Economist's View

A Solar Power Revolution?

Instead of all the drivel about offshore drilling from Republicans, this is what we need - technological solutions as described below. We aren't going to solve our energy problems, or even make a noticeable dent in them, by allowing offshore drilling. That's a ruse to capture votes. The solution lies in alternatives and conservation, and if the claims made below are correct, this looks like a big step in the development of solar power:

'Major discovery' from MIT primed to unleash solar revolution, Anne Trafton, News Office: In a revolutionary leap that could transform solar power from a marginal, boutique alternative into a mainstream energy source, MIT researchers have overcome a major barrier to large-scale solar power: storing energy for use when the sun doesn't shine.

Until now, solar power has been a daytime-only energy source, because storing extra solar energy for later use is prohibitively expensive and grossly inefficient. With today's announcement, MIT researchers have hit upon a simple, inexpensive, highly efficient process for storing solar energy.

Requiring nothing but abundant, non-toxic natural materials, this discovery could unlock the most potent, carbon-free energy source of all: the sun. "This is the nirvana of what we've been talking about for years," said MIT's Daniel Nocera ... senior author of a paper describing the work in the July 31 issue of Science. "Solar power has always been a limited, far-off solution. Now we can seriously think about solar power as unlimited and soon."

Inspired by the photosynthesis performed by plants, Nocera and Matthew Kanan, a postdoctoral fellow in Nocera's lab, have developed an unprecedented process that will allow the sun's energy to be used to split water into hydrogen and oxygen gases. Later, the oxygen and hydrogen may be recombined inside a fuel cell, creating carbon-free electricity to power your house or your electric car, day or night.

"The 'Big Push' and Economic Development in the American South"

David Beckworth on evidence for The Big Push theory of economic development, the idea that "publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies." Given recent debate over using infrastructure spending as a means of stimulating the economy, the long-run supply-side effects of stimulating the economy through spending on infrastructure are noteworthy:

The 'Big Push' and Economic Devlopment in the American South, by David Beckworth: One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region’s economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

Unemployment and Hours of Work over the Business Cycle

Why has unemployment remained relatively low even though the economy is sputtering?:

A Hidden Toll on Employment: Cut to Part Time, by Peter S. Goodman, NY Times: ...On the surface, the job market is weak but hardly desperate. Layoffs remain less frequent than in many economic downturns, and the unemployment rate is a relatively modest 5.5 percent. But that figure masks the strains of those who are losing hours or working part time because they cannot find full-time work — a stealth force that is eroding American spending power.

All told, people the government classifies as working part time involuntarily — predominantly those who have lost hours or cannot find full-time work — swelled to 5.3 million last month, a jump of greater than 1 million over the last year.

These workers now amount to 3.7 percent of all those employed, up from 3 percent a year ago, and the highest level since 1995.

“This increase is startling,” said Steve Hipple, an economist at the Labor Department.

The loss of hours has been affecting men in particular — and Hispanic men more so. ... Some 28 percent of the jobs affected were in construction, 14 percent in retail and 13 percent in professional and business services...

“The unemployment rate is giving you a misleading impression of some of the adjustments that are taking place,” said John E. Silvia, chief economist of Wachovia in Charlotte. “Hours cut is a big deal. People still have a job, but they are losing income.”

Many experts see the swift cutback in hours as a precursor of a more painful chapter to come: broader layoffs. Some struggling companies are holding on to workers and cutting shifts while hoping to ride out hard times. If business does not improve, more extreme measures could follow.

“The change in working hours is the canary in the coal mine,” said Susan J. Lambert of the University of Chicago,... an expert in low-wage employment. “First you see hours get short, and eventually more people will get laid off.” ...

The growing ranks of involuntary part-timers reflect the sophisticated fashion through which many American employers have come to manage their payrolls, say experts.

In decades past, when business soured, companies tended to resort to mass layoffs, hiring people back when better times returned. But as high technology came to permeate American business, companies have grown reluctant to shed workers. Even the lowest-wage positions in retail, fast food, banking or manufacturing require computer skills and a grasp of a company’s systems. Several months of training may be needed to get a new employee up to speed.

“Companies today would rather not go through the process of dumping someone and hiring them back,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “Firms are going to short shifts rather than just laying people off.” ...

And it works just the opposite way on the other side when GDP begins to recover. At first, firms will increase hours rather than employment. Firms won't invest in new workers until they are sure that the economy is improving, and that doesn't happen with just a single month or a single quarters worth of improved data. It takes a time for enough data to accumulate to convince firms that business really has taken a turn for the better, that what they are seeing is not just a temporary blip, and that it is worthwhile to pay the costs of hiring and training new workers.

This provides one potential explanation for why employment growth has been sluggish in the recovery period after the last two recessions, both of which occurred after the revolution in digital technology. To the extent that technology has increased training costs over time, the delay in the recovery in employment would be even longer. With higher training costs, firms would need to be even more certain that things have improved, i.e. they would need to wait for and analyze more data than before to be convinced that it's worthwhile to pay the cost of investing in new workers, and that increases the delay between the uptick in GDP and the uptick in employment (and to the extent that technology can substitute for labor, the employment response could be even more sluggish and muted).

links for 2008-07-31

• Whither Federal Reserve Communications - FRB: Mishkin
• Don't cry for Doha - Dani Rodrik
• Is the European Commission making the right merger decisions? - Vox EU
• Ballance at the Washington Post - Robert's Stochastic thoughts
• Our Immigration Policy Makes Life Hard on Cops - Op-Ed - NYTimes.com
• Decline Seen in Numbers of People Here Illegally - NYTimes.com
• Discovering How Greeks Computed In 100 B.C. - NYTimes.com
• $70 Million Effort Seeks New Safety Net for Workers - NYTimes.com
• McCain ad says Obama will raise taxes on electricity (false) - FactCheck.org

Marginal Company

Robert Reich on what not to take to the beach:

Robert Reich, Marketplace: Ordinarily, I'd never recommend you take a book by an economist to the beach. I wouldn't even recommend you take an economist to the beach. ...

An example of an economist at the beach? Robert Reich again:

Moral Hazard, by Robert Reich: One day while sitting on a beach last summer I overheard a father tussle with his young son about whether the child was old enough to take out a small sailboat. The father finally relented. "Go ahead, but I’m not gonna save you," he said, picking up his newspaper. A while later, the sailboat tipped over and the child began yelling for help, but father didn’t budge. When the kid sounded desperate I put down my book, walked over to the man, and delicately told him his son was in trouble. "That’s okay," he said. "That boy’s gonna learn a lesson he’ll never forget." I walked down the beach to notify a lifeguard, who promptly went into action.

Letting children bear the consequences of their risky behavior -- what some parents call "tough love" -- is equally applicable adults, and conservatives have made something of a fetish out of it. A few weeks ago, as George W. announced a paltry plan to help out a few of the millions of homeowners who got caught in the sub-prime loan mess, he reiterated the credo: "It’s not government’s job to bail out ... those who made the decision to buy a home they knew they could not afford."

It’s true that people tend to be less cautious when they know they’ll be bailed out. Economists call this "moral hazard." But even when they’re being reasonably careful, people cannot always assess risks accurately...

When it comes to risky behavior in the market, America has a double standard. We’re told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it’s amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. ...

CEOs get away with stupid mistakes all the time. .... But... If you’re an average American who gets canned from his job, even through no fault of your own, you probably won’t even get unemployment insurance (only 40 percent of job-losers qualify...). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard.

Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have "known they could not afford" when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald ("you’re fired!") Trump’s casino empire has gone into bankruptcy twice -- most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets -- with no apparent diminution of the Donald’s passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you’re an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued -- you guessed it -- moral hazard.

Bush’s "ownership society" has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.

Economists see economics in everything. If you take them to the beach, or pretty much anywhere else, you're just going to have to put up with that.

Robert Reich is going on vacation again, and he notes:

The Myth of Summer Vacation, by Robert Reich: I'm about to take a few weeks off. If you are, too, we're in the minority. A Conference Board poll last April found fewer than 40 percent of Americans planning a summer vacation.

Of course, for most Americans, there's not much summer vacation to begin with. The average American employee gets a total of 14 days off each year. If you want to take a few of them around Thanksgiving, between Christmas and New Years, and maybe when the kids are home on spring break, summer vacation is already practically gone.

Those 14 days, by the way, are the fewest vacation days in any advanced economy. The average French worker gets 37 days off annually; In Britain, it's 26.

And even when we take those 14 days, we don't always get paid for them. The Bureau of Labor Statistics tells us 1 out of 4 workers gets no paid vacation days at all. Every other advanced nation -- and even lots of developing nations -- mandate them.

On top of all this comes the current economic squeeze. That figure of 40 percent of Americans planning a summer vacation is the lowest in 30 years.

Not incidentally, consumer confidence in the economy is the lowest it's been in 28 years. In other words, there's a correlation between the small number of Americans taking a vacation this summer and this very bad economy.

It's not that we're too busy to vacation. Just the opposite: There's not enough work go around. Which means we don't dare leave work, lest we lose us a customer who might just happen to want us when we're gone. Or we could even lose the job, because employees on vacation might seem expendable to an employer looking for a way to cut costs.

Despite all this, you need a summer vacation. I do, too. ...

Should the government require firms to offer paid vacation after some period of time, say after a year of employment? If so, how much?

Whistles Along The Low Road Express?

The NY Times blog discusses Not The One's new ad:

Do Mr. McCain’s strategists actually think they can win the White House by whining incessantly about how popular their opponent is? What sort of message is that?

“Vote for McCain. Nobody Likes Him.”

The WSJ's Washington Wire gives this interpretation:

Kenneth Rogoff: The Global Economy is Still Growing Too Fast

Kenneth Rogoff says we need to raise interest rates to prevent inflation, to quit trying to stimulate the economy with fiscal policy, and allow financial institutions to fail:

The world cannot grow its way out of this slowdown, by Kenneth Rogoff, Financial Times: As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. ...

Absent a significant global recession..., it will probably take a couple years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil...) In the meantime, if all regions attempt to maintain high growth through macro­economic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation..., has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach. ... Of the major regions, only ... the European Central Bank has resisted joining the stimulus party... But even the ECB is coming under increasing ... pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus... But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. ... But as goods prices rise, wage pressures will eventually follow. ...

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? ... Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to ... bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities...

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail? ...

[T]he need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

Where I differ is on the risk of inflation over the longer run - I am more inclined toward Mark Gertler's view -  and on the fragility of the financial system. Inflation is a concern, but raising interest rates too fast risks throwing the financial sector into a tailspin, and that would bring the economy down with it, and that's a risk I'd rather not take. We need to keep an eye out for signs that inflation is becoming embedded and self-reinforcing, but we need to be even more concerned about a domino effect taking hold in the financial sector. That danger is not yet over.

