suspect those positive inflation dynamics will be reversed. The Fed effectively replaces one inflation concern with another by advocating what amounts to a Dollar drop.

In any event, it is not clear that the Fed can implore enough nations to tighten rates to have a meaningful impact on global growth. As Brad Setser reminds us, Dollar policy is inconsistent – the US government wants Asian nations to accept a weaker Dollar, but not oil exporters. And massive reserve growth in China suggests that nation is not interested in accelerating the appreciation of the yuan anytime soon.

Which is something of a good thing given that while Kohn is imploring the rest of the world to tighten policy and effectively let the Dollar go, the odds of a second stimulus package are rising. Obama again:

Democratic presidential candidate Barack Obama said the U.S. will continue dealing with ''short- term pain'' from an economic slowdown and the country needs a second round of stimulus checks to spur consumer spending.

''We know that consumer confidence is at all-time lows. We have to give people some sense that they could absorb the rising costs in gas, food and medical care,'' Obama said in an interview with Bloomberg Television today in Pittsburgh.

The US needs the rest of the world to buy that debt necessary to support the stimulus. If not China and the rest of the Dollar bloc nations, then who? Is it any wonder that financial markets are in disarray? From MarketWatch:

I can't remember the last time Dow futures in freefall the way they've been today," said Dale Doelling, chief market technician at Trends In Commodities. It's "an absolute boycott by buyers in stocks and the dollar."

But "the exact opposite happened in the commodity markets. You name it, oil corn, gold bonds -- everything up, up and away," he said in emailed comments.

Also providing support for oil Thursday, Algerian Energy Minister Chakib Khelil, who serves as president of OPEC, said oil prices could jump as high as $150 to $170 dollars a barrel this summer, according to reports.

However, he thinks crude will fall short of $200 a barrel. At a meeting in Paris, Khelil said a further fall of 1% to 2% of the dollar vs. the euro could add another $8 a barrel to oil prices. He cited the weakness of the greenback as a major cause of spiking oil prices.

The failure of the FOMC to issue a more hawkish statement weighs on the Dollar and pushes commodities upward, which only adds to the misery in US equities. But if the Fed hiked rates, financial markets might implode.

This is a no win situation...which way will the Fed turn? The Fed will hold the current policy in place until policymakers becomes sufficiently distressed by the impact of energy price inflation (September, October, next year; just not August). Note that market participants are increasingly aware that the Fed’s default policy for the time being is higher inflation, as evidenced by the rise in 10 year TIPS breakeven levels to 254bp today.

In theory, the best outcome is to find is a sweet spot that allows global growth outside of the US to decelerate while avoiding a free fall in the Dollar. In the absence of such equilibrium, the US economy can hobble along only as long as the following three conditions hold:

1. The Federal Reserve can maintain easy monetary policy.

2. The US government can sustain repeated fiscal stimulus measures.

3. China and the rest of the dollar bloc continue to be willing to accumulate US assets, primarily the Treasury debt needed for fiscal stimulus.

When these conditions no longer hold – such as the Fed needs to tighten to counter energy inflation, or the demand for US debt drops sharply – then I suspect the US economic environment will shift decisively toward higher inflation or significant recession.

Or both.

The Speculation Continues...

As I continue to gather thoughts on the speculation question... [i.e. the question of whether speculation is driving up oil and other commodity prices, previous entries: Speculative Nonsense, Once Again, More Speculation, Even More Speculation, Speculation Continued..., An Answer?] [Update: New version of model here]:

Steve Waldman added another piece to the speculation model, so let me show how it fits into the graphical model that is being used to illustrate ideas.

First, let's review the model of speculation and inventory storage. I'll use Brad DeLong's pictures to illustrate. In the left-hand panel of the first picture shown below, the interest plus storage line (which I'll denote as i+s) represents the marginal cost of holding inventory, and this is always positive since interest rates and storage costs cannot be negative (I show how to add interest rate determination to the model here). The expected appreciation line, E=(expected future price - spot price)/(spot price), represents the expected marginal benefit from holding speculative inventory. If benefits exceed costs (E>s+i), inventories will increase, if costs are greater than benefits (E<s+i), inventories will decrease, and when they are equal (E=s+i), inventories will stabilize. Note, however, that inventories cannot be negative.

The spot price, in this case, is determined in the right-hand panel by the flow supply and demand curves for the good (say oil). However, at this spot price, and given the expected future price, expected appreciation (E) is negative. Since the benefit is expected to be negastive, and the costs (i+s) are positive, no inventory is held. [Note for now that, since i+s (interest plus storage) is always positive, if E is negative no inventory will ever be stored in this version of the model. Even if E is positive it has to be large enough to cover the interest plus storage costs before any inventory will be held for speculative purposes.

Okay, now let's generate inventory storage. We need to do (at least) one of three things. First, we could let the expected future price go up shifting E to the right. Second, demand could shift in. Third, supply could shift out.

Taking the first case, an increase in the expected future price, this shifts the E curve to the right. Looking at the diagram above, as E shifts out the intersection of the blue lines in the left-panel moves up and, when it crosses the dotted line showing the spot price, speculators are at the indifference point on storing inventory. This is shown in the next diagram (the orange line is the new E curve after the increase if the expected future price):

Now, if expectations rise even further, then the E curve will shift out even more. As it does, and speculators begin demanding some of the good for storage, the spot price is driven upward (and is hence determined by speculators as the label in the graph indicates). The result, after E is done shifting (and it turns from orange to blue), is the equilibrium below:

Thus, this shows how an increase in the expected future price can cause the equilibrium to move from one where there is no storage to one where there is. So, when higher future prices are expected, we should see both inventories and the spot price rising.

How else could we go from the first to the third diagrams, i.e. from no storage to storage? Go back to the first diagram above. Now, imagine either the demand curve shifting in (demand falling) or the supply curve shifting out (supply increasing). All we need is for the spot price to fall (holding the expected future price constant), and either change will accomplish that. As the spot price falls, the horizontal dotted line in the first diagram showing the spot price will also fall, obviously, and you can see that it will eventually hit the intersection of the two blue lines in the left-hand panel. i.e. it will hit the point of indifference over speculative inventories. Here's how the graph would look for an increase in supply:

links for 2008-06-26

• The convenience yield - Interfluidity
• Science envy? - Stumbling and Mumbling
• Is the Fed living in a fairy-tale world? - Michael Mandel
• A New Report Card on Iraq - New York Times Blog
• Remembering Exxon Valdez - Robert Reich
• Reader Mailbag - Economists for Obama
• A Deadline on Malaria - Jeff Sachs - Scientific American
• Two goals, one instrument: Central banks and financial crises - Vox EU
• The Puzzle of Quantum Spacetime - Slideshow (2nd slide) - Scientific American
• Using Causality to Solve the Puzzle of Quantum Spacetime - Scientific American
• Data Deluge Makes the Scientific Method Obsolete? - AndrewGelman
• The cost of central bank transparency: Closed doors, open minds? - Vox EU

"Is Income Volatility Really Rising?"

I've presented quite a bit of Jacob Hacker's work here, so it's only fair that I also present intelligent responses to it. Justin Wolfers has the details, and I added a few comments at the end:

Is Income Volatility Really Rising? For Whom?, by Justin Wolfers: Jacob Hacker’s Great Risk Shift described rising income risk over recent decades as an important and quite general phenomenon. While there’s been plenty of controversy around that claim, the most careful analysis I have seen roughly supports Hacker’s contention. ...

