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Monday, November 30, 2009
At MoneyWatch, Will Consumption Growth Return to Its Pre-Recession Level? discusses this graph comparing the path of consumption in the current recession to the path of consumption in the three most recent recessions, and there is a brief discussion of why consumption growth is likely to be lower in the future:
It's (past) time for the administration to get serious about creating jobs:
The Jobs Imperative, by Paul Krugman, Commentary, NYTimes: If you’re looking for a job right now, your prospects are terrible. There are six times as many Americans seeking work as there are job openings, and the average duration of unemployment ... is more than six months, the highest level since the 1930s.
You might think, then, that ... the employment situation would be a top policy priority. But now that total financial collapse has been averted, all the urgency seems to have vanished... There’s a pervasive sense in Washington that ... we should just wait for the economic recovery to trickle down to workers.
This is wrong and unacceptable. ... Historically, financial crises have typically been followed ... by anemic recoveries; it’s usually years before unemployment declines to anything like normal levels. And all indications are that ... the latest financial crisis is following the usual script. ...
And the damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills... Meanwhile, students who graduate into a poor labor market ... pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn’t just cruel, it’s short-sighted.
So it’s time for an emergency jobs program.
How is a jobs program different from a second stimulus? It’s a matter of priorities. The 2009 Obama stimulus bill was focused on restoring economic growth. ... That strategy might have worked if the stimulus had been big enough — but it wasn’t. And as a matter of political reality, it’s hard to see how the administration could pass a second stimulus big enough to make up for the original shortfall.
So our best hope now is for a somewhat cheaper program that generates more jobs for the buck. Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation... Instead, it should consist of measures that more or less directly save or add jobs.
One such measure would be another round of aid to beleaguered state and local governments... More aid would help avoid ... the elimination of hundreds of thousands of jobs.
Meanwhile, the federal government could provide jobs by ... providing jobs. It’s time for at least a small-scale version of the New Deal’s Works Progress Administration, one that would offer relatively low-paying (but much better than nothing) public-service employment. There would be accusations that the government was creating make-work jobs, but the W.P.A. left many solid achievements in its wake. And the key point is that direct public employment can create a lot of jobs at relatively low cost. ...[T]he Economic Policy Institute, a progressive think tank, argues that spending $40 billion a year for three years on public-service employment would create a million jobs, which sounds about right.
Finally, we can offer businesses direct incentives for employment. It’s probably too late for a job-conserving program... But employers could be encouraged to add workers as the economy expands. The Economic Policy Institute proposes a tax credit for employers who increase their payrolls, which is certainly worth trying.
All of this would cost money, probably several hundred billion dollars, and raise the budget deficit in the short run. But this has to be weighed against the high cost of inaction in the face of a social and economic emergency.
Later this week, President Obama will hold a “jobs summit.” Most of the people I talk to are cynical about the event, and expect the administration to offer no more than symbolic gestures. But it doesn’t have to be that way. Yes, we can create more jobs — and yes, we should.
Sunday, November 29, 2009
If people had to pay for the cost of the war with an explicit, dedicated tax for that purpose, would they still support it? I think it's a good idea to make clear what the war costs - e.g. the $11 billion per month the war effort costs would pay for a lot of health care and other domestic needs - but I'm not sure that raising taxes during a recession (or during the inklings of a recovery) is a good idea.
The economic effects of a tax increase are one of the worries, though the size of those effects depends upon where the burden falls. If the Bush tax cuts didn't do much to help middle and lower class income and employment -- and I don't see any strong evidence that they did -- it's hard to see how reversing such taxes would have much of an effect either. But the tax surcharge proposal is broad-based, everyone would face higher taxes not just the wealthy, and the effects of a broad-based tax change might be larger. Why take a chance when the job market doing so poorly?
The main worry for me is not the size of the debt or the economic consequences (though the latter is of concern), it's the political message that raising taxes right now would send. Raising taxes to pay for the war would send the message that the federal debt is such a large problem we have to implement a tax surcharge even while the economy is struggling to recover from a recession. That is the opposite of the message I think we should be sending -- the economy and labor markets still need more help -- and it's hard to imagine how to get that help after sending a message that the debt is so worrisome.
We do have debt problems down the road, and rising health care costs are the driving force behind the budget trajectory. We will need to address this problem. In addition, we should pay for the wars and the stimulus package when the economy is on better footing. Thus, I would support legislation that raises taxes (or cuts "wasteful" spending, though good luck with that) to pay for these items at some point in the future. That would highlight the cost of the war without simultaneously sending a message that the budget problem is urgent, so urgent that it ties our hands from doing anything more. It would also blunt the inevitable "tax increases will kill jobs" objection that is sure to come.
So yes, let's raise taxes now to pay for these things, but the tax changes shouldn't take effect until the economy surpasses some metric for health -- unemployment falling below a particular number could be one trigger -- or it could come at some date certain in the future, e.g. two years from now, (assuming that gives the economy enough time to regain more solid footing).
If I thought that the Obey tax surcharge plan would actually end the war, or stop it sooner, I might see this differently. But it seems to me that highlighting budget problems now would be more likely to affect funding for needed social programs such as food stamps and unemployment compensation than it would be to affect the war effort.
I'm curious to hear your thoughts on this:
Will the Obey Plan End the War?, by Bruce Bartlett, Commentary, Forbes: In recent years, Republicans have been characterized by two principal positions: They like starting wars and don't like paying for them. George W. Bush initiated two major wars in Iraq and Afghanistan, but adamantly refused to pay for either of them by cutting non-military spending or raising taxes. Indeed, at his behest, Congress actually cut taxes and established a massive new entitlement program, Medicare Part D.
Bush's actions were unprecedented. During every previous major war in American history, presidents demanded sacrifices from rich and poor alike. As Robert Hormats explains in his 2007 book, The Price of Liberty: Paying for America's Wars, "During most of America's wars, parochial desires--such as tax breaks for favored groups or generous spending for influential constituencies--have been sacrificed to the greater good. The president and both parties in Congress have come together … to cut nonessential spending and increase taxes."
During World War II, federal revenues roughly tripled as a share of the gross domestic product (GDP) and the number of people paying income taxes expanded tenfold, from 3% of the population in 1939 to 30% by 1943. In 1940, a family of four needed close to $80,000 of income in today's dollars before it paid any federal income taxes at all. By the war's end, it saw its effective tax rate rise from 1.5% to 15.1%. (Today such a family only pays a federal income tax rate of about 6%.) But taxes weren't the only way the war was paid for. Spending on nondefense programs was cut almost in half, from 8.1% of GDP in 1940 to 4.4% in 1945.
Even during wars closer in magnitude to those in which we are presently engaged, significant sacrifices were made. In 1950 and 1951 Congress increased taxes by close to 4% of GDP to pay for the Korean War, even though the high World War II tax rates were still largely in effect. In 1968, a 10% surtax was imposed to pay for the Vietnam War, which raised revenue by about 1% of GDP. And there was conscription during both wars, which can be viewed as a kind of tax that was largely paid by the poor and middle class--young men from wealthy families largely escaped its effects through college deferments.
However, Bush and his party, which controlled Congress from 2001 to 2006, never asked for sacrifices from anyone except those in our nation's military and their families. I think that's because the Republicans understood, implicitly, that the American people's support for the wars in Iraq and Afghanistan has always been paper thin. Asking them to sacrifice through higher taxes, domestic spending cuts or reinstatement of the draft would surely have led to massive protests akin to those during the Vietnam era or to political defeat in 2004. George W. Bush knew well that when his father raised taxes in 1990 in part to pay for the first Gulf War, it played a major role in his 1992 electoral defeat.
Dangers of an Overheated China, by Tyler Cowen, Commentary, NY Times: ...Several hundred million Chinese peasants have moved from the countryside to the cities over the last 30 years... To help make this work, the Chinese government has subsidized its exporters by pegging the renminbi at an unnaturally low rate to the dollar...; additional subsidies have included direct credit allocation and preferential treatment for coastal enterprises.
These aren’t the recommended policies you would find in a basic economics text, but it’s hard to argue with success. ... Those same subsidies, however, have spurred excess capacity... China has been building factories and production capacity in virtually every sector of its economy... Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. ...
Regional officials have an incentive to prop up local enterprises and production statistics... Chinese fiscal and credit policies are geared toward jobs and political stability, and thus the authorities shy away from revealing which projects are most troubled or should be canceled.
Put all of this together and there is a very real possibility of trouble. ... What will the consequences be ... if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments... American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And ... the Chinese ... may have less to lend to the United States government. ... The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.
That’s not so much a prediction as a very possible contingency, and we should be prepared for it. For now, we should avoid two big mistakes. The first would be to assume that just because borrowing costs are now low, we can postpone fiscal responsibility and keep running up the tab — with the aid of Chinese lending, of course. The history of financial crises shows that turning points can come swiftly...