As for fiscal policy, first, I am not worried about one shot increases in spending creating the continuous increases in demand needed to fuel a long-run inflation (see here for a summary of the estimated effects of the stimulus on GDP). However, beyond that, it's important to remember that our problems are not just from high world demand causing high commodity prices. If that was the only problem we face - it this was just a "plain vanilla supply shock recession" - I'd be inclined to agree. But we are also having a financial crisis and that requires a different response (and makes our policy needs different from countries that are not having a mortgage meltdown - our problem isn't plain vanilla). The evaporation of credit represents a shock to demand, and unless that demand is replaced during the period when financial markets are recovering, we will have lower output and employment growth than we are able to sustain.

Update: Paul Krugman:

The Rogoff doctrine, by Paul Krugman: Ken Rogoff is one of the world’s best macroeconomists, so I take whatever he says seriously. But — you know that’s the kind of statement that is followed by a “but” — I’m having a hard time understanding his demands for a world slowdown.

Ken tells us that

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.

And then he calls for

a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

I agree that

Dollar bloc countries have slavishly mimicked expansionary US monetary policy

and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

Since this is coming from Ken Rogoff, I assume that there’s some deeper analysis here. But I can’t infer it from the articles I’ve read. Please, sir, can I have some more?

Bandwidth Competition

A call for more competition in the market for broadband connections to information and entertainment services:

OPEC 2.0, by Tim Wu, Commentary, NY Times: Americans today spend almost as much on bandwidth — the capacity to move information — as we do on energy. A family of four likely spends several hundred dollars a month on cellphones, cable television and Internet connections, which is about what we spend on gas and heating oil.

Just as the industrial revolution depended on oil and other energy sources, the information revolution is fueled by bandwidth. If we aren’t careful, we’re going to repeat the history of the oil industry by creating a bandwidth cartel. ... That’s why, as with energy, we need to develop alternative sources of bandwidth.

Wired connections to the home ... are the major way that Americans move information. In the United States and in most of the world, a monopoly or duopoly controls the pipes that supply homes with information. These companies [are] primarily phone and cable companies...

But just as with oil, there are alternatives. ... Encouraging competition...

links for 2008-07-30

• The WTO failure in light of the GATT’s history - Vox EU
• Look whos talking - Paul Krugman Blog
• Economics of catastrophe - Paul Krugman Blog
• Pegging the export price - Vox EU
• Would You Work Harder If You Were Paid Less? - EconomistMom
• Covered by whom? Bonds on what? - Interfluidity
• Do Covered Bonds Have a Government Guarantee? - Felix Salmon
• Research challenges notion that dinosaur soft tissues still survive - EurekAlert
• Hopes of World Trade Deal Collapse - NYTimes.com
• Credit Cards Feeling the Crunch - Zubin Jelveh
• 2008 Economic Stimulus: First Take on Consumer Response - RTE
• Fed Debate Heats Up Over Rising Inflation Risk - John M. Berry 

"Why Does Gasoline Cost So Much?"

This column concludes that recent increases in gas prices are due to stagnant oil supplies and growing global demand from emerging Asian economies, not speculation, and that these factors are likely to keep gas prices relatively high in the future:

Why does gasoline cost so much?, by Lutz Kilian, Vox EU: At the end of 2007, both gasoline and crude oil prices (adjusted for inflation) were at levels last seen in 1981 and they continued to climb throughout much of 2008. While Europe has been cushioned in part from these developments, as the dollar depreciated against the euro, the fundamental forces that drove up US gasoline prices have done the same in Europe.

With retail gasoline prices in the US persistently above $4 per gallon, the determinants of gasoline prices is no longer an esoteric topic best left to industry insiders. The debate has moved into the mainstream. Congressional committees as well as media pundits have advanced explanations and proposed policy changes to stem or reverse the increase in gasoline prices.

Why did this surge occur? To answer this, it is important to distinguish between:

• the price of gasoline and other motor fuels, and
• the price of crude oil in global markets.

A distinction often ignored in discussions of higher energy prices. In a recent Vox column, Francesco Lippi discussed the price of crude. My column focuses on the US gasoline market, which is an interesting case for understanding the underlying market forces because of the availability of high quality data for extended periods.

Arnold Kling Doesn't Understand

Arnold Kling [Update: Arnold's response to this post]:

I Don't Understand Mark Thoma, by Arnold Kling: He writes,

But focusing on the immediate problems brought about by tax cuts and military spending should not divert us from the more formidable problem of solving the escalating health cost problem. If Obama wins and tries to institute some form of universal care, it will be opposed as a budget breaker (and for other reasons), but I think universal care will help a lot in bringing down health care cost growth.

There is health care spending paid for by the private sector. Call it P. There is health care spending paid for by the government. Call it G.

The problem with G is that it is busting the budget. I do not understand how reducing P and raising G represents a solution. Even if you think that government can do health care more efficiently, you are still raising G and making the budget problem worse.

P can grow as a percent of GDP as much as it wants to, and be as wasteful as it wants to, without affecting the fiscal outlook. Only G affects the fiscal outlook.

What happens when you take people out of P and put them into G? You might make people's lives better (that's a separate disagreement). You might increase the overall efficiency of the health care system (another separate disagreement). But you do not improve the fiscal outlook. You make it worse.

I absolutely do not see how anyone can say otherwise.

Agreed there is spending on health care in both sectors. That's why I wrote recently that:

At some point we do have to face budget realities... [T]his ... is mainly a problem with rising health care costs (and that will be a problem whether it's paid for publicly or privately)

I didn't explain fully, but the answer to Arnold's question is straightforward. Health care in the private sector is not free. Using his notation, when I think about moving P to G, I also think about moving the revenue stream with it (e.g. individuals would pay monthly premiums in taxes rather than to the insurance company). Thus, if we move all of P to G, we also move all of the revenue with it. Therefore I don't see why the budget problem has to get worse:

Even if you think that government can do health care more efficiently, you are still raising G and making the budget problem worse.

You are also raising T, taxes, to pay for more G (raising is the wrong word, moving the revenue stream is better). Since costs per unit fall (as he says, "You might increase the overall efficiency of the health care system"), you could provide the same overall service with an improved budget (smaller deficit), or provide better service (e.g. expand care) with no change in the budget deficit.

Why do costs per unit fall? Because of all the administrative savings, savings from buying drugs in bulk, and the ability to manage care (e.g. preventative measures, solving information problems that cause wasteful expenditures by doctors and consumers). Thus, if we did move all of P to G we would be able to rebate some of the taxes, expand coverage, etc.. Even if we did nothing but eliminate fights over who pays the bills, or eliminate the costs of screening out the unhealthy (who end up in public sector programs anyway), as we would, health costs would fall substantially.

"No Time to Think, Liberalize!"

Not too long ago, I posted a Vox EU article on the controversy over how large the benefits from trade are for the U.S. Josh Bivens of the EPI is mentioned in the article, and he would like to respond:

No time to think, liberalize!, by Josh Bivens: Hufbauer and Adler's VoxEU piece doesn't really advance the ball much further down the field in this debate. But, just to sum up for any interested readers: a paper by Bradford, Hufbauer, and Grieco (BGH, henceforth) was released in 2005 that had estimates of the US gains from trade liberalization that were far, far outside those estimated by previous research: they claimed past trade liberalizations had added almost a trillion dollars to the US economy by 2004, and, future liberalizations offered the promise of adding another half-trillion.

Dani Rodrik didn't think much of it. And, after seeing these numbers used to great effect in the political debate, I wrote a long-ish working paper and two associated issue briefs detailing why they were unreliable. My over-arching critique was that their study was a literature review that cherry-picked the research for the absolute maximum gains that could be attributed to liberalization while ignoring any reasons (even within this same literature) as to why these gains might be much, much smaller. In the end, I found nothing to shake my belief (based on staid, mainstream economics) that the real gains from liberalizations are closer to a tenth or less of what they claim.

"Bush Midsession Budget: Profound Sadness"

Stan Collender is feeling down:

Bush Midsession Budget: Profound Sadness, by Stan Collender: It says more about me than I should probably admit, but back in 2000 I found the  prospect of paying off the national debt to be very exciting.

To me, the pledge to do that, which Bill Clinton made towards the end of his presidency and George W. Bush made as his years in the White House were just beginning, was absolutely thrilling. Because of the lower annual interest payments that would result, no other change then being seriously talked about had the potential to alter the long-term federal budget outlook as positively and permanently.

That's why I found the mid-session review of the budget released yesterday to be so depressing.  It was the official notice that the pledge, and all the good things that would come from it, would not be fulfilled. It was also time to admit that the budget politics, economics, and limits of the past decade would continue...and continue...and continue.

That's just not a happy occasion for anyone but those of us who blog, write, and talk about the budget. Business will be booming.

None of this was a surprise, of course. The prospects for paying down the national debt firmly ended back in the first year of the Bush administration. And the close to $490 billion deficit that OMB projected for 2009 has long been assumed or leaked.

Nevertheless, the release of the midsession review on July 28, 2008 should be noted as the official date when the dream of a very different budget debate and fiscal policy opportunities died.

I'll have more about the following shortly.  But other observations:

The bad news absolutely is understated. The $482 billion projected fiscal 2009 deficit will actually be closer to $600 billion before the year is over.

The much-ballyhooed Bush administration pledge to cut the deficit in half was a gimmick. There clearly was no commitment to do it more than once (that is, if there really ever was a commitment to do it even once).

From a budget, deficit, debt, interest rate, and fiscal policy perspective, the Bush administration is leaving the country so much worse off than it found it that it will likely hamstring the next president and Congress in ways that aren't yet fully understood.

Based on what we now know for sure about next year's budget, none of the presidential candidates' promises should be taken seriously. Unless they, the country, and those lending us money are willing to tolerate much higher nominal deficits and a larger debt than has so far been imaginable, the next president's options will be severely limited.

More to come.

How should Democrats respond? Recall Brad Delong's thoughts:

[S]hould 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.

Fear of a deficit didn't stop the Republicans from putting their agenda into place, should Democrats take the same approach? Medicare, Social Security, and other programs for the elderly aren't going away, not with an aging population that will have considerable political power, so the question is how we pay for these programs. 

The current budget problem is mainly from tax cuts and increases in military and domestic security expenditures, but the problem going forward is mainly health care costs. We can't cut enough out of the budget or raise taxes high enough to meet projections if the current health care system is unchanged, so this comes down to one question, how do we reign in health care costs?

I don't mean that health care spending shouldn't grow as a percentage of GDP as we get wealthier. It is quite reasonable for us to devote new income from growth toward health care spending. But even so, current projections are that growth in health care costs will need to be lowered to be sustainable.

All of the focus on getting the budget in shape in the short-run is necessary, though we should recognize that as a percentage of GDP deficits have been much higher in the past without disastrous consequences, so there's no need for drastic cuts in programs to make ends meet and tax increases are probably out of the question (and actual fat should not be eliminated from the budget, but there's not much there). This would be easier if Republicans hadn't squandered the surplus they inherited. But focusing on the immediate problems brought about by tax cuts and military spending should not divert us from the more formidable problem of solving the escalating health cost problem. If Obama wins and tries to institute some form of universal care, it will be opposed as a budget breaker (and for other reasons), but I think universal care will help a lot in bringing down health care cost growth. But whatever we do, it's time to get started.