What Hacker actually shows is that the average level of income volatility is rising. But we know that an average can hide as much as it reveals. And this is the point brilliantly developed in a provocative new working paper by my Wharton colleague Shane Jensen, and my former colleague Stephen Shore (full paper available here; warning, there are some econometric pyrotechnics involved).

Income volatility is not a single number — some people’s incomes move around over time more than others. And while Hacker and others have documented a rise in the average level of income volatility, Jensen and Shore document changes in the entire distribution of different people’s income volatilities.

A stock market analogy might be useful: some stocks are more volatile, some are less, and it is interesting to see what is happening to the volatility of different types of stocks, and not just some mythical “average stock.”

The Jensen-Shore findings are pretty stark and are sure to stir the policy debate: Despite sharp growth since the 1970’s in the average level of income volatility, median income volatility is basically unchanged. (There are some differences in samples and methods..., but I would be surprised if that explains much.)

Indeed, there’s been no change in income volatility for most of the distribution:

Here’s the punch line:

The key driver of rising average levels of income risk is that life among the already risky has become even riskier. Indeed, you really need to look to the riskiest 5 percent of the distribution to find the rise in income risk. And this rise in risk among the already risky is so great as to be responsible for nearly all the rise in average income volatility. And who are these riskiest 5 percent? Jensen and Shore find that they are particularly likely to be self-employed.

The Jensen-Shore analysis yields an interesting scorecard: Hacker was right on average, but wrong for 95 percent of us. ...

Perhaps the debate about the Great Risk Shift isn’t such a big deal after all: the best argument for a social safety net is that there is too much risk, not that risk has grown.

Full details, including technical wizardry, here.

I'll keep an eye out for any response from Jacob Hacker, but let me anticipate what he might say. This is from an email he sent in response to earlier questions about his work (the email addresses questions raised by a CBO report that comes to different conclusions about income volatility, something Justin Wolfers discusses in parts of the post above that I didn't include, and something that Jacob Hacker and Elisabeth Jacobs discuss and attempt to resolve here). I think Jacob Hacker would argue that income volatility is just one dimension of the risk shift he was talking about:

[F]amily income volatility is scarcely the only measure of economic insecurity or the “risk shift” that I and others have discussed. Only one chapter in my book is about family income instability. The rest are about pensions, health care, the decline in traditional job security, the increasing debt burdens reflected in families’ financial balance sheets—in short, about the whole range of economic risks that Americans face. Many of these risks, such as health costs, retirement insecurity, bankruptcy, and mortgage foreclosure, either do not show up in the incomes of working-age people or show up only weakly.

As I put it in The Great Risk Shift, “The up-and-down movement of income among working-age families is a powerful indicator of the economic risks faced by Americans today. Yet economic insecurity is also driven by the rising threat to families’ financial well-being posed by budget-busting expenses like catastrophic medical costs, as well as by the massively increased risk that retirement has come to represent, as more and more of the responsibility of planning for the post-work years has shifted onto Americans and their families. When we take in this larger picture, we see an economy not merely changed by a matter of degrees, but fundamentally transformed—from an all-in-the-same boat world of shared risk toward a go-it-alone world of personal responsibility.”

Fed Watch: Cutting It Down the Middle

Tim Duy assesses today's decision from the FOMC to leave the target interest rate unchanged:

Cutting It Down the Middle, by Tim Duy: Today’s FOMC statement was largely in-line with expectations – worries were tilted toward higher inflation risks, but fell short of setting the stage for a rate hike in August. Will we see a rate hike this latter this year? I still tend toward expecting a rate hike sometime this fall, vacillating between September and October depending upon the intensity of Fedspeak, largely in response to energy/Dollar driven inflation concerns. Recent Fedspeak pulled me to the earlier date; this statement pushes me toward the later date.

Mark Thoma compares the two most recent statements side by side here. Some points of interest:

1. The Fed identifies some “firming in household spending,” which at first glance appears inconsistent with weak consumer confidence numbers. That firming, however, likely reflects the impact of tax rebates, and confidence remains low because households realize the spending boost is only temporary. Also, the Fed now acknowledges that higher energy prices weigh on real spending.

2. The language on the inflation forecast is tightened, but qualitatively similar, maintaining a benign outlook, although the Fed dropped its optimistic assessment of the direction of commodity prices.

3. The inclusion of the sentence “[a]lthough downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,” shifts the balance of risks toward inflation, but not so much as to expect a rate hike in the near term.

4. There is no mention of the Dollar, although I suspect the minutes will reveal concern on that front.

The Fed is attempting to walk a fine line, with enough hawkish talk to keep the Dollar and oil in check, but not so much that they trigger a substantial rise in longer term rates such that they undermine the current fragile and tentative signs of economic stability. As the FOMC statement suggests, both growth and inflation prospects depend on the path of oil prices (See, for example, Dow Chemical’s second price increase in a month.), and I believe policymakers are genuinely concerned that easy US monetary policy is a contributing factor to this trend. Indeed, this is the only rational explanation for the heightened hawkishness at the Fed given the weak economy. Across the Curve succinctly notes:

An Answer?

I asked a question at the end of this post. Arnold Kling answers:

Mark Thoma's Question, by Arnold Kling: He asks,

how do you explain the large run up in, say, agricultural commodities which cannot be left "in the ground" until later?

Interesting question. Some off-the-cuff observations.

1. The point about the run-up in other commodities raises questions about any oil-specific story. ...

2. I disagree with Mark on the storability of agricultural commodities. Wheat can be stored as crackers. Corn can be stored as corn flakes. If speculators drive up the price of corn nine months from now, but there is abundant corn today, my reaction as Kellogg's is to ramp up corn flake production today, so that I don't have to rely as much on the expensive corn that is coming in nine months. But that means I buy lots of corn today, which raises the price, just as if I were buying it to store in a silo.

Let me emphasize that I am not saying that high commodity prices are a speculative bubble. Tyler and I tend to think the opposite. I like his term anti-bubble. That is, speculators guessed wrong a year ago, and prices now are catching up to reality.

What I am saying is that speculators do drive the prices of oil and other commodities. Moreover, they do so in the futures markets. Furthermore, there are alternative ways of storing commodities other than grain silos or oil storage tanks, so you can't rely on those inventory figures as indicators of the presence or absence of speculation.

I should mention that I am not opposed to having speculative markets in commodities. On the contrary...

I have been arguing that the news in oil markets has not been particularly dramatic in the past year. Paul Krugman takes a different view:

Declining Russian production, growing doubts about whether the alleged Saudi excess capacity really exists, etc.. Basically, CERA-type optimism about big new oil supplies coming on line any day now has been fading.

Whether this is "big news" or not is a matter of opinion. I am not going to go to the mat to defend my view.

I would just point out that Thoma's question raises the bar a bit for the "big news" view. What "big news" has at the same time hit agricultural markets and other commodity markets? It seems to me this nudges things in the direction of monetary surprises or autonomous changes in speculative sentiment.

A quick reaction: I don't think I'd like year old crackers or cereal very much.