The second mistake would be to demand too many concessions from the Chinese. What we see in the numbers today are a growing China... Yet there’s a real chance that, soon enough, Chinese economic weakness will be a bigger problem than was Chinese economic strength.
Saturday, November 28, 2009
As a follow up to the recent post on non-linear dynamics that continued the discussion on what's wrong with modern macroeconomics, here is a paper written many years ago by Hal Varian that extends the Goodwin-Kaldor model of business cycles. It is old-fashioned macro, but the interesting part is the wealth effect causing the difference between recessions and depressions. In particular, the results of the paper imply that shocks to wealth that change savings propensities -- as we are seeing now -- can cause recoveries that "may take a very long time, and differ quite substantially from the recovery pattern of a [typical] recession."
Here are a few selections from the paper:
Catastrophe Theory and the Business Cycle, by Hal Varian: In this paper we examine a variation on Kaldor's (1940) model of the business cycle using some of the methods of catastrophe theory. (Thom (1975), Zeeman (1977)). The development proceeds in several stages. Section I provides a brief outline of catastrophe theory, while Section II applies some of these techniques to a simple macroeconomic model. This model yields, as a special case, Kaldor's business cycles. ... In Section III, we describe a generalization of Kaldor's model that allows not only for cyclical recessions, but also allows for long term depressions. Section IV presents a brief review and summary.
As you might guess given my recent posts defending Fed independence, I agree with this:
The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating... Understandably, many people are calling for change. ... As a nation, our challenge is to design a system of financial oversight that will ... provide a robust framework for preventing future crises...
I am concerned ... that ... some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures ... would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation. ...
The proposed measures are at least in part the product of public anger over ... the rescues of some individual financial firms. The government's actions... -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity...
Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.
The Federal Reserve ... did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems. ... There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks...
This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.
Of course, the ... ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance...
Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities... Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation. ...
Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.
While I agree on the independence and regulation statements, one thing I do wonder about is why there is such widespread acceptance of the idea that we have to live with institutions that are so big that their failure is a threat to the financial system and the economy. The notion seems to be that large, dangerous firms are inevitable, so we need special procedures in place that we hope will allow them to fail without the problems spreading and creating a devastating domino effect. The concern seems to be mainly about having the procedures and authority to allow orderly dissolution of large, dangerous firms rather than preventing these firms from getting too large and too interconnected to begin with.
We need procedures for orderly dissolution in any case -- we didn't think firms were systemically important before the crash, so we need to be ready (e.g., recall the many, many statements that the crisis would be "contained"). But what is the minimum efficient scale (MES) for financial firms? That is, what is the smallest size at which economies of scale and economies of scope are fully realized?
There has been some discussion of this (e.g. Economics of Contempt versus The Baseline Scenario), but it doesn't seem to me that this question is very close to being settled. I want to know how the MES relates to the minimum size where a bank becomes systemically important. If the MES is smaller than the size where banks become systemically dangerous, break them up - their size adds nothing but risk. But if the MES is greater than the minimum dangerous size, then we have a tradeoff to make -- safety for efficiency -- and we may or may not want to force firms to reduce their size and connectedness. It depends upon the tradeoff.
But until we know what these tradeoffs are -- and I don't think we have a good sense of this -- it's very difficult to determine if the costs of breaking up banks and reducing their connectedness are greater than the benefits. I suspect that if the MES is greater than the minimum safe size, then the extra safety from reducing bank size and connectedness would be worth the loss of efficiency, and I'd like to push that position much more than I have to date. But without knowing the MES, the minimum threatening size, the minimum threatening degree of connectedness, and the costs and benefits of reducing size and connectedness, it's hard to do so with confidence.
Friday, November 27, 2009
Brad DeLong says those who argue that fiscal stimulus policies can't work and are too costly "rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious":
Why Are Good Policies Bad Politics?, by J. Bradford DeLong, Commentary, Project Syndicate: From the day after the collapse of Lehman Brothers last year, the policies followed by the United States Treasury, the US Federal Reserve, and the administrations of Presidents George W. Bush and Barack Obama have been sound and helpful. The alternative – standing back and letting the markets handle things – would have brought ... higher unemployment than now exists. Credit easing and support of the banking system helped significantly...
The fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Every extra percentage point of unemployment lasting for two years costs $400 billion. A recession twice as deep as the one we have had would have cost the US roughly $2 trillion – and cost the world as a whole four times as much. In comparison, the bonuses at Goldman Sachs are a rounding error. ...
The Obama administration’s fiscal stimulus has also significantly helped the economy. Though the jury is still out on the effect of the tax cuts in the stimulus, aid to states has been a job-saving success, and the flow of government spending on a whole variety of relatively useful projects is set to boost production and employment in the same way that consumer spending boosts production and employment.
And the cost of carrying the extra debt incurred is extraordinarily low: $12 billion a year of extra taxes ... at current interest rates. For that price, American taxpayers will get an extra $1 trillion of goods and services, and employment will be higher by about ten million job-years.
The valid complaints about fiscal policy ... are not that it has run up the national debt..., but rather that ... we ought to have done more. Yet these policies are political losers now: nobody is proposing more stimulus. This is strange... Good policies that are boosting production and employment without causing inflation ought to be politically popular, right?
With respect to Obama’s stimulus package, it seems to me that there has been extraordinary intellectual and political dishonesty on the American right, which the press refuses to see. For two and a half centuries, economists have believed that the flow of spending in an economy goes up whenever groups of people decide to spend more... – and government decisions to spend more are as good as anybody else’s. ...
Obama’s Republican opponents, who claim that fiscal stimulus cannot work, rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious. Remember that back in 1993, when the Clinton administration’s analyses led it to seek to spend less and reduce the deficit, the Republicans said that that would destroy the economy, too. Such claims were as wrong then as they are now. But how many media reports make even a cursory effort to evaluate them?
A stronger argument, though not by much, is that the fiscal stimulus is boosting employment and production, but at too great a long-run cost because it has produced too large a boost in America's national debt. If interest rates on US Treasury securities were high and rising rapidly as the debt grew, I would agree... But interest rates on US Treasury securities are very low...
Those who claim that America has a debt problem, and that a debt problem cannot be cured with more debt, ignore (sometimes deliberately) that private debt and US Treasury debt have been very different animals – moving in different directions and behaving in different ways – since the start of the financial crisis. /blockquote>
What the market is saying is not that the economy has too much debt, but that it has too much private debt, which is why prices of corporate bonds are low and firms find financing expensive. The market is also saying – clearly and repeatedly – that the economy has too little public US government debt, which is why everyone wants to hold it.
Just one comment: Brad's right.
John Berry defends the Fed and Treasury's assistance to AIG:
Muddying the waters on AIG, by John M. Berry, Commentary, Reuters: Neil Barofsky, inspector general of the Troubled Asset Relief Program, is making a name for himself with a misleading analysis of actions by the Federal Reserve and Treasury in combating the financial crisis.
A column in the New York Times called Barofsky “one of the few truth tellers in Washington”... Barofsky’s report, which is logically flawed, uses loaded language to create the impression that saving the economy wasn’t the Fed’s goal at all. No, it was all about helping the central bank’s friends on Wall Street.
“Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG counterparties...,” the report says. ... The report duly notes that Fed officials deny a backdoor bailout was their objective. But the next sentence suggests the officials must be lying.
“Irrespective of their stated intent, however, there is no question that the effect of the Federal Reserve Bank of New York’s decisions — indeed the very design of the federal assistance to AIG — was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG’s counterparties.” (Emphasis in the original.)
Well, AIG had sold the counterparties a great many credit default swap contracts covering collateralized debt obligations secured by mortgages. ...AIG owed the counterparties a whole pot full of money which it couldn’t pay.
If AIG was to be kept out of bankruptcy, of course the very design of the federal assistance had to include funneling tens of billions of dollars to the institutions to which it was owed. There was no other way to avoid a bankruptcy that would have affected not just big financial institutions but thousands of municipalities, individual savers and other investors. ...
The report does not offer an alternative way to avoid an AIG bankruptcy, and there wasn’t one. It does, however, suggest the Fed should have used its power as a banking regulator to force the AIG creditors to accept less than full payment of what they were owed.
The report acknowledges that the New York Fed tried to negotiate such a haircut... But the French banking regulator said it would be illegal for the two French institutions involved to take a haircut unless AIG was in formal bankruptcy, and the Fed said it had to treat all the banks the same way.
Nevertheless, Barofsky insists the Fed should have used its authority to force concessions. Unsaid, but implied: The Fed didn’t do that because its goal was to help its Wall Street friends.