"Another Quasi-Governmental Agency that's Lending Hundreds of Billions to Troubled Banks"

Daniel Gross on another GSE we haven't heard much about:

Freddie and Fannie's Healthy Cousin, by Daniel Gross: The Federal Reserve's extraordinary efforts to help investment banks have effectively put the taxpayer on the hook for enormous potential losses..., we could end up paying tens or hundreds of billions...

But the actual amount of credit extended so far through these public-rescue efforts pales in comparison with the credit that has quietly been extended to banks in the past year—another lifeline that taxpayers could end up paying dearly for. ... For the past 12 months, an obscure agency created by President Herbert Hoover during the Great Depression has come to the rescue of the banking industry. It is called the Federal Home Loan Banks.

Like Fannie Mae and Freddie Mac, the FHLB (here's ... a brief history, and an overview) is a government-sponsored enterprise. But it differs from the wounded giants in some significant ways. Instead of being owned by public shareholders, as Fannie and Freddie are, the 12 independent regional FHLBs are owned by their 8,100 members. Banks large and small, representing about 80 percent of the nation's financial institutions, own shares in the FHLB and share in the profits.

The FHLB has a simple business model.... Basically, it funnels cash from Wall Street to banks on Main Street. Member banks present mortgages they've issued—high-quality ones, not junky subprime ones—as collateral to the FHLB and borrow money so they can have more cash to lend. To finance its activity, the FHLB sells debt to big investors in the capital markets. As with Fannie and Freddie, the FHLB benefits from a unique status. ... While the FHLB takes pains to note that "Federal Home Loan Bank debt is not guaranteed by, nor is it the obligation of, the U.S. government," there's an assumption afoot in the marketplace that were the FHLB to encounter serious trouble, the government would step in. In return for this special treatment, the FHLB provides some vital public services. Twenty percent of its net earnings are used to help cover interest on debt issued by the Resolution Funding Corp., which paid for the Savings & Loan bailout. The FHLB also channels one-tenth of its profits to affordable-housing loans and grants.

During the mortgage boom, FHLB quietly did its job and avoided many of Fannie and Freddie's excesses. ... Subprime holdings were minimal. And since commercial banks were able to raise capital from Wall Street to make any kinds of loans they wanted, they didn't have all that much need for the FHLB's services. As the chart ... shows, the number of loans extended to member banks rose modestly in the boom years, up 7 percent in 2005 and only 3 percent in 2006. ...

But last year the mortgage house of cards began to collapse. And as Wall Street's securitization machine, which had enabled banks to raise cash with alacrity, broke down, banks staged their own run on the FHLB. .... Since ... the broken-down Wall Street mortgage securitization machine was sold for scrap, FHLB loans to member banks ...[rose] to $914 billion at the end of this June. In the past 12 months, FHLB loans to its members have risen by 43 percent, representing an additional $274 billion in real credit provided by the system to its member banks. That sum dwarfs the actual amount of credit extended to investment banks by the Fed—or by the government to Fannie and Freddie.

Does the increase in FHLB's balance sheet mean taxpayers may be on the hook for another trillion dollars in mortgage debt? It's unlikely. FHLB has a much better track record than Fannie and Freddie. Because it maintains high standards, it has never suffered a credit loss on a loan extended to a member. It doesn't spend hundreds of millions of dollars each year on executive compensation or lobbying, as Fannie and Freddie did. And it didn't lower standards ... as a way of increasing market share.... Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists.

Why does the FHLB exist at all?:

The Housing Giants in Plain View, by William R. Emmons, Mark D. Vaughan and Timothy J. Yeager , FRB St. Louis, July 2004: ...The Federal Home Loan Bank System was the first housing GSE. The FHLBanks were established by Congress in 1932 to advance funds against mortgage collateral. At the time, the country was in the midst of an unprecedented wave of depositor runs. Depository institutions faced the risk that loans would have to be liquidated at fire-sale prices to pay off anxious depositors. The FHLBanks enabled their members, primarily savings and loan associations and savings banks, to obtain cash quickly should depositors come calling. This access to ready cash reduced the liquidity risk of mortgage lending, thereby freeing FHLB members to originate more home loans.

Trash Talk: Pay-As-You-Throw Systems

Should communities adopt "pay-as-you-throw systems" for garbage collection to reduce the amount of garbage flowing into landfills or incinerators?:

Kicking the Cans, by Robert Tomsho, WSJ: Plymouth, Mass. -- In this historic community ... garbage has become ... a touchy subject...

During months of debate, Mr. Quintal, chairman of the town's governing board of selectmen, argued that people who throw out more trash should pay higher disposal bills. "I got emails from people saying they thought I was right," he says. "But there were just as many from those who thought I was an idiot."

Like Plymouth, more and more communities are grappling with whether to abandon traditional garbage service and adopt so-called pay-as-you-throw systems. With PAYT, residents are charged based on how much garbage they generate, often by being required to buy special bags, tags or cans for their trash. Separated recyclables like glass and cardboard are usually hauled away free or at minimal cost. ...

PAYT represents an effort to curb garbage's impact on the ecosystem by pressuring consumers to create less of it. But the effort to make people change their habits has often stirred tension...

While Americans are accustomed to paying for utilities like water and electric based on use, that's not true about garbage in most places. ...

Tampering with that notion can be tricky in communities that switch to PAYT. Illegal dumping has cropped up in about 20% of such communities, according to a 2006 U.S. Environmental Protection Agency report. Local officials also complain about variations of the so-called Seattle stomp (named after one of the first PAYT cities), where homeowners try to beat the system by compacting huge amounts of trash into a single can or bag.

There has also been a recent backlash in some locales over costs and inconvenience...

Supporters of PAYT say it gives residents a direct economic incentive to recycle. Skumatz Economic Research Associates, a waste-consulting concern in Superior, Colo., estimates that PAYT programs lead to a 17% reduction in the flow of residential waste to incinerators and landfills... "Every analysis shows that this is a very cost-effective thing to do," says Lisa Skumatz, the firm's principal.

I should stop here and comment, every analysis doesn't show that, but we'll come back to the cost-effectiveness in a moment. Continuing:

links for 2008-07-29

• Mishkin Makes His Final Push for Inflation Target - Real Time Economics
• Bens got the whole world on a string - Paul Krugman Blog
• Carbon-motivated tariffs: Old wine in green bottles? -  Vox EU
• The Economic Paradoxes of Contemporary Art - Felix Salmon
• Lost in Space (physics) - WSJ.com
• Economists and Rationality? - Tom Bozzo
• Money Market Spreads Signal Continued Stress - naked capitalism
• Trading Places (changes in city organization/demographics) - TNR
• The return of global inflation (email suggestion) - Martin Hutchinson
• Energy efficiency, electricity, power plants - Salon News
• Amid EU Expansion, Limited Migration - Real Time Economics
• Know your Constitution: the 14th Amendment - Edge of the American West
• The Nature of Glass Remains Anything but Clear - NYTimes.com
• How Important Was the Surge? - The American Prospect
• The Biggest Issue (education) - David Brooks - NYTimes.com
• Mortgaged to the World - NY Times

"America Must Not Act Rashly over Inflation"

I agree with this - the Fed should not be in a hurry to raise interest rates due to concerns about inflation. This inflation, unlike some in the past, is being driven by increases in the price of oil, food, and other commodities, it's not primarily the result of excessive increases in liquidity (money growth).

Inflation that is driven by excessive money growth needs to be controlled, and the solution is for the central bank to reduce the growth in liquidity by increasing interest rates. But inflation that is driven by changes in relative prices is different. These price changes are providing important signals to the economy about where resources are needed most and about the opportunity cost of employing them, and we don't want to mute those signals (though it is sometimes useful to attenuate the signals and smooth the adjustment). Eventually, the relative prices of these goods will increase enough to bring global growth in demand and global growth in supply back into balance, at which point prices will stabilize and so will inflation. The increase in relative prices is necessary to bring the underlying fundamentals driving supply and demand growth back into balance. As Mark Gertler says below, "the relative increase in energy and food prices is something beyond the central bank’s control...," but once the relative price increases have occurred, inflation should subside on its own. The biggest danger to the economy is further credit market troubles, not inflation, and increasing interest rates in an attempt to stave off inflation would increase the risk lower output growth, lower employment, and prolonged stagnation in the economy:

America must not act rashly over inflation , by Mark Gertler, Commentary, Financial Times: The startling jump in US consumer price inflation ... has sparked concern over whether the economy is entering an inflationary spiral similar to that of the 1970s.

Lost in most of the commentary about inflation has been a careful inspection of its underlying mechanics. Almost all the recent increase in headline consumer price index inflation is due to rocketing energy and food prices. Inflation excluding energy and food is significantly lower.

The increase in the core CPI over the past year was just 2.4 per cent, slightly above the Federal Reserve’s comfort zone of 1 to 2 per cent. The feeding through of food and energy costs to core prices did produce an uptick this past month. Over the coming year, however, below-capacity output growth and softening oil and commodity prices are likely to push core inflation back towards the comfort zone.

Why care about headline inflation versus core inflation? Simply put, a sustained move of headline inflation to the levels of the 1970s is unlikely without an accompanying increase in the core component. The reason is simple: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it. ...

Indeed, there are signs that the forces that have pushed headline above core inflation are beginning to reverse course. ...

Could it be that high headline inflation is unmooring inflation expectations, leading us back to the 1970s through this painful route? Some measures of inflation expectations are edging upwards. This needs to be taken seriously. However, where we should expect the impact of increasing expectations to show up is exactly in the behaviour of core prices and wages.

So far this is not happening. Not only has core inflation remained stable but the growth in nominal unit labour costs, on which most pricing of core items is based, also remains benign. It may very well be that the Fed’s reputation for keeping core inflation stable has kept the expectations relevant for price- and wage-setting in line. Also relevant is that ... wage- setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank’s control that they must live with. ...

Keeping inflation under control is a real concern and I do not mean to suggest otherwise.

What is required, however, is a policy response that recognises the complexities of the inflationary process, including its global nature, and not a simple knee-jerk reaction. From Japan in the 1990s we know that a fractured credit system can induce prolonged stagnation, even in an advanced economy. Given the uncertain condition of the US financial and real sectors, the goal should be to achieve price stability in a way that continues to keep low the possibility that this economy could suffer a similar fate.

Paul Krugman: Another Temporary Fix

Paul Krugman says "financial regulation needs to be extended to cover a much wider range of institutions" if we are to avoid "even bigger future disasters":

Another Temporary Fix, by Paul Krugman, Commentary, NY Times: So the big housing bill has passed Congress. That’s good news: Fannie and Freddie had to be rescued, and the bill’s other main provision — a special loan program to head off foreclosures — will help some hard-pressed families. ...

But I hope nobody thinks that Congress has done all ... of what needs to be done.

This bill is the latest in a series of temporary fixes to the financial system ... that have, at least so far, succeeded in staving off complete collapse. But those fixes have done nothing to resolve the system’s underlying flaws. In fact, they set the stage for even bigger future disasters — unless they’re followed up with fundamental reforms.

Before I get to that, let’s be clear...: Even if this bill succeeds..., it ... will, at best, make a modest dent in ... foreclosures. And it does nothing ... for those who aren’t in danger of losing their houses but are seeing much if not all of their net worth wiped out — a particularly bitter blow to Americans ... nearing retirement...