On the storage question, Krugman looked at stocks of grains and other commodities back in April when he first began making this point (e.g., see his graphs for oil and metals):

The USDA data (big pdf) show stocks of wheat and other grains declining in recent years.

The link shows the data on stocks for wheat, but it isn't in graphical form. So here's a bit more on grain stocks:

Wheat

Feed Grains

Rice

World Grain and Oilseed

The question I have for Arnold's story is that while it may be possible to store grains and other commodities in non-traditional forms, if the claim is that's what's gong on now, why store grains in (what I presume are) more costly non-traditional methods when, with stocks this low, there is plenty of storage space available?

On the "big news" point, I agree that the "big news" story is hard to apply across the commodity groupings, but I don't think we are only left with the two possibilities he cites as explanations.

FOMC Keeps Target Rate at 2%

As expected, the FOMC left the target federal funds rate unchanged:

Speculation Continued...

The debate over whether speculation is an important factor in oil markets continues. Here's a round up of today's debate (so far):

Jim Hamilton: How big a contribution could oil speculation be making?

I do believe that speculation has been another factor that contributed to recent high oil prices. However, a key element of the bubble story is that there needs to be a very limited response of quantity demanded to the price increases, which the most recent data persuade me is no longer the case. Some of the estimates I've been hearing of the size of the contribution speculation is currently making to the price are therefore difficult to defend. Here I explain why, essentially elaborating on Paul Krugman's theme.  ...

Arnold Kling: My Model of the Oil Market: Option Value

Near the end of a "tiny theoretical paper," Paul Krugman writes,

the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango.

...My model of the oil market treats inventories and oil in the ground as the same. I don't care whether it is sitting in a storage tank or sitting under the Saudi sand--it's all part of the stock of oil. To look for shifts between under-sand oil and in-tank oil as evidence one way or the other on speculation does not strike me as compelling...

Arnold Kling: My Question for James Hamilton

...My question is: what were speculators thinking a year ago, when oil prices, including prices for futures contracts expiring in 2008, were substantially lower than spot prices are today? ...

If you believe Hamilton's view of fundamentals, and you believe my view that it's the job of speculators to anticipate fundamentals, then what you should blame speculators for is keeping prices too low in 2006 and 2007 (in fact, in all previous years).

That is, in fact, the most plausible story. But it could be that today's speculators have it wrong, and that today's futures price for June of 2009 over-estimates the realized spot price that we will observe then. And if speculators do have it wrong, I do not know where to look for evidence of that.

Tyler Cowen: Exasperating Paul Krugman

Krugman writes here on why speculation is not driving higher oil prices and offers a simple model here.  I agree with Krugman's conclusion but not his reasoning.  Arnold Kling responds here and basically Arnold is right...

Paul Krugman: Confusions about speculation

OK, Tyler Cowen weighs in — but I think that he partly misunderstands my point. ...

Also, I see that Arnold Kling has a question for Jim Hamilton. Here’s my answer...

In the stories where speculation is playing a large role, and storage somewhere (in ground or in tanks) occurs, how do you explain the large run up in, say, agricultural commodities which cannot be left "in the ground" until later? There's no evidence of substantial inventory accumulations for commodities generally. Perhaps Arnold and Tyler can explain this, but it seems problematic to me. And what about Krugman's point about iron, how is that explained?

If prices suddenly come crashing down and stabilize at a lower level, I'll change my mind (and Krugman's distinction in the post linked above between bubbles and speculation is important to keep in mind here), but for now I don't find the speculative bubble story as the most likely cause of (most of) the oil price run up, or the increase in the price of commodities more generally.

A Political Economy Perspective on the Failure of the Washington Consensus

Why did the Washington Consensus reforms fail to improve economic performance in many developing countries?:

When does policy reform work? The case of central bank independence, by Daron Acemoglu, Simon Johnson, Pablo Querubín, and James A Robinson, Vox EU: Institutional and policy reforms are promoted as a way to improve economic performance and growth in poor countries. Reforms that have received substantial attention over the past decade or so are often referred to as the "Washington consensus". These include trade opening, financial liberalisation, judicial reform, privatisation, reduction of entry barriers, tax reform, removal of targeted industrial subsidies and central bank independence. Although there are sound economic theories suggesting why these reforms might be important in improving economic performance, the experience of many developing nations that have embraced these reforms over the last two decades shows that the gains anticipated by the proponents of reform have often not materialized.

Why do seemingly sensible reforms fail to generate the benefits that they promise?

Although one can undoubtedly dream up reasons why sensible reforms will lead to bad economic outcomes because of "second best" reasons, it is fairly implausible that the removal of the very high entry barriers and the corruption-ridden targeted industrial subsidies or putting an end to hyperinflation will be counterproductive. So why has the result of the Washington consensus reforms been so dismal?

State Coincident Indexes

The Philadelphia Fed released its state level coincident indexes for May. Here's a description of the index, and here's a summary of the latest data:

May 2008: The Federal Reserve Bank of Philadelphia has released the coincident indexes for all 50 states for May 2008. The indexes increased in only six states for the month, decreased in 39, and were unchanged in the remaining five (a one-month diffusion index of -66). For the past three months, the indexes have increased in 12 states, decreased in 35, and were unchanged in the other three (a three-month diffusion index of -46).

It's informative, as Jim Hamilton recommends here, to look at how the index changes over time (e.g. see this graph from Jim Hamilton's post). Here are the graphs from January of 2005, 2006, and 2007, and the graphs for January through May of 2008. Basically, blue is good, darker blue is better, pink and red are bad, darker shading is worse  (be careful since the scales change between 2007 and 2008 from five to seven color gradations, but changes from a shade of blue to a shade of red still indicates the index went from positive to negative):

links for 2008-06-25

• Bill Bennett Criticizes Obama’s Economic Proposals - pgl
• Fed Vacancies Likely to Remain Until Next Year - Real Time Economics
• The Bluefin Tuna in Peril - Scientific American
• The Pendulum of Economic Outrage Is About to Swing Again - Robert Reich
• Pascal’s Fallacy - EconoSpeak
• Optimal Capital Income Taxation - Robert's Stochastic thoughts
• Sharing the Boom (Windfall Profits Tax Pros and Cons) - Andrew Leigh
• Savings help the medicine go down - EurekAlert

Measurement Error and School Achievement

Robert Waldmann says to be careful when using income as a control in studies measuring school (or other) achievement:

Robert Waldmann: I just thought of something. It was triggered by this "studies show that race exhibits a substantial, income-independent influence on school achievement," (don't blame Matt he's just the messenger and is making a very good point about something else).

You know what else? Race exhibits a substantial, income-independent influence on consumption -- Black households consume less than White households with the same income.

Few suggest this proves that Blacks are more prudent and patient than Whites. It is similar to the information on school achievement, Blacks have outcomes similar to poorer Whites.

The economics profession's favored explanation for the consumption fact is that consumption doesn't depend only on current income but also on permanent income (not at all on current income if people are not liquidity constrained and rational). Blacks are on average poorer than Whites. A Black household at say the 50th percentile of the income distribution is more likely to have had an unusually good year than a White household with the same income.

The income measure which is likely to explain school achievement and consumption is income averaged over a long period of time (lagged income for school achievement and, I suspect, consumption).

Now it is possible to construct a race specific mapping from current to permanent income (using the PSID say) and use that to see if there is a permanent income independent difference in school achievement. However, just using current income as a control is a mistake.