Barofsky is getting great press and kudos on Capitol Hill by pandering to the public anger at Wall Street. Pity he’s not really a truth teller at all.
Is it time to impose a financial transactions tax?:
Taxing the Speculators, by Paul Krugman, Commentary, NY Times: Should we use taxes to deter financial speculation? Yes, say top British officials... Other European governments agree — and they’re right.
Unfortunately, United States officials — especially Timothy Geithner... — are dead set against the proposal. Let’s hope they reconsider: a financial transactions tax is an idea whose time has come.
The dispute began back in August, when Adair Turner, Britain’s top financial regulator, called for a tax on financial transactions as a way to discourage “socially useless” activities. Gordon Brown, the British prime minister, picked up on his proposal...
Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.
Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation.
Tobin’s idea went nowhere... But the Turner-Brown proposal, which would apply a “Tobin tax” to all financial transactions ... is very much in Tobin’s spirit. It would ... deter much of the churning that now takes place in our hyperactive financial markets.
This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there’s broad agreement ... that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?
The main argument made by opponents of a financial transactions tax is that ... traders would find ways to avoid it. Some also argue that it wouldn’t do anything to deter the socially damaging behavior that caused our current crisis. But neither claim stands up to scrutiny.
On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. ... This centralization keeps the cost of transactions low... It also, however, makes these transactions relatively easy to identify and tax.
What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.
But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.
As Gary Gorton and Andrew Metrick ... have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions... Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”
And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.
Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street’s thrall.
Thursday, November 26, 2009
Rajiv Sethi continues the discussion on the state of modern macroeconomics:
On Buiter, Goodwin, and Nonlinear Dynamics, by Rajiv Sethi: A few months ago, Willem Buiter published a scathing attack on modern macroeconomics in the Financial Times. While a lot of attention has been paid to the column's sharp tone and rhetorical flourishes, it also contains some specific and quite constructive comments about economic theory that deserve a close reading. One of these has to do with the limitations of linearity assumptions in models of economic dynamics:When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no ‘bounded instability’ in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.Buiter is objecting here to a vision of the economy as a stable, self-correcting system in which fluctuations arise only in response to exogneous shocks or impulses. This has come to be called the Frisch-Slutsky approach to business cycles, and its intellectual origins date back to a memorable metaphor introduced by Knut Wicksell more than a century ago: "If you hit a wooden rocking horse with a club, the movement of the horse will be very different to that of the club" (translated and quoted in Frisch 1933). The key idea here is that irregular, erratic impulses can be transformed into fairly regular oscillations by the structure of the economy. This insight can be captured using linear models, but only if the oscillations are damped - in the absence of further shocks, there is convergence to a stable steady state. This is true no matter how large the initial impulse happens to be, because local and global stability are equivalent in linear models.
A very different approach to business cycles views fluctuations as being caused by the local instability of steady states, which leads initially to cumulative divergence away from balanced growth. Nonlinearities are then required to ensure that trajectories remain bounded. Shocks to the economy can make trajectories more erratic and unpredictable, but are not required to account for persistent fluctuations. An energetic and life-long proponent of this approach to business cycles was Richard Goodwin, who also produced one of the earliest such models in economics (Econometrica, 1951). Most of the literature in this vein has used aggregate investment functions and would not be considered properly microfounded by contemporary standards (see, for instance, Chang and Smyth 1971, Varian 1979, or Foley 1987). But endogenous bounded fluctuations can also arise in neoclassical models with overlapping generations (Benhabib and Day 1982, Grandmont 1985).
The advantage of a nonlinear approach is that it can accomodate a very broad range of phenomena. Locally stable steady states need not be globally stable, so an economy that is self-correcting in the face of small shocks may experience instability and crisis when hit by a large shock. This is Axel Leijonhufvud's corridor hypothesis, which its author has discussed in a recent column. Nonlinear models are also required to capture Hyman Minsky's financial instability hypothesis, which argues that periods of stable growth give rise to underlying behavioral changes that eventually destabilize the system. Such hypotheses cannot possibly be explored formally using linear models.
This, I think, is the point that Buiter was trying to make. It is the same point made by Goodwin in his 1951 Econometrica paper, which begins as follows:Almost without exception economists have entertained the hypothesis of linear structural relations as a basis for cycle theory. As such it is an oversimplified special case and, for this reason, is the easiest to handle, the most readily available. Yet it is not well adapted for directing attention to the basic elements in oscillations - for these we must turn to nonlinear types. With them we are enabled to analyze a much wider range of phenomena, and in a manner at once more advanced and more elementary.
By dropping the highly restrictive assumptions of linearity we neatly escape the rather embarrassing special conclusions which follow. Thus, whether we are dealing with difference or differential equations, so long as they are linear, they either explode or die away with the consequent disappearance of the cycle or the society. One may hope to avoid this unpleasant dilemma by choosing that case (as with the frictionless pendulum) just in between. Such a way out is helpful in the classroom, but it is nothing more than a mathematical abstraction. Therefore, economists will be led, as natural scientists have been led, to seek in nonlinearities an explanation of the maintenance of oscillation. Advice to this effect, given by Professor Le Corbeiller in one of the earliest issues of this journal, has gone largely unheeded.And sixty years later, it remains largely unheeded.
Thanks to everyone who visits this blog, and I hope you have a nice Thanksgiving.
Wednesday, November 25, 2009
Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes, by Mark Thoma: There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified. ...
Tuesday, November 24, 2009
Tim Duy says -- correctly -- "that a significant portion of policymakers are simply clueless":
Ahead of Black Friday, by Tim Duy: We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America. Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event. Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday. We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.
Oooo, how I have come to loathe this exercise. And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list. It is like a car wreck - you don’t want to watch, but you can't take your eyes off it.
Car wreck is something of an appropriate comparison. Recently I have begun using charts of this sort to depict the current economic environment:
Not fancy econometrics, I know - most of my audiences are not interested in unit root tests. The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening. Much, much faster growth is necessary to close that gap. And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits. To be sure, Bloomberg trumpeted today's data:
Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.
How much did the outlook brighten? The story continues:
The Conference Board’s confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board’s index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.
Not much brighter. Indeed, Economix more accurately reports the dismal mood of consumers, noting:
Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.
Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels. This tells us something about the strength of consumer spending. Using the parallel measure from the University of Michigan:
Real year over year growth in the 1% range is not going to bring households back to trend anytime soon. To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending. That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower. Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future. And they will increasingly look for someone to blame. No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke. They are the public faces for an Administration that now owns this economy.
And where are policymakers as we slog through the final month of 2009? The Administration is poised to do virtually nothing:
The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.
There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.
...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.
Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now. Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.
Likewise, monetary policymakers too are caught in the headlights. As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy:
...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.
Read that carefully and realize this: An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels. Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet. That whole credit channel thing. If not to expand lending during a credit crunch, then what else are they expecting?
I am in shock that this sentence made it into the minutes. One can only conclude that a significant portion of policymakers are simply clueless. Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns. Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?
At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:
Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.
"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.
Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."
Maybe if unemployment continues to rise Bullard's vote will matter next year. Maybe.
Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:
New reports Monday didn’t paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.
“Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season,” said Lynn Franco, director of the Conference Board Consumer Research Center.
A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.
Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy: Economic activity is now increasing, something for which we should all be thankful this weekend. The alternative would be very unpleasant. But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation. By all forecasts, it simply falls far short of what is necessary to restore confidence among households. 2.8% just won't cut it.
Like Tim Duy in the post above this one, David Altig is also puzzled by analysts who, to quote from the FOMC minutes highlighted in Tim's post, that "banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially":
The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end.
"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. ...
The intuition behind this point really is pretty simple. When the economy is struggling ... the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:
"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. ..."
Demand also appears to be quite weak:This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:
"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."
The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:
Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.
Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.
Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad.
The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:
But the quantity of bank lending is decidedly not on the rise:
There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?
If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?
I was curious how the the composition of durable and nondurable goods consumption changes during recessions. This graph shows the monthly variation in the ratio of nondurable to durable consumption since 1959 (click on figures for larger versions):
And, for a better comparison over time, the log of the ratio:
As you can see, there has been a fairly consistent decline in this ratio over time, from about 7 dollars of nondurables per dollar of durables in 1960 to close to 2 dollars in nondurables per dollar of durables today. But there is also variation around the declining trend. Most of the deviation around the trend appears to be due to recessions, but there are also time periods such as the late 70s and the late 80s where the series takes noticeable upward turn outside of recessionary conditions (and in other cases the increase in the ratio appears to lead -- as opposed to being caused by -- the recession, e.g. in the 69-70 and 73-74 downturns). In most recessions the ratio rises as consumers cut back on durables more than they cut back on nondurables, and the ratio falls once the recession ends (the 2000 recession is an obvious exception).