It’s too late to avoid that pain. But we can try to ensure that we don’t face more and bigger crises in the future.

The back story to the current crisis is the way traditional banks — banks with federally insured deposits, which are limited in the risks they’re allowed to take and the amount of leverage they can take on — have been pushed aside by unregulated financial players. We were assured by the likes of Alan Greenspan that this was no problem: the market would enforce disciplined risk-taking, and anyway, taxpayer funds weren’t on the line.

And then reality struck.

Far from being disciplined in their risk-taking, lenders went wild. ... Lenders ignored ... warning signs because they were part of a system built around ... heads I win, tails someone else loses. Mortgage originators didn’t worry about the solvency of borrowers, because they quickly sold off the loans they made, generally to investors who had no idea what they were buying. Throughout the financial industry, executives received huge bonuses when they seemed to be earning big profits, but didn’t have to give the money back when those profits turned into even bigger losses.

And as for that business about taxpayers’ money not being at risk? Never mind. ...

Meanwhile, those traditional, regulated banks played a minor role in the lending frenzy, except to the extent that they had unregulated, “off balance sheet” subsidiaries. The case of IndyMac — which failed because it specialized in risky Alt-A loans while regulators looked the other way — is the exception that proves the rule.

The moral of this story seems clear...: financial regulation needs to be extended to cover a much wider range of institutions. Basically, the financial framework created in the 1930s, which brought generations of relative stability, needs to be updated to 21st-century conditions. ...

If the government is going to stand behind financial institutions, those institutions had better be carefully regulated — because otherwise the game of heads I win, tails you lose will be played more furiously than ever, at taxpayers’ expense.

Of course, proponents of expanded regulation, no matter how compelling their arguments, will have to contend with very well-financed opposition from the financial industry. And as Upton Sinclair pointed out, it’s hard to get a man to understand something when his salary — or, we might add, his campaign war chest — depends on his not understanding it.

But let’s hope that the sheer scale of this financial crisis has concentrated enough minds to make reform possible. Otherwise, the next crisis will be even bigger.

Economics "is at Last a Science"

The subtitle on this article says:

The dismal science is at last a science—and the world is the beneficiary.

Here are a few parts of the article, though much is omitted, which is mostly an argument about the virtues of the market system:

Economics Does Not Lie, by Guy Sorman, City Journal: Though economics as a discipline arose in Great Britain and France at the end of the eighteenth century, it has taken two centuries to reach the threshold of scientific rationality. Previously, intuition, opinion, and conviction enjoyed equal status in economic thought; theories were vague, often unverifiable. Not so long ago, one could teach economics at prestigious universities without using equations and certainly without the complex algorithms, precise (though not infallible) mathematical models, and computers integral to the field today.

links for 2008-07-28

• Rising Inequality Hinders Upward Mobility - Consider the Evidence
• The underconsumption hypothesis - Paul Krugman
• He (Martin Feldstein) Changed Economics - Economic Principals
• Ben Stein Says Everything is Fine - Beat the Press Archive
• Ben Stein Watch: July 27, 2008 - Felix Salmon
• Worried Banks Sharply Reduce Business Loans - NYTimes.com
• Why I'm not a fan of Cass Sunstein - Kathy G
• The Myth of Summer Vacation - Robert Reich
• Former Employees of Google Prepare Rival Search Engine - NYTimes.com
• Thinking About the Dollar - Martin Feldstein

The Value of a Statistical Life is Not the Value of Life

This article by Seth Borenstein of the AP generated quite a bit of subsequent commentary:

An American life worth less today, by Seth Borenstein, AP: It's not just the American dollar that's losing value. A government agency has decided that an American life isn't worth what it used to be.

The "value of a statistical life" is $6.9 million in today's dollars, the Environmental Protection Agency reckoned in May — a drop of nearly $1 million from just five years ago. ...

Some environmentalists accuse the Bush administration of changing the value to avoid tougher rules — a charge the EPA denies. ...

Agency officials say they were just following what the science told them. ... EPA officials say the adjustment was ... based on better economic studies. ...

As noted below, the rest of the AP article does a decent job of explaining the reasons for the change in the value of a statistical life, but the headline "an American Life Worth Less Today," and the opening paragraph supporting that claim is what most people heard about in the follow-up coverage.

For example, the Colbert Report weighs in here. Most of the commentary that came after the AP article ran along the lines in the Colbert Report video, i.e. that the Bush administration has devalued life in an attempt to avoid costly regulation. I'm not known as a defender of the Bush administration, but I don't think this characterization is fair. Let me turn the microphone over to a colleague.

Trudy Cameron has been researching these issues for the past six years, has served on the Science Advisory Board for the US EPA for almost a decade (until just last year) -- first on the Environmental Economics Advisory Committee, then on the Advisory Council for Clean Air Compliance Analysis (the committee which monitors the EPA's in-house benefit-cost analysis of the Clean Air Act) and on the Executive Committee. She is also the current President of the Association of Environmental and Resource Economists (AERE), the main professional organization in the US for environmental economists, with about 800 members. Thus, she can speak with some authority and, after reading Borenstein article, she decided she would like to set the record straight. Here is a shorter, less technical, newspaper version of her response from an op-ed that appeared today:

‘Value of life’ figures help government measure risk, by Trudy Anne Cameron, Commentary, The Register-Guard: On July 11, The Register-Guard ran a front-page Associated Press article the lead paragraph of which trumpeted that, “A government agency has decided that an American life isn’t worth what it used to be.” The story and its headline could easily give readers the impression that government agencies assign monetary values to human life in an arbitrary, perhaps even amoral, fashion. This is not the case. ...

And here is a longer version with a bit more detail:

On July 11, on the front page, the Register-Guard ran an AP article by Seth Borenstein entitled “In the numbers game of life, we’re cheaper than we used to be.” The reporting on this issue was better than the misleading title, but there are a few points which should be clarified.

The “value of a ‘statistical’ life” is not the same thing as the “worth of a life.”

Summers and Poole on Fannie and Freddie

William Poole and Larry Summers discuss whether a bailout of Fannie and Freddie is needed, and what to do with Fannie and Freddie in the future.

Steve Waldman's Crude Thoughts

Steve Waldman:

Hello, by Interfluidity: Err... is this thing on? Am I back? I think I'm back. ...

The whole oil thing seems so, like, last month, although I notice there was some kind of deadhead revival in SoCal a couple of days ago. Some quick, crude thoughts: the whole "fundamental" vs "speculative" debate is terribly miscast, as emphasized most recently by Jeff Frankel (via Mark Thoma), but also by Tyler Cowen, and me too.

What I liked best about the Thoma / Krugman model is that it gave us four lines to think about, two kinds of demanders (people who want to burn oil vs people who want to store it) and two kinds of suppliers (people who suck oil from the ground vs people who drain their tanks). An imbalance of speculation on futures (more longs than shorts) creates incentives for people with tanks to fill them, potentially shoving up one of the two demand lines (the one on the left-hand panel of the Thoma/Krugman graphs). But four lines is a lot of moving parts. I think the really interesting line is the right-panel supply line. Rather than "speculation" vs "fundamentals", I wonder whether discretionary oil producers are flat-out producing as much as they are able, given the infrastructure currently in place, and whether over the past few years they have held back on developing capacity, or whether they are in fact eager to pump but hitting "peak oil" limits.

When Things Get Tough

The Whiny Republicans are now turning to their stock trade, dishonesty, particularly where the troops are concerned:

...[McCain is] willing to adopt pretty much any policy position and launch pretty much any dishonest attack on his opponent that he thinks will help him... If that means totally fictitious ads about Obama refusing to meet with soldiers, then fine. [via]

"Not The One" is showing how he reacts when the pressure is on - when things aren't going his way - and it's not the way I want to see a president respond to difficult situations. It reminds me of how the Bush administration reacts when it is having trouble selling its policies to the public.

When things get tough, the tough start whining and lying?

links for 2008-07-27

• Calculating the nation's inflation index is meticulous process - LA Times
• The economy: the problem - Workingman’s blues - Economist.com
• IMF Data Mapper - IMF
• Central bank independence and transparency: Not just cheap talk - Vox EU
• The Devastation of Iraq's Past - The New York Review of Books
• First Save Fannnie and Freddie, Then Destroy Them. - Op-Ed - NYTimes.com

Cash for Clunkers

What do you think about this proposal?:

A Modest Proposal: Eco-Friendly Stimulus, by Alan S. Blinder, Economic View, NY Times: Economists and members of Congress are now on the prowl for new ways to stimulate spending in our dreary economy. Here’s my humble suggestion: “Cash for Clunkers,” the best stimulus idea you’ve never heard of.

Cash for Clunkers is a generic name for a variety of programs under which the government buys up some of the oldest, most polluting vehicles and scraps them. If done successfully, it holds the promise of performing a remarkable public policy trifecta — stimulating the economy, improving the environment and reducing income inequality all at the same time. Here’s how.

Macroeconomic Models and Monetary Policy

Paul De Grauwe is critical of the macroeconomic models used by central banks:

Cherished myths fall victim to economic reality, by Paul De Grauwe, Commentary, Financial Times: ...But that is not the world of the macro­­economic models that are now in use in central banks. The world of these models is one of supernatural and God-like creatures for which the world has few secrets. These creatures can perfectly compute the risks they take and estimate with great precision how an oil price shock will affect their present and future production and consumption plans. They may not be able to predict each shock, but they know the probability distribution of these shocks. Thus the risk involved in financial instruments is correctly evaluated by individuals populating these models.

These superbly informed individuals want the central bank to keep prices stable so that as consumers they can optimally set their consumption plans with minimal uncertainty, and as producers they can set prices equal to marginal costs (plus a mark-up). If the central banks keep prices stable, these individuals, helped by well-functioning markets, will take care of all the rest and ensure that the outcome is the best possible one. This is a world in which free and unfettered markets are always efficient.

This is also a world where individual agents cannot make systematic mistakes. Their consumption and production plans are optimal. They will never build up unsustainable debts. In the world of these macroeconomic models financial crises should not occur. And if they do, it cannot be because of malfunctioning markets. Governments that impose silly constraints on rational individuals are messing things up, and central banks that do not keep their promises to maintain price stability are the source of macroeconomic instability. ...

There is a danger that the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.

There is quite a bit of research on monetary policy that is devoted to the issues he is worried about, particularly the literature on adaptive learning. See here, and some of his publications here for and example from a European central bank. These ideas are also well-known and of considerable interest to the US Fed, e.g. one example is here, but there are many more. Some of the recent work of Chris Sims is also of interest in this regard:

...Most recently, theories that postulate deviations from the assumption of rational, computationally unconstrained agents have drawn attention. One branch of such thinking is in the behavioral economics literature (Laibson, 1997; Benabou and Tirole, 2001; Gul and Pesendorfer, 2001, e.g.), another in the learning literature (Sargent, 1993; Evans and Honkapohja, 2001, e.g.), another in the robust control literature (Giannoni, 1999; Hansen and Sargent, 2001; Onatski and Stock, 1999, e.g.).