Another way of looking at is it that current income is permanent income plus noise so the coefficient of say achievement on current income is the coefficient of interest (achievement on permanent income) biased down by errors in measurement of permanent income. Thus one might impose coefficients higher than the estimated coefficients.

Milton Friedman first considered the effect of measurement error on estimates when arguing that the true elasticity of consumption with respect to permanent income is 1 even though the elasticity estimated with cross sectional data is less than one. He thus reconciled the cross sectional estimates with the aggregate time series evidence that the savings rate doesn't increase systematically with economic growth.

[That's not even close to Robert's wonkiest post of the day.]

Even More Speculation

Paul Krugman with even more on speculation:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

After reading the paper, which explains when you would and would not expect to see inventories, what contango and backwardization mean, and importantly the signatures of speculation, some of you may wonder how monetary policy fits into the model. Here's a quick first pass at showing how this works (the two graphs in the top row mimic the graphs in Krugman's model in the paper, I'm adding the money-demand money supply diagram much as Krugman and Obstfeld do in their analysis of exchange rates in their book on international economics):

In this graph, starting in the upper left-hand diagram. E is the expected appreciation in oil prices, i.e. E=E(p, pf)=(pf-p)/p, where p is the spot price and pf is the future price. E is decreasing in p and increasing in pf. The line s+i represents the sum of interest foregone on stored inventory, i, and the actual storage cost, s. The storage cost is exogenous to the model, and the interest rate is assumed to be set by monetary policy. (Think of E as the expected benefit and s+i as the cost, the equilibrium (pf-p)/p = s+i sets the marginal cost of holding one more unit in inventory equal to the marginal benefit).

The diagram on the upper right is the flow supply and demand diagram for oil. The distance ab, the excess of flow supply over flow demand at the initial spot price of p₁, is the initial level of inventories. [The supply and demand curves are drawn relatively flat for ease of illustration.]

The diagram in the bottom row is the supply and demand diagram for money. Real money demand is L(y,i), nominal money demand in PL(y,i), and as usual L is increasing in y and decreasing in i. The money supply is M, and it is controlled by the monetary authority. It is assumed the i is the policy variable, so that M takes whatever value is needed to hit the target value of i for a given level of money demand.

The initial target for the interest rate is i₁. At i₁, the spot price of oil is p₁ and inventories are ab. Now let the monetary authority ease up and lower the interest rate to i₂. This will cause the i+s line to shift to the left, and this in turn will increase the spot price of oil to p₂. At the higher price of p₂ inventories increase from ab to cd, so the net result of easing is to increase the price of oil in spot markets, and to increase inventories. Thus, an increase in liquidity from an easing of monetary policy would have an increase in the spot price and increases inventories as a signature.

Intuitively, the model starts in equilibrium with (pf-p)/p=s+i. Then, i falls due to the increase in liquidity causing (pf-p)/p>s+i. Since the benefits of speculation now exceed the cost at the margin, there is more demand for oil to be put into inventory, and this drives up the spot price until (pf-p)/p=s+i once again.

[I should add that if the market is in backwardization, which Krugman argues has been the case recently  - see figure 3 in Krugman's paper and the associated discussion - then variations in the i+s line will not change the equilibrium. Thus, in this case changes in the target interest rate will not change the spot price or change inventories (which are zero, again, see figure 3 and picture the i+s line shifting left or right).]

There are lots of thought experiments one can conduct with this model, e.g. ask what might happen if pf goes up, y goes down, etc., and I should stress that this is partial or short-run equilibrium, for example there are no feedback effects through the aggregate price level P or output y, both of which are held constant in the analysis, and if p is permanently higher, pf might increase as well (and these sorts of "chase your tail" mechanisms can lead to bubbles, e.g. pf goes up for some mysterious reason shifting E to the right, this causes an increase in p, which could increase pf if it's thought to be permanent, which increases p, then pf again, etc., until it eventually peaks and then comes crashing back to fundamentals), but this should give some idea of how it all fits together.

You Make the Call

[I wrote this last night, then decided against posting it, but the issue is getting more attention than I expected and I don't have much else right now...]

John McCain proposes government intervention - industrial policy - intended to direct private investment into a particular area:

McCain Proposes a $300 Million Prize for a Next-Generation Car Battery By Michael Cooper, NY Times: ...Senator John McCain is suggesting a new national prize: He said here Monday that if elected president he would offer $300 million to anyone who could build a better car battery. ... Mr. McCain ... [also] called for ... big tax credits for nonpolluting cars. ...

John McCain (a) recognizes that markets can work imperfectly, and that government intervention to correct incentives can fix the problem (even though, in this case, the private market probably does provide the correct incentives - so this would be yet another demonstration of poor economic reasoning from the McCain campaign), or (b) whether he gets economics or not, and I'll take his word that he doesn't, he has no real commitment to "core" principles such as his belief in free markets and their ability to provide the optimal level of investment in goods like batteries, and is instead a political opportunist who will propose or agree to whatever is convenient at the moment.

Here's more since I first wrote this (and feel free to add an option (c)). First, we have Cafe Hayek:

John McCain's proposal that Uncle Sam offer a $300 million prize to whoever develops a battery ... is silly -- as explained well by the Denver Post's David Harsanyi. ... Here are Mr. Harsanyi's closing paragraphs:

But when McCain peddles prize money, he also feeds the perception that industry and scientists aren't already working diligently on energy breakthroughs — with batteries and areas unknown — or that the market doesn't incentivize them to do so.

Worse, McCain makes it seem that a cure for oil is just beyond our grasp. Around $300 million away.

In this arms race of goofy ideas between the candidates — windfall taxes and gas-tax holidays, to name two — we're sure to see more poorly thought-out plans in the near future.

Let's hope they are just empty promises. ...

Tom Lee, through Ezra Klein, echoes this theme:

A Better Battery? or a Better Candidate?, by Ezra Klein: I didn't blog about John McCain's $300 million prize for a better car battery yesterday because it seemed too banal. But as Tom Lee points out, it also suggests a basic ignorance of the economic rationale for "prize" proposals:

I should be able to avoid saying anything as dumb as McCain's battery-prize proposal. Not that I don't like batteries, mind you! But if someone were to invent a better one they'd already be poised to make a huge amount of money through its commercialization. Offering prizes for innovation isn't always a terrible idea - for pharmaceuticals with a limited market of potential users it can make sense due to the huge costs associated with developing and testing a new drug. But everyone in the developed world needs better energy storage technology, and they need it right now. And while it's important to make sure your new batteries are safe and robust (e.g. they don't explode too much), that's still much easier and cheaper to do than it is to conduct a set of double-blind human trials. So sweetening the pot is unnecessary. Anyone who has a good idea about how to build a better battery is already working on the problem.

Over the past couple of days, McCain has come out with a couple of these small bore proposals. Today he promised to make the government use more fuel efficient cars. ...A bunch of micropolicies meant to demonstrate attention to the issue without, you know, solving it. ... To the average person, a $300 million prize for a better car battery sounds like a lot of money. But it's a big pot of nothing in the face of climate change.

More Speculation

Thomas Palley takes a contrary position on speculation and oil prices:

Beating the Oil Barons, by Thomas Palley: Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories... The fact that inventories have not risen supposedly exonerates oil speculators. ...