What has happened in this recession? In the earlier part of the downturn, the ratio rose abruptly (this is the unlogged series). It then fell sharply in August of this year, and increased again in September. The dip in the ratio this August appears to be due to the Cash for Clunkers program:
What will happen after the crisis? If the economy grows as before and as incomes grow along with it, there's no reason to rule out the possibility that the ratio will continue to decline. So it will be interesting to see if the economy picks up this long-run downward trend again once things return to (the new?) normal. In the meantime, though I'm not quite sure what to make of this ratio, whatever good news might have been taken from its sharp decline in August was surely tempered in September.
Does competitive behavior come from nurture or nature?:
Competition and Context, by Catherine New, Columbia Business School: It’s nurture, not nature. At least when it comes to competition and gender, new research suggests. In a recent column in Slate, professor Ray Fisman discussed a study (PDF) by economists that demonstrates that the competitive male warrior stereotype, prevalent in Western culture, may not be universal.
The study looked at the Khasi community of northeast India, where inheritance and social status are passed through daughters. Khasi women were more competitive than men in the same group when they competed in a ball-toss game, the research showed. Why is that? Fisman writes:
The authors suggest that it may stem from the relatively uncommon practice of female-directed household decision making and inheritance. In the Khasi society, women who learn to compete for resources get to keep the fruits of their efforts, and also pass on the wealth they generate to their daughters. Regardless of the underlying cause … [the study] proves that the Western stereotype of the male competitor isn’t universal: The male “warrior instinct” is a matter of socialization rather than instinct.
Adding another dimension to the competition debate is new research from Pranjal Mehta, a postdoctoral research scholar in the Management division at Columbia Business School, Elizabeth V. Wuehrmann and Robert A. Josephs.
Their study, published in the journal Hormones and Behavior, examined the effect of testosterone on competitive performance. In the study of 30 men and 30 women, participants completed analytical reasoning tests in both individual and intergroup competition. The researchers’ findings showed that the higher the participant’s level of testosterone, the better the performance in individual competition; however, high testosterone had the opposite effect for intergroup competition. In other words, social context appears to moderate the relationship between testosterone and performance.
Taken together, these studies might nudge us closer to the conclusion that the debate is neither nurture nor nature, but some intricate combination therein, where socialized expectations and incentives interplay with physiology. ... Competitive success might be a matter of incentive alignment, not chromosomes.
Update: Just noticed this opinion piece at the Financial Times: Alpha males must trade on more than machismo which opens with:
"Male traders, like animals in the wild, take more risk when their testosterone levels rise. Research by myself and my colleagues found that moderately elevated levels of this hormone increased the profits of high-frequency traders – although at higher levels it can cause overconfidence and risky behavior, morphing traders into Masters of the Universe. What we could not say, however, was whether testosterone was having its beneficial effects by increasing the trader’s skill or merely by increasing his appetite for risk. In a study published on Wednesday in PLoS ONE we found that testosterone had little to do with trading skill. ...
[I'm between classes, so as with the other posts today I don't have time to say much, but I suppose -- or at least hope -- that "echo mode" is better than not posting anything at all.]
I fully agree that price discrimination schemes are far more prevalent than people realize (some are disguised as two-part pricing schemes, e.g. cell phone contracts where there is a fixed amount for usage up to some point, and then high fees for anyone who goes beyond the fixed allocation is way for producers to extract surplus from consumers):
[Ten previous posts on price discrimination.]
Michael Spence says developed countries should pay the cost of reducing carbon emissions, including paying for abatement measures in developing countries:
Escaping the Fossil Fuel Trap, by Michael Spence, Project Syndicate: ...[The] use of fossil fuels, and hence higher CO2 emissions, seems to go hand in hand with growth. This is the central problem confronting the world as it seeks ... to combat climate change. Compared to the advanced countries, the developing world now has both low per capita incomes and low per capita levels of carbon emissions. Imposing severe restrictions on their emissions growth would impede their GDP growth and severely curtail their ability to climb out of poverty.
The developing world also has a serious fairness objection to paying for climate-change mitigation. The advanced countries are collectively responsible for much of the ... carbon in the atmosphere... As a consequence, the developing world’s representatives argue, the advanced countries should take responsibility for the problem.
But a simple shift of responsibility to the advanced countries by exempting developing countries from the mitigation process will not work. ... If developing countries are allowed to grow, and there is no corresponding mitigation of the growth in their carbon emissions, average per capita CO2 emissions around the world will nearly double in the next 50 years, to roughly four times the safe level... Advanced countries by themselves simply cannot ensure that safe global CO2 levels are reached. ...
So the world’s major challenge is to devise a strategy that encourages growth in the developing world, but on a path that approaches safe global carbon-emission levels by mid-century. ...
These considerations suggest that no emission-reduction targets should be imposed on developing countries until they approach per capita GDP levels comparable to those in advanced countries. ...[A]dvanced countries ... should be allowed to fulfill their obligations, at least in part, by paying to reduce emissions in developing countries (where such efforts may yield greater benefits). ...
The best way to implement this strategy is to use a “carbon credit trading system” in the advanced countries, with each advanced country receiving a certain amount of carbon credits to determine its permissible emission levels. If a country exceeds its level of emissions, it must buy additional credits from other countries... But an advanced country could also undertake mitigation efforts in the developing world and thus earn additional credits...
Such a system would trigger entrepreneurial searches for low-cost mitigation opportunities in developing countries, because rich countries would want to pay less by lowering emissions abroad. As a result, mitigation would become more efficient...
Conflict between advanced and developing countries over responsibility for mitigating carbon emissions should not be allowed to undermine prospects for a global agreement. A fair solution is as complex as the challenge of climate change itself, but it is certainly possible.
Monday, November 23, 2009
Marty Ellison and Thomas Sargent defend the FOMC:
Bad forecasters can be good policymakers, by Martin Ellison and Thomas J. Sargent, Vox EU: The value of the Federal Reserve’s Open Market Committee (FOMC)1 has recently been questioned in a highly provocative paper by two professors at the University of California, Berkeley. The two professors are husband-and-wife team Christina and David Romer, who are amongst the most influential economists in the world today. Christina Romer is Chair of the Council of Economic Advisers in the Obama administration and a co-author of Obama’s plan for recovery, and David Romer is the author of a very popular macroeconomic graduate textbook. Their paper was published in The American Economic Review, arguably the most influential journal in economics.
The Romers criticize the FOMC because of its poor performance in forecasting economic developments. Specifically, the Romers show that the FOMC is even worse at forecasting than its underlings, the staff of the Federal Reserve System. This is surprising because the FOMC should have all the advantages when forecasting. The FOMC has the staff forecast available when preparing its own forecast and the FOMC presumably knows its own policy objectives and preferences better than anyone else. Despite this, the Romers find that:
- It is best to ignore the FOMC forecast when predicting inflation or unemployment.
- The FOMC makes larger forecast errors than the staff.
- Monetary policy reacts when the FOMC forecast differs from the staff forecast
The Romers use these findings to paint a bleak picture of the FOMC as "not using the information in the staff forecasts effectively" and accuses that the FOMC "may indeed act on information that is of little or negative value". In their opinion, the evidence is sufficiently damning to warrant a radical restructuring of the role of the FOMC in policymaking:
"a more effective division of labor within the Federal Reserve System might be for the staff to present policymakers with policy options and related forecast outcomes, and for policymakers to take those forecasts as given. With this division, the role of the FOMC would be to choose among the suggested alternatives, not to debate the likely outcome of a given policy."
These criticisms are understandable in a world where consumers, workers, policymakers, and researchers perfectly understand the workings of the economy. In such a context, it is difficult to justify the apparently poor forecasting performance of the FOMC. Our defense of the FOMC therefore rests on asking what happens if the FOMC doubts how much the staff understands about how the economy works (Ellison and Sargent 2009). In our view of policymaking, the staff uses state-of-the-art but imperfect economic models to produce the best possible forecasts, but these forecasts are not taken at face value by the members of the FOMC. Instead, the FOMC suspects that the staff's model is imperfect and wants policies that will work well even if the staff model is misspecified.
Why do people oppose immigration? Here's the introduction and part of the conclusion to a recent paper on this topic by David Card, Christian Dustmann, and Ian Preston. The bottom line is that the effects of immigration on wages and taxes -- to the extent that such effects exist -- are of concern, but according to this research it is not the primary objection:
Immigration, Wages, and Compositional Amenities, by David Card, Christian Dustmann, and Ian Preston, NBER Working Paper No. 15521, November 2009 [Open Link]: Introduction Standard economic reasoning suggests that immigration, like trade, creates a surplus that in principle can be redistributed so all natives are better off (Mundell, 1957). In practice the redistributive mechanisms are incomplete so both policies tend to create winners and losers. Even so, public support for increased immigration is far weaker than for expanding trade. While the two policies have symmetric effects on relative factor prices, immigration also changes the composition of the receiving country’s population, imposing externalities on the existing population. Previous studies have focused on the fiscal externalities created by redistributive taxes and benefits (e.g., MaCurdy, Nechyba, and Bhattacharya, 1998; Borjas, 1999, Hanson, Scheve and Slaughter, 2005). A wider class of externalities arise through the fact that people value the ‘compositional amenities’ associated with the characteristics of their neighbors and co-workers. Such preferences are central to understanding discrimination (Becker, 1957) and choices between neighborhoods and schools (e.g., Bayer, Ferreira, and McMillan, 2007) and arguably play an important role in mediating views about immigration.