This paper suggests yet another direction for deviation from the seamless model, based on the idea that individual people have limited capacity for processing information. That people have limited information-processing capacity should not be controversial. It accords with ordinary experience, as do the basic ideas of the behavioral, learning, and robust control literatures. The limited information-processing capacity idea is particularly appealing, though, for two reasons. It accounts for a wide range of observations with a relatively simple single mechanism. And, by exploiting ideas from the engineering theory of coding, it arrives at predictions that do not depend on the details of how information is processed.

Returning to the article above criticizing macroeconomic models, the author goes on to explain why he thinks the reliance of central banks on macroeconomic models is a problem:

This intellectual framework helps to explain the single-minded focus of many central bankers on inflation. Clearly, inflation is important and maintaining price stability is an important task of the central bank. It is not the only task, though. Financial stability is equally important. But this dimension is completely absent from the macroeconomic models now in use.

Perhaps more attention to financial market instability is warranted, there's a lot of work on that currently underway, but as this overview of the learning literature makes clear, if you drop the rational expectations assumption and assume agents must learn about their economic environment (one means of generating financial market instability), it may still be that the an aggressive response to inflation is optimal:

Expectations, Learning and Monetary Policy: An Overview of Recent Research, by George W. Evans and Seppo Honkapohja, July 16, 2008: ...contemporaneous Taylor-type interest-rate rules should respond to the inflation rate more than one for one in order to ensure determinacy and stability under learning...

So central banks' focus on inflation comes solely from examination of standard macroeconomic models.

The point is that, unlike the implication in the article, central banks are quite anxious to explore the implications of agents that are less than fully informed or fully rational, how that impacts behaviors such as risk assessment, and to examine the implications of financial market instability. They are particularly interested in how these factors impact the conduct of stabilization policy. The models aren't perfect, and standard models do miss a lot of these elements, but standard models are not all we have and central bankers are quite aware of, and actively engaged in exploring the policy implications of alternative theoretical structures that can tell us more about these issues.

links for 2008-07-26

• We knew the web was big... - Official Google Blog
• My Experience at Indy Mac: Fraud, Corruption, Criminality - The Big Picture
• More Reflections on the Tax Duel - Economists for Obama
• How Free Trade Can Help Solve the Energy Crisis - WSJ.com
• What's really killing the land-line telephone business - Daniel Gross
• Global sourcing: Evidence from French firms - Vox EU
• How can we end poverty? The determinants of development - Vox EU
• Educational inequality persistence - Vox EU

"Housing Supply and Housing Bubbles"

Edward Glaeser, Joseph Gyourko, and Albert Saiz construct a model of housing bubbles that is consistent with movements in housing prices and quantities during the two most recent housing bubbles (the current episode and the prior episode in the 1980s). Looking at the data, they note that areas with inelastic housing supply had large price run-ups and subsequent long, drawn out crashes in both episodes. However, "The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion." Because it is unprecedented, there is considerable uncertainty about how much prices might fall in the areas where supply is elastic. However, using the model as a guide, they find that "If these markets return to their historical norm..., then they will experience further sharp price declines," though there is a lot of uncertainty surrounding this prediction.

Maybe another way to think about this is that in some areas, those areas where supply is termed inelastic, the quantity response is essentially symmetric -- housing supply moves sluggishly whether prices are rising or falling. However, other areas could have housing supply that responds elastically when prices are rising (though sometimes there can be bubbles in these markets anyway - see below), but inelastically when prices are falling. In these markets, housing comes online relatively easily when prices are rising, but quantity responds much more sluggishly when prices fall, and the response could be similar to the symmetrically inelastic cases.

Why might the two sets of markets have similar responses on the down-side? Think about the inelastic markets where supply cannot increase due to geographic limitations (they use a geographic measure to sort the data). Geography limits the expansion of housing, but when there is an oversupply of housing, geography does not prevent the supply from falling, so it must be something else that prevents quantity adjustment and whatever it is could certainly be present in markets where geography is not an issue  (i.e. the markets that are elastic when prices rise). If this is right, then there's reason to believe that the two sets of markets will generate similar responses for price and quantity on the down-side, and this would explain the finding in the paper that "elasticity was uncorrelated with either price or quantity changes during the bust" (so long as other factors such as regulation are similar, e.g., it's equally easy to replace a house with a restaurant after remodeling in the two markets). This would mean that - as predicted (with qualifications) in the paper - the elastic markets may mimic the inelastic markets and be in for a sharp price decline.

One more note from the paper about elastic markets, "Even though elastic housing supply mutes the price impacts of housing bubbles, the social welfare losses of housing bubbles may be higher in more elastic areas, since there will be more overbuilding during the bubble." Thus, it's possible for markets with sharp price adjustments to fare better in a welfare sense than markets where price changes are more muted. Here's some of the introduction from the paper [can anyone find an open link?] [Update: Richard Green: Mark Thoma thinks housing supply elasticities may be asymmetric ... I have reason to think Mark is right. My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.]:

Housing Supply and Housing Bubbles, by Edward L. Glaeser, Joseph Gyourko, and Albert Saiz, NBER WP 14193, July 2008: Introduction In the 25 years since Shiller (1981) documented that swings in stock prices were extremely high relative to changes in dividends, a growing body of papers has suggested that asset price movements reflect irrational exuberance as well as fundamentals (DeLong et al., 1990; Barberis et al., 2001). A running theme of these papers is that high transactions costs and limits on short-selling make it more likely that prices will diverge from fundamentals. In housing markets, transactions costs are higher and short-selling is more difficult than in almost any other asset market (e.g., Linneman, 1986; Wallace and Meese, 1994; Rosenthal, 1989). Thus, we should not be surprised that the predictability of housing price changes (Case and Shiller, 1989) and seemingly large deviations between housing prices and fundamentals create few opportunities for arbitrage.

The extraordinary nature of the recent boom in housing markets has piqued interest in this issue, with some claiming there was a bubble (e.g., Shiller, 2005). While nonlinearities in the discounting of rents could lead prices to respond sharply to changes in interest rates in particular in certain markets (Himmelberg et al., 2005), it remains difficult to explain the large changes in housing prices over time with changes in incomes, amenities or interest rates (Glaeser and Gyourko, 2006). It certainly is hard to know whether house prices in 1996 were too low or whether values in 2005 were too high, but it is harder still to explain the rapid rise and fall of housing prices with a purely rational model.

However, the asset pricing literature long ago showed how difficult it is to confirm the presence of a bubble (e.g., Flood and Hodrick, 1990). Our focus here is not on developing such a test, but on examining the nature of bubbles, should they exist, in housing markets.

"Oil Prices and Economic Fundamentals"

Jim Hamilton looks at the question of whether changes in oil prices have been driven by fundamentals:

Oil prices and economic fundamentals, by Jim Hamilton: Oil was selling for $123 a barrel on May 7, and that's where it closed this week. Sounds like a calm and rational market, except for the fact that just last week it was going for $145. ...

Which price was right, $123, $145, or something else? Before you let anybody give you an answer to that question, try to get them to comment first on the following two facts. (1) According to the Energy Information Administration, China consumed 7.6 million barrels of petroleum each day of 2007, which is 860,000 barrels/day more than in 2005. (2) EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005. ...

Now, how could it be that China is burning 860,000 b/d more than it used to, but no more is being produced? Well, it could be that there are errors in the consumption or production numbers, and both will likely be revised. Or it could be that we're drawing down global inventories. But the most natural inference is that somebody else in the world must have been persuaded to reduce their consumption of oil between 2005 and 2007 to free the barrels now being used in China. And indeed, according to preliminary EIA estimates, petroleum consumption in the U.S., Japan, and those countries in Europe for which data are now available fell by 760,000 b/d between 2005 and 2007.

Here's the framework I would propose for answering the question of how much the price of oil should have risen since 2005-- the price of oil needed to go up by whatever it took to persuade places like the U.S., Europe, and Japan to reduce their consumption by the amount that China, the newly industrialized countries, and oil-producing countries were increasing theirs.

And how big a price increase would that be, exactly? Somebody who claims to know that would need to have more confidence in their estimate of the price-elasticity of oil demand than I have in mine. But if your answer is that a much smaller price increase than the one we observed would have been sufficient to produce the requisite decline in quantity demanded, that would seem to imply that, since price went up by much more than you believe was needed to reduce demand, the quantity demanded must have fallen by much more than was called for. One place that might have been expected to show up is in the form of an accumulation of inventories. The black line in the figure below shows the average seasonal behavior of U.S. crude oil inventories. The red line demonstrates that current inventories are if anything below normal. On what basis, then, could one insist that the quantity of oil consumed has fallen more than was necessary?

OK, suppose you believed that the price increase we actually saw-- from $42/barrel in January 2005 to $96 in December 2007-- was just the right amount to accomplish the task of balancing global demand and supply for 2007. Should the price have held steady from there in 2008? Figures reported by Rigzone imply that China imported an additional 8.97 million tons of crude and 2.96 million tons of refined product in the first half of 2008 compared with 2007:H1, which converts to a 480,000 barrel/day increase. Where's that supposed to come from? A U.S. recession, which many of us were anticipating in January, certainly would have brought demand down. But current U.S. GDP growth is likely to come in higher than many of us had predicted earlier, meaning if you gave one answer for the correct price of oil in January, you should be giving a higher value for that number today. On the other hand, the data coming in the last two weeks have raised the probability of a recession in Europe. If that occurs, it will bring a reduction in the quantity demanded from those areas even if the price begins to fall. Whatever the correct price of oil was two weeks ago, I think it's a lower value today.

What about the delayed response of quantity demanded to the price increases already in place? If that proves to be substantial (and I'm of the opinion that it will), U.S. petroleum consumption should continue to decline during 2008 even with no further price increases and no recession. There's also been some increase in global production this year, and more is expected. Won't that be enough to satisfy those new and thirsty Chinese vehicles? If so, $123/barrel may be way too high a price.

But don't forget, while you're doing these calculations, you'll need to meet Chinese demand for 2009, and 2010, and 2011.... Which, if you project the current trend and tried to satisfy entirely by cuts in U.S. consumption, would have us down to consuming zero barrels of oil in the United States in about 17 years.

Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.

In that case, I'm glad my last comment on this topic was "I'm absolutely certain I could be wrong."

Are Inflation Expectations Becoming Unglued?

This Economic Letter argues the Fed has not lost credibility as an inflation fighter. The idea is to estimate a model of expectations through 2003 or 2005, i.e. to just use data where credibility is still present, forecast inflation expectations through the end of the sample, and compare the forecast of inflation expectation to the actual value of inflation expectations (from surveys). If expectations are losing their anchor, then the predicted expected inflation rate should lie below the the actual expected inflation rate since the predicted rate will be based only upon data that came before the potential loss of credibility. I'm not sure how much weight to give this evidence since I have questions about the adequacy of the adaptive expectations model used to forecast future inflation expectations, which the authors argue is forced upon them by limited data availability:

Unanchored Expectations? Interpreting the Evidence from Inflation Surveys, by Wayne Huang and Bharat Trehan, FRBSF Economic Letter: Recent surveys have shown that households are expecting higher inflation in the future. These readings, coming at the same time as surging commodity prices, have raised concerns that inflation expectations are no longer well-anchored and that the Fed has lost credibility. Unstable expectations could stoke higher inflation and possibly lead to a return to the stagflation of the 1970s.