But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity. ...

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators. [uncut version]

Paul Krugman might respond with:

Iron Resolution, by Paul Krugman: Chinese steelmakers have agreed to a 96 percent increase in the price they pay for Australian iron ore.

One interesting point about this case is that, as I understand it, iron ore isn’t traded on an international exchange; trade takes place through bilateral deals between producers and consumers. In other words, there isn’t any easy way to speculate on future iron ore prices.

Yet ore prices are surging like oil prices. A bit more evidence against the speculative frenzy hypothesis.

Arnold Kling says:

Oil Speculation: Paul Krugman Mis-speaks, by Arnold Kling: Paul Krugman writes,

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.

He can't mean that. Think of the foreign currency market. If speculators bid up the future price of Japanese yen, then the spot price of Japanese yen will go up. And you won't see any particular pattern of inventories among currency dealers. The inventory issue is much closer to a red herring than to the decisive empirical data that Krugman maintains it to be. ...

My views on the oil market are almost the exact opposite of Krugman's. I believe that the futures price has to be the key determinant of the spot price. Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon, and those expectations ought to be embedded in futures prices. ...

I agree with Krugman that blaming oil speculators for the high price of oil is unhelpful. The politicians make it sound as though there has been a sudden outbreak of greed among oil speculators. Instead, there has been a change of expectations about future supply and demand. From what I can tell, there was no real news to cause this change in expectations. Either speculators were badly wrong six months ago or they are badly wrong today. It is more likely that they were wrong six months ago, but the probability that they were closer to correct then is far from zero. [Full Post]

Paul Krugman might follow this up with:

Various notes on speculation, by Paul Krugman: First, Friedrich von Schiller was right. ... Right now I see well-trained economists getting ... hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.

Second, some ... have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners.

To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen. [graph]

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation. I first broached the manipulation issue in California screaming, written in December 2000. I didn’t really figure it out, however — I was still giving too much credence to the conventional wisdom about underinvestment — until The Price of Power, published in March 2001. The Real Wolf, published a month later, pulled it all together.

During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor.

And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

Update: And Paul Krugman might also respond with:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

Sovereign Debt Risk

Something else to worry about?:

Watch Out for Sovereign Debt Risk, by Carmen M. Reinhart and Kenneth Rogoff, Commentary, WSJ: Optimists say that emerging-market defaults are a thing of the past. Emerging markets today, the argument goes, are relying more on domestically issued local currency debt, both inflation-indexed and non-indexed. This means their debts are far more stable and reliable than in the recent past, when a much larger share of government debt was issued externally and denominated in hard currency.

This argument is wrong. In the past, the combination of high levels of domestic debt and inflation surges has often proven deadly for both foreign and domestic investors. Just look at Argentina today...

Already, a good share of Argentina's debt is in default. What else do you call it when a government that owes over $30 billion in inflation-indexed debt ... is publishing an understated inflation rate that is used for calculating indexation payments. The official inflation rate in Argentina ... is under 10%. But the true inflation rate appears to be at least 30%... Fudging indexation clauses to effectively default on debt is an old game. ...

Over the course of history, emerging-market economies have had a hard time shaking off serial default. Each period of quiescence has been invariably followed by more turmoil, with the share of total countries in the world in default sometimes exceeding 40%, as it did during the mid-19th and 20th centuries.

Considering the duress of domestic bond holders across the world as global inflation rises, it is surprising that both private investors and multilateral international financial institutions seem so complacent about the rising risks of defaults on external debts.

The "this time is different" mentality is based on two mistakes. The first is the idea that domestic debt is something new. The other is the faulty economic logic that payments to domestic debt holders come out of a different pot than payments to external debt holders. ...

Earlier eras offer scant evidence that external creditors have been much safer than domestic debt holders. When India effectively defaulted on its domestic debt through massive inflation and financial repression in the early 1970s, external debt holdings suffered payment reschedulings even though they constituted only a tiny fraction of overall debt.

Emerging markets could be in much greater trouble than the optimistic consensus suggests. If today's tepid growth in the U.S., Japan and Europe begins to take hold in emerging markets, Argentina's miserable indexed bond holders may soon have company.

links for 2008-06-24

• Twenty years later: tipping points near on global warming - James Hansen
• Across the Curve - John Jansen  - Back after Brief Pause
• Britain's last Neanderthals were more sophisticated than thought - EurekAlert
• Is the Great Moderation in Danger? - Zubin Jelveh
• The Game Theory Boom - EconoSpeak
• Do Businesses Suffer when Wal-Mart Moves In? - washingtonpost.com
• Gresham's Law in the Euro Area - Macro and Other Market Musings
• Sexual pseudoscience from CNN - Language Log
• Jerry Seinfeld on George Carlin - Op-Ed - NYTimes.com
• A Question For 'Saving Glut' Advocates - Macro and Other Market Musings
• An Extraordinary Statement About Torture, Honor, Law, ... - Discourse.net

Is a Financial Transactions Tax the Answer?

Dean Baker says a financial transactions tax has attractive properties:

Bloodletting on Wall Street, by Dean Baker: There were two noteworthy episodes last week in the ... the housing market meltdown. First, the New York Times ... found that the Wall Street banks had already written down ... almost half of their profits in their boom years from 2004 through the first half of 2007.

The other big item was that two Bear Stearns hedge fund managers were marched off to jail, charged with fraud and other related offences. ...

This raises many questions...

"Speculative Nonsense, Once Again"

I think it would be fair to describe Paul Krugman as frustrated:

Speculative nonsense, once again, by Paul Krugman: OK, one more try. ...[T]he mysticism over how speculation is supposed to drive prices drives me crazy, professionally.

So here's my latest attempt to talk it through.

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won't. What direct effect does this have on the spot price of oil - the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn't make any difference.

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that's true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.

As I've tried to point out, there just isn't any evidence from the inventory data that this is happening.

And here's one more fact: by and large, futures prices over the period of the big price runup have been slightly below spot prices. The figure below shows monthly data from the EIA; as the spot price shot up, the futures price (that's contract 4, the furthest out) actually lagged a bit behind. In other words, there hasn't been any incentive to hoard.

As I've said, I don't have a political dog in this fight. But the nonsense in this debate makes me want to shoot someone in the face.

Update: I see that Michael Masters, about whom I had some flattering things to say a few days ago, is now telling Congress that gasoline will go back to $2 a gallon if we crack down on speculators. He forgot to mention that cold fusion will solve all our energy problems any day now.

Where's the incentive to hoard?

Update: Also see Free Exchange.

Externalities from Home Ownership

More thoughts on the home ownership versus renting question:

No time to blog, but hey, it's homeownership!, by Richard Serlin: With regard to Mark Thoma's June 23rd post, "Paul Krugman: Home Not-So-Sweet Home", there's really a lot I'd like to say, but I'll have to restrain myself. ... That said, some quick but I think important things regarding this post:

First, I promote it a lot, but I think my brief working article, "Let's Cut the Ammunition to the Housing Arms Race Permanently", really explains well some of the best things we can do to help homeowners over the long run.

Second, one of the most important things in deciding whether the government should promote something is whether it produces net positive externalities (and how much). I think home ownership does have large net positive externalities, but only for people in certain situations, not for all people in all situations. So government promotion of homeownership could be efficiency and welfare enhancing – if well designed.