This paper presents a new method for quantifying the relative importance of compositional amenities in shaping individual attitudes toward immigration. The key to our approach is a series of questions included in the 2002 European Social Survey (ESS) that elicited views on the effects of immigration on specific domains – including impacts on relative wages and the fiscal balance, and a country’s culture life – as well as on the importance of maintaining shared religious beliefs, language, and customs. ...
Our empirical analysis leads to three main conclusions. First, we find that attitudes to immigration – expressed by the answer to a question of whether more or fewer immigrants from certain source countries should be permitted to enter, for example – reflect a combination of concerns over compositional amenities and the direct economic impacts of immigration on wages and taxes. Second, we find that the strength of the concerns that people express over the two channels are positively correlated. This means that studies that focus exclusively on one factor or the other capture a reasonable share of the variation in attitudes for or against increased immigration.
Our third conclusion is that concerns over compositional amenities are substantially more important than concerns over the impacts on wages and taxes. Specifically, variation in concerns over compositional amenities explain 3-5 times more of the individual-specific variation in answers to the question of whether more or fewer immigrants should be permitted to enter than does variation in concerns over wages and taxes. Concerns over compositional amenities are even more important in understanding attitudes toward immigrant groups that are ethnically different, or come from poorer countries. Similarly, differences in concerns over compositional amenities account for about 70% of the gap between high- and low-education respondents over whether more immigrants should be permitted to enter the country.
Interestingly, concerns over the direct economic impacts of immigration explain a much larger share of variation in responses to a summary question of whether immigration is good or bad for the economy. The contrast suggests that respondents make a distinction between the wage and tax effects of immigration and the effects on the composition of the host country, and place substantial weight on the latter in forming overall views about immigration policies. ...
Differences in compositional concerns also explain most of the differences in attitudes between older and younger respondents. The age gap is a particular puzzle for models of immigration preferences that ignore compositional amenities, because many older people are retired, and face a much lower threat of labor market competition than young people.
While our inferences are based on purely observational data, and rely on a restrictive structural model, we present a number of robustness checks and extensions that support our general conclusions about the importance of compositional concerns. ...
Jeffrey Sachs says government is broken:
America's broken politics, by Jeff Sachs, Project Syndicate: ...The difficulties that Barack Obama is having in passing his basic program, whether in healthcare, climate change, or financial reform, are hard to understand at first glance. After all, he is personally popular, and his Democratic party holds commanding majorities in both houses of Congress. Yet his agenda is stalled and the country's ideological divisions grow deeper.
Among Democrats, Obama's approval rating in early November was 84%, compared with just 18% among Republicans. ... Only 18% of Democrats supported sending 40,000 more troops to Afghanistan, while 57% of Republicans supported a troop buildup. ...
Part of the cause for these huge divergences ... is that America is an increasingly polarized society. Political divisions have widened between the rich and poor, among ethnic groups (non-Hispanic whites versus African Americans and Hispanics), across religious affiliations, between native-born and immigrants, and along other social fault lines. American politics has become venomous as the belief has grown, especially on the vocal far right, that government policy is a "zero-sum" struggle between different social groups and politics.
Moreover, the political process itself is broken. The Senate now operates on an informal rule that opponents will try to kill a legislative proposal through a "filibuster"... To overcome a filibuster, the proposal's supporters must muster 60 of 100 votes... This has proved impossible on controversial policies...
An equally deep crisis stems from the role of big money in politics. Backroom lobbying by powerful corporations now dominates policymaking... The biggest players, including Wall Street, the automobile companies, the healthcare industry, the armaments industry, and the real-estate sector, have done great damage to the US and world economy... Many observers regard the lobbying process as a kind of legalized corruption...
Finally, policy paralysis around the US federal budget may be playing the biggest role of all in America's incipient governance crisis. The US public is rabidly opposed to paying higher taxes, yet the trend level of taxation (at about 18% of national income) is not sufficient to pay for the core functions of government. ... Powerful resistance to higher taxes, coupled with a growing list of urgent unmet needs, has led to chronic under-performance by the US government and an increasingly dangerous level of ... government debt. ...
Obama so far seems unable to break this fiscal logjam. To win the 2008 election, he promised that he would not raise taxes on any household with income of less than $250,000 a year. That no-tax pledge, and the public attitudes that led Obama to make it, block reasonable policies. ... America, in fact, needs a value-added tax,... but Obama himself staunchly ruled out that kind of tax increase during his election campaign.
These paralyzing factors could intensify in the years ahead. ... A breakthrough will require a major change in direction. The US must leave Iraq and Afghanistan, thereby saving $150bn a year for other purposes and reducing the tensions caused by military occupation. The US will have to raise taxes in order to pay for new spending initiatives, especially in the areas of sustainable energy, climate change, education, and relief for the poor.
To avoid further polarization and paralysis of American politics, Obama must do more to ensure that Americans understand better the urgency of the changes... Only such changes – including lobbying reforms – can restore effective governance.
The opportunity cost of the spending on the war effort doesn't receive enough attention -- Democrats are still worried about the weak on defense label and that has allowed the right to dominate policy -- so it's nice to see the issue raised. But on another topic, I like the filibuster when George Bush is president (even though it wasn't enough to stop all of the right's damaging policies from being passed into law), but dislike it now (we did manage to get health care by the filibuster, but at what cost?). So, here's a question: Is it time for the filibuster to be reformed or eliminated entirely, or does it provide a useful check on the political process? I find myself hesitant to get rid of it, but I can't fully justify that position.
At MoneyWatch, some brief comments (and links to other discussions by Calculated Risk, The Big Picture, and Free Exchange) on today's news that existing home sales rose 10.1 percent in October:
Why is the administration so fearful of doing more to help employment recover?:
The Phantom Menace, by Paul Krugman, Commentary, NY Times: A funny thing happened on the way to a new New Deal. ... Consider the contrast between what Mr. Obama’s advisers were saying on the eve of his inauguration, and what he himself is saying now.
In December 2008 Lawrence Summers ... called for decisive action. “Many experts,” he warned, “believe that unemployment could reach 10 percent by the end of next year.” In the face of that prospect, he continued, “doing too little poses a greater threat than doing too much.”
Ten months later unemployment reached 10.2 percent, suggesting that despite his warning the administration hadn’t done enough to create jobs. You might have expected, then, a determination to do more.
But in a recent interview..., the president sounded diffident and nervous about his economic policy. He spoke vaguely about possible tax incentives for job creation. But “it is important though to recognize,” he went on, “that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession.”
Most economists I talk to believe that the big risk to recovery comes from the inadequacy of government efforts: the stimulus was too small, and it will fade out next year, while high unemployment is undermining both consumer and business confidence.
Now, it’s politically difficult for the Obama administration to enact a full-scale second stimulus. Still, he should be trying to push through as much aid to the economy as possible. ...
Instead, however, Mr. Obama is lending his voice to those who say that we can’t create more jobs. And a report on Politico.com suggests that deficit reduction, not job creation, will be the centerpiece of his first State of the Union address. What happened?
It took me a while to puzzle this out. But the concerns Mr. Obama expressed become comprehensible if you suppose that he’s getting his views, directly or indirectly, from Wall Street.
Ever since the Great Recession began ... some (not all) major Wall Street firms have warned that efforts to fight the slump will produce even worse economic evils. In particular, they say, never mind the current ability of the U.S. government to borrow long term at remarkably low interest rates — any day now, budget deficits will lead to a collapse in investor confidence, and rates will soar.
And it’s this latter claim that Mr. Obama echoed in that ... interview. Is he right to be worried? ... A ... model ... is Japan in the 1990s, which ran persistent large budget deficits, but also had a persistently depressed economy — and saw long-term interest rates fall almost steadily. ...
And shouldn’t we consider the source? As far as I can tell, the analysts now warning about soaring interest rates tend to be the same people who insisted, months after the Great Recession began, that the biggest threat facing the economy was inflation. ...
Still, let’s grant that there is some risk that doing more about double-digit unemployment would undermine confidence in the bond markets. This risk must be set against the certainty of mass suffering if we don’t do more — and the possibility, as I said, of a collapse of confidence among ordinary workers and businesses.