In this Economic Letter, we argue that focusing only on whether the level of expected inflation has gone up may not be the best strategy for determining whether there has been a loss in credibility. Instead, it may be more useful to try to determine whether there has been a change in the way households and firms perceive the inflation process (and consequently form expectations about inflation). We use two surveys of inflation expectations, one based on household respondents, and the other on professional forecasters, to examine this issue. In neither case do we find evidence suggesting that expectations have recently become unanchored, even though consumer expectations of inflation have clearly gone up.

Speculation and Commodity Prices

Ah, good - I've been meaning to do something like this myself, but never got around to it. Jeff Frankel sorts speculation into three types and notes that only one of the three types, "bandwagon behavior," is worrisome. However, there's little evidence that this type of speculation is present in commodities markets:

Commodity Prices, Again: Are Speculators to Blame, by Jeff Frankel: ...Many currently are trying to blame speculators for the high prices of oil and other mineral and agricultural products. Is it their fault?

Sure, speculators are important in the commodities markets, more so than they used to be. The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases. Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode. Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them. One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them. Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices. First, there is the “bearer of bad tidings”... The news that, in the future, increased demand will drive prices up is delivered by the speculator. Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand. Without him, the subsequent price rise would be even greater, because supply would be less. But it does not appear that speculators played this role in the commodity boom that started earlier this decade: as already mentioned they, if anything, lagged behind the spot price.

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price. This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some case, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends and self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium. Examples of previous bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior or speculative bubbles) about which politicians, pundits, and the public tends to worry. There is little evidence that this has played a role in the run-up of commodity prices. So far, that is. Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase. The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively: rising US real interest rates, 1980-84; easy money and rapid growth in Japan, 1987-89; US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001). It could happen yet in commodity markets.

Smart Cost Sharing

Robert Waldmann is thinking about how to give insurance companies a long-term stake in the health of their clients. This is an example of the type of policy I had in mind when I said:

...preventative care ... ought to be encouraged, and one way to help with this is ... to forge an unbreakable lifetime relationship between the insurance company and the consumer so that expected lifetime costs are important to the insurance carrier.

Here's Robert Waldmann's plan:

Smart cost sharing, by Robert Waldmann: Ezra Klein writes about smart cost sharing. He wants a committee to decide reimbursement rates.

Oddly, I had another idea about smart cost sharing. Make the doctors pay for the care and pay the doctors based on outcomes. This is based on a Cutler et al result that very small financial incentives to doctors based on their patients' blood pressure, glucose and cholesterol can cause big changes in those outcomes.

Does HUD Need to Be Razed and Rebuilt?

For the urban and regional economics experts - is this argument correct? Does urban development policy as administered through HUD need major restructuring? If so, can HUD be reformed, or would it be best to, as suggested below, eliminate HUD and start over?:

To Fight Poverty, Tear Down HUD, by Sudhir Venkatesh, Commentary, NY Times: ...It might be best to simply close the [Department of Housing and Urban Development] and create a new cabinet-level commitment to urban development.

In 1965, when HUD was created, its mission was to spur growth in and around cities. The agency provided mortgage assistance to veterans and first-time homeowners, it built housing for the urban poor, and the Federal Housing Administration spurred suburban expansion by recruiting developers and home buyers to a relatively new, untested market.

Since its inception, HUD has had a fairly straightforward recipe: develop good relations with mayors and local real estate leaders, then award grants and underwrite loans that affirm local development priorities. ...

But in the last four decades the urban landscape has changed from discrete, independent cities to vast, interdependent regions where people and goods move freely..., cities have no choice but to collaborate on decisions over land use and economic development. ... And for the first time in our nation’s history, poverty is rising faster in suburbs than in urban cores. In this new era, HUD’s each-city-is-a-separate-whole approach is not only too inflexible and short-sighted, it also hinders effective regional growth.

To see why, consider HUD’s most prominent urban development program: Housing Opportunities for People Everywhere (VI). ...

How could a program aimed at curbing inequality and helping the poor end up creating new pockets of poverty? The answer lies partly in HUD’s myopic focus on gentrifying urban cores. The agency ignored studies showing that former project residents would have difficulty finding rental housing in outlying neighborhoods and did not provide assistance for inner-ring suburbs with high rates of foreclosures. HUD resisted calls to slow down housing demolition and to move the poor to areas of high job growth.

By making no effort to ascertain needs and resources on a regional scale, HUD has ended up eliminating poverty in one place while creating distressed, low-income communities in others. If HUD had developed a broader vision, one that tied together inner city and suburb, it could have created policies to help both areas adjust to the modern urban landscape.

In correcting HUD’s missteps, we must first separate “housing policy” from “urban development.” ...

Then, the development needs of our nation’s regions — wide areas like the Northeast corridor or Southern California — could be considered anew. Block grants could provide incentives for municipal and county governments to collaborate. Regionalism must be embraced, even if it tests local officials who fear losing their traditional sources of government financing. ...

Americans live ... spread out, and economic activity is no longer limited to downtowns. Community-based initiatives — from vocational programs to rezoning efforts to designing effective transportation corridors and recreational space — are sorely needed but will be effective only if they tie into a broader vision that anticipates growth on a large scale.

Even our most persistent problems of inequality will require new strategies. A federal agency devoted to regional planning could help the Health and Human Services Department reconfigure anti-poverty programs to aid suburban communities that have so far gone unnoticed but are desperately in need. It could motivate the Labor Department to develop training programs and support the transportation needs of workers.

We need an agency that can work outside old boundaries and design a regional approach to revitalizing cities and suburbs. Dismantling HUD would be a great place to start.

Update: Richard Florida says "He's absolutely right."
Update: Ryan Avent   says "HUD’s mission should be changed, [but] blowing it up probably isn’t necessary."

links for 2008-07-25

• The Other Home Equity Crisis - Judith Warner
• Study: No gender differences in math performance - EurekAlert
• Globalized Banking Blunts Monetary Policy - Real Time Economics
• Should trade multilateralists fear regionalism? - Vox EU
• Firm Said to Manipulate Oil Market - NYTimes.com
• Unobserved Country Heterogeneity: GDP Levels or Growth Rates - Angry Bear
• World must look to Europe as capitalisms clash - FT.com
• It is time to embrace freer trade with China - FT.com
• A World that Stands as One - Barack Obama
• Systemic Risk and Financial Markets - Federal Reserve Bank of New York
• Technology, Not Globalization, Feeds Income Inequality - Real Time Economics
• How Anecdotal Evidence Can Undermine Scientific Results - Scientific American
• Why do Foreigners Invest in the United States? - NBER Digest
• Do economists need brains? - Economist.com

Making Fannie and Freddie Pay for Their Free Lunch

Joseph Stiglitz says just say no to free lunches:

Fannie’s and Freddie’s free lunch, by Joseph Stiglitz, Commentary, Financial Times: ...The US government is about to embark on ... a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bail-out of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.

Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system.

Even if they are too big to fail, they are not too big to be reorganised ...[to] meet the basic tenets of what should constitute such a publicly sponsored scheme.

First, it should be fully transparent, with taxpayers knowing the risks they have assumed...

Second, there should be full accountability. Those who are responsible for the mistakes – management, shareholders and bondholders – should all bear the consequences. Taxpayers should not be asked to pony up a penny while shareholders are being protected.

Finally, taxpayers should be compensated for the risks they face. ...

All of these principles were violated in the Bear Stearns bail-out. ... The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bail-out, is now asking the American people to write a blank cheque. They say: “Trust us.” Yes, we can trust the administration – to give the taxpayers another raw deal.

Something has to be done; on that everyone is agreed. We should begin with the core of the problem, the fact that millions of Americans were made loans beyond their ability to pay. We need to help them stay in their homes.... This will bring clarity to the capital markets – reducing uncertainty about the size of the hole in Fannie Mae’s and Freddie Mac’s balance sheets. ...

We should not be worried about shareholders losing their investments. In earlier years, they were amply rewarded. The management remuneration packages that they approved were designed to encourage excessive risk-taking. They got what they asked for. Nor should we be worried about creditors losing their money. Their lack of supervision fuelled the housing bubble and we are now all paying the price. We should worry about whether there is a supply of liquidity to the housing market, so that those who wish to buy a home can get a loan. This proposal provides the necessary liquidity.

A basic law of economics holds that there is no such thing as a free lunch. Those in the financial market have had a sumptuous feast and the administration is now asking the taxpayer to pick up a part of the tab. We should simply say No. [...much more here...]

"Why Large American Gains from Globalisation are Plausible"

[This spends some time setting the stage by repeating past posts, if you want to skip to the new part - a defense of the gains from globalization from Gary Hufbauer and Matthew Adler of the Peterson Institute - click here.]

Awhile back, I issued a challenge:

In a recent speech, Federal Reserve Chairman Ben Bernanke said:

How important is [international trade] for the health of our economy to trade actively with other countries? As best we can measure, it is critically important. According to one recent study that used four approaches to measuring the gains from trade, the increase in trade since World War II has boosted U.S. annual incomes on the order of $10,000 per household (Bradford, Grieco, and Hufbauer, 2006). The same study found that removing all remaining barriers to trade would raise U.S. incomes anywhere from $4,000 to $12,000 per household. Other research has found similar results. ...

...You can read Dani Rodrik if you want to know "under what conditions will trade liberalization enhance economic performance?" ... Whatever the theory says, the evidence in this paper and the evidence more generally is pretty clear, globalization has large net benefits.

If you want to have this debate, fine, let's have it. But let's engage on a professional level... If you disagree that trade benefits the US overall, what are the problems with the econometric methodology used to produce these results or the results in other papers coming to similar conclusions? Saying the results must be wrong because they don't support your point is not an argument. What specifically in the data, estimation procedures, etc., do you think is problematic and leads to the wrong result? Are there other notable academic papers that come to different conclusions? If so, what is the source of the difference in the estimates? Is it the data, the estimation technique, the theoretical assumptions, or what? Help us to understand why we should be doubtful about the results Bernanke cited, or about the results of other papers reaching similar conclusions.

If you dig into a paper, you can always find its weaknesses. And it's important to do so because finding such weaknesses allows us to check to see if correcting the problems alters the conclusions. So please, have at it, take an honest look at the evidence and tell us why we should doubt this papers conclusions or the conclusion that trade is beneficial more generally, and help us to move things forward in our attempts to find the correct answers to these important problems. My own view is that the results from the papers in this area are very clear - trade is highly beneficial overall and it's the distribution of benefits and costs across individuals that's at issue - but I'm very open to well constructed arguments to the contrary....

Dani Rodrik took up the challenge:

[He] responds...:

The globalization numbers game, by Dani Rodrik: ...Mark Thoma's post, which focuses on the magnitude of the gains from globalization. He says "there's something important that's generally missing from the attacks on globalization's supporters, actual evidence." He refers to a Bernanke speech and at length to a paper which Bernanke cites by Bradford, Grieco, and Hufbauer... The Bradford et al. study argues that removing all remaining barriers to trade would raise U.S. incomes anywhere from $4,000 to $12,000 per household (or 3.4-10.1% of GDP). That is a whole chunk of change! ...