Brad DeLong identifies potential positive externalities:

You can make a political-economy argument that local communities work best on a political level when a majority of the voters have a big equity financial stake in the health of the community via homeownership (as opposed to renting), and an economic-myopia argument that encouraging homeownership is one of the few tools we have to push personal savings up toward what they should be. But you have to make those arguments: you can't just assume that widespread homeownership is a very good thing.

Are there others?

What are the negative externalities of home ownership? One was identified in the column, long commute times causing more energy to be used resulting in environmental damage, etc., an argument I didn't fully embrace (I think it's the amenities of the suburbs that are attractive rather than ownership per se, and those amenities cause both renters and owners to locate long distances from their jobs - if ownership is all that matters, buy a condo in the city), but what are the others? (The other two, illiquidity and price risk fall on the individual, but I'm not sure they cause significant costs to parties outside the transaction, i.e. externalities, though certainly things like less effective labor market matching due to illiquidity of houses does impose an aggregate cost, so maybe I need to think that part through a bit more.)

On net, which why do the externalities work? If we were to correct both the positive and negative externalities, would that result in our promoting ownership, discouraging ownership, or remaining fairly neutral? I find it hard to make an argument that negative externalities dominate, and I find myself persuaded by the arguments for positive externalities, but even there I have qualifications.

The questions, I suppose, are (a) is it the equity stake alone that brings about "local communities that work best," or can long-time residents who happen to be renters feel just as invested in the community? If they can and do, then similar externalities exist for (long-time residents who happen to be) renters and there would be no reason to favor owners, policies that give renters a long-run interest in the community would also be desirable (What polices would work for renters? How would you make renters feel more invested in the community, or is it incorrect to assume renters don't care enough, or need to be long-time residents? For those who don't exhibit much investment in the community, would it be any different if they were owners, or is selectivity at work here?); and (b) is home ownership the best mechanism for promoting personal saving? We've observed recently that there is substantial risk to sinking one's life saving into a home, so maybe we want to promote saving in some other fashion, something that is equally available and equally attractive to both owners and renters.

Lots of questions, so interested in your thoughts on this...

Update: More discussion from Arnold Kling.

Paul Krugman: Home Not-So-Sweet Home

Should the government promote home ownership?:

Home Not-So-Sweet Home, by Paul Krugman, Commentary, NY Times: “Owning a home lies at the heart of the American dream.” So declared President Bush in 2002, introducing his “Homeownership Challenge” — a set of policy initiatives that were supposed to sharply increase homeownership, especially for minority groups.

Oops. While homeownership rose as the housing bubble inflated, temporarily giving Mr. Bush something to boast about, it plunged — especially for African-Americans — when the bubble popped. Today, the percentage of American families owning their own homes is no higher than it was six years ago...

But here’s a question...: Why should ever-increasing homeownership be a policy goal? How many people should own homes, anyway?

Listening to politicians, you’d think that every family should own its home — in fact, that you’re not a real American unless you’re a homeowner. “If you own something,” Mr. Bush once declared, “you have a vital stake in the future of our country.” Presumably, then, citizens who live in rented housing, and therefore lack that “vital stake,” can’t be properly patriotic. Bring back property qualifications for voting!

Even Democrats seem to share the sense that Americans who don’t own houses are second-class citizens. ...Austan Goolsbee,... one of Barack Obama’s top advisers, warned against a crackdown on subprime lending. “For be it ever so humble,” he wrote, “there really is no place like home, even if it does come with a balloon payment mortgage.”

And the belief that you’re nothing if you don’t own a home is reflected in U.S. policy..., the federal tax system provides an enormous subsidy to owner-occupied housing. On top of that, government-sponsored enterprises — Fannie Mae, Freddie Mac and the Federal Home Loan Banks — provide cheap financing for home buyers...

In effect, U.S. policy is based on the premise that everyone should be a homeowner. But here’s the thing: There are some real disadvantages to homeownership.

First of all, there’s the financial risk... borrowing to buy a home is like buying stocks on margin: if the market value of the house falls, the buyer can easily lose his or her entire stake.

This isn’t a hypothetical worry... Now that the bubble has burst,... there are probably around 10 million households with ... mortgages that exceed the value of their houses.

Owning a home also ties workers down. Even in the best of times, the costs and hassle of selling one home and buying another ... tend to make workers reluctant to go where the jobs are.

And these are not the best of times. Right now,... homeowners ... are constrained from seeking opportunities elsewhere, because it’s very hard to sell their houses.

Finally, there’s the cost of commuting. Buying a home usually ... means buying ... a long way out, where land is cheap. In an age of $4 gas and concerns about climate change, that’s an increasingly problematic choice.

There are, of course, advantages to homeownership... But homeownership isn’t for everyone. In fact, given the way U.S. policy favors owning over renting, you can make a good case that America already has too many homeowners.

O.K., I know how some people will respond: anyone who questions the ideal of homeownership must want the population “confined to Soviet-style concrete-block high-rises” (as a Bloomberg columnist recently put it). Um, no. All I’m suggesting is that we drop the obsession with ownership, and try to level the playing field that, at the moment, is hugely tilted against renting.

And while we’re at it, let’s try to open our minds to the possibility that those who choose to rent rather than buy can still share in the American dream — and still have a stake in the nation’s future.

It's only fair that the playing field be leveled, I can remember the feeling of inequity as I was filling out my taxes in the years I was a renter. And there's certainly no reason to disparage anyone just because they rent rather than own a home.

But there is something special about owning your own home, I think, and we should be careful not to erect new barriers to ownership and do our best to remove those that already exist. Thus, if fluctuations in the value of a house after purchase is a big risk, then we can think about protecting people with some type of price insurance, one type would protect the downside in return for a share of the upside (this already exists, but should it be required in some cases?). If liquidity is the problem, there may be ways for financial innovation or government to help there too, surely there's some way to help get workers where the jobs are when the only thing holding them back is an unsold house. And ownership, even in "Soviet-style concrete-block high-rises" is possible, condos come to mind, so it's not ownership itself that causes the long commute, but rather a desire for something else that isn't available in high density areas, a yard, room for a dog, something like that. [Within high density areas, ownership should be available for those who prefer it so as not to force those who prefer ownership but don't care about a yard into a long commute. That way, even if there is a distortion toward ownership, it doesn't force people to move into the suburbs to take advantage of the tax or other benefits.]

I'd like to see everyone who wants to own a home and has the means to do so be given a fair chance to make that happen, and to have them fully protected against risks that could wipe them out or prevent them from responding to new opportunities in other areas (though a lease with several months left to go can tie a person down as well). But, I don't see any reason to distort the choice one way or the other. Having to take care of a yard, the roof, rake leaves, worry about having to repair internal plumbing problems, and so on isn't for everyone. Some people would prefer to shift these duties and risks onto someone else and I agree that they shouldn't be penalized for doing so.

One last thought. If we are going to try to level the playing field, as we should, there are two ways to proceed. One is to remove the special advantages that homeowners currently enjoy. That's the hard way since it takes something away from people. The other is to add new perks for renters until they get as many breaks as homeowners now enjoy. That's the easy way since it gives people new goodies instead of taking away the benefits they already have. But from an economic standpoint, the hard way is best, so if we are going to level the playing field, I hope that politicians will take the more difficult but more rewarding path. But, realistically, the politics makes it unlikely they'll move in either direction.