And Mr. Summers was right the first time: in the face of the greatest economic catastrophe since the Great Depression, it’s much riskier to do too little than it is to do too much. It’s sad, and unfortunate, that the administration appears to have lost sight of that truth.
Sunday, November 22, 2009
Robert Shiller wonders if the recovery is based upon a self-fulfilling prophecy:
What if a Recovery Is All in Your Head?, by Robert J. Shiller, Commentary, NY Times: Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy.
Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned... but economic theorists have long been fascinated by such a possibility.
The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession ... is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.
Certainly, people did not always believe that there is a regular “business cycle” that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression... “Recession,” a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. ...
Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover... A depression came to be another matter entirely.
It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article ... titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase...
In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course.
For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means. ...
The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.
Barry Ritholtz responds [Note: Updated version posted at Barry's request]:
How Overrated is Sentiment in Economics?, by Barry Ritholtz: There is a small cadre of Economists — original thinkers, contrarians, out of the box theorists — whom I respect a great deal. It is a modest list ranging from Richard Thaler to David Rosenberg to Robert Shiller, with lots of smart econ wonks in between.
This morning, however, I find myself somewhat disagreeing with one of the smarter of the economists, Professor Bob Shiller... Hence, it is with trepidation that I point out the flaws in Shiller’s discussion about the recovery, (titled “What if a Recovery Is All in Your Head?“). It is a thought provoking but unpersuasive argument... To be fair, he uses the column to incite a debate, rather than defend the position that the recovery is “mostly mental.”
I find numerous things worth challenging in the column... Let me offer 10 items..:
1. Time: The typical post-war Recession lasts 8 months, not “a couple of years”; We are now in month 23. If people started to spend because they sensed it was “late in the recession” or somehow intuited that it was time for the contraction to end, well then, based upon history, that would have been somewhere around August 2008.
2. Not Totally Irrational: One of my complaints about economics is it over-emphasizes people as rational, unemotional actors. However, when it comes to sentiment, economics seems to make the same mistake in the opposite direction — it assumes that people are foolish, unthinking creatures unable to engage in ANY rational thought whatsoever. All sentiment, no rationality at all.
The reality is quite different: Sometimes, people behave the way they do because they have figured out a problem and are responding to it intelligently.
Home Economicus does not really exist — but then again, neither does Homo Idiotus.
3. Healthy Fear of Job Loss: Employed people began to spend their money more carefully when they saw coworkers getting laid off in increasing numbers. That is a rational act in the face of an increasing possibility of a loss of income. This is unlikely to change in the near future, so long as large public layoffs remain a news item. Is this a Sentiment factor — or a rational response to changing conditions?
4. Asset Deflation: Consumers cut back their spending when they saw their biggest assets (Homes, Stocks) lose a significant value. Again, a rational response to a change in personal financial conditions, or bad sentiment?
5. False Belief System: Earlier this year, the Dow had dropped over 5,000 points in 6 months. One of the collective fallacies our culture operates under is the delusion that the market is some kind of astute forecasting machine. It is not — it represents the collective wisdom of 10 million panicked monkeys. That millions of slightly clever, pants wearing primates can combine their collective ignorance, their intellectual foibles, biases and false beliefs somehow into something resembling intelligence was one of the false beliefs of the era. Unfortunately, this is a condition the monkeys are prone towards (Witch burning, bloodletting, organized religion, etc.).
Note however that this does not reflect collective negative sentiment, but is actually the result of what happens when a faulty belief system dominates a society.
6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. ... Why did this group suddenly gain traction in 2008? Maybe it was because the population is not nearly so stupid as the politicians believe. The masses saw with their own two eyes the decay in the economy. Suddenly, the warnings were not as far fetched as they previously seemed.
7. Reacting to Flat Income: Families have recognized their incomes have remained flat to negative over the past decade, while their expenses have increased. What should be the rational reaction to this realization? (Hint: a new car, a bigger house, a new vacation are not on the list of options).
8. Time to Exit the Bunkers: Ten months ago, people were betting the economic world was coming to an end. The economy was in freefall, consumers froze, dramatically reduced spending. But the freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) most of us will agree that the Great Recession ended sometime in Spring of ‘09.
The US consumer is no longer frozen like deer in headlights. Is that sentiment, of just the reality of the situation — what happens when the ice melted?
9. The Cheerleaders Now Look Like Fools: At the onset of a recession, we often see cheerleaders, OpEd writers, and money losing fund managers make the argument that there is no economic slowdown — that the weakness is only in people’s minds. I call these people the Pervasive Pollyannas of Prosperity. (Think Phil Gramm, Amity Shlaes, Don Luskin). Some are partisans, others are dumb, others still merely incompetent — a few are all three. Yet despite their best efforts of the cheerleaders, the economy still went into freefall. Perhaps the public has learned (a teeny bit) who to listen to and who to ignore.
10. Deleveraging: We know why this recession was so deep and long — the wanton use of leverage by people and financial institutions. The deleveraging that is taking place is a long slow process. It is rational, it is intelligent, and it will be how families will restore their balance sheets — the paradox of thrift be damned . . .
I appreciate that Professor Shiller was not arguing in favor of “its all mental.” He sought to spark a debate; I hope this response rose to the challenge . . .
I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.
But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.
Saturday, November 21, 2009
More on what's wrong with modern macro, this time from Axel Leijonhufvud:
Stabilities and instabilities in the macroeconomy, by Axel Leijonhufvud, Vox EU: Fifty-some years ago, students were taught that the private sector had no tendency to gravitate to full employment, that it was prone to undesirable fluctuations amplified by multiplier and accelerator effects, and that it was riddled with market failures of various sorts. But it was also believed that a benevolent, competent, democratic government could stabilize the macroeconomy and reduce the welfare consequences of most market failures to relative insignificance.
Fifty years later, around the beginning years of this century, students were taught that representative governments produce pointless fluctuations in prices and output but, if they can be constrained from doing so – by an independent central bank, for example – free markets are sure to produce full employment and, of course, many other blessings besides. Macroeconomic policy doctrine had shifted from stabilizing the private to constraining the public sector.
This long swing in our understanding of the economy spans a half-century of prolific technical accomplishments in economics (Blanchard 2008). But what the story shows is that, ontologically, economics has been completely at sea, drifting on the surface in currents of our own making. We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.
The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?
Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:
An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.
Friday, November 20, 2009
At MoneyWatch, I attempt to explain why employment lags output in recoveries, and why the lag has been increased after 1990:
I give three reasons, and then use one of them to try to explain the increased lag since 1990.
What’s Wrong With the Dodd Proposal to Restructure the Fed, by Mark Thoma: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal reserve system and politicize the selection process, both of which are the opposite of the where reform should take the system. ...[...continue reading...]...
The economy needs more help from the government, but it's unlikely to get it:
The Big Squander, by Paul Krugman, Commentary, NYTimes: Earlier this week, the inspector general for the Troubled Asset Relief Program ... released his report on the 2008 rescue of the American International Group... The gist of the report is that government officials made no serious attempt to extract concessions from bankers, even though these bankers received huge benefits from the rescue. And more than money was lost. ...
Throughout the financial crisis key officials — most notably Timothy Geithner... — have shied away from doing anything that might rattle Wall Street. And ... this play-it-safe approach has ended up undermining prospects for economic recovery. For the job of fixing the broken economy is far from done — yet finishing the job has become nearly impossible now that the public has lost faith in the government’s efforts, viewing them as little more than handouts to the people who got us into this mess.
About the A.I.G. affair:... why protect bankers from the consequences of their errors? Well, by the time A.I.G.’s hollowness became apparent, the world financial system was on the edge of collapse and officials judged — probably correctly — that letting A.I.G. go bankrupt would push the financial system over that edge. So A.I.G. was effectively nationalized; its promises became taxpayer liabilities.
But was there any way to limit those liabilities? After all, banks would have suffered huge losses if A.I.G. had been allowed to fail. So it seemed only fair for them to bear part of the cost of the bailout... Indeed, the government asked them to do just that. But they said no — and that was the end of the story. Taxpayers ... ended up honoring foolish promises made by other people ... at 100 cents on the dollar.
Could things have been different? ... Major financial firms are a small club, with a shared interest in sustaining the system; ever since the days of J.P. Morgan, it has been common in times of crisis to call on the big players to forgo short-term profits for the industry’s common good. Back in 1998, it was a consortium of private bankers — not the government — that put up the funds to rescue the hedge fund Long Term Capital Management.
Furthermore, big financial firms ... can pay a price if they act selfishly in times of crisis. Bear Stearns ... earned itself a lot of ill will by refusing to participate in that 1998 rescue, and it’s widely believed that this ill will played a major factor in the demise of Bear Stearns itself, 10 years later.
