Economist's View

'Will American Innovation Slow If We Go 'Cuddly'?'

I hope you read the post by Lane Kenworthy in today's list of links, but let me highlight one section in particular (there's quite a bit more in the full post):

Will everyone be worse off if the United States turns social democratic? by Lane Kenworthy: Daron Acemoglu, James Robinson, and Thierry Verdier have a new paper that asks “Can’t We All Be More Like Scandinavians?” Their answer is no. The answer follows from a model they develop...

Acemoglu, Robinson, and Verdier say the model might help us understand patterns of economic growth and well-being in the United States and the Nordic countries — Denmark, Finland, Norway, and Sweden. The United States chose cutthroat capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for a short time, but since then all five countries have grown at the roughly same pace. America’s high inequality encourages innovation. The Nordics can be cuddly and still grow rapidly because of technological spillover. If the U.S. were to decide to go cuddly, innovation would slow. Both sets of nations would grow less rapidly. ...

Will American innovation slow if we go “cuddly”?

The really interesting question posed by Acemoglu, Robinson, and Verdier is whether innovation would slow in the United States if we strengthened our safety net and/or reduced the relative financial payoff to entrepreneurial success. I’m skeptical, for three reasons.

The first flows from America’s past experience. According to Acemoglu et al’s logic, incentives for innovation in the U.S. were weakest in the 1960s and 1970s. In 1960 the top 1%’s share of pretax income had been falling steadily for several decades and had nearly reached its low point. Government spending, meanwhile, had been rising steadily and was close to its peak level. Yet there was plenty of innovation in the 1960s and 1970s, including notable advances in computers, medical technology, and others.

Second, the Nordic countries, with their low income inequality and generous safety nets, currently are among the world’s most innovative countries. The World Economic Forum’s Global Competitiveness Index has consistently ranked them close to the United States in innovation. The most recent report, for 2012-13, rates Sweden as the world’s most innovative nation, followed by Finland. The U.S. ranks sixth. The 2012 WIPO-Insead Global Innovation Index ranks Sweden second and the United States tenth. Whether or not this lasts, it suggests reason to doubt that modest inequality and generous cushions are significant obstacles to innovation.

Third, if Acemoglu and colleagues are correct about the value of financial incentives in spurring innovation, we should see this reflected not only in the United States but also in other nations with relatively high income inequality and low-to-moderate government spending, such as Australia, Canada, Ireland, New Zealand, and the United Kingdom. But we don’t. ...

There’s one additional possibility worth considering. If financial incentives truly are critical for spurring innovation, it could be the opportunity for large gains that matters, rather than the absence of cushions. Suppose we were to increase government revenues in the United States via higher taxes on everyone — steeper income taxes on the top 1% or 5% plus a new national consumption tax. And imagine we used those revenues to expand public insurance and services — fully universal health insurance, universal early education, a beefed-up Earned Income Tax Credit, a new wage insurance program, more individualized assistance with training and job placement. These changes wouldn’t alter income inequality much, but they would enhance economic security and opportunity. Would innovation decline? I doubt it. ...

An enhanced safety net -- a backup if things go wrong -- can give people the security they need to take a chance on pursuing an innovative idea that might die otherwise, or opening a small business. So it may be that an expanded social safety net encourages innovation.

As for the effect of reducing the financial payoff by raising taxes on high incomes to support an expansion in the safety net, I don't think it's any secret that I think the distribution of income in recent decades has pushed too much income toward the top and too little toward the middle and bottom (relative to changes in productivity). That is, the distribution of income is distorted. To the extent that taxing high incomes removes these distortions, it's helpful rather than harmful.

And there must be diminishing returns to incentives in any case. If we take away $50 million in taxes leaving someone the prospect of earning "only" $100 million in net profit (i.e. taxes are 33%), would the person really decide to give up the project? Would someone really decide it isn't worth it to only earn $100 million and work less or give it up altogether? Or is it the case that by the time you get to that much income, a marginal increase of decrease in profit has almost no effect on incentives? I'd guess that's the case (and for those in the game simply to see who can accumulate the most, so long as the rules are the same for all, incentives won't change either). There could be an effect at the margin, i.e. profitable projects become unprofitable due to the increase in the tax rate, and that could impact innovation and growth. But growth doesn't seem to decline when taxes at the top are higher, so this case is hard to make.

Links for 09-30-2012

• Who lives longer and why - vox
• Obamanomics - A Counterhistory - NYTimes.com
• Inequality and Growth - Jared Bernstein
• Short Political Memories - Paul Krugman
• Walrasian with Indivisible Goods -Leisure of the Theory Class
• Will we be worse off if the US turns social democratic? - Lane Kenworthy

'For the Wealthy, a 28 Percent Solution'

Richard Thaler likes the number 28:

For the Wealthy, a 28 Percent Solution, by Richard Thaler, Commentary, NY Times: Everyone knows that America’s tax code is a mess... But there is a possible solution. ...

I can state my idea in just one sentence: All income above $1 million a year for a household will be taxed at 28 percent. There are no deductions, and all income, including capital gains and dividends, is included. President Reagan favored something like this...

While we’re at it, let’s make the corporate tax rate 28 percent, too, because our current rate is high by international standards. Oh, and the estate tax exemption? On amounts above $3.5 million for individuals, the rate would be, of course, 28 percent. ...

But what about the argument that taxing capital gains and dividends at the same rate as ordinary income will discourage investment? I don’t find this claim convincing. ...

Of course, I haven’t said what would happen to the households in the middle, or what the taxes would be on the first $1 million for the rich... One possibility is to scale back deductions smoothly, starting at household incomes above $250,000, and completely eliminate them for incomes above $1 million. ... A more radical plan, curtailing deductions for this large group, is probably politically infeasible...

And what if the resulting revenue falls a bit short...? I suggest that we get our gasoline tax more in line with those of the rest of the world. Gradually raising it to something like $1 a gallon would both bring in revenue and help reduce emissions. In the long term, we could set the rate as a percentage of the price at the pump. Maybe 28 percent?

Paul Ryan's View of Social Insurance as a Socialist, Collectivist System That Must Cease to Exist

Brad DeLong says Paul Ryan's view of social insurance should get more attention:

Paul Ryan: Socialism Must Be Destroyed, and by "Socialism" I Mean Things Like Social Security, Medicare, Food Stamps, and Unemployment Insurance by Brad DeLong: The Paul Ryan audiotape did not get the same attention as the Romney videotape. Yet I find it as damning:

Paul Ryan:

Social Security right now is a collectivist system. It is a welfare transfer system…. And so what we have coming now at the beginning of this century is a fight…. [A]ll they have to do is to stop us from succeeding. Autopilot will get them to where they want to go. It will bring more government, more collectivism, more centralized government if we do not succeed in switching these programs and reforming these programs from what some people call a defined-benefit system to a defined-contribution system--and I am talking about health-care programs as well--from a third-party socialist-based system to an individually-prefunded individually-directed system. We can do this. We are on offense on a lot of these issues…

In Paul Ryan's eyes, Social Security, Medicare, Medicaid, Unemployment Insurance, SNAP, etc. are all socialist, collectivist systems that must cease to exist in anything like their present form.

And let me stress that shifting health care to an "individually-prefunded individually-directed system" means that poor people die in the gutter outside the hospital when they get sick: if you are unlucky and get seriously ill, then unless you are rich there is no way that you can have individually-prefunded enough to pay for your treatment. ...

Leaving social insurance to the marketplace -- for example assuming that individuals will rationally prefund their future needs -- has never worked. It didn't work in the US before we had a broad social insurance program, and it hasn't worked in other countries either. Are markets suddenly so much better than they used to be that we can now expect them to function in instances where they have always failed in the past? I don't see any reason to believe that's the case. There are good reasons why countries choose to institute social insurance programs, and those reasons haven't gone away.

Fed Watch: Is Low Inflation Always Good?

Tim Duy:

Is Low Inflation Always Good?, by Tim Duy: I was intrigued by something Scott Sumner wrote last week:

I’d also point out that the US has experienced 3 major equity or residential real estate bubbles in periods of relatively low inflation and NGDP growth (1929, 2000, 2006) and zero major bubbles in periods with high inflation and NGDP growth (1968-81). The 1987 stock market bubble was an intermediate case (which did zero harm, as NGDP continued growing after the bubble.)

I was further intrigued when I saw this chart from the IMF (h/t FT Alphaville):

This was from a chapter covering the history of all situation in which public debt rose above 100 percent of GDP. See the gap in the timeline? The relatively high inflation late 1960's and 1970's. Another reason to at least think about the possibility that while high and variable inflation is not ideal, perhaps neither is very low inflation.

'Economy and Economics of Ancient Greece and Ancient China'

We had our first seminar of the year today. It was by Professor Takeshi Amemiya of Stanford. Takeshi is best known for his econometric research on a wide range of topics, including a series of highly influential theoretical papers in the 1970s and 1980s. His more recent research has been in a very different area -- the economics of ancient Greece. The title of his talk was:

"Economy and Economics of Ancient Greece and Ancient China"

One of the things I took from the talk was how many of the ideas in Adam Smith's Wealth of Nations can be found in these ancient texts, concepts such as the division of labor, supply and demand, the role of prices, monopoly power, wealth accumulation, and so on.

But it was also interesting to see echoes of so many modern debates, e.g. about wealth inequality, taxes, etc., from so long ago. Here are a few quotes from the section "Economic Thoughts" in his slides (there is a timeline in the slides showing when each of the people quoted below lived):

...Economic Thoughts

(1) Warriors, Farmers, Craftsmen, and Merchants

In Athens from the 7th to the 6th century BC, the middle and lower class, which engaged in commerce and industry, gradually gained its status, becoming a threat to the aristocrats who depended on farming. Also in China there was a deep-rooted idea that agriculture is primary and commerce and industry are secondary. ... Contempt for commerce and industry, as in Greece, started ... when commerce and industry started growing.

It is noteworthy, however, that in China scholars who defended commerce and industry also emerged. Actually it is surprising that such scholars are not known in Greece. ...

 A. Confucius
Confucius argued for income equality: “I hear that the man who governs a nation and the man who governs home are more concerned with inequality than scarcity, more concerned with anxiety than poverty.”

B. Guan Zhong
Guan Zhong was a financial adviser to Lord Huan of Qi (?—643). Scholars belonging to the Guan Zhong school kept publishing works in the name of Guan Zi up to the days of Emperor Wu of Early Han.

Guan Zhong believed the four classes should live in separate areas, warriors near the army, farmers near the farm, craftsmen near the government agencies, and merchants near the market. He also believed the four classes should be hereditary in principle, although he would allow an exceptionally stout farmer to be a warrior. ...

He feared the antagonism between the rich and the poor: “When the income inequality exceeds a limit, everything is lost.” (“Five Aids”). Plato said a similar thing in The Laws (744D). Guan Zhong tried to solve this problem by the government’s direct buying selling and its price policy. He encouraged trade across nations. “Show hospitality to the surrounding nations.” (“Book of Questions”) “Please build guest houses for foreign merchants.” (“Gravity Part B”).

 C. Mo Zi
“When the lower class works hard, public finance prospers.” (“Heaven’s Will” Part B). He criticized li and yue (morals and music) emphasized by Confucianism as luxury and extravagance. “We should give food to the hungry, clothes to the cold, rest to the laborer, and peace to the disorderly.” (“Against Fate” Part C).

“Therefore the ancient sage kings in their governance appointed the virtuous people for high positions and valued the wise. They appointed even people from the lower three classes as long as they were able and promoted them to peerage, gave them high salaries, and gave them the right to make important political decisions.” (”Merit of Wisdom” Part A) ...

 D. Meng Zi
“Those who exert mind rule others, those who exert body are ruled, the ruled feed the rulers, the rulers govern the ruled, and this is universal truth.” (“Lord Wen of Teng Part A”). ...

“There was an ignoble man, who would climb to a high place, look around, and if he finds a place where he is likely to make a profit, goes there and monopolizes the profit. Everyone despised this man, and the government started imposing the merchant tax.” (Gong Sun Chou Part B”).

 E. Xun Zi
“A son of a craftsman always succeeds his father’s profession.” (“Influence of a Great Scholar”).

“Man by nature cannot live without forming a group. If a group does not have classes, people quarrel. If people quarrel, they become disordered, and if they are disordered, they fall into trouble. Therefore, life without classes brings the greatest harm, and that with classes brings the greatest benefit.” (“National Wealth”)

“The best way to repair disorder and eliminate harm is to establish classes and group people accordingly.” (“National Wealth”).

“If the descendants of lords and aristocrats do not make an effort to observe morality, they should be relegated to the rank of commoners, and if the descendants of commoners enhance culture and scholarship, adhere to right conduct, and strive for moral life, they should be elevated to the rank of aristocrats and ministers.” (“Kingdom”).

“We should lower the farm tax, unify the market and import-export taxes, minimize recruiting farmers for nonfarm work so that farmers can concentrate on farming, then the wealth of a nation will increase.” (“National Wealth”)

F. Sima Qian (“Biography of Millionaires”)
“Many commoners without a rank, without meddling with politics, without interfering with the lives of people, increased wealth by trading at the right moment. Intelligent people can learn from this.”