"One of the Two Central Banks Must be Making a Mistake"

Guido Tabellini discusses difficulties faced by central banks, including the current debate over whether central banks should be more worried about inflation or about weak economic growth. He says that because the Fed or the ECB have made different choices about "the primary objective – inflation or growth," one of the two is making a mistake:

Why central banking is no longer boring, by Guido Tabellini, Vox EU: Until a year ago, central bankers could boast with satisfaction that monetary policy had become boring. A widely shared “best practice” was followed by almost all central banks. Any controversies concerned technical nuances that were really only relevant to professionals in the field. Then came the credit crisis – and all certainties went out the window. Now new dilemmas are emerging, and many central banks have embarked on different routes. Within a few years, we will know who was right and who wasn’t.

Fighting inflation or avoiding recession?

A first question: what’s the primary objective – inflation or growth? The American Federal Reserve has chosen growth. For fear of recession, it lowered the interest rate to 2% - two points below the rate of inflation. The gamble is that the cyclical slowdown will still put the brakes on price increases, despite the energy shock and agricultural prices, and even though inflation forecasts have reared their heads – above all (but not only) in the short term. Paul Volcker, the architect of disinflation in the 80s, has said that recent months remind him of the early 70s. Even then the oil shock was accompanied by a rise in agricultural prices, a weakening of the dollar, and an expansive monetary policy to counteract recession. The result was a decade of inflation.

The Bank of England made the opposite choice – it’s keeping interest rates at 5% (2 points above the inflation rate), because it wants inflation to fall towards the target of 2%, while recognising that the English economy risks winding up in recession, driven by tight credit, the drop in house prices, and the oil shock. The economic situation in England still isn’t as serious as that in America, yet the orientations of the two central banks are very different. Mervyn King, governor of the Bank of England, has emphasised that the Bank “did not fall prey to the sirens who were pressing us to cut interest rates as rapidly as some other central banks have done”.

The European Central Bank is going even further, surprising everyone with a warning that a hike in interest rates is imminent, despite the global slowdown and the ongoing credit crunch. This is remarkable, because the source of higher inflation is clearly exogenous to the Euro area and not due to domestic overheating or wage increases. By implication, the ECB welcomes a slowdown of the European economy to make sure that external inflationary pressures do not ignite a domestic wage-price spiral. The contrast with the Fed approach could not be more striking; one of the two central banks must be making a mistake.

links for 2008-06-23

• The Chicago School (and the Russert Wing) - Economic Principals
• Obama Targets Speculation On Energy - washingtonpost.com
• Stuart Thiel knows why people are unhappy (about George Bush) - Richard Green
• The price of hunger - Los Angeles Times
• Why World Bank's Governance Indicators suck - The Bayesian Heresy
• Census Damage Control - Editorial - NYTimes.com
• Resetting Earth's thermostat - Los Angeles Times
• The Case for Mining Law Reform - Editorial - NYTimes.com
• Study Finds Imbalance on 3 Newspapers’ Op-Ed Pages - NYTimes.com

"People are Really Angry at George Bush"

We keep hearing from Republicans that the economy is doing well, but the media has left people with the opposite impression. I think Republicans are correct, they should ignore what the polls are telling them, keep insisting that people have been manipulated by that evil liberal media and that things are actually great, continue to appear insensitive to the situation faced by typical households, propose little in the way of help, and actively oppose policies proposed by political opponents directed at helping middle and lower income households. It's a winning strategy - for Democrats:

Can Republicans Win In This Environment?, by Stan Collender [Creative Commons]: I've been traveling much of the past two weeks for work. Nine cities, seven states, and close to 30 presentations about the election and the economy.

What I'm about to say is based purely on anecdotal information. It is not meant to be statistically significant or a good sample. And my audiences were anything but a good cross section of the general population.

But my conclusion is as straight forward as possible: Americans, or at least those I spoke to and with, are very very angry.

Their anger initially seemed to be directed at specific things. Understandably, gasoline prices always seemed to be the first thing mentioned, for example. In fact, the economy in general was a constant source of anger. No one I spoke with over the past few days seems to be looking at the current economic situation as positive. Costs are going up, jobs are going down, inflation is rising, housing is unsettled, investment opportunities are limited, etc.

People are really angry at George Bush.

Adam Smith on Poverty

Gavin Kennedy finds Don Arthur at Club Troppo asking "What if Adam Smith was Right about Poverty?" This relates to the idea often heard in debates about poverty that since the material well-being of the poor has increased over time, there's no need to worry about inequality:

Adam Smith on Poverty, by Gavin Kennedy: A post by Don Arthur in the Australian Blog, Club Troppo, (here) which has been quoted on Lost Legacy in the past when I referred to articles by Nicholas Gruen, opens an interesting and important discussion on poverty in societies and Adam Smith’s expressed view on the issue. I only quote some parts of it, and I have deleted several excellent references and discussions of recent work by academics on related matters. Check the link and read them for yourself:

What if Adam Smith was right about poverty? Don Arthur,  June 22: Well-being isn’t just about our relationship with things, it’s also about our relationships with each other. Poverty hurts, not just because it can leave you feeling hungry, cold and sick, but because it can also leave you feeling ignored, excluded and ashamed. In The Theory of Moral Sentiments Adam Smith argued that all of us want others to pay attention to us and treat us with respect. And "it is chiefly from this regard to the sentiments of mankind, that we pursue riches and avoid poverty."

Recent research confirms Smith’s intuitions — social pain is every bit as aversive as physical pain. ...

So if Smith is right then what should we do about involuntary poverty? Is it enough to provide state subsidised goods such as housing and healthcare and to dole out money for necessities?

Adam Smith — Poverty as social exclusion
According to Adam Smith, human beings are by nature social creatures. In The Theory of Moral Sentiments, he wrote:

Nature, when she formed man for society, endowed him with an original desire to please, and an original aversion to offend his brethren. She taught him to feel pleasure in their favourable, and pain in their unfavourable regard. 

The reason poverty causes pain is not just because it can leave people feeling hungry, cold and sick, but because it is associated with unfavourable regard. As he explains:

Inflation or Unemployment?

Should the Fed be more concerned with inflation, or with weak output growth and rising unemployment? Robert Kuttner says the answer is easy, worry about output growth and employment:

My dissent on the risk of inflation, by Robert Kuttner, Commentary, Boston Globe: The Federal Reserve and the European Central Bank are both signaling a tighter money policy. The reason? Inflation...

The consensus is that combating inflation is more important than other economic goals, such as rescuing the financial system or preventing recession. Please permit me a dissent.

Unemployment went up a full half point to 5.5 percent in May, the biggest monthly jump in 22 years, and worse is forecast. Subprime fallout continues. Home foreclosures are running at 25,000 a month, and housing values are still dropping. If the economy is not quite in official recession, tight money will push it over the edge.

Consider the sources of today's inflation. The standard explanation is that inflation results when the economy overheats. Tight money helps cool it down. But today's American economy is too weak, not too strong. ...

Why the price increases? One theory is that China and India are consuming more energy and food, bidding up world prices. Another view is that Wall Street speculators ... are ... causing prices to spike.