So officials could have called on bankers to offer a better deal,... and simultaneously threatened to name and shame those who balked. It was their choice not to do that...
And, as I said, these seemingly safe choices have now placed the economy in grave danger.
For the economy is still in deep trouble and needs much more government help. Unemployment is in double-digits; we desperately need more government spending on job creation. Banks are still weak, and credit is still tight; we desperately need more government aid to the financial sector. But try to talk to an ordinary voter about this, and the response you’re likely to get is: “No way. All they’ll do is hand out more money to Wall Street.”
So here’s the real tragedy of the botched bailout: Government officials, perhaps influenced by spending too much time with bankers, forgot that if you want to govern effectively you have retain the trust of the people. And by treating the financial industry — which got us into this mess in the first place — with kid gloves, they have squandered that trust.
I agree with this:
Threatening the Fed's independence, by By Alan S. Blinder, Commentary, Washington Post: The Federal Reserve's performance in this ... crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. ... But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.
In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.
But not in the political world. The Fed is extremely unpopular in Congress and is facing hostile and potentially detrimental actions from both sides of the aisle. ... Christopher Dodd ... would clip the Fed's regulatory wings substantially.
Worse, legislation that just proceeded through the House Financial Services Committee could imperil the Fed's ability to conduct an independent monetary policy. With more than two-thirds of the House co-sponsoring the so-called Paul bill, prospects for floor passage unfortunately look good.
The ... bill would subject the Fed's monetary policy decisions and its dealings with foreign central banks to audit by the Government Accountability Office (GAO) -- which normally acts on requests from Congress. Under current law, these aspects of Fed business have been explicitly ruled off-limits (though the rest is auditable).
Is this extension of the GAO's reach, and hence that of Congress, a good idea? If you believe we'd get better monetary policy with decisions made by Congress in open debate, or heavily influenced by congressional opinion, it certainly is. But how many actually believe that? Very, very few. ...
The ... GAO is already authorized to examine most aspects of Fed operations. It can audit the Fed's special financial arrangements for Bear Stearns, AIG, Citigroup and Bank of America -- to name the most prominent examples. ...
But a congressional audit of monetary policy -- remember, the GAO works for Congress -- could easily develop into something quite different. ... It is entirely predictable that some in Congress will be unhappy with the Fed's decisions... Would we welcome a critical GAO audit of monetary policy, which members of Congress could use to browbeat, perhaps even to intimidate, members of the Fed's rate-setting body, the Federal Open Market Committee? ... Would we like Congress to override the Fed's decisions and set monetary policy -- which is its constitutional right? I think and hope not.
An independent monetary policy ... is one of the great and enduring achievements of the Progressive Era. ... Passage of the Paul bill would be a step away from independent monetary policy and a step toward ending the Fed as we know it. That is a step we should not take.
Thursday, November 19, 2009
Robert Reich refuses to give up on the public option:
Harry Reid, and What Happened to the Public Option, by Robert Reich: First there was Medicare for all 300 million of us. But that was a non-starter because private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it was too much like what they have up in Canada -- which, by the way, cost Canadians only 10 percent of their GDP and covers every Canadian. (Our current system of private for-profit insurers costs 16 percent of GDP and leaves out 45 million people.)
So the compromise was to give all Americans the option of buying into a "Medicare-like plan" that competed with private insurers. Who could be against freedom of choice? Fully 70 percent of Americans polled supported the idea. Open to all Americans, such a plan would have the scale and authority to negotiate low prices with drug companies and other providers, and force private insurers to provide better service at lower costs. But private insurers and Big Pharma wouldn't hear of it, and Republicans and "centrists" thought it would end up too much like what they have up in Canada.
So the compromise was to give the public option only to Americans who wouldn't be covered either by their employers or by Medicaid. And give them coverage pegged to Medicare rates. But private insurers and ... you know the rest.
So the compromise that ended up in the House bill is to have a mere public option, open only to the 6 million Americans not otherwise covered. The Congressional Budget Office warns this shrunken public option will have no real bargaining leverage and would attract mainly people who need lots of medical care to begin with. So it will actually cost more than it saves.
But even the House's shrunken and costly little public option is too much private insurers, Big Pharma, Republicans, and "centrists" in the Senate. So Harry Reid has proposed an even tinier public option, which states can decide not to offer their citizens. According to the CBO, it would attract no more than 4 million Americans.
It's a token public option... And yet Joe Lieberman and Ben Nelson mumble darkly that they may not even vote to allow debate on the floor of the Senate about the bill if it contains this paltry public option. And Republicans predict a "holy war."
But what more can possibly be compromised? ... Make it available to only twelve people?
Our private, for-profit health insurance system, designed to fatten the profits of private health insurers and Big Pharma, is about to be turned over to ... our private, for-profit health care system. Except that now private health insurers and Big Pharma will be getting some 30 million additional customers, paid for by the rest of us.
Upbeat policy wonks and political spinners ... will point out some good things: no pre-existing conditions, insurance exchanges, 30 million more Americans covered. But... Most of us will remain stuck with little or no choice -- dependent on private insurers who care only about the bottom line, who deny our claims, who charge us more and more for co-payments and deductibles, who bury us in forms, who don't take our calls.
I'm still not giving up. I want every Senator who's not in the pocket of the private insurers or Big Pharma to introduce and vote for a "Ted Kennedy Medicare for All" amendment to whatever bill Reid takes to the floor. And if this fails, a "Ted Kennedy Real Public Option for All" amendment. Let every Senate Democratic who doesn't have the guts to vote for either of them be known and counted.
I think it's important to have a public option in the bill in some form, even an unsatisfactory one, because it will be much easier to expand the option once it's in place than it would be to pass new legislation in the future that creates a public option.
Jeff Sachs says that if world population doesn't stabilize relatively soon, we're headed for trouble:
Transgressing Planetary Boundaries, by Jeff Sachs, Scientific American: We are eating ourselves out of house and home. ... The green revolution that made grain production soar gave humanity some breathing space, but the continuing rise in population and demand for meat production is exhausting that buffer. ...
Food production accounts for a third of all greenhouse gas emissions... Through the clearing of forestland, food production is also responsible for much of the loss of biodiversity. Chemical fertilizers cause massive depositions of nitrogen and phosphorus, which now destroy estuaries in hundreds of river systems and threaten ocean chemistry. Roughly 70 percent of worldwide water use goes to food production, which is implicated in groundwater depletion and ecologically destructive freshwater consumption from California to the Indo-Gangetic Plain to Central Asia to northern China.
The green revolution, in short, has not negated the dangerous side effects of a burgeoning human population, which are bound to increase as the population exceeds seven billion around 2012 and continues to grow as forecast toward nine billion by 2046. ...
It is not enough to produce more food; we must also simultaneously stabilize the global population and reduce the ecological consequences of food production—a triple challenge. A rapid voluntary reduction in fertility rates in the poor countries, brought about by more access to family planning, higher child survival and education for girls, could stabilize the population at around eight billion by 2050.
Payments to poor communities to resist deforestation could save species habitats. No-till farming and other methods can preserve soils and biodiversity. More efficient fertilizer use can reduce the transport of excessive nitrogen and phosphorus. Better irrigation and seed varieties can conserve water and reduce other ecological pressures. And a diet shifted away from eating beef would conserve ecosystems while improving human health.
Those changes will require a tremendous public-private effort that is yet to be mobilized. ... The window of opportunity to achieve sustainable development is closing.
Wednesday, November 18, 2009
When Paul DeGrauwe presented this paper at the What's Wrong with Modern Macroeconomics conference (papers here), his argument that rational expectations models are the intellectual heirs of central planning seemed to ruffle a few feathers:
Top-down versus bottom-up macroeconomics, by Paul De Grauwe, Commentary, Vox EU: There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.
Evidence on rationality from other sciences
These developments in mainstream macroeconomics are surprising for other reasons. While macroeconomic theory enthusiastically embraced the view that some if not all agents fully understand the structure of the underlying models in which they operate, other sciences like psychology and neurology increasingly uncovered the cognitive limitations of individuals (see e.g. Kahneman 2002, Camerer et al. 2005, Kahneman and Thaler 2006, and Della Vigna 2007). We learn from these sciences that agents only understand small bits and pieces of the world in which they live, and instead of maximising continuously taking all available information into account, agents use simple rules (heuristics) in guiding their behaviour (Gigerenzer and Todd 1999). The recent financial crisis seems to support the view that agents have limited understanding of the big picture. If they had understood the full complexity of the financial system, they would have understood the lethal riskiness of the assets they piled into their portfolios.
Top-down and bottom-up models
In order to understand the nature of different macroeconomic models, it is useful to make a distinction between top-down and bottom-up systems.