“Therefore, farmers provide food, forest guards supply mountain resources, and merchants distribute these goods. The government did not order the collection of the goods. It was done because each person did what he could best and wanted to get what he needed. When the prices are high, that is a sign they will soon become low. Everybody diligently attends to his task and enjoys doing it just as water flows to a lower place. He keeps working days and nights, comes even if he is not called, and supplies goods even if they are not demanded. This stands to reason and is the way it should be.”

After mentioning how various millionaires obtained their fortunes, he concludes, “These people did not get rich because they were given land by the government, nor did they thwart law or did evil things. They observed the law of nature and found the right moment to act and make a profit. They made a fortune by the secondary occupation (commerce) and preserved it by the primary occupation (agriculture). What they got by force, they kept it by civility. As the world changed, they reacted with moderation. That is why it is worthwhile mentioning them.”

 G. Sang Hongyang
Sang Hongyang (152BC – 80BC) was the finance minister of Emperor Wu and in 120BC became the officer in charge of salt and iron monopoly. “Salt Iron Debate” is a record of the debate between Sang Hongyang versus the Learned and the Wise chosen from the public regarding the pros and cons of the monopoly of salt and iron, which took place in 81BC and 30 years later recorded by Huan Kuan.

“Wealth is obtained by strategy, and not by labor. Profit comes from power, and not from tillage.” (Salt and Iron Debate “distribution”).

“Xian Gao contributes by selling cattle to Zhou, Wu Gu by lending vehicles in Qin, Gong Shuzi by making use of compasses and measures, and Ou Ye by smelting. Craftsmen perform their tasks in the shops and farmers and merchants trade and benefit each other.” (Ibid.) And yet, in order to convince the Learned, he argues that the monopoly of salt and iron has the benefit of suppressing the avarice of the big merchants.

...

4 Theory of Prices
Guan Zhong was well aware of the fact that a price is determined by supply and demand, and conversely, supply and demand respond to price (which he calls Theory of Light and Heavy).

“The market determined the level of prices. … By observing the market one can tell whether the nation is orderly or disorderly, whether the supply of goods is sufficient or deficient. But the market itself cannot determine the supply.” (“Riding Horses”). ...

Xenophone states, “An increase in the number of coppersmiths, for example, produces a fall in the price of copper work, and the coppersmiths retire from business. The same thing happens in the iron trade. Again, when corn and wine are abundant, the crops are cheap, and the profit derived from growing them disappears, so that many give up farming and set up as merchants or shopkeepers or money-lenders.”(Ways and Means iv 6). ...

Links for 09-29-2012

• Another Reason Kocherlakota Changed His Mind - RTE
• Imaginary foe in the presidential election - FT.com
• Internal Devaluation and the Road to Wigan Pier - Paul Krugman
• What's Up With the Dodd-Frank Legislation? - Tim Taylor
• Thomas Hoenig Read All of Basel III . . . - The Baseline Scenario
• Simple thoughts on NGDP = RGDP x P - Nick Rowe
• Facts for Jame Bullard - Macro and Other Market Musings
• The Beginnings of the Fed’s Jackson Hole Symposium - Liberty Street
• Multipliers, yet again - Josh Bivens
• Is Taxing Capital Income Fair? - Next New Deal
• Debt Is a Drug (And So Is Austerity) - Paul Krugman
• Redistribution of Wealth in America - Uwe E. Reinhardt

Easterlin: When Growth Outpaces Happiness

My attempt to defend the social safety net in a recent column received a fairly ho-hum response, so let me see if (and hope that) Richard Easterlin can do better:

When Growth Outpaces Happiness, by Richard Easterlin, Commentary, NY Times: ... As the recent riots at a Foxconn factory in northern China demonstrate, growth alone, even at sustained, spectacular rates, has not produced the kind of life satisfaction crucial to a stable society — an experience that shows how critically important good jobs and a strong social safety net are to people’s happiness.

Starting in 1990, as China moved to a free-market economy, real per-capita consumption and gross domestic product doubled, then doubled again. Most households now have at least one color TV. Refrigerators and washing machines — rare before 1990 — are common in cities.

Yet... If anything, they are less satisfied than in 1990, and the burden of decreasing satisfaction has fallen hardest on the bottom third of the population in wealth. ... It is startling to find ... a U-shaped pattern of happiness over time... What explains the “U” at a time of unprecedented economic growth?

Before free-market reforms kicked in, most urban Chinese workers enjoyed what was called an “iron rice bowl”: permanent jobs and an extensive employer-provided safety net, which included subsidized food, housing, health care, child care, pensions and jobs for grown children. Life satisfaction ... among urban Chinese, despite their much lower levels of income, was almost as high as in the developed world.

The transition to a more private economy in the 1990s abruptly overturned the iron rice bowl. ... Life satisfaction in urban areas declined markedly..., its market transition has given birth to increasing concerns ... about such matters as finding and holding a job, the availability of reliable and affordable health care, and provision for children and the elderly. ...

It is noteworthy that at a time when the need for a strong safety net is under attack in the United States, the world’s most fervent capitalist nation has inadvertently demonstrated its critical importance for people’s happiness.

Paul Krugman: Europe’s Austerity Madness

A false portrayal of the nature of the problems in Europe may undermine the ability of the ECB to do what’s necessary to save the euro:

Europe’s Austerity Madness, by Paul Krugman, Commentary, NY Times: ...Just a few days ago, the conventional wisdom was that Europe finally had things under control. The European Central Bank, by promising to buy the bonds of troubled governments if necessary, had soothed markets. All that debtor nations had to do ... was agree to more and deeper austerity — the condition for central bank loans — and all would be well.

But the purveyors of conventional wisdom forgot that people were involved. Suddenly, Spain and Greece are being racked by strikes and huge demonstrations. The public in these countries is, in effect, saying that it has reached its limit: With unemployment at Great Depression levels..., austerity has already gone too far. And this means that there may not be a deal after all.

Much commentary suggests that the citizens of Spain and Greece are just delaying the inevitable... But ... the protesters are right. More austerity serves no useful purpose...

Consider Spain’s woes. What is the real economic problem? Basically, Spain is suffering the hangover from a huge housing bubble... Spain didn’t get into trouble because its government was profligate. ... Spain actually had a budget surplus and low debt. Large deficits emerged when the economy tanked...

Spain doesn’t need more austerity..., savage cuts to essential public services, to aid to the needy, and so on actually hurt the country’s prospects for successful adjustment. Why, then, are there demands for ever more pain?

Part of the explanation is that ... a significant part of public opinion in Europe’s core — above all, in Germany — is deeply committed to a false view of the situation. Talk to German officials and they will portray the euro crisis as a morality play, a tale of countries that lived high and now face the inevitable reckoning. ...

Worse yet, this is also what many German voters believe, largely because it’s what politicians have told them. And fear of a backlash from voters who believe, wrongly, that they’re being put on the hook for ... southern European irresponsibility leaves German politicians unwilling to approve essential emergency lending to Spain and other troubled nations unless the borrowers are punished first. ...

And it’s long past time to put an end to this cruel nonsense.

If Germany really wants to save the euro, it should let the European Central Bank do what’s necessary to rescue the debtor nations — and it should do so without demanding more pointless pain.

Links for 09-28-2012

• When Growth Outpaces Happiness - Richard Easterlin
• A River Runs Through…Gale Crater - Scientific American
• Notes On Internal Devaluation (Wonkish) - Paul Krugman
• A Non-random Walk Down Campaign Street - Andrew Gelman
• 'Harvest Them at Significant Profit - Robert Reich
• How Big Is the Output Gap? - macroblog
• Not The Election They Were Expecting - Paul Krugman
• Extractive Growth in the United Arab Emirates - Acemoglu and Robinson
• Ignoring the nation’s poor: A political peril in 2012? - Jeffrey Buchanan
• Fed joins ECB in a high-risk move - Martin Feldstein
• Which candidate’s plans are more Keynesian? - Josh Bivens
• The Koch/Ryan Ticket Endangers Social Security - Pam Martens
• Does economic growth make you happy? - Robert Skidelsky
• Preliminary benchmark revision shows 386,000 more jobs - Calculated Risk
• Stage Three for the Euro Crisis? - J. Bradford DeLong
• Fiscal Confrontation Undermines the U.S. - Simon Johnson
• Weekly Initial Unemployment Claims decline - Calculated Risk
• Same As It Ever Was - Paul Krugman

'There Aren’t That Many Takers in America'

I was checking my rss feed after class today, and for some reason -- I don't know what came over me -- I clicked through to a Washington Times article by Ted Nugent:

Mitt Romney was right about the 47 percent

It contains just what you'd expect from both the paper and the writer, things like:

Mitt Romney hit the bull’s-eye with his comments regarding the 47 percent of Americans who do not have any skin in the game as it pertains to paying federal income tax. Facts are facts.

Romney did hit a bull's-eye, I'll agree with that, but he scored for the wrong team. Anyway:

Mr. Romney is not backing down. Good. The truth is the truth and it’s long past time someone said it.

As I’ve written before, for at least the past 50 years the Democratic Party has intentionally engineered a class of political “victims” who have been bamboozled into being dependent on the federal government for their subsistence, including food, housing and now health care. They get this without paying any federal income taxes, and that’s wrong. Something for nothing is always a scam. This is how you buy votes, plain and simple. ...

The Democratic Party exists because it promotes the creation of dependence on Fedzilla. ... No able-bodied American should get anything for free while doing nothing to earn it. ...

Good advice Ted, I hope Romney follows it. Tell the 47% off but good!

Fortunately, the next thing I read was this (see the full post for the calculations being the numbers presented below):

There Aren’t That Many Takers in America, by  Nathan Kelly: ...Mitt Romney said...:“... there are 47% ... who are dependent upon government, who believe that they are victims, who believe that government has a responsibility to care for them, who believe that they are entitled to health care, to food, to housing, to you name it.”

The ... discussion of dependence on government is at the heart of the Republican case against Democrats... I attempt to gain some empirical leverage on this question using information ... from 2011 Current Population Survey March Supplement microdata.

Creating a working definition of takers is tricky. ... It’s not a sliding scale. Either you’re a maker or you’re a taker. Since the rhetoric is dichotomous, my strategy for identifying takers will be dichotomous as well.

So who should we count as a pure taker? ... Of the 24.7% of Americans who did not work and received government benefits in 2010, more than 70% are either disabled or retired. 7.7% are not working in order to care for home or family – not a group that family values conservatives typically malign. 12.8% are going to school, which likely indicates at least a degree of taking responsibility for oneself. ...

The bottom line here is that there aren’t that many takers in America. The most restrictive definition pegs the percentage of takers at 2.4%. If we’re willing to include people in households with at least one earner, that number increases to 5.2%. ... But these numbers simply don’t line up with the rhetoric of a massive class of lazy people taking advantage of the rest of us while eating solely at the trough of government.

Finally, it’s worth pointing out that these are really upper-bound estimates. Being a taker involves motives as well as work and benefit status. Takers, so the argument goes, feel no responsibility for themselves and believe that they are entitled “to you name it.” The CPS data don’t allow us to examine motives, but if we could, we would likely find even fewer takers.

Workers have not received their fair share of output in recent decades -- wages have lagged behind increased productivity -- so other groups must have received more than their share. Another definition of "takers" would ask who it was that received more than they contributed, and I think it's pretty clear who that group is. Mitt carries their torch.

'Paul Ryan’s Magic Budget Caps'

Ezra Klein on budget caps:

Paul Ryan’s magic budget caps, by Ezra Klein: I’ve gotten some confused e-mails over David Rogers’ report on Paul Ryan’s ... decision to cap the growth of Medicare spending at GDP+0.5 percentage points (a rate that is slower than health-care costs typically grow) to make the rest of his budget numbers add up. ...

Ryan needs these caps because there’s no good evidence that any of his premium support plans will actually save much money in Medicare. ... So he includes these caps and tells the CBO that if his premium support plan fails, he’ll save the money in a different way. In his 2011 budget proposal, that’s through shifting costs to seniors. In Ryan’s most recent budget, it’s left blank. But the CBO has no choice. They have to assume Congress will abide by the cap.

This isn’t a trick unique to Paul Ryan. President Obama’s budget proposal also includes a GDP+0.5 percentage point cap on Medicare’s spending growth. ... The Simpson-Bowles plan is also thick with spending caps. ...

One of our worst tendencies in Washington is to debate budget plans ... dependent on these kinds of caps. The question ... isn’t whether it says it will save money, but whether the policies in it will actually save money. If Ryan’s fond hopes for premium support don’t pan out, then his budget has no chance of meeting its targets. Similarly, if Medicare proves incapable of saving money by paying for quality, Obama’s numbers aren’t going to happen. And for all that you hear about how Congress should “just pass Simpson-Bowles,” if Congress can’t figure out the right mix of policies to hit those caps, then Simpson-Bowles won’t solve our deficit problems. 

These questions, in the end, require a judgment about what’s actually the best way to save money in the health-care system, how we can raise more tax revenue, or what will move the needle on growth. But too often, when we say we’re debating budget policy, we’re actually just debating budget caps. And budget caps don’t work if the underlying policies fail.

From a footnote that shouldn't be overlooked, more on Paul Ryan's budget wonkery (or maybe it should be wankery):

Ryan also caps other forms of spending, and his most recent budget implausibly assumes that all non-entitlement spending will fall from 12.5 percent of GDP today to 3.75 percent of GDP in 2050. This is more important to his numbers than his Medicare plan, and it’s also a complete joke. See page 13 of the CBO report for more.