As Thoma says, we cannot dismiss "evidence" just because we disagree with it. ...[W]hile I would not quarrel with the assertion that globalization increases the size of the pie for the U.S., I do have a big quarrel with the kind of numbers presented by Hufbauer and company. They seem to me to be grossly inflated. Let me take up Thoma's challenge and explain why.

Wanted: A New Consensus on Globalization

Dani Rodrik argues that the survival of globalization will require a " new intellectual consensus to underpin it":

The Death of the Globalization Consensus, by Dani Rodrik, Project Syndicate: The world economy has seen globalization collapse once already. The gold standard era – with its free capital mobility and open trade – came to an abrupt end in 1914 and could not be resuscitated after World War I. Are we about to witness a similar global economic breakdown?

The question is not fanciful. ... Unlike national markets, which tend to be supported by domestic regulatory and political institutions, ...[t]here is no global anti-trust authority, no global lender of last resort, no global regulator, no global safety nets, and, of course, no global democracy. In other words, global markets suffer from weak governance, and therefore from weak popular legitimacy.

Recent events have heightened the urgency with which these issues are discussed. The presidential ... campaign ... has highlighted the frailty of the support for open trade... The sub-prime mortgage crisis has shown how lack of international coordination and regulation can exacerbate the inherent fragility of financial markets. The rise in food prices has exposed the downside of economic interdependence... Meanwhile, rising oil prices have increased transport costs, leading analysts to wonder whether the outsourcing era is coming to an end. ...

So if globalization is in danger, who are its real enemies? There was a time when global elites could comfort themselves with the thought that opposition to the world trading regime consisted of violent anarchists, self-serving protectionists, trade unionists, and ignorant, if idealistic youth. Meanwhile, they regarded themselves as the true progressives, because they understood that ... advancing globalization was the best remedy against poverty and insecurity.

But that self-assured attitude has all but disappeared, replaced by doubts, questions, and skepticism. Gone also are the violent street protests and mass movements against globalization. What makes news nowadays is the growing list of mainstream economists who are questioning globalization’s supposedly unmitigated virtues.

So we have Paul Samuelson ... reminding his fellow economists that China’s gains in globalization may well come at the expense of the US; Paul Krugman ... arguing that trade with low-income countries is no longer too small to have an effect on inequality; Alan Blinder ... worrying that international outsourcing will cause unprecedented dislocations for the US labor force; ... and Larry Summers, ... the Clinton administration’s “Mr. Globalization,” musing about the dangers of a race to the bottom in national regulations and the need for international labor standards.

While these worries hardly amount to the full frontal attack mounted by the likes of Joseph Stiglitz ... they still constitute a remarkable turnaround in the intellectual climate. ...

None of these intellectuals is against globalization, of course. What they want is not to turn back globalization, but to create new institutions and compensation mechanisms – at home or internationally – that will render globalization more effective, fairer, and more sustainable. ...

[C]onfrontation over globalization has clearly moved well beyond the streets... That is an important point for globalization’s cheerleaders to understand, as they often behave as if the “other side” still consists of protectionists and anarchists. Today, the question is no longer, “Are you for or against globalization?” The question is, “What should the rules of globalization be?” ...

The first three decades after 1945 were governed by the Bretton Woods consensus – a shallow multilateralism that permitted policymakers to focus on domestic social and employment needs while enabling global trade to recover and flourish. This regime was superseded in the 1980’s and 1990’s by an agenda of deeper liberalization and economic integration.

That model, we have learned, is unsustainable. If globalization is to survive, it will need a new intellectual consensus to underpin it. The world economy desperately awaits its new Keynes.

links for 2008-07-24

• Robert Samuelson Thinks the Economy is Doing Just Great - pgl
• Dispute Over the Economics of File Sharing Intensifies - Chronicle.com
• The Federal Reserve’s Term Auction Facility - FRBNY
• Beige Book: Isolated Bright Spots May Be Dimming - Real Time Economics
• Fed Report Portrays Stressed Economy - washingtonpost.com
• How Medicare Payments Discourage Doctor-Patient - Op-Ed - NYTimes.com
• A global agency is needed for the energy crisis - FT
• Where Are The Arctic's Big Oil and Gas Deposits? - Arctic Economics
• Northwest Passage Transits - Arctic Economics
• Doubts rise over economics of ecological city - China Daily
• Report from the Duel of Economic Advisors - Economists for Obama

Why Is Airline Service So Bad?

Chris Hayes wants to know why air travel is so lousy. A source inside the industry responds:

Why Airline Travel Sux: Big Air Responds!, by Christopher Hayes: So I’ve been on a bit of a jag about how awful flying is. I’ve flown four of the last eight weeks and every single return trip has had some very significant problems: three cancellations and one flight delayed long enough we would have missed our connection. What gives?

Megan McArdle made some good points on the general topic of complaints about air travel, which Matt added to here.

I decided to email my super secret source inside a major air carrier, and I’m pasting in his response below, which I found pretty fascinating. The subject of my email to him was “Why does flying suck so hard?” His response:

Actually, people have been asking me this question for the entirety of the ten years I have worked in this business. I think the best thing I can do is to basically give you the answer I gave ten years ago, and then take you through the ways in which that answer has changed (or, really, gained additional layers and nuance) as 1) the tech bubble burst, 2) 911 and aftermath 3) the current fuel crisis happened. First off, flying today *doesn't* suck so hard. There, I said it. Flying today, however, is often racked with numerous small frustrations and irritations, and on occasion is a complete pain in the ass. What is the difference?

"Tough Times Prompt Patients to Skip Care"

An indication of how people respond to paying more for health care:

Tough Times Prompt Patients to Skip Care, by Benjamin Brewer, WSJ: With gas prices hovering around $4 a gallon, my patients are cutting back on medical care.

A 59-year-old woman decided not to have a mammogram this year. At her age, she should be screened for colon cancer, too, but she is holding off until she becomes eligible for Medicare at 65. ... If she develops cancer of the colon or breast she won't have saved anything. ...

Rising deductibles, stiff drug co-payments and increasing prices for just about everything are forcing some hard choices about health. Care that doesn't strike patients as critical is getting delayed. As the economy squeezes my patients, they are showing up sicker.

A patient ... came to the office with severe pneumonia two days after refusing to let an E.R. doctor admit him to the hospital. My patient was afraid of the expense and all the time he would go without pay from work.

To make matters worse, he didn't fill the antibiotic prescription he was given either. The $50 co-payment was unaffordable, he said. This is a case when an insurer would have been better off picking up the antibiotic tab to avoid a larger expense. But there's no easy way for a doctor to override a plan's co-pay or to let an insurer know its rules are about to make something very expensive happen.

When the patient came to see me, his condition had deteriorated. I persuaded him to let me admit him to the local hospital. He was in such bad shape that he was soon transferred to the ICU of a large medical center. His care will end up costing tens of thousands of dollars.

It was no surprise to me to read recently that claims severity and costs for health insurers took an unexpected jump this year. ...

As a result of lean times, accounts receivable from uninsured patients in my practice is trending up...

Patients are still having babies at the same rate. But elective procedures, preventive exams and compliance with prescriptions are all down.

Some of my patients are taking themselves off medications. Just last week I encountered patients who stopped their cholesterol medication...

I noticed an uptick in patients canceling appointments and just not showing up over the last few weeks. ...

Many of our patients travel 20 or 30 miles to see us, and I think gas prices are affecting no-show and cancellation rates, particularly with low income patients.

My total number of office visits is off 5% from last year. ... I'm pretty well caught up on my daily deluge of paperwork... When things are busy, I almost never get those things accomplished.

It occurred to me in an idle moment that I would be a lot busier if the $600 government stimulus checks had been spent on a basket of basic primary care services. That would have paid for 130 million people to have had most of their health needs met for a year. Instead, folks around here seem to be spending more on $4 gas.

I think universal insurance offers the best solution to the problem of people skipping preventative measures to save themselves money in the short-run (provided, of course that the insurance covers preventative measures that are cost effective in the long-run). If people are uninsured, or are insured but must pay for preventative measures out-of-pocket, they tend to skip these important cost-saving measures. Perhaps it's due to a type of moral hazard - people believing that society will step in and provide care for life-threatening but curable illnesses - I don't know, it could be some sort of myopia, some other market failure, or an inconsistency in preferences. And insurance companies have no incentive to provide this care if they can disqualify people when they do become sick and shift the costs to the public sector, so the problem isn't necessarily on the consumer side. But whatever the cause, the solution to the health care problem should not induce people to forgo preventative care. Instead, such care ought to be encouraged, and one way to help with this is use universal insurance to forge an unbreakable lifetime relationship between the insurance company and the consumer so that expected lifetime costs are important to the insurance carrier.

Sachs: Where are the Global Leaders?

Jeffrey Sachs urges leaders to recognize that "working with the UN agencies is in fact the only way to solve global problems":

Where are the global leaders?, by Jeffrey Sachs, Commentary, Project Syndicate: The G8 Summit in Japan earlier this month was a painful demonstration of the pitiful state of global cooperation.

The world is in deepening crisis. Food prices are soaring. Oil prices are at historic highs. The leading economies are entering a recession. Climate change negotiations are going around in circles. Aid to the poorest countries is stagnant, despite years of promised increases. And yet in this gathering storm it was hard to find a single real accomplishment by the world's leaders. The world needs global solutions for global problems, but the G8 leaders clearly cannot provide them. Because virtually all of the political leaders that went to the summit are deeply unpopular at home, few offer any global leadership. They are weak individually, and even weaker when they get together and display to the world their inability to mobilize real action.

There are four deep problems.

Reich: McCainomics Versus Obamanomics

Robert Reich characterizes differences in the economic philosophies of Obama and McCain:

A Short Primer on McCainomics Versus Obamanomics: Top-Down or Bottom-Up, by Robert Reich: McCain and Obama represent two fundamentally different economic philosophies. McCain's is top-down economics; Obama's is bottom-up.

Top-down economics holds that:

"Immigration and National Wages: Clarifying the Theory and the Empirics"

Gianmarco I.P. Ottaviano and Giovanni Peri on immigration and wages:

Immigration and National Wages: Clarifying the Theory and the Empirics, Gianmarco I.P. Ottaviano, Giovanni Peri. NBER WP No. 14188,
Issued in July 2008 [open link]: Abstract This paper estimates the effects of immigration on wages of native workers at the national U.S. level. Following Borjas (2003) we focus on national labor markets for workers of different skills and we enrich his methodology and refine previous estimates. We emphasize that a production function framework is needed to combine workers of different skills in order to evaluate the competition as well as cross-skill complementary effects of immigrants on wages. We also emphasize the importance (and estimate the value) of the elasticity of substitution between workers with at most a high school degree and those without one. Since the two groups turn out to be close substitutes, this strongly dilutes the effects of competition between immigrants and workers with no degree. We then estimate the substitutability between natives and immigrants and we find a small but significant degree of imperfect substitution which further decreases the competitive effect of immigrants. Finally, we account for the short run and long run adjustment of capital in response to immigration. Using our estimates and Census data we find that immigration (1990-2006) had small negative effects in the short run on native workers with no high school degree (-0.7%) and on average wages (-0.4%) while it had small positive effects on native workers with no high school degree (+0.3%) and on average native wages (+0.6%) in the long run. These results are perfectly in line with the estimated aggregate elasticities in the labor literature since Katz and Murphy (1992). We also find a wage effect of new immigrants on previous immigrants in the order of negative 6%.