The market system is also a bottom-up system. The best description made of this bottom-up system is still the one made by Hayek (1945).
- In its most general definition, a top-down system is one in which one or more agents fully understand the system. These agents are capable of representing the whole system in a blueprint that they can store in their mind. Depending on their position in the system, they can use this blueprint to take command or to optimise their own private welfare. An example of such a top-down system is a building that can be represented by a blueprint and fully understood by the architect.
- Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system. Most living systems follow this bottom-up logic (see the beautiful description of the growth of the embryo by Dawkins 2009).
Hayek argued that no individual is capable of understanding the full complexity of a market system. Instead, individuals only understand small bits of the total information. The main function of markets consists in aggregating this diverse information. If there were individuals capable of understanding the whole picture, we would not need markets. This was in fact Hayek’s criticism of the “socialist” economists who took the view that the central planner understood the whole picture and would therefore be able to compute the whole set of optimal prices, making the market system superfluous.
Rational expectations models as intellectual heirs of central planning
My contention is that the rational expectations models are the intellectual heirs of these central-planning models. Not in the sense that individuals in these rational expectations models aim at planning the whole, but in the sense that, as the central planner, they understand the whole picture. These individuals use this superior information to obtain the “optimum optimorum” for their own private welfare. In this sense, they are top-down models.
In a recent paper, I contrast the rational expectations top-down model with a bottom-up macroeconomic model (De Grauwe 2009). The latter is a model in which agents have cognitive limitations and do not understand the whole picture (the underlying model). Instead, they only understand small bits and pieces of the whole model and use simple rules to guide their behaviour. I introduce rationality in the model through a selection mechanism in which agents evaluate the performance of the rule they are following and decide to keep or change their rule depending on how well it performs relative to other rules. Thus agents in the bottom-up model learn about the world in a “trial and error” fashion.
These two types of models produce very different insights. I mention three differences here. First, the bottom-up model creates correlations in beliefs that in turn generate waves of optimism and pessimism. The latter produce endogenous business cycles which are akin to the Keynesian “animal spirits” (see Akerlof and Shiller 2009).
Second, the bottom-up model provides for a very different theory of the business cycle compared to the business cycle theory implicit in the rational expectations (DSGE) models. In the DSGE models, business cycle movements in output and prices arise because rational agents cannot adjust their optimal plans instantaneously after an exogenous disturbance. Price and wage stickiness prevent such instantaneous adjustment. As a result, these exogenous shocks (e.g. productivity shocks, or shocks in preferences) produce inertia and business cycle movements. Thus it can be said that the business cycle in DSGE models is exogenously driven. As an example, in the DSGE model, the financial crisis and the ensuing downturn in economic activity is the result of an exogenous and unpredictable increase in risk premia in August 2007.
In contrast to the rational expectations model, the bottom-up model has agents who experience an informational problem. They do not fully understand the nature of the shock or its transmission. They use a trial-and-error learning process aimed at distilling information. This process leads to waves of optimism and pessimism, which in a self-fulfilling way create business cycle movements. Booms and busts reflect the difficulties of economic agents trying to understand economic reality. The business cycle has a large endogenous component. Thus, in this bottom-up model, the financial crisis and the ensuing economic downturn should be explained by the previous boom.
Finally, the bottom-up model confirms the insight obtained from mainstream macroeconomics (including the DSGE models) that a credible inflation targeting is necessary to stabilise the economy. However, it is not sufficient. In a world where waves of optimism and pessimism (animal spirits) can exert an independent influence on output and inflation, it is in the interest of the central banks not only to react to movements in inflation but also to movements in output and asset prices so as to reduce the booms and busts that free market systems produce quite naturally. ...
The president is in Beijing as part of his tour through several Asian countries to address economic challenges. He spoke candidly about the precarious balancing act his administration is trying to perform. He wants to spend money to kick-start the economy, but at the same time is in danger of creating too much red ink.
Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate.
"There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett.
"I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."
I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular.
Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession).
These comments also make it sound like any jobs program, if we get one at all, will be limited to (right-wing approved) tax cuts which is, in my opinion, inferior to direct job creation strategies. Tax cuts can be part of the mix, but by themselves are unlikely to do enough to solve the employment problem.
Obama's Vietnam syndrome, by Jonathan Schell, Commentary, Project Syndicate: There can be no military resolution to the war in Afghanistan, only a political one. Writing that sentence almost makes me faint with boredom..., who wants to repeat a point that’s been made thousands of times? Is there anyone on earth who does not know that a guerrilla war cannot be won without winning the “hearts and minds” of the people? ...
Americans are accustomed to thinking that their country’s bitter experience in Vietnam taught certain lessons that became cautionary principles. But historical documents recently made available reveal... those lessons were in fact known -- though not publicly admitted -- before the U.S. escalated the war in Vietnam. That difference is important. If the Vietnam disaster was launched in full awareness of the “lessons,” why should those lessons be any more effective this time? ...
Why did President Lyndon Johnson’s administration steer the U.S. into a war that looked like a lost cause even to its own officials? One possible explanation is that Johnson was thoroughly frightened by America’s right wing. ... His national security adviser, McGeorge Bundy, fueled Johnson’s fears. In a 1964 memo, he wrote that “the political damage to Truman and Acheson from the fall of China arose because most Americans came to believe that we could and should have done more than we did to prevent it. This is exactly what would happen now if we should be seen to be the first to quit in Saigon.”...
Did Johnson’s advisers push the country into a disastrous war in order to win an election -- or, to be more exact, to avoid losing one? ...
What is uncanny about the current debate about Afghanistan is the degree to which it displays continuity with the Vietnam debates, and the Obama administration knows it. To most Americans, Vietnam taught one big lesson: “Don’t do it again!” But, to the U.S. military, Vietnam taught a host of little lessons, adding up to “Do it better!”
Indeed, the military has in effect militarized the arguments of the peace movement of the 1960s. If hearts and minds are the key, be nice to local people. If civilian casualties are a problem, cut them to a minimum. If corruption is losing the client government support, “pressure” it to be honest, as Obama did in recent comments following President Hamid Karzai’s fraud-ridden re-election.
The domestic political lessons of Vietnam have also been transmitted down to the present. George McGovern, the Democratic presidential candidate in 1972, proposed to end the war, which by then was unpopular, yet lost the election in a landslide. That electoral loss seemed to confirm Johnson’s earlier fears: Those who pull out of wars lose elections. That lesson instilled in the Democratic Party a bone-deep fear of “McGovernism” that continues to this day.
There is unmistakable continuity between Joseph McCarthy’s attacks on President Harry Truman’s administration for “losing” China, and for supposed “appeasement” and even “treason” and Dick Cheney’s and Karl Rove’s refrains assailing Obama for opposing the Iraq war... It is no secret that Obama’s support for the war in Afghanistan, which he has called “necessary for the defense of our people,” served as protection against charges of weakness over his policy of withdrawing from Iraq. So the politics of the Vietnam dilemma has been handed down to Obama virtually intact. Now as then, the issue is whether the U.S. is able to fail in a war without becoming unhinged.
Does the American body politic have a reverse gear? Does it know how to cut losses? Is it capable of learning from experience? Or must it plunge over every cliff that it approaches?
At the heart of these questions is another: Must liberals and moderates always bow down before the crazy right over national security? What is the source of this right-wing veto over presidents, congressmen and public opinion? Whoever can answer these questions will have discovered one of the keys to a half-century of American history -- and the forces that, even now, bear down on Obama over Afghanistan. ...
I just posted this at MoneyWatch:
Housing starts fell unexpectedly last month. The Census report gives the details:
Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000.
Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of 511,000. The October rate for units in buildings with five units or more was 48,000.
This graph shows the recent trend in housing starts:
As the graph shows, starts bottomed several months ago, and have been "moving sideways" ever since. What is causing housing starts to move sideways rather than recover? Calculated Risk, one of the best sites for analysis of the housing industry, gives this explanation (which I agree with):
Total housing starts were at ... the all time record low in April of 479 thousand (the lowest level since the Census Bureau began tracking housing starts in 1959). Starts had rebounded to 590 thousand in June, and have move sideways (or down) for five months.
Single-family starts were at 476 thousand (SAAR) in October... Just like for total starts, single-family starts have been at this level for five months.
As he notes, an important piece of the puzzle is that the percentage of vacant units has been climbing and is now at a record level (see this report):
It is very unlikely that there will be a strong rebound in housing starts with a record number of vacant housing units.
The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times.
It appears that ... starts are now moving sideways - and will probably stay near this level until the excess existing home inventory is reduced.
This raises the question of whether the overall economy will echo this pattern of falling backwards after apparent improvement, i.e. of moving sideways for a period of time. This is something I don't think we can or should rule out as we think about the appropriate economic policies that we should have in place to help the economy recover from the recession.