I think people take the budget promises issued in campaigns with a grain of salt. It's the underlying philosophy behind the promises that's important. Who are the winners and losers under each of the plans? That's one thing I'd like to see the press pay more attention to. But even more important, I think, is for the press to stop playing along with fear-mongering over the deficit designed to force cuts to programs that will do little to address the long-run problem. We do have debt problems, but do people understand the precise nature of the problem, when the big budget problems are likely to arise, and why? How many people think our long-run budget problem has something to do with the stimulus package, for example, when that is simply not the case? I'm all for more precision in the discussion of budget plans, and for being clear about credible versus non-credible assumptions that the CBO must honor. But I also think the public needs a much better understanding of the problem before they can evaluate the efficacy of proposed solutions.

Green Shoots and the Gardeners at the Fed

David Altig says monetary policymakers are better described as gardeners than engineers, and that "when it comes to policymakers, I'll take a green thumb any day." But I can't help thinking of Bernanke's statement in 2009 that he was seeing "green shoots" and renewed confidence, but those green shoots soon withered. It's true that the "gardener cannot make the sun shine," but many of us thought more needed to be done at the time so that "growing conditions are the best that they can be," and have been pushing the Fed to do more ever since:

Scientists? Engineers? How about Gardeners?, by David Altig: In the past few days Simon Wren-Lewis (at Mainly Macro) and Noah Smith (at Noahpinion) have revisited some past musings by Greg Mankiw on whether we should think of macroeconomists as scientists or engineers. The separation between the two in Mankiw's telling occurs at the point where macroeconomics meets policy—when macroeconomists leave the academic cloister and take up the causes of the real world. In Mankiw's original words:

God put macroeconomists on earth not to propose and test elegant theories but to solve practical problems.

Wren-Lewis and Smith each have their own issues with the scientist/engineer taxonomy, but both seem to more or less buy into the notion of macroeconomist cum policymaker as an engineer.

For my part, I'm not a fan of the engineer metaphor. It seems a little—well, immodest. Consider these comments, to take just a select few, from Federal Reserve officials following the decision of the most recent Federal Open Market Committee (FOMC) meeting. First, from Fed Chairman Ben Bernanke (via Econbrowser):

The policies that we have undertaken have had real benefits for the economy in that they have provided some support, that they have eased financial conditions and helped reduce unemployment. All that being said, monetary policy, as I've said many times, is not a panacea, it is not by itself able to solve these problems. We are looking for policymakers in other areas to do their part. We will do our part and we will try to make sure that unemployment moves in the right direction, but we can't solve this problem by ourselves.

And this, from a September 18 speech by Chicago Fed President Charles Evans:

Given the slow and fragile recovery, the large resource gaps that still exist, and the large risks we face, it remains clear that we needed a more resilient economy that can withstand the headwinds that might come its way. Last week the FOMC provided a more accommodative monetary policy that can help us achieve such resilience.

Or this, from a September 21 speech by Atlanta Fed President Dennis Lockhart:

The core rationale of my support [for the FOMC decision] was to better assure that the economy remains on a growth trajectory sufficient to steadily, if gradually, reduce the rate of national joblessness. I am not expecting miracles.

I think the action recently taken by the committee has improved the country's economic prospects by reducing the potential downside apparent in the incoming data. In this sense, the policy action was a preventative. But I expect policy will do more than just prevent backsliding.

To be sure, each of the three express confidence that the FOMC's actions will yield better outcomes than would otherwise occur. I guess you could say “engineer” better outcomes, if you like. But I am struck by some of the other ideas expressed in these comments, related to reducing downside potential, promoting resilience, and providing some support.

I credit my colleague Mike Bryan (who credits former Cleveland Fed President Jerry Jordan, our mutual former boss) for suggesting that these types of motivations are better associated with gardening than engineering science. The good gardener does not presume to create growth, but knows that he or she can play a part by ensuring that growing conditions are the best that they can be. The gardener cannot make the sun shine by applying scientific knowledge, but can take measures to promote resilience and support until it does.

Science and engineering are important, without doubt. But when it comes to policymakers, I'll take a green thumb any day.

Links for 09-27-2012

• Fed’s Evans Wants Central Bank to Do Even More - RTE
• Perspectives on Current Economic Issues - Charles Evans
• The impossibility of meritocracy - Chris Dillow
• China's economic slowdown - Econbrowser
• Craigslist and monopoly power - Digitopoly
• After Brief QE3 Fever, Inflation Expectations Cool - RTE
• One in Five Households Owe Student Debt - WSJ
• Is It Moral for Lefties to Vote for Obama? - Crooked Timber
• My "Must Read" (Econometrics Papers) List - Dave Giles
• Euro Update: The Perils of Pointless Pain - Paul Krugman
• Predistribution – a bad idea whose time has come? - Crooked Timber
• Peter Coy for Governor of the Bank of England! - Businessweek
• Fractal Kitties and Julia Sets - Scientific American
• New Home Prices: Average Highest since 2008 - Calculated Risk
• Reducing the Tax Favoritism for Housing - Tim Taylor
• Taxes & Cheating: The Other 47 Percent - Stan Collender
• Finding the Keys to National Prosperity - Jeffrey D. Sachs
• Rebalancing the Economy under Fiscal Consolidation - Liberty Street
• Repackaging Mitt as a Compassionate Conservative? Too Late - Robert Reich

Should Home-Ownership be Discouraged?

Richard Green, in a debate at The Economist on home ownership:

The opposition's closing remarks Sep 26th 2012, by Richard K. Green: In his comments, Ed Glaeser makes a point that I wholeheartedly agree with: the American system of housing subsidies makes little sense. The largest housing subsidy, the mortgage interest deduction,... does little to help those at the margin of home-owning...

Nevertheless, I think Mr Glaeser sells his own study short when he argues that the civic connections established through home-owning are not very important. Home-owning can help countries overcome legacies in which property owners have exploited property users—legacies that include the hacienda system in Latin America and the Philippines, and sharecropping and company towns in America. There are important links between ownership, personal independence and the sense of control, as well as the ability to be socially mobile.

One could argue that we in America engaged in an experiment in discouraging home-ownership for ... minorities in general and African-Americans in particular. For many years, real-estate agents and lenders in America discriminated against minorities who tried to purchase houses, and American housing finance policy discriminated against African-American and central city neighborhoods. ... Hence the inability of African-Americans to own homes was very much the result of policies that targeted African-Americans.

One of the upshots of this is that the home-ownership rate among African Americans, at 46%, is considerably lower than it is for white Americans, at 71%. Controls for wealth, income and demographics are not sufficient to explain the gap. And ... African-Americans continue to get loans at less favorable terms than others.

But does any of this matter? ...—home equity explains the likelihood that children will complete college better than any other type of asset... It seems that a lack of access to owner-occupied housing has prevented African-Americans' access to a college degree. ... Educational attainment is crucial to social mobility. ... This is both economically and socially destructive.

The entire debate is here.

Fed Watch: Plosser Opposes the 1933-37 Expansion

Tim Duy:

Plosser Opposes the 1933-37 Expansion, by Tim Duy: Philadelphia Federal Reserve Charles Plosser spoke yesterday, reiterating his opposition to QE and his expectation that it will have no impact on growth. I don't think any of that should have been a surprise. What caught my attention was this:

Once the recovery takes off, long rates will begin to rise and banks will begin lending the large volume of excess reserves sitting in their accounts at the Fed. This loan growth can be quite rapid, as was true after the banking crisis in the 1930s, and there is some risk that the Fed will need to withdraw accommodation very aggressively in order to contain inflation.

I am somewhat concerned that a Federal Reserve official would use loan growth in the 1930s as an example of what could go wrong with quantitative easing. It should be seen as an example of what could go right.

Presumably, Plosser is talking about something like this graph:

This is a problem because...why? The inflation, that's right:

Yes, there was inflation after 1933. And no, this wasn't a bad thing. The inflation, as well as the loan growth were part of the recovery. They were features, not bugs, of easier policy. And even by 1937, both the price level and loans were below pre-recession peaks. Yet, policy turned prematurely tighter, tipping the US economy back into recession and deflation.

Bottom Line: Fed hawks obsess with the issue of having to unwind quantitative easing when the economy improves. We should be so lucky. Shouldn't we wait until we see some hope that rates can sustain themselves above at least 3% before we worry about this? Somehow the hawks fail to understand that policy is always reversed in the next pahse of the business cycle. Simply put, if we need to unwind quantitative easing, the policy was indeed effective. Plosser takes the wrong lesson away from rapid loan growth in the 1930s. The lesson is not that we should fear recovery. The real lesson was to avoid premature tightening of policy.

The 'World-Straddling Engine of Theft, Degradation, Manipulation and Social Control We Call the Welfare State'

John Kay is tired of hearing the same old same rants about the unaffordable welfare state that he's been hearing for decades:

The economy depends on the welfare state, by John Kay: It is more than 30 years since I first attended a conference on the global welfare crisis. Rarely have a few months passed without an invitation to another. Last week, Tom Palmer, the American libertarian, came to London to denounce the “world-straddling engine of theft, degradation, manipulation and social control we call the welfare state”.

The content of these rants is familiar. Levels of welfare provision are unaffordable; government finance is a huge Ponzi scheme. A common conclusion is to provide an estimate of the discounted value of the cost of some hated item of expenditure if its current provision were continued into the indefinite future. Mr Palmer reported that the present value of unfunded liabilities of US medicine and social security is $137tn.

Social security is a means of inter-generational transfer..., but why ... should we look after old people, who can no longer do anything for us?

The obvious answer invokes Kant’s categorical imperative: it would be good for everyone (including ourselves when we are old) if everyone acted in this way. We feed the generations of our parents and grandparents in the expectation future generations will come along and do the same for us. But the consequences of this arrangement do have the character of a Ponzi scheme. One day, the world will end and the last generation of workers will have been cheated of their expectation of a peaceful retirement. In the meantime it is possible to calculate enormous measures of unfunded obligations, and it doesn’t matter. The value of these obligations is offset by the implied commitments of future generations. ...

Exaggeration can sometimes be forgiven when it is used to draw attention to a problem that has received insufficient attention. It is less easy to excuse when it threatens the fragile social arrangements on which economic security depends.

Are Oil Prices 'Determined Solely by Fundamentals'?

Jim Hamilton on what determines prices in oil markets:

...The Wall Street Journal carried this account last week:

Oil prices dropped more than $3 in less than a minute late in the trading day on Monday, just as trading volume spiked. The move also dragged down prices of gold, copper and even the euro.

"Traders were looking like deer in the headlights," said Peter Donovan, a floor trader... "I called four different desks, and they all said, 'we don't know.' " ...

The move sparked talk of an erroneous trade—called a "fat-finger" error in industry parlance—or a computer algorithm gone awry.

Fat finger or no, there was an even bigger drop on Wednesday...

Those who doubt that oil prices are determined solely by fundamentals would naturally ask, what aspect of the supply or demand for oil could have possibly changed in the course of less than a minute last Monday? The obvious and correct answer is, there was no change in either the supply or the demand for physical oil over the course of that minute. The minute-by-minute price of a NYMEX contract is determined by how many people are wanting to buy that financial contract and at what price, not by how much gasoline motorists burned in their cars that minute. But since changes in the price of crude oil are the key determinant of the price consumers pay for gasoline, doesn't that establish pretty clearly that the whims or fat fingers of financial traders are ultimately determining the price we all pay at the pump?

In one sense, the answer to that question is yes-- last week's decline in the price of crude oil will soon show up as a lower price Americans pay for gasoline. But here's the problem you run into if you try to carry that theory too far. There are at the end of this chain real people who burn real gasoline when they drive real cars. And how much gasoline they burn depends in part on the price they pay-- with a higher price, some people use a little bit less. Not a lot less-- the price of gasoline could change quite a lot and it would take some time before you could be sure you see a response in the data. That small (and often sluggish) response is why the price of oil can and does move quite a bit on a minute-by-minute basis, seemingly driven by forces having nothing to do with the final users of the product.

But if the price of oil that emerges from that process turns out to be one at which the quantity of the physical product that is consumed is a different amount from the physical quantity produced, something has to give. Indeed, the bigger price drops we saw on Wednesday followed news that U.S. inventories of crude were significantly higher than expected ...

Links for 09-26-2012

• What About the Questions That Economics Can’t Answer? - Robert Johnson
• The impossibility of a behavioural welfare economics - Frances Woolley
• Temporary Spending Increases Do Not Drive LR Deficits - Jared Bernstein
• Mitt Romney's Income Was Not Taxed at the Corporate Level - Dean Baker
• Actor-centered sociology and agent-based models - UnderstandingSociety
• Let’s not get ‘carried away’ by Bernanke’s latest twist - Economists' Forum
• Mitt Romney's Housing Plan Is a Joke - Matthew O'Brien
• Delusions of Wonkhood - Paul Krugman
• Elephant Poaching and Policy Options - Tim Taylor
• Republicans Champion 'Voluntary Taxes' - Bruce Bartlett
• Getting Real on Jobs and the Environment - Robert Pollin
• Central Banks on the Offensive? - Jean Pisani-Ferry
• EconoTrolls: An Illustrated Bestiary - Noahpinion
• Coulda Been Worse - Paul Krugman

Fed Watch: Why I Agonize About The Zero Bound

Tim Duy:

Why I Agonize About The Zero Bound, by Tim Duy: I increasingly agonize about the zero lower bound. It's really no secret that I believe that the faster we normalize interest rates, the better. Such a goal should appeal to those who believe current monetary policy is reckless. To be sure, the Fed's forecast that the US economy will be stuck at the zero bound into 2015 does not leave me filled with confidence; the risks are all too high that the economy will experience a recession before then. But I very much doubt the Fed can simply raise interest rates to normalize the yield curve. That would simply invert the yield curve, and such inversion is a harbinger of recession. As long as the economy is operating at sub-optimal levels, monetary policy will be constrained by the zero bound. To lift the economy well clear of the lower bound, we need greater cooperation between fiscal and monetary authorities. I suspect this will require making explicit what is often viewed as crazy but many would argue is already implicit in recent policy, the monetization of some fiscal spending.

Japan serves as a role model for the zero bound problem. As Paul Krugman notes, fiscal policy has been effective in staving off the worst consequences of the Japanese financial crisis. But the associated fiscal deficits appear never ending; the Japanese economy never gained enough strength to eliminate the dependency on fiscal stimulus, leading to what looks like an excessive build-up of government debt that now exceeds 200% of GDP.

We frequently see concerns that a build-up of government debt will lead to a new Japanese financial crisis. Peter Boone and Simon Johnson are the latest addition to that long line of thought. On the surface, it might be easy to dismiss such concerns, as they have been regularly voiced over at least the past 12 years, so far proving to be incorrect. Japanese interest rates have not skyrocketed, the crisis has not arrived.

That said, I would not bet against that crisis over the decade, and I think that the longer the economy is stuck at the zero lower bound, the more likely it becomes. Boone and Simon note:

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse...

...A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

The basic story is straightforward. Japan has a fiscal problem, but cannot find the political will to fix it via tax increases or spending cuts. I am not surprised. It is too easy to claim that this is simply the outcome of a broken political system. Fiscal austerity will be met with a recession, just as it has been elsewhere. And with the economy operating at the zero bound, the Bank of Japan will have relatively few tools to counteract the recession (actually, no, but more on that later). Fiscal austerity is easy to say, hard to do.

It is hard to believe, however, that the debt situation in Japan is sustainable indefinitely (see Noahpinion here). At some point the Japanese will not be able to finance their deficit without deep budget cuts, hard default, or soft default in the form of outright monetizing of debt.

Austerity will prove to be ineffective; I don't think it will be politically possible. Too many people starving in the streets. Eventually, the hit will be taken by bondholders. It is simply a question of whether they take that hit in the form of hard or soft default.

And herein lies the problem with the zero bound. Japan has long moved past the point where their citizens can worry only about the lost income from low interest payments. Now it is all about capital preservation, making it harder to implement either a hard or a soft debt default. In effect, the outcome of being at the zero bound is an every increasingly large political class that has a lot to lose by anything that increases interest rates, inflation or a drop in confidence.

Worse, that large political class makes it increasingly difficult to do what seems to be the best path, a gradual erosion of the real value of that debt through inflation. The failure of generate inflation over a period of decades actually makes it more difficult politically to create that inflation as the capital losses would be borne more intensely by an ever increasing part of the population. They are all taxpayers and bondholders. They take the hit in taxes, spending, or capital position. The longer they wait to take that hit, the bigger it will be.

What I expect to happen is this: The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur. And dramatically higher inflation, I fear. Japan has not had inflation for two decades. I suspect they will experience all that pent-up inflation in the scope of a couple of years.

In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once. But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger.

Now, how does this apply to the US? After all, the US does in fact have inflation, with prices projected to grow at something less than 2% annually. But this argument assumes that 2% is the "right" inflation rate. I would argue that it is not the right inflation rate if it is insufficient to lift the economy from the zero bound. The Fed's own forecasts, and the fear of the fiscal cliff and the subsequent recession, says we are not yet there.

I suspect the US needs higher inflation, just like Japan. The commitment to ultra-low inflation seems to be a pendulum that has swung too far. Policymakers need to take the danger of the zero-bound seriously. And I think the Fed's forecast imply they are not taking it seriously.

Think we can't create inflation? Think again. Federal Reserve Chairman Ben Bernanke gave the answer:

There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not...

...My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent....

...The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about "broken" channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.

Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example....

Lifting off the zero bound probably requires a high degree of cooperation between the fiscal and monetary authorities that may, gasp, require some outright monetization of government debt. Such monetization is what Bernanke advocated for Japan, but this advice fell on deaf ears. Because such cooperation is feared, it is essentially off the table. For now. But what I think will be the case is that instead of small amounts of cooperation now, we are setting the stage for large amounts in the future. Debt reduction via inflation will come; the longer we wait, the more disruptive it will be.

Such thoughtful, careful, technocratic cooperation between monetary and fiscal authorities, however, is no where to be found. In the US, Europe, and Japan, at best we have is monetary authorities trying to offset real and expected fiscal austerity. That path, I fear, only leads us deeper into permanent zero bound territory.

Bottom Line: 2015 is too long to wait to emerge from the zero bound. Policymakers need to make efforts to normalize the economic environment a priority. That may require a level of fiscal and monetary cooperation that today seems to be unthinkable. But if gets to the point where central banks are pulled kicking and screaming into such cooperation (the European Central Bank may be the first to explicitly monetize government spending; I suspect it will be the only way to keep Greece in the Euro and live up to Draghi's pledge that the Euro is permanent), then I think we will all wish we had engaged in such cooperation sooner than later.

Romney's Misleading Attack on Social Insurance

I have a new column I hope you'll want to read:

Romney's Misleading Attack on Social Insurance

[I shoul dnote that the embedded links are, for the most part, added by the editors.]

Sheila Bair on the Financial Crisis

From a Marketplace interview of Sheila Bair:

... Jeremy Hobson: Now you don't paint a very pretty picture of the relationship between the various regulators -- in particular, your relationship with the New York Fed, which was at the time headed by Timothy Geithner. What was the issue there with you and Geithner?

Bair: Well, I think Tim and I just had profoundly different ways of viewing the world. He, I think, viewed the large financial institutions as entities that needed to be supported, because he viewed them as central to the functioning economy. And I realized their importance to the economy, but I wanted them to have accountability.

In 2009, when the system was stabled, I wanted to launch programs that would have forced banks to cleanse their balance sheet; to sell off a lot of these bad assets. He was not particularly supportive of that approach. So there was little accountability, and also, I think our economy continues to suffer today because we just never dealt with a bloated, inefficient financial sector. We propped it up the way the Japanese did; we didn't have them take their medicine.

Hobson: Well do you think that looking back, then, that we are going to look back at the crisis and the government's response to the crisis, as a bunch of people acting honorably and selflessly and in the interest of the country; or that we will look back and see a rather pathetic picture of people acting in their own interest, or in the interest of these Wall Street firms?

Bair: I think we will look back and see a regulatory response and a Congressional response that was unwilling to show independence to these large financial institutions and that at the end of the day -- not withstanding the rhetoric -- implemented policies that were highly friendly to these institutions.

I don't think that's nefarious; I think it's a skewed perspective. I think Tim Geithner is an honorable person, and he did what he thought was right. But what he thought was right was saving institutions like Citigroup. He identified saving them with saving the country, and they are two very, very different things. ...

In a tweet, Zachary Goldfarb says:

Sheila Bair: "I don’t think helping home owners was ever a priority for" Geithner and Summers.

And:

Beyond their policy disputes, it's clear Geithner and Bair just hated each other. Much have had an impact on quality of outcome.

To repeat a complaint I've made many times, we had a balance sheet recession. In response, one set of balance sheets -- those of financial institutions -- received plenty of attention and help. Not so for household balance sheets, and that is one of the reasons the recovery remains so lethargic.

Labor's Declining Share of Income and Rising Inequality

Labor's share of income has been declining, and inequality has been increasing. Will these trends continue?:

Labor's Declining Share of Income and Rising Inequality, by Margaret Jacobson and Filippo Occhino, FRB Cleveland: Labor income has declined as a share of total income earned in the United States. This decline was caused by several factors, including a change in the technology used to produce goods and services, increased globalization and trade openness, and developments in labor market institutions and policies.

One consequence of the labor share decline has raised concerns. Since labor income is more evenly distributed across U.S. households than capital income, the decline made total income less evenly distributed and more concentrated at the top of the distribution, and this contributed to increase income inequality. In this Commentary, we look at how the labor share decline has affected income inequality in the past, and we study the likely future path of the labor share and its implications for inequality.

The Decline in Labor’s Share of Income

Household income comes in two types: labor income, which includes wages, salaries, and other work-related compensation (such as pension and insurance benefits and incentive-based compensation), and capital income, which includes interest, dividends, and other realized investment returns (such as capital gains). During the last three decades, labor’s share of total income has declined in favor of capital income (see “Behind the Decline in Labor’s Share of Income” for more detail).

There are a number of ways to measure the share of income that accrues to labor. We look at three different data sources, and each provides broad evidence of the decline. According to data from the Bureau of Economic Analysis, labor’s share of gross national income fluctuated around 67 percent during the 1980s, 1990s, and early 2000s, but it has declined since then and now stands at 63.8 percent.¹ (See figure 1.) According to the Bureau of Labor Statistics, the ratio of compensation to output for the nonfarm business sector fluctuated around 65 percent until the early 1980s and has declined steadily since, from 63 percent during the 1980s and 1990s to 58.2 percent most recently. Finally, a 2011 study of income tax returns and demographic data by the CBO (CBO 2011) finds that labor’s share of income decreased from 75 percent in 1979 to 67 percent in 2007.

These three data sources measure slightly different labor share concepts, which is why their estimated levels are different. But they agree in indicating a significant drop of 3 to 8 percentage points in labor’s share of income since the early 1980s, with the trend accelerating during the 2000s.

Such a decline had implications for the distribution of incomes. Labor income is more evenly distributed across U.S. households than capital income, while a disproportionately large share of capital income accrues to the top income households. As the share that is more evenly distributed declined and the share that is more concentrated at the top rose, total income became less evenly distributed and more concentrated at the top. As a result, total income inequality rose.

Income Inequality

Income inequality is the dispersion of annual incomes across households, relative to the average household income. Inequality affects a variety of other important economic variables, such as the composition of consumption and investment, tax revenue and government spending, government policies, economic mobility, human capital accumulation, and growth. Some economists—most prominently Raghuram Rajan in his book Fault Lines—have suggested that rising income inequality contributed to the debt accumulation and financial imbalances that led to the recent financial crisis. And of course income inequality is the focus of much attention as an indicator, albeit imperfect, of the inequality of lifetime income and welfare across households.

Several indicators suggest that inequality was declining up to the late 1970s, but it has since reversed course. It rose sharply during the 1980s and early 1990s and currently is at near record-high levels. ... [facts and figures on inequality, several measures presented] ...

This is a sizeable effect. More importantly, most of the effect occurred during the last decade, when the decline in the labor share was accelerating. Is this trend going to continue, and how will it affect income inequality going forward?

Future Paths

We use the model described in box 2 to learn about the future path of the labor share. The model decomposes the labor share into its long-run trend and its transitory components, and then it forecasts the future path of the overall labor share. We do all the calculations twice, once with the BEA data and once with the BLS data.

According to our model, the labor share trend has declined since 1980, with an accelerated drop in the 2000s, in both sets of data (figure 4). In the BEA data, the trend declined from levels as high as 69 percent before 1980 to 66.9 percent in 2000, to 64.9 percent today. In the BLS data, the trend declined from levels of approximately 64.5 percent before 1980 to 62.8 percent in 2000, to 59.8 percent today. According to these measures, the trend in the labor share declined 1.5 to 2 percentage points between 1980 and 2000, and then dropped an additional 2 to 3 percentage points, for a total of 4 to 4.5 percentage points.

Our model indicates that the labor share is currently 1 to 1.5 percentage points below its long-run trend level. Part of the decline in the labor share in the past five years was temporary, and it will be reversed as the recovery continues. Going forward, the labor share will pick up and converge to its long-run trend value. This will tend to decrease income inequality, lowering the Gini index by up to 0.5 (0.33 × 1.5) percentage points, as the decomposition in box 1 indicates.

Income inequality will not necessarily decrease though. As shown in box 1, inequality is affected not only by the relative shares of labor and capital income, but also by the concentrations of each. Concentration refers to the way each type of income is distributed across the households that earn it. In particular, concentration indexes measure how concentrated capital or labor income is at the top of the income distribution.

The future path of labor concentration is hard to predict, as it depends on the evolution of the returns to education and of the wage-skill premium. The concentration of capital income, however, is strongly procyclical, rising during recoveries (figure 5), and this suggests that capital income will become more concentrated at the top in the coming years of the recovery, helping to raise income inequality even further. This effect has dominated the dynamics of income inequality during the past two business cycles, so the future path of income inequality will likely be determined by the strength of the recovery and the associated pickup of the concentration of capital income.

...

'Kim Clausing on Signaling, Tax Return Disclosure, and Toads'

From the perspective of the economics of signaling, Mitt Romney is behaving like "an awfully small toad":

Romney’s Tax Returns and The Economics of Signaling : Why Small Toads Still Croak, by Kimberly Clausing, Reed College: When toads compete for mates, they face important strategic decisions regarding whether to fight over mates or continue searching. Wanting to take on smaller rivals and avoid larger ones, toads gauge the wisdom of fighting each other in part by hearing each others’ croaks. Deep croaks belong to larger toads since toad vocal cord length is associated with toad size. This raises a puzzle, though, for one might think larger toads would croak and smaller toads would stay quiet, yet most toads tend to croak, whether or not their voice is deep.

The economics of signaling can help explain this puzzle. As soon as the largest toads croak, that gives the next largest toads an incentive to croak since otherwise they’d be assumed to be the average size of the remaining pool of toads. Once somewhat large toads croak, medium sized toads have an incentive to croak lest they be assumed smallish, and the situation unravels until nearly all toads are croaking.

This situation is a useful example of the full disclosure principle at work. As long as some individuals benefit from revealing beneficial characteristics of themselves, others are forced to disclose their less stellar characteristics, lest they be assumed to be a representative member of the remaining pool. ...

Candidates for office have long shared many years of tax returns in order to allay citizen concerns... Yet Mitt Romney steadfastly refuses to provide the public with more than two years of tax returns.

How are we to understand this refusal? Does Romney think that his tax returns are so bad that disclosure is really worse than nondisclosure, even knowing that the public must be assuming that there is something unpleasant in there? ...

 If Romney is a rational strategist, surely he would release the returns unless he thought there was something in there that was genuinely worse than what we are already assuming. In the case of animal behavior, that would make Romney an awfully small toad.

Links for 09-25-2012

• The Financial Crisis and Inflation Expectations - FRBSF
• Sympathy For The Doofus - Paul Krugman
• The Journal of Econometric Methods - Dave Giles
• Conservatives and the Zombie Apocalypse - Nancy Folbre
• QE3 and the Kocherlakota Move - Next New Deal
• Democracy’s Burning Ships - Luigi Zingales
• All Economists Do Not Agree on Low Capital Tax Rates - Dean Baker
• The Macroeconomic Effects of Interest on Reserves - NBER
• Sentiments and Aggregate Demand Fluctuations - NBER
• Export Networks and the Incidence of Cross-Border M&A - NBER
• Republicans' invocation of entrepreneurism has a hollow ring - Dean Baker
• I.M.F. Warns of Economic Deterioration Ahead - NYTimes.com
• Refinancing Reduces the Risk of Mortgage Defaults - Liberty Street
• Kickstarter tries to clarify what it’s about - Digitopoly
• Maybe Another Economist With The Same Name? - Paul Krugman
• The Price of Fame - Environmental Economics
• The Oswald-Green Debate on Home Ownership - Richard Green

What's Romney's Problem?

Reminiscent of the signal extraction problem in the Lucas Island model, how much of the difficulty Romney is having is due to Mitt in particular, and how much is due to dislike of the GOP more generally? Robert Reich says it's mostly that people are "beginning to see how radical the GOP has become," but personally, I'd have to give at least partial credit to Mitt Gaffe-a-Day Romney and his sidekick Paul Marathon-Man Ryan:

The Two Major Views About Why Romney is Losing, and Why the Second is More Convincing, by Robert Reich: ... There are two major theories about why Romney is dropping in the polls. One is Romney is a lousy candidate, unable to connect with people or make his case. The second is that Americans are finally beginning to see how radical the GOP has become, and are repudiating it.

Many Republicans ... hold to the first view, for obvious reasons. If Romney fails to make a comeback this week, I expect even more complaints from this crowd about Romney’s personal failings, as well as the inadequacies of his campaign staff. 

But the second explanation strikes me as more compelling. The Republican primaries, and then the Republican convention, have shown America a party far removed from the “compassionate conservatism” the GOP tried to sell in 2000. Instead, we have a party that’s been taken over by Tea Partiers, nativists, social Darwinists, homophobes, right-wing evangelicals, and a few rich people whose only interest is to become even wealthier. ...

The second view about Romney’s decline also explains the “negative coat-tail” effect — why so many Republicans around the country in Senate and House races are falling behind. ...

Romney’s failing isn’t that he’s a bad candidate. To the contrary, he’s giving this GOP exactly what it wants in a candidate. And that’s exactly the problem for Romney — as it is for every other Republican candidate — because what the GOP wants is not at all what the rest of America wants.

Fed Watch: Excuses Not To Do More

Tim Duy:

Excuses Not To Do More, by Tim Duy: Josh Lehner (via CR) reviews some of his earlier work on the Reinhart and Rogoff results and concludes:

...when the Great Recession is compared not to other U.S. cycles but to the Big 5 financial crises and the U.S. Great Depression (thanks to U.S. Treasury for adding that to the graph), the current cycle actually compares pretty favorably. This is likely due to the coordinated global response to the immediate crises in late 2008 and early 2009. While the initial path of both the global and U.S. economies in 2008 and 2009 effectively matched the early years of the Great Depression – or worse – the strong policy response employed by nearly all major economies – both monetary and fiscal – helped stop the economic free fall.

This is worth highlighting because of the eagerness of policymakers to embrace Reinhart and Rogoff as an excuse to avoid fiscal and monetary policy. For instance, see St. Louis Federal Reserve President James Bullard in the Financial Times:

Some may argue that real output and employment in the US have not returned to the pre-crisis, bubble-induced path that seemed to prevail in the mid-2000s. Indeed, US employment is about 4.7m lower than at its peak in January 2008. But this is to be expected. Recoveries in the aftermath of financial crises tend to be especially protracted, as the work of Carmen Reinhart and Kenneth Rogoff has documented.

Bullard sees Reinhart and Rogoff as an excuse to do nothing. After all, why even try when history has proved the long-lasting impact of financial crises? Bullard completely misses the alternative argument - that if financial crises are long-lasting, then the policy response needs to be more aggressive. As Lehner points out, aggressive policy response can mitigate the impact of the crisis. Bullard should read Reinhart and Rogoff as a demand to do more, not an excuse to do less.

Indeed, Reinhart and Rogoff have said as much. Via Ezra Klein:

...if you look at the leaked memo that the Obama administration was using when they constructed their stimulus, you’ll find, on page 10 and 11, a list of prominent economists the administration consulted as to the proper size for the stimulus package. And there, on page 11, is Rogoff, with a recommendation of “$1 trillion over two years” — which is actually larger than the American Recovery and Reinvestment Act. So if they’d been following Rogoff’s advice, the initial stimulus would have been even bigger — not nonexistent.

As for Reinhart, I asked her about this for a retrospective I did on the Obama administration’s economic policy. “The initial policy of monetary and fiscal stimulus really made a huge difference,” she told me. “I would tattoo that on my forehead. The output decline we had was peanuts compared to the output decline we would otherwise have had in a crisis like this. That isn’t fully appreciated.”

Bullard also argues against a higher inflation target:

To argue against monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation above the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and unemployment have been above desirable levels. In the 1970s this phenomenon was labelled stagflation. Monetary policy has been regarded as poor during that period.

Scott Sumner already identified the sad mistake Bullard makes here. Essentially, Bullard has a limited sense of history - he knows of only two possible monetary equilibriums, one with 2% inflation and low unemployment, the other with infinite inflation and high unemployment. What about the Great Recession? Couldn't current monetary policy, with below target inflation and above target unemployment, also be regarded as poor? And isn't that the situation we are in now, as Bullard himself admits?

What does Rogoff have to say about the 2% inflation target? From the FT last year:

If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years. Any inflation above 2 per cent may seem anathema to those who still remember the anti-inflation wars of the 1970s and 1980s, but a once-in-75-year crisis calls for outside-the-box measures.

And more recently:

...many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.

Rogoff apparently does not take his research to imply that policymakers should give up. And he explicitly identifies higher inflation targets as a potential tool. Yet Bullard (like most of the Fed) is married to the 2% target without any consideration that the appropriate inflation target may vary across time and economies, and he essentially cites Rogoff as a reason to justify this position. You can't do more, so why try?

Bottom Line: Policy is effective even in the aftermath of a financial crisis. Don't let policymakers fool you into believing otherwise.

Update: I notice some Twitter chatter of surprise that Rogoff was not completely opposed to fiscal stimulus (I thought everyone read Ezra Klein). Some additional quotes from the FT would be helpful:

At the root of today’s credibility deficit is a failure to come to grips with the long, slow growth period that is typical of post-financial crisis recovery...By far the main problem is a huge overhang of debt that creates headwinds to faster normalisation of post-crisis growth – that is why post-financial crisis growth is typically very slow...It is far from clear that any huge temporary fiscal stimulus will rev up the engine enough to achieve self-sustaining growth...The most direct remedy, of course, would be to find expeditious approaches to cleaning up balance sheets whilst maintaining the integrity of the financial system...If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years.

I think the story here is that fiscal stimulus is only a temporary measure, not a long-run solution. The long-run solution is dealing with the debt overhang, which can be addressed with more aggressive monetary policy.

Nobody Pays Attention to the Working Class

Not having much luck finding new things to post or talk about -- while I continue to look here's an echo of a Brad DeLong echo of John Sides:

John Sides: There Is No White Working Class. There Is a Southern White Working Class and a Rest-of-the-Country White Working Class, and Nobody Pays Attention to Either: John Sides on the centrality of race in this sliver of the electorate:

Puncturing Myths about the White Working Class: A new survey… is a valuable corrective…. For example, consider this:

In mid-August, Romney held a commanding 40-point lead over Obama among white working-class voters in the South (62% vs. 22%). However, neither candidate held a statistically significant lead among white working-class voters in the West (46% Romney vs. 41% Obama), Northeast (42% Romney vs. 38% Obama), or the Midwest (36% Romney vs. 44% Obama)….

In my experience, the white working class gets a ton of attention, especially when elections come around…. But when we discuss the white working class during elections, another fact rarely raises its head: the enormous inequalities in political voice that arguably marginalize the white working class when it comes to policy-making…. [O]nly the views of the upper class appear to affect whether policies are enacted in law. So the problem isn’t that the white working class is trending Republican or that it votes against its economic interests or that it’s being hoodwinked by social issues.  The the problem is that no matter what the white working class thinks, no one is listening.

Paul Krugman: The Optimism Cure

Mitt Romney thinks he can use his magical powers to make the economy recover "without actually doing anything":

The Optimism Cure, by Paul Krugman, Commentary, NY Times: Mitt Romney is optimistic about optimism. In fact, it’s pretty much all he’s got. And that fact should make you very pessimistic about his chances of leading an economic recovery. ...

Mr. Romney’s five-point “economic plan” is very nearly substance-free. It vaguely suggests that he will pursue the same goals Republicans always pursue... But it offers neither specifics nor any indication why returning to George W. Bush’s policies would cure a slump that began on Mr. Bush’s watch.

In his Boca Raton meeting with donors, however, Mr. Romney revealed his real plan, which is to rely on magic. “My own view is,” he declared, “if we win..., there will be a great deal of optimism about the future of this country. We’ll see capital come back, and we’ll see — without actually doing anything — we’ll actually get a boost in the economy.”

Are you feeling reassured? ... You should ... know that efforts to base policy on speculations about business psychology have a track record — and it’s not a good one.

Back in 2010, as European nations began implementing savage austerity programs to placate bond markets, it was common for policy makers to deny that these programs would have a depressing effect... Why? Because these measures would “increase the confidence of households, firms and investors.”...

I ridiculed such claims as belief in the “confidence fairy.” And sure enough, austerity programs actually led to Depression-level economic downturns across much of Europe.

Yet here comes Mitt Romney, declaring, in effect, “I am the confidence fairy!”

Is he? As it happens, Mr. Romney offered a testable proposition in his Boca remarks: “If it looks like I’m going to win, the markets will be happy. If it looks like the president’s going to win, the markets should not be terribly happy.” How’s that going? Not very well. Over the past month conventional wisdom has shifted from the view that the election could easily go either way to the view that Mr. Romney is very likely to lose; yet markets are up, not down, with major stock indexes hitting their highest levels since the economic downturn began.

It’s all kind of sad. Yet the truth is that it all fits together. Mr. Romney’s whole campaign has been based on the premise that he can become president simply by not being Barack Obama. Why shouldn’t he believe that he can fix the economy the same way?

But will he get a chance to put that theory to the test? At the moment, I’m not optimistic.

Fed Watch: Gramm and Taylor Don't Get It

Tim Duy:

Gramm and Taylor Don't Get It, by Tim Duy: As a general rule, I stay clear of the Wall Street Journal editorial pages. I'll be honest - I just don't have the emotional energy for it anymore. But Brad DeLong forced it on all of us this weekend, drawing attention to another anti-QE article, this time penned by Phil Gramm and John Taylor.

DeLong gets to the heart of the problem. Gramm and Taylor don't seem to realize that the stock of Treasuries is the same regardless of who owns them. What GT see as higher future interest rates would simply be higher current interest rates if the Fed was not temporarily substituting some cash for bonds. DeLong summarizes:

So why are Taylor and Gramm arguing that returning interest rates in 2016 and after to what they would have been anyway is a cost to QE III? It's a zero. It's not a change. It simply does not compute.

Yet there is still room to build upon DeLong's critique. GT get off to a bad start:

That kind of monetary expansion would normally be a harbinger of inflation. However, with banks holding excess reserves rather than lending them out—and with velocity (the rate at which money turns over generating national income) at a 50-year low and falling—the inflation rate has stayed close to the Fed's 2% target..

While the Fed considered its previous rounds of easing—QE1, QE2 and Operation Twist—the argument was consistently made that the cost of such actions was low because inflation was nowhere on the horizon. The same argument is now being made as the central bank contemplates QE3 during the Federal Open Market Committee meetings on Wednesday and Thursday.

Inflation is not, however, the only cost of these unconventional monetary interventions.

Notice that they admit that inflation has remained under control, yet then proceed to claim that inflation is a cost of QE. How can inflation be both under control and a cost? It can't, of course; GT just can't admit that inflation is not a problem even after actually admitted that fact. GT continue:

As investors try to predict the timing and effect of Fed policy on financial markets and the economy, monetary policy adds to the climate of economic uncertainty and stasis already caused by current fiscal policy.

QE3 actually reduces the uncertainty about monetary policy. Rather than defining QE by arbitrary amounts and end dates, we now have a steady flow of QE tied only to improving economics conditions in the context of price stability. No more uncertainty that the Fed will pull policy support regardless of the state of the economy. More:

Since September 2008, the Fed has acquired $1.16 trillion of government securities—in fiscal year 2011 (Oct. 1, 2010-Sept. 30, 2011), the central bank bought 77% of all the additional debt issued by the Treasury. Aside from the monetary impact of these debt purchases, the Fed allowed the federal government to borrow a trillion dollars without raising the external debt of the Treasury and without having to pay net interest on that portion of the debt, since the central bank rebated the interest payments to the Treasury.

So GT do not consider the Treasury debt held by the Fed as real debt because...why? Apparently because all of the Fed's profit need to be returned to the Treasury at the end of the year. That doesn't mean it isn't real debt, issued to cover deficit spending and issued without the expectation of outright monetiziation. Moreover, private investors see the Fed's holdings as part of the aggregate Treasury debt and will set their price expectations accordingly. GT continue:

When the Fed must, in Chairman Ben Bernanke's words, begin "removing liquidity," by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public. Selling a trillion dollars of Treasury bonds on the market—at the same time the government is running trillion-dollar annual deficits—will drive up interest rates, crowd out private-sector borrowers and impede the recovery.

This just makes my head hurt. If the Fed needs to sell their portfolio into the market, this will be because interest rates are already rising. Let's take this slowly: Currently, interest rates are at very low levels. If the economy improves, there will be upward pressure on interest rates. Yes, interest rates will rise, and supposedly "impede the recovery." Yes, this will have an impact on growth, but that is exactly what you might expect if the LM curve slopes upward (if the IS curve increases, both output and interest rates rise). And yes, the Fed will likely follow rising long term interest rates by reversing the current situation.

This should be absolutely, 100%, not a controversial subject because, surprise, surprise, the Fed reverses their policy stance in every expansion. That is a feature of monetary policy, not a defect.

Moreover, assuming the economy is operating near potential, the Fed would not be crowding out the private sector; they would only be controlling inflation. Only the fiscal authority can crowd out the private sector by not engaging in counter-cyclical policy. And if the fiscal authority does indeed not control deficit spending as needed, it would be the Fed's job to compensate to the best of their abilities.

GT continue:

In addition, Operation Twist, by shortening the average maturity date of externally held debt, will require the Treasury to borrow more money sooner when the economy recovers and interest rates start to rise. This too will drive up interest costs and the deficit.

The issue here, I think, is that the Fed is swapping out short-dated assets that they normally would have rolled over when the assets matured (assuming they wanted to hold the balance sheet constant). Thus, the Treasury needs to increase its debt issuance to the public compensate in the near term. But guess what? First, if the Fed didn't hold the debt in the first place, then the public would hold the debt with the same consequences for the Treasury at maturation. Second, the US Treasury is wisely extending the maturity of its debt; see Jim Hamilton here. Extending the maturity will help reduce the pressure to refinance short term debt and lock in low longer term interest rates. Moreover, the Treasury has time time to implement these changes; interest rates are not skyrocketing overnight.

GT make similar errors with mortgage rates:

The same problems will occur as the Fed begins to sell its holdings of mortgage-backed securities to reduce the monetary base. When the Fed bought these securities, it may have marginally reduced mortgage interest rates. Selling them during a real recovery will likely cause mortgage rates to rise.

Yes, once again in a real recovery mortgage rates will rise. Just as in the past. And guess what happens if they don't rise - then you might in fact get that inflation the authors so fear. Again, rising rates are a feature, not a defect. GT, inexplicably, continue:

Proponents of QE3 argue that while the Fed's balance sheet must be reduced at some future time, it has the tools to minimize the impact on interest rates by slowing down the pace of the sales. But the Fed's ability to act has already been compromised by its pledge to maintain low interest rates through 2014. Having to time open-market sales to minimize interest-rate increases will further limit the Fed's ability to preserve price stability.

Once again, with emphasis, it is not a commitment. Believe me, many of us would like to see a commitment to be irresponsible. This isn't it. It is a conditional forecast; if economic activity exceeds current projections, the Fed will tighten policy sooner than currently anticipated. Finally:

The Fed could raise the interest rate that it pays banks on reserves they hold in lieu of reducing its balance sheet. Where would the money come from? It has to come out of the money the Fed is currently paying the Treasury, driving up the federal budget deficit. How will taxpayers feel about subsidizing banks not to lend them money?

Yes, the profits from monetary policy accrue to the US Treasury. Yes, profits are currently unusually high. Yes, if interest rates, and along with them policy, normalizes, then those profits will fall. Will this drive up the budget deficit? Consider the bigger picture. If the economy is accelerates such that there is upward pressure on interest rates, then the deficit will be eased by the activation of automatic spending and revenue stabilizers. In other words, we will have a choice - the Fed can hold the economy down now by withdrawing monetary stimulus, which will in turn widen the deficit, or foster stronger activity which will lower the deficit in the future. The Fed's profits are of third or fourth or fifth order importance in this process.

Bottom Line: If the US economy was not operating at the zero bound, the Federal Reserve would react to improving economic conditions and tighten policy by selling Treasury securities in the process of targeting a higher Federal Funds rates. John Taylor should know this. Now, with quantitative easing, if economic conditions improve, the Fed will tighten policy by...yes, the same thing, selling Treasury securities. In either case, the Fed will only do this if interest rates are already responding to stronger activity. In this light, the Fed isn't really doing anything new. I don't think you should fear the Fed having to withdraw the stimulus. Indeed, I think you should really fear the opposite - that the economy does not lift off the zero bound before the next recession hits. If that happens, we will all be wishing the Fed had done more, and sooner.

Links for 09-24-2012

• Macroeconomists: Scientists or Engineers? - mainly macro
• Engineering vs. "Science" in macroeconomics - Noahpinion
• Fat fingers and the price of oil - Econbrowser
• James Medoff, Stagflation, ... and the Greenspan Boom - Andy Harless
• Puncturing Myths about the White Working Class - Monkey Cage
• Taylor and Gramm Have Sharply Reduced My Utility - Brad DeLong
• Expectations and the Confidence Fairy - Paul Krugman
• The economics of paywalls - Frances Woolley
• Different Views on Significance testing - Dave Giles
• The case for euro deposit insurance - vox
• Mr. Mental Recession - Paul Krugman
• Poorer without aid programs - vox
• Romney to Teacher: 'I Didn't Ask You a Question' - C&L
• Global Rebalancing 2.0 - vox

'Hard Times Come Again Once More?'

This is David Warsh on the worries about a great stagnation in our future (I remain an optimist about the future, at least when it comes to productivity. I think that, since we are part of it, it's hard to see how big of an impact the digital revolution will have on the future, or even how big of an impact it has had already. So I believe we will continue to grow robustly once our current troubles are behind us. But as digital technology advances and eliminates working class jobs -- jobs with decent pay and decent benefits -- there is a danger of an increasingly two-tiered society. For that reason, I think we are worried about the wrong thing. The big problems of the future will be about distribution, not production. We'll have plenty of stuff, but wil it be distributed in a way that allows prosperity to be widely shared?):

Hard Times Come Again Once More?, by David Warsh: I keep a couple of books on the shelf above my desk to remind me of how much things have changed over the past hundred years. One is Only Yesterday: An Informal History of the 1920s, by Frederick Lewis Allen, which first appeared in 1931. The other is The Great Leap: The Past Twenty-Five Years in America, by John Brooks, published in 1966. Some crackerjack journalist is surely working today on a similarly successful treatment of the as-yet hard-to-characterize years since 1966. In the meantime, The Good Life and Its Discontents: The American Dream in the Age of Entitlement 1945-1995, by Robert Samuelson, takes the story forward.

The really interesting question, though, has to do with what to expect in the next twenty years.

One thing that Yesterday and Leap have in common, a characteristic that in all likelihood will be shared by the book that eventually joins them, is that there are hardly any numbers in them – nothing to link together the two  epochs, or to foreshadow the future.  Measurement is the province of economists. Compelling journalism seldom has time.

Therefore I have been reading, with special interest (and a certain dread), Is US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds, by Robert J. Gordon, of Northwestern University.  In fact, I read it last summer, even before it was a National Bureau of Economic Research working paper, since Gordon is a friend. It’s a short report (25 pages) on an ambitious work in progress.

Beyond the Rainbow: The American Standard of Living Since the Civil War, a book version of the article, already long in preparation, will be anything but brief when it’s finally done. It will, however, be the definitive survey of American living standards over the last 150 years. (Think Carmen Reinhart and Kenneth Rogoff, This Time Is Different, on the history of financial crises.) It will formulate an educated guess about the future as well.  And since that prediction has implications for anyone following the election campaign (and more than just them!), there is good reason for considering it now.

The standard assumption is that, after the disruptions of the financial crisis, and once various fiscal imbalances have been resolved (pensions, health care obligations, etc.), the United States will resume the real per capita GDP growth of around 2 percent a year that we’ve enjoyed since 1929.  In the immediate aftermath of the crisis, I toyed with it myself.  Technology, the growth of knowledge, will see us through.

What if it won’t? ... There are two sides to Gordon’s argument... [continue reading] ...

'Mitt Romney's Housing Market Plan Has to Be a Joke'

Brad DeLong points to Joe Weisenthal's response to the Romney campaign's housing plan (calling it a "plan" gives it more credit than it deserves):

Mitt Romney's Housing Market Plan Has Got to Be a Joke, by Joe Weisenthal: At this point, we have no choice but to conclude that the Mitt Romney campaign is just trolling whiny journalists who have complained about the lack of detail in his plans.

Yesterday evening (a Friday evening!) the campaign revealed a whitepaper titled Securing the American Dream and The Future of Housing Policy that's so unsubstantial, we half-suspect the timing was done so that nobody would see it amid the release of the 2011 tax documents, which came out about 20 minutes earlier. This is honestly a sentence in his whitepaper on The Future Of Housing Policy:

The Romney-Ryan plan will completely end “too-big-to-fail” by reforming the GSEs.

Romney and Ryan believe that "too-big-to-fail", which generally refers to the assumption that a collapse of a major Wall Street institution would be catastrophic to the overall economy, thus making a bailout imperative, would be solved by the reform of Fannie and Freddie. Or maybe Romney and Ryan believe that only Fannie and Freddie are too big to fail, and that the collapse of a mega-bank would be fine. Those are the only possible readings of that sentence. As for Romney and Ryan's plan to reform the GSEs, the plan is to... reform them..., basically there are no details at all. Too Big To Fail will be fixed by reforming the GSEs, and the GSEs will be fixed... somehow….

It's reasonable to think that the challenger who is trying to disrupt the status quo, actually says something that would... disrupt the status quo. Failing to provide any details or a plan during the heart of the campaign undermines the notion that he is a serious alternative.

Bonus Brad DeLong ridicule of the "plan":

"End 'Too-Big-to-Fail' by Reforming the GSEs": Are Romney and His Campaign That Pig-Ignorant?

The Romney-Ryan plan will completely end “too-big-to-fail” by reforming the GSEs. The four years since taxpayers took over Fannie Mae and Freddie Mac, spending $140 billion in the process, is too long to wait for reform. Rather than just talk about reform, a Romney-Ryan Administration will protect taxpayers from additional risk in the future by reforming Fannie Mae and Freddie Mac and provide a long-term, sustainable solution for the future of housing finance reform in our country.

That is the Romney housing white paper's section on the GSEs and "Too-Big-to-Fail".

That is not the introduction to the section.

That is the section.

That is the entire section.

I don't know which is scarier:

1. That Romney and everybody else in his campaign think that a "white paper" on housing can cover both the GSEs and "Too-Big-to-Fail" in 85 words.

2. That Romney and everybody else in his campaign think that if the GSEs are somehow "reformed" that that can somehow magically resolve "Too-Big-to-Fail" as well--make it so that there are no longer any problems of systemic risk associated with the potential bankruptcy of Citi, JPMC, Wells-Fargo, BoA, GS, Morgan Stanley, or any of the other systemically-important financial institutions.

People: which scares you more?...

Links for 09-23-2012

• Taking Responsibility on Welfare - NYTimes.com
• Romney Says, "I Am The Confidence Fairy!" - Paul Krugman
• Nation’s Choices Needn’t Be Painful - Robert Frank
• The Geography of the 47% - Richard Florida
• Self-contradictory Fed Bashing - Paul Krugman
• Not All That Glitters Is Gold - Otaviano Canuto
• Inequality Kills - Paul Krugman
• On the diminishing marginal utility of Stuff - Charlie's Diary
• Mitt Romney's Housing Market Plan ... Unholy Madness - Brad DeLong

Is Japan Doomed?

Noah Smith:

Time to Japanic?, by Noah Smith: The Atlantic has a big story on the impending Japanese crash; one of the authors is the brilliant Simon Johnson. ...

This prophecy is hardly unique; I have beaten this drum myself. If Japan doesn't change course, it will have a major crisis within the next decade.

If. But what people need to understand is, the Japanese government does have the power to avert a crisis. It is not inevitable.

There is one way that the crisis can definitely be averted: Raise taxes. Japan's fiscal woes can be boiled down to one sentence: Japan has European levels social spending and European levels of aging with American levels of taxation. But this could change; if Japan raised taxes to European levels, crisis would be instantly averted. According to analyses I've seen, this would require raising Japan's taxes from their current level of 32.5% of GDP to somewhere between 40% and 50% of GDP. That's comparable to France or Sweden. Painful, but not impossible.

Now for the rumor (rumor always being a large component in Western analyses of Japan). My sources at the Bank of Japan and Ministry of Finance tell me that domestic Japanese investors are betting that, after all the grumbling and fighting and ending of political careers, Japan's government will suck it up and raise taxes. This, my shadowy sources say, is why pension funds are still willing to put the Japanese people's money into JGBs.

But this story is not really outlandish. It's similar to what we're observing in America right now. U.S. borrowing is at all-time highs, but demand for Treasuries shows no sign of flagging, and most of that demand - more than in the past - is from domestic U.S. investors. Yes, we have shown a reluctance to raise taxes - witness the apocalyptic debt ceiling fight from last year. But if the public really thought the U.S. government was willing to default, domestic Treasury buyers would be heading for the exits. That they are not heading for the exits probably indicates that they believe that when push comes to shove, the U.S. government will suck it up and raise taxes. There are signs that the Republicans are quietly recognizing the necessity of this. At this point, it's just a fight between Democrats and Republicans to see who takes the fall for raising taxes - that's what the "fiscal cliff" is really all about.

Japan seems to be in a similar situation. It is not really unusual or outlandish at all. Everyone in the country still seems to believe that the government will continue to function. The day that that that belief falters - or is proven wrong by main force, when interest payments swamp the primary budget - is the day that Japan collapses (the same goes for the U.S.). But if Japan's government is less dysfunctional than the often skittish Western press believes, that day will never come.

(Anyway...oh yeah, I did mention that there might be two ways out of Japan's fiscal trap, didn't I? The other way is to use monetary policy to create negative interest rates. If that can be done in a stable way (without accelerating inflation) and if stable growth persists, then Japan can use an "inflation tax" to erode the value of its government debt instead of an actual tax. Econ bloggers (and commenters), who tend to believe that central banks can hit any NGDP target they want, will probably advocate this "solution"...)

One Rule to Ring Them All?

In macroeconomic models, if everything works perfectly -- if all markets clear at all points in time, prices are fully and instantaneously flexible, people have the information they need, and so on -- then monetary policy will have no affect on real variables such as output and employment. Only nominal variables such as the price level will change. This is known as monetary neutrality.

In order to get non-neutrality, i.e. in order to make it so that changes in the money supply can change real output and employment in a theoretical model, there must be a friction of some sort. One popular friction is price/wage rigidity, but it is not the only type of friction that can generate non-neutralities. Any friction that prevents optimal and instantaneous response to a shock will overcome neutrality and restore the ability of the Fed to affect the course of the real economy.

The point I want to emphasize is that the optimal monetary policy rule depends upon the underlying friction that is being used to generate non-neutralities in the theoretical model. For example, Calvo type price rigidity combined with some sort of social objective function such as maximizing the welfare of the representative household often gives you something that resembles the standard Taylor rule (though whether the level and/or the growth rates of price and output belong on the right-hand side of the Taylor rule depends upon the nature of the friction, i.e. even in this case the standard Taylor rule may not be the optimal rule).

I am willing to believe that during the Great Moderation the standard Taylor rule may have at least been close to the optimal rule. If you believe price frictions were the source of the mild fluctuations we had during that time, then theory tells us that's possible. What puzzles me is why people think the same rule should work now. I don't think that Calvo type price rigidities are the reason for the problems we are having right now, and hence this does not give us much insight and explanatory power for the Great Recession. Mild price sluggishness is plainly and simply not the dominant friction at work right now, and if that is the case, why would we think the same monetary policy rule should be optimal? If, in fact, there has been a switch in the dominant type of friction affecting the economy -- and I would argue there has been -- it would be quite remarkable for the same monetary policy rule to be optimal in both situations.

So, I have to agree with Paul Krugman:

Self-contradictory Fed Bashing: David Glasner continues to be unhappy with the Bernanke/QE bashers, this time going after claims that the Fed’s monetary policy was too easy before the crisis.

Much of this discussion is couched in terms of the Taylor Rule, which John Taylor originally suggested — a rule that sets the Fed funds rate based on inflation and either unemployment or some measure of the output gap. This was a clever idea, and has proved useful as a rule of thumb for both description and prediction. But a funny thing happened on the way to the crisis: Taylor and others have elevated this rule to sacred status — and not only that: they have insisted that the original coefficients Taylor suggested, which he basically pulled out of, um, thin air, are sacrosanct.

Surely this is silly. ...

Krugman is not making the argument that the nature of the friction has changed and therefore the optimal rule should change as well. That's my argument so blame me, not him. But the idea that the Taylor rule should have "sacred status" is "silly," and I don't understand why Taylor and others insist that the coefficients of the rule -- let alone the rule itself -- are optimal always and everywhere (there may be a robustness argument -- this is the best possible rule in the face of model uncertainty -- but that's not the argument being made).

Links for 09-22-2012

• Notes on the Political Economy of Redistribution - Paul Krugman
• Are Romney and His Campaign That Pig-Ignorant?
• What Mitt Romney Really Represents - Robert Reich
• Adam Smith Never Mentioned Laissez-Faire - Gavin Kennedy
• Kocherlakota: Some Iffy Ideas - Stephen Williamson
• U.S. Economic Outlook and Monetary Policy - Dennis Lockhart
• Fedspeak NGDP portfolio - Nick Rowe
• China's rural transition - Dan Little
• So Many QE-Bashers, So Little Time - Uneasy Money
• Calm down people. Kocherlakota is still a hawk. - John Barrdear
• Keene on Bernanke: Never Seen This Much 'Hatred': Video - Bloomberg
• 150 Years after the Morrill Act - Liberty Street Economics
• David Brooks' Concern for Entrepreneurial Spirit - Beat the Press

'Primetime Fox News And WSJ Editorial Climate Coverage Mostly Wrong'

Climate scientists document News Corporation's distortions on climate change:

Brenda Ekwurzel is a climate scientist with the Union of Concerned Scientists. She announced in New York City on September 21st the results of an analysis of climate change coverage at two major properties of the News Corporation, the Fox News Channel and the Wall Street Journal.

“What we found in our analysis was that a staggering 93 percent of all occurrences in the last six months in the prime time news of Fox News were misleading occurrences of climate science. Okay, for the Wall Street Journal opinion section in the last year, we found a surprising 81 percent of the occurrences were misleading. And of the accurate ones, these were all letters to the editor that were submitted in response to misrepresentations in editorials or other letters. So, a broad swath of News Corporation viewers and readership are being misled about the science.”

'This Dynamic All But Guarantees a Permanent Underclass'

Laura Tyson:

The United States is caught in a vicious cycle largely of its own making. Rising income inequality is breeding more inequality in educational opportunity, which results in greater inequality in educational attainment. That, in turn, undermines the intergenerational mobility upon which Americans have always prided themselves and perpetuates income inequality from generation to generation.

This dynamic all but guarantees a permanent underclass.

Redistribution

Via Jared Bernstein, who says of the first graph, "All told, clearly some redistribution here but not anything that would lead to stark divisions between 'makers and takers'":

But tax expenditures go mostly to -- surprise! -- the top of the income distribution:

More here.

Paul Krugman: Disdain for Workers

Today's GOP doesn’t have much respect for workers:

Disdain for Workers, by Paul Krugman, Commentary, NY Times: By now everyone knows how Mitt Romney, speaking to donors in Boca Raton, washed his hands of almost half the country — the 47 percent who don’t pay income taxes... By now, also, many people are aware that the great bulk of the 47 percent are hardly moochers; most are working families who pay payroll taxes, and elderly or disabled Americans make up a majority of the rest.

But here’s the question: Should we imagine that Mr. Romney and his party would think better of the 47 percent on learning that the great majority of them actually are or were hard workers, who very much have taken personal responsibility for their lives? And the answer is no.

For ... the modern Republican Party just doesn’t have much respect for people who work for other people... All the party’s affection is reserved for “job creators,” a k a employers and investors. ...

Am I exaggerating? Consider the Twitter message sent out by Eric Cantor, the Republican House majority leader, on Labor Day...: “Today, we celebrate those who have taken a risk, worked hard, built a business and earned their own success.” Yes, on a day set aside to honor workers, all Mr. Cantor could bring himself to do was praise their bosses.

Lest you think that this was just a personal slip, consider Mr. Romney’s acceptance speech at the Republican National Convention. What did he have to say about American workers? Actually, nothing...

Where does this disdain for workers come from? Some of it, obviously, reflects the influence of money in politics... But it also reflects the extent to which the G.O.P. has been taken over by an Ayn Rand-type vision of society, in which a handful of heroic businessmen are responsible for all economic good, while the rest of us are just along for the ride.

In the eyes of those who share this vision, the wealthy deserve special treatment, and not just in the form of low taxes. They must also receive respect, indeed deference, at all times. That’s why even the slightest hint from the president that the rich might not be all that — that, say, some bankers may have behaved badly, or that even “job creators” depend on government-built infrastructure — elicits frantic cries that Mr. Obama is a socialist. ...

The point is that ... the Boca Moment wasn’t some trivial gaffe. It was a window into the true attitudes of what has become a party of the wealthy, by the wealthy, and for the wealthy, a party that considers the rest of us unworthy of even a pretense of respect.

Links for 09-21-2012

• Why micro success doesn’t guarantee macro success - vox
• The Narrative Structure of Global Weakening - Robert J. Shiller
• Bullard Defends the Indefensible - Uneasy Money
• Things Mitt Romney Can't Do - Paul Krugman
• Beware the Weasel Word “Statistical” ... - Freakonomics
• The doomsday cycle turns: Who’s next? - Johnson and Boone
• Should Fed Stand Down to Compel Congressional Action? - David Wessel
• Examining the Recession’s Effects on Labor Markets - macroblog
• The Potential GDP Perspective on Business Cycles - Tim Taylor
• Weekly Initial Unemployment Claims at 382,000 - Calculated Risk
• Restoring The Legitimacy Of The Federal Reserve - Baseline Scenario
• Four Reasons Why Romney Might Still Win - Robert Reich
• What explains low long-term interest rates? - Jonathon Portes
• The GOP's Zombie Dodd-Frank - Rortybomb
• The Trouble With Fedspeak - Paul Krugman
• The big problem with small risks - Tim Harford
• The Unmentionable War - NYTimes.com

Is Europe Saved?

Acemoglu and Robinson argue Europe's troubles aren't over yet:

Is Europe Saved?, by Daron Acemoglu and James Robinson: September has been a good month for the euro-zone. ... So is Europe saved?

We think not. The problems underlying the European crisis were institutional. What we are seeing now are mostly short-term fixes, not true solutions to these institutional problems.

The roots of the crisis lie in the difficulty of operating a currency union without centralized fiscal authority. ... For the euro to survive and contribute to European economic prosperity in the medium term, Europe needs to follow the example of the United States as it transitioned from the Articles of Confederation of 1781 to the U.S. Constitution, which entailed strengthening the currency union with debt renegotiation (with the federal government assuming state liabilities) and more importantly, meaningful fiscal centralization.

And yet, there is no realistic plan for true fiscal centralization in Europe..., [which] means a European organization with the power to set taxes and harmonize labor, product and credit market institutions. But this is not possible without some centralization of political and military power. It was crucial that with the U.S. Constitution, political and military power shifted to the federal government.

This is not on the cards for Europe... So for the time being, we have to make do with short-term fixes, and in all likelihood, Europe isn’t saved just yet.

Fed Watch: Getting Lonely to be a Hawk

Tim Duy:

Getting Lonely to be a Hawk, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota today gave a speech that was something of a shocker. But a little background first. Kocherlakota has generally be viewed as a hawk, more so than his colleague St. Louis Federal Reserve President James Bullard. See, for example, the Credit Suisse mapping of Fed policymakers. I referred to Kocherlakota as one of the "Three Stooges" among the voting members of the 2011 FOMC meetings in regards to his dissents. So it came as something of a surprise today when he said:

The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

At first blush, this sounds like a light version of Chicago Federal Reserve President Charles Evans' policy approach in which Evans would explicitly allow for an inflation rate as high as 3% as long as unemployment was above 7%. With this sentence, Kocherlakota appears to have decisively moved from the hawkish column to the dovish. Credit Suisse needs to update their charts, and the remaining hawks become even more marginalized.

Mark Thoma, however, argues that there is less here than meets the eye, noting that Kocherlakota shows no willingness to accept that inflation greater than 2% may be helpful. Indeed, Kocherlakota seems focused on the Fed's 2% target, with the 2.25% simply allowing for some uncertainty of plus or minus 25bp around that target. A true dove, in the classic definition (as I explain here), is a policymaker that seeks relatively higher inflation than his/her colleagues. But by that definition, Evans is the only true dove. The rest of the FOMC worships at the altar of their newly enshrined 2% target. The hawks/doves divide is now about how one views the upside or downside inflation risks to the target rather than the target itself.

A further distinction can be made. Hawks tend to view high upside risks to inflation because they believe structural factors limit the pace of growth. Thus, more monetary policy can only show up in higher inflation. Doves tend to view current challenges as largely cyclical. With the economy operating well below trend, further monetary policy can be applied without stoking inflation.

Now let's go back to our friend from Minneapolis. Recall that last year, Kocherlakota believed that the Fed funds rate would need to rise in 2011:

These two elements—the increase in core PCE inflation and decline in labor market slack—imply that the target fed funds rate should be raised by at least a percentage point. However, there is a third effect that partially offsets the first two effects. The level of accommodation provided by the Fed’s holdings of long-term securities depends on how long people expect those holdings to last...By putting these three elements together, I arrive at my conclusion: If PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points.

Last year, Kocherlakota was citing 1.5% (core) inflation as a trigger for immediate action; now he sees 2.25% as a threshold that may call for tighter policy. Thus, he exhibits a higher tolerance for inflation, which in and of itself makes him less hawkish in the classic sense than we saw last year.

In addition, last year Kocherlakota argued that monetary policy is incapable of achieving full employment in the near term. In this presentation, he modifies an IS-LM model to define an output level "FEDMAX" that is below the full employment level of output. That Kocherlakota would not have believed that the unemployment rate could be pushed to 5.5%, even in the context of price stability, before the Fed needed to tighten policy. See also Robin Harding on this point.

So by my read, Kocherlakota has definitely come off the hawkish side of the FOMC. He appears to be both more tolerant of inflation and putting less weight on concerns that structural factors could be limiting growth.

Bottom Line: The ranks of Fed hawks grows even thinner, down to just four clear hawks (plus or minus Bullard) out of nineteen policymakers. Barring an "sustainable and substantial" shift in the tone of the data, expect this Fed to keep their foot on the pedal for the foreseeable future.

Kocherlakota: Planning for Liftoff

[This is a pretend interview with Narayana Kocherlakota based on his speech today, Planning for Liftoff, laying out an exit strategy for the Fed.]

Hi. Good to see you again. What are you going to say in your speech?

In my remarks today, I’ll briefly discuss the objectives of the Federal Open Market Committee, or FOMC, which is the monetary policymaking arm of the Federal Reserve. Next, I’ll present a pictorial review of the evolution of macroeconomic data over the past five years.

With that background, I will then turn to a discussion of monetary policy. My jumping-off point is a phrase in the FOMC statement issued last Thursday. In that statement, the Committee said that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I’m going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.²

So if I understand correctly, now that the Fed has eased further -- something I would not have expected you to support given your past remarks -- your main goal is to be clear about how soon the Fed can begin reversing policy? Your goal is to clarify the exit strategy?

I will suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

The price stability part seems to be a bit of a catch. This appears to say that the Fed will only continue with stimulative policy so long as it is not worried about inflation. That doesn't seem much different from current policy, except it's dressed up with a few numbers and some bolded text. What's new here?

I’ll be much more precise later about the meaning of the phrase “satisfies its price stability mandate.” Briefly, though, I mean that longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent. The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent.

Wait a minute. I asked you very specifically last spring why the Fed had an asymmetric aversion to inflation -- there seems to be much more tolerance of inflation below target than inflation above target. In fact, 2 percent inflation looks more like a hard ceiling for than a central value. At that time, you insisted that the Fed had a symmetric tolerance -- it was just as willing to tolerate inflation above target as below. Now you're telling us a hard ceiling of 2.25 percent is needed? How is that consistent with the symmetry you claimed in the past? 

Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

Thus, my proposed liftoff plan contains a specific definition of the phrase “a considerable time after the economic recovery strengthens.” In my talk, I will argue that this specificity—about an event that may not take place for four or more years—will provide needed current stimulus to the economy.

I'll listen closely when you get to that part. But can you explain a bit more now?

A key question is: How much leeway around 2 percent is appropriate?

The Committee has made no formal decision about this issue, and my own thinking continues to evolve. But I currently believe that allowing the medium-term outlook for inflation to deviate from 2 percent by a quarter of a percentage point in either direction would provide sufficient flexibility to the Committee, while posing no threat to the credibility of the long-run target. I’ll provide more details on my thinking about this issue later in the talk.

To sum up, the FOMC defines its price stability mandate as a 2 percent inflation target over the longer run. When operationalizing this definition, though, it is necessary to take into account the lags associated with monetary policy and to allow for some medium-term flexibility around the long-run target. Given these considerations, in my view, the FOMC can be said to be satisfying its price stability mandate as long as its medium-term outlook for inflation is between 1 3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain stable.

So you basically have a hard 2 percent target, and only allow tolerance around that due to technical constraints that prevent tighter bounds? I suspect some people are going to think you have increased your tolerance for inflation, but you really haven't, have you?

Let's talk a bit more about your "liftoff" plan. Can you summarize how it works?

I think that it is safe to say that, relative to historical norms, the current stance of monetary policy is quite unusual. In June 2011, the FOMC released a statement describing its exit strategy—that is, the sequence of steps involved in returning monetary policy to a more normal stance. However, that 2011 statement said nothing about the conditions that would trigger the initiation of this exit strategy. This omission is problematic. The current economic impact of both forms of accommodation—low interest rates and asset purchases—depends on when the public believes that accommodation will be removed.

To understand this critical point, consider two possible scenarios. In the first, the public believes that the FOMC will initiate liftoff once the unemployment rate hits 7 percent. In the second, the public believes that the FOMC will defer initiation of liftoff until the unemployment rate hits 6 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity. In other words, the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.

So what is the specific plan?

The proposed plan is the following:

As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

As discussed earlier, by “satisfy its price stability mandate,” I mean that longer-term inflation expectations are stable, and the Committee’s outlook is that the annual inflation rate in two years will be within a quarter of a percentage point of the target inflation rate of 2 percent.

Why so much sensitivity to inflation? Why not, say, a 3 percent threshold instead?

Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can provide more current stimulus by using a lower unemployment rate threshold for liftoff. Of course, additional monetary stimulus will give rise to more inflationary pressures, and those pressures are problematic because they could lead the FOMC to violate its price stability mandate. However, in my view, the Committee should choose the lowest unemployment rate threshold that it sees as unlikely to generate a violation of the price stability mandate.

This seems far too sensitive to inflation to me. Why such a low tolerance?

The proposed liftoff plan does allow the FOMC to contemplate raising the fed funds rate if the Committee’s medium-term inflation outlook rises above 2 1/4 percent. However, the following chart shows that recent historical evidence suggests that this possibility is unlikely to occur. It documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the last 15 years.⁶ Thus, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, it seems unlikely that the price stability mandate would be violated.

I'm not asking about the likelihood of inflation rising above 2.25 percent, I'm asking why you have such intolerant bonds on the inflation rate.

The liftoff plan does not say that the Committee will raise the fed funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only that it could. The Committee’s decision in this context would hinge on a delicate cost-benefit calculation that would weigh the inflation increases against the employment gains. That policy conversation would, I conjecture, be a challenging one. Among other issues, it could well involve a reassessment of the long-run unemployment rate that is consistent with 2 percent inflation.⁷

So your policy, in a nutshell, is that the Fed should be accommodative, but if inflation rises above 2.25 percent, or threatens to do so, the Fed should have a serious talk?

In the same vein, the unemployment rate of 5.5 percent should be viewed as only a threshold to initiate a policy conversation, not as a trigger for action. For example, it is possible that macroeconomic shocks could lead the Committee’s medium-term outlook for inflation to be below 2 percent when the unemployment rate falls below 5.5 percent. At that point, the Committee might want to defer initiating exit, and the liftoff plan allows the Committee to consider doing so.

One thing I don't understand, how is this supposed to work if you won't allow inflation to rise above 2.25 percent -- basically the minimum technical tolerance associated with a hard 2 percent medium run target?

I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy’s aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.

Thus, the liftoff plan that I’ve discussed only applies when the FOMC satisfies its price stability mandate. How then does the proposed liftoff plan generate stimulus? The plan recommends that the FOMC clearly communicate its intention to pursue policies that are fully supportive of much higher levels of economic activity. Thus, the plan commits to keeping the fed funds rate extraordinarily low until the unemployment rate is much nearer historical norms, as long as inflation remains under control. With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss. People will spend more today, and that will drive up economic activity.⁸

So because it might end up as too much inflation, your answer is none at all? You're saying that some inflation would, in fact be useful, but one is too many and a hundred not enough? One taste of inflation, and it rips out of control? I have more faith in you and your colleagues than that. The Fed can allow inflation to, say, go to three percent without risking that it spirals out of control, I think, but you don't seem to have much faith in your colleagues.

You are likely to get a lot of credit for dropping your inflation hawkery, but I don't see it. The target is still 2% + min possible error of .25 percent, so I don't see that you've loosened much at all relative to the past (and even if the "min possible error" interpretation is incorrect, plus or minus .25 percent is hardly the definition of tolerant). You certainly have not embraced a transmission mechanism for policy that runs through elevated inflation expectations, the way most economists think these policies work. How would you respond to that?

I’ve spent much of my time describing what I see as an appropriate liftoff plan. I’ve proposed that, given current Committee thinking about the economy’s productive capacity, the Committee should plan on deferring exit until the unemployment rate falls below 5.5 percent. Critically, there are important inflation safeguards embedded in the plan: The Committee could consider initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4 percent. The evidence from the past 15 years suggests that this event is unlikely to occur.

President Charles Evans of the Federal Reserve Bank of Chicago has also proposed what I’m calling a liftoff plan. As I said last year in answer to a media query, I very much liked his approach to thinking about the problem. Those familiar with his plan will see that my thinking has been greatly influenced by his. This is perhaps hardly surprising, since he sits next to me at every FOMC meeting!

My building on President Evans’ creative proposal in this fashion is, I think, indicative of how the Federal Open Market Committee operates. The making of monetary policy under Chairman Ben Bernanke’s leadership is a distinctly collaborative process. Obviously, we don’t always agree with one another. It would be surprising if we did in such unusual economic conditions. But we learn continually from each other’s points of view. In that way, I believe that we can start to make progress on the challenging economic problems we face.

I hope you continue to sit by Evans, I sat by him not too long ago at a conference and I learned from him as well. You are still a ways from him -- you remain far more hawkish than he is, at least in my assessment -- but maybe, just maybe your views will continue to evolve towards his. One last thing. I know Jim Bullard respects you a lot, can you bring him along as well?

Perhaps not, but in any case, thanks for allowing me pretend I'm interviewing you.

Update: After posting this, I tweeted:

Pushback on previous post: Significance of Kockerlakota's speech is his changed view of structural vs. cyclical unemployment, not inflation.

Couldn't ask about that in pretend interview since he didn't say much about it in his speech.

But not so sure he's changed his mind, though he has allowed for the chance he's wrong. If it is structural, inflation will rise above 2.25 ... as QE proceeds, and he'll favor tightening even if unemployment > 5.5%. Only difference I see is that he isn't insisting it's structural ... as he was before. Perhaps the paper by Lazear at Jackson Hole raised some doubt.

'Mitt and the Moochers'

A quick one as I run off to a meeting. This is Simon Johnson taking on big banks once again:

Mitt and the Moochers, by Simon Johnson, Project Syndicate: The Republican Party has some potentially winning themes for America’s presidential and congressional elections in November. Americans have long been skeptical of government...

But Republican presidential candidate Mitt Romney and other leading members of his party have played these cards completely wrong in this election cycle. Romney is apparently taken with the idea that many Americans, the so-called 47%, do not pay federal income tax. He believes that they view themselves as “victims” and have become “dependent” on the government.

But this misses two obvious points. First, most of the 47% pay a great deal of tax on their earnings, property, and goods purchased. They also work hard to make a living in a country where median household income has declined to a level last seen in the mid-1990’s.

Second, the really big subsidies in modern America flow to a part of its financial elite – the privileged few who are in charge of the biggest firms on Wall Street. ...

Former Utah Governor and Republican presidential candidate Jon Huntsman addressed this issue clearly and repeatedly as he sought – unsuccessfully – to win his party’s nomination to challenge President Barack Obama. Force the banks to break up, he argued, in order to cut off their subsidies. Make these financial institutions small enough and simple enough to fail – then let the market decide which of them should sink or swim.

That is an argument around which all conservatives should be able to rally. After all, the emergence of global megabanks was not a market outcome; these banks are government-sponsored and subsidized enterprises, propped up by taxpayers. (This is as true in Europe today as it is in the US.)

Romney is right to raise the issue of subsidies, but he badly misstates what has happened in the US during the last four years. The big, nontransparent, and dangerous subsidies are off-budget, contingent liabilities generated by government support for too-big-to-fail financial institutions.  These subsidies do