But either way, it's not clear how higher interest rates in the United States will moderate worldwide prices of oil and food. ...

Rather, the nation needs ... to end its reliance on imported oil. It needs sensible food policies worldwide, so that the productive capacities of underperforming agricultural regions are realized. And it needs policies to restrict the purely speculative influences on commodities prices. ...

I think caution in pulling the trigger to fight inflation is in order, this doesn't look like a repeat of the wage-price inflation spiral of the 1970s, but Nouriel Roubini doesn't think it's as clear what the Fed and other central banks should do:

...central banks in many advanced and emerging economies are facing a nightmare scenario, in which they simultaneously must tighten monetary policy (to fight inflation) and ease it (to reduce the downside risks to growth)... [...full article...]

links for 2008-06-22

• Lisbon Treaty as Trojan horse - Vox EU
• Big Bump in Post's Budget Reporting: It Doesn't Add Up - Beat the Press
• In Fertile India, Population Has Outstripped Agriculture - NYTimes.com
• What Happens if We’re Wrong? - NYTimes.com
• The Specter of Global Stagflation - Nouriel Roubini
• The effects of school-starting age- Vox EU
• Public opinion and immigration policy - Vox EU
• Sea of Trash - NYTimes.com

Can "Real, Transformative Change" Actually Happen?

If Democrats win this fall, what will it take to bring about change? Here are two answers. First, a call "to address Americans' insecurities about their economic futures as well as the future security of their nation":

A New Social Contract, by Michael Kazin and Julian E. Zelizer, Commentary, Washington Post: For the first time since 1964, Democrats have a good chance not just to win the White House and a majority in Congress but to enact a sweeping new liberal agenda. Conservative ideas are widely discredited...

The long Democratic primary battle masks the fact that the party faithful agree on the basic outlines of a new social contract. It fits a post-industrial society that was barely visible when Lyndon B. Johnson was ramming a series of landmark measures through Congress.

The new agenda focuses on protecting middle-class families from the insecurities of the global economy. ...

The emphasis on protecting middle-class families reflects a major historical shift. During the 1930s and '40s, liberals struggled to create a vibrant middle class out of the industrial wage-earners who had immigrated to the United States and rural people of all races who lacked electricity and jobs. New Deal programs focused on workingmen and depressed regions. The National Labor Relations Act legitimized unions and boosted the purchasing power of the working class. The Rural Electrification Administration and the Tennessee Valley Authority enabled Southern communities to participate fully in the modern manufacturing economy. Social Security gave support to the elderly, lessening the burden on their children. The GI Bill gave a generation the ability to purchase a home and get a college education.

In the 1960s, Democrats turned to expanding the middle class. John F. Kennedy and LBJ sought to increase the number of Americans who could enjoy the economic and social benefits of a booming economy. The rights revolution made it possible for African Americans, Latinos and women from all backgrounds to compete for most of the same jobs as white men. Medicare and Medicaid provided new health benefits for the elderly and the poor.

Now, Democrats are grappling with insecurities faced by entire families, that institution conservatives always claim to represent. The past three decades have produced growing economic inequality and a shrinking middle class. ... Wage-earners fear for the future of their jobs and incomes. No family is secure.

This is the reality of a global, nonunion economy that the new agenda attempts to address. But before the reunited Democratic Party can start to make a forceful case to the nation, it will have to address its great weakness. Democrats have not yet been able to equal what was perhaps Franklin Roosevelt's greatest political success: to offer a bold foreign policy to match his domestic ambitions. FDR had an internationalist vision: that the United States should use military force only against clearly defined threats and with the aid of international, democratic institutions. This vision, with some exceptions, defined America's stance in the world until Vietnam.

Krugman on Calvo on Commodities

In his discussion of the cause of skyrocketing commodity prices, which he attributes in large part to central bank behavior creating excessive liquidity, Guillermo Calvo said:

Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).[1] But that is not valid.

Paul Krugman replies:

Calvo on commodities: Guillermo Calvo is one of my favorite economists. But - you know there had to be a but - I just don't buy his latest missive. Still, it's important that we have this debate: something awesome is happening to oil and other commodities, and figuring out what it means is crucial.

So, a couple of points.

Economic Opportunity and Out of Wedlock Births

How important is lack of economic opportunity in explaining out of wedlock births? Bob Herbert argues it's a significant factor:

A Dubious Milestone, by Bob Herbert, Commentary, NY Times: ...Barack Obama spoke on Father’s Day about the tragic flight of so many American fathers, especially black fathers, from their children’s lives.

His comments came as the Center for Labor Market Studies ... revealed a dubious milestone. In 2006, for the first time in U.S. history, a majority of all births to women under 30 — 50.4 percent — were out of wedlock. Nearly 80 percent of births among black women were out of wedlock.

By comparison, ... in 1960, just 6 percent of all births were to unmarried women under 30. Since then, the percentages have risen across the ethnic spectrum. One-third of white, non-Hispanic women under 30 who gave birth in 2006 were unmarried. For Hispanics, it was 51 percent. ...

Senator Obama, in remarks he delivered ... in Chicago... [said] “But if we are honest with ourselves, we’ll admit that too many fathers are missing — missing from too many lives and too many homes. They have abandoned their responsibilities, acting like boys instead of men. And the foundations of our families are weaker because of it.”

This is not a simple matter. Obviously, fathers should care for their children. But just wagging a finger and telling them sternly to step up to their responsibilities is about as effective as hollering at the wind.

Senator Obama touched on this when he talked about the need for certain policy changes to make it easier for young men to fulfill their parental obligations — for example, offering tax incentives and job training to those making a sincere effort. ...

But a lot more is needed. One of the main reasons out-of-wedlock births have skyrocketed in recent decades is because it has become so difficult for poor and poorly educated young men to earn enough to support a family.

There is no doubt that a lot of clowns have fathered babies when they shouldn’t have, and too many have irresponsibly taken a walk. But it’s also incredibly difficult for many of these young people to find the kind of employment that makes raising a family feasible. ...

At the lowest end of the economic ladder the crisis in employment is reminiscent of the Great Depression in its intensity. It is in this group of poor and educationally deprived young people that out-of-wedlock births are highest.

Andrew Sum, director of the Center for Labor Market Studies, put it this way in a research paper:

“The marriage rates of all native-born young males and young black males (22-32 years old) in the U.S. are strongly correlated with the annual earnings of these young men. The higher their annual earnings, the more likely they are to be married. Among native-born black males, those men with earnings over $60,000 were four times more likely to be married than their peers with annual earnings under $20,000.

“Unfortunately, the mean annual earnings of young men without four-year college degrees have plummeted substantially over the past 30 years, and declined again over the 2000-2007 period. Declining economic fortunes of young men without college degrees underlie the rise in out-of-wedlock child-bearing, and they are creating a new demographic nightmare for the nation.” ...

Employment is the master key to the thriving families that Senator Obama talked about... If we can’t achieve something close to full employment for the wider society, there is very little hope for those mired at the bottom.

links for 2008-06-21

• A.M.D. and Its War With Intel - NYTimes.com
• Why Is Oil So High? Pick a View - NYTimes.com
• Earth Will Survive After All, Physicists Say - NYTimes.com
• Lander Finds Ice on Mars - washingtonpost.com
• White House invokes executive privilege in EPA inquiry - Los Angeles Times