Moral Hazard Misconception

In this debate:

Moral hazard misconception, Economist's Forum

I (mostly) side with Ricardo Caballero, as summarized here.

links for 2008-07-23

• The strange economics of landfill management - Environmental Economics
• Will Offshore Drilling Lower Gasoline Prices to Two Dollars a Gallon? - pgl
• Usury Bill - Credit Slips
• Fed Satisfied With Performance of TAF - Real Time Economics
• Discount Minutes Indicate Torn Fed - WSJ.com
• How not to fact-check political ads - Brendan Nyhan
• Not so lost in translation - The Washington Monthly
• A Natural Selection - Olivia Judson
• Satellites With Solar Panels - Op-Ed - NYTimes.com
• Will the dollar lose its throne? Fundamentals vs network effects - Vox EU
• World Bank Criticized on Environmental Efforts - NYTimes.com

Why Tyler Cowen is "Not So Crazy about HSAs"

Tyler Cowen:

Health savings accounts, Marginal Revolution: A few readers have written me or asked in the comments why I am not so crazy about HSAs.  From the past, read here and here, and here, or here is an index of previous MR posts on the topic; in any case my take is relatively straightforward:

1. I favor tax-free savings (albeit with some fiscal qualifications), so you can make a case for HSAs on this ground, noting that we do already have other tax-free savings vehicles.

2. HSAs take one market segment -- usually a relatively wealthy and health care-satisfied segment -- and introduce one marginal improvement of incentives.  This doesn't seem to help much in terms of lowering aggregate costs.

3. HSAs introduce greater care into any single medical expenditure by creating a direct private opportunity cost for the spender.  I am less sure it will limit medical expenditures in general; that depends on how people frame withdrawals, once funds are committed to an HSA account, and to what extent they use HSAs for what would have been cash payments anyway.

4. As Paul Krugman says, "too much health insurance" is not the fundamental problem in the health care market.  (Unlike Krugman, I don't see single-payer plans as the solution; I see the incentives of producers, combined with the fear and unreasonableness of buyers, as the key problem on the cost side.)

5. Re Bryan Caplan on Singapore, HSAs might work much better in another setting, noting that the other features of Singapore also might account the difference in performance in health care systems. 

6. Given #1 and #2, it is easy for me to believe that HSAs bring net social benefit.  It is much harder for me to see HSAs as "the one health care idea we would promote if we had one shot at health care reform."  The main beneficiaries are the healthy and the wealthy, and, while I am all for helping those people, surely that is odd, no?

7. I will profess my agnosticism on many health care policy issues, but one of the better plans is Jason Furman's and/or spending more on medical R&D and some public health programs and lots of cost-lowering deregulation while in the meantime getting expenditures and costs under control.  I also recommend Arnold Kling's work.

Infrastructure Spending and Stabilization Policy

Megan McArdle:

Infrastructure is so . . . stimulating, Megan McArdle: Mark Thoma wants us to look at spending for stimulus, instead of tax cuts:

I agree that Fed policy alone may not be enough to get the economy back on track, I've argued that for a long time. But tax cuts are not the only option for stimulating the economy, government spending can also be used, and in theory on short-run stabilization policy, a one dollar increase in government spending has a bigger impact on GDP than a one dollar tax cut. Infrastructure is an obvious target for spending, it's surely needed, but there are other areas that could use help as well.

The idea that we should use emergency infrastructure spending as a stimulus is gaining strength among liberals. ... I can certainly vouch for the fact that many areas of American infrastructure are in dire need of improvement.

However, ... I regret to report that the idea of using infrastructure spending as a stimulus is a complete fantasy. This is not your grandfather's stimulus spending. FDR could spend whacking great sums on dams and roads and rural electrification, and hope to have an immediate effect, because FDR was working on a multi-year depression, and in the pre-1960s regulatory environment.

Between the environmental impact statements, public review periods, and byzantine bidding process, the development cycle for anything more complicated than painting a bus station is now measured in decades, not years. ...

The reason we rely mostly on monetary policy and tax cuts for stimulus is that it is possible to rapidly implement whatever stimulus you decide on.  With the exception of a few transfer programs such as food stamps and unemployment insurance, which are hard to funnel very large sums of money through, there is nothing on the spending side that matches tax cuts for speed.  You could allocate the money, to be sure, but by the time it actually hit an agency and went through the bureaucratic procedures necessary to actually spend it, the window for effective stimulus would have passed.

We could improve matters by ripping out all of the procedural hurdles and community review procedures we've forced on the government, and in my opinion, that wouldn't be a bad thing.  But in my opinion, this is[n't] ... likely to be achieved...

The other thing we might consider is just not having the stimulus. It seems to me that both monetary and fiscal stimulus at this point are trying to attack supply shocks by goosing demand. America is going to have to get used to consuming less oil and less cheap foreign credit some time, and maybe the best way to do that is to let the shocks work their way through the system.

While I was thinking over a response, Free Exchange covered most of the points I wanted to make:

An Infrastructure Stimulus, Free Exchange: Mark Thoma writes ... [and] Megan McArdle responds...

One initial point is that if this slump is anything like the last one (and it probably is), then America can probably look forward to at least another year of the doldrums before regular growth conditions return. That takes a little of the need for immediacy out of the stimulus calculations.

I'd just add that if you go by the last two recessions, the recovery of employment has lagged behind the recovery in output, and may not have fully recovered at all, so from that perspective, the slowdown could be even more extended. This gives more weight to policies that have impacts over a longer time period. Back to Free Exchange:

But Ms McArdle is still right that the appropriate time-frame for an infrastructure project, from idea to ribbon cutting, is at least a decade (in America; China, I believe, is a different story). What's important to note is that there are many infrastructure projects available that are quite close to the construction stage, that have been on the books for some time and only lack final say on funding to begin. In some cases, these projects might have already been underway, had the economic slowdown and credit issues not constrained local and state budgets. It's quite possible, then, that a quick injection of federal funding for ready-to-go projects might provide the economy with a nice shot in the arm. Given the attraction of infrastructure projects as investments generally, this also reduces the economic downside to getting the timing wrong. These are, after all, things that America should be doing anyway.

"The Culture of Debt?"

Which type are you?:

The Culture of Debt, by David Brooks, Commentary, NY Times: On the front page of Sunday’s Times, Gretchen Morgenson described Diane McLeod’s spiral into indebtedness, and now a debate has erupted over who is to blame.

Some people emphasize the predatory lenders who seduced her with too-good-to-be-true credit lines and incomprehensible mortgage offers. Here was a single mother made vulnerable by health problems and divorce. Working two jobs and stressed, she found herself barraged by credit card companies offering easy access to money. Mortgage lenders offered her credit on the basis of the supposedly rising value of her house. These lenders had little interest in whether she could pay off her loans. They made most of their money via initial lending fees and then sold off the loans to third parties.

In short, these predatory companies swooped down..., took what they could and left her careening toward bankruptcy.

Other people emphasize McLeod’s own responsibility. She is the one who took the credit card offers knowing that debt is a promise that has to be kept. After her divorce, she went on a shopping spree to make herself feel better. After surgery, she sat at home watching the home shopping channels, charging thousands more.

Free societies depend on individual choice and responsibility, those in this camp argue. People have to be held accountable for their indulgences or there is no justice. ...

And yet..., there is a third position. This is the position held in overlapping ways by liberal communitarians and conservative Burkeans.

This third position begins with the notion that people are driven by the desire to earn the respect of their fellows. ...Decision-making — whether it’s taking out a loan or deciding whom to marry — ... is a long chain of processes, most of which happen beneath the level of awareness. We absorb a way of perceiving the world from parents and neighbors. We mimic the behavior around us. Only at the end of the process is there self-conscious oversight.

According to this view, what happened to McLeod, and the nation’s financial system, is part of a larger social story. America once had a culture of thrift. But over the past decades, that unspoken code has been silently eroded.

Some of the toxins were economic. ... Some were cultural. ... Some were moral. ... Norms changed...

McLeod and the lenders were not only shaped by deteriorating norms, they helped degrade them. ... Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. ...

And now the reckoning has come. The turn in the market punishes many of those seduced by financial temptations. ...

Meanwhile, social institutions are trying to re-right the norms. ... But the important shifts will be private, as people and communities learn and adopt different social standards. ... As the saying goes: People don’t change when they see the light. They change when they feel the heat. [Brooks discussed the same topic not too long ago.]

I'm not sure I buy the changing cultural norm story, but even if it's true, it doesn't answer the deeper question of what caused the change in attitudes. Why now? Brooks offers:

Some of the toxins were economic. Rising house prices gave people the impression that they could take on more risk. Some were cultural. We entered a period of mass luxury, in which people down the income scale expect to own designer goods. Some were moral. Schools and other institutions used to talk the language of sin and temptation to alert people to the seductions that could ruin their lives. They no longer do.

But I don't find these particularly compelling. The house price story seems to hold together, having a valuable asset as backup would allow more debt, but in the past when there were housing price run-ups, why didn't norms erode then, why was this episode different? Blaming schools seems to miss the mark, and why is it suddenly so important to keep up with the neighbors, more so than in the past? For that reason, I prefer a technological based explanation - a change in the availability of credit for example - but that story seems less than fully satisfactory as well.

Has there been a cultural shift, or is it just "economic fundamentals" (or something else entirely)? I find myself resisting the cultural shift story and wanting, instead, to cite factors that make the increase in debt holding by households a rational economic choice (hence the attempt to find a technology story, credit card availability on the internet, etc.), but if it was a cultural shift, what caused it? Is Brooks right?

Update: See also Tanta at Calculated Risk and Jim Sleeper at TPM Cafe.

"What’s Causing Global Food Price Inflation?"

This research argues that India, China, and speculators are not the cause of the food price explosion, the cause is biofuel support policies. Thus, since the "OECD’s recent report on the economic assessment of biofuel support policies has clearly shown that their effectiveness is disappointingly low," the conclusion is that governments should reconsider their biofuel support policies:

What’s causing global food price inflation?, by Stefan Tangermann, Vox EU: Global food prices have exploded since early 2007, causing major social, political, and macroeconomic disruption in many poor countries and adding to inflationary pressure in the richer parts of the world.[1] Concerns about high food prices have been expressed at the highest political level, including during the recent G8 summit on Hokkaido.

What has caused the explosion of food prices? Several culprits have been blamed.

• Newspapers have cited an internal World Bank document as having found that 75% of the price increase was due to biofuels.
• Several governments and commentators see speculation as a major driving force.
• A widely held view has it that rapidly growing food demand in the emerging economies is pushing up global food prices.

Which contributions have these or other factors made to rising food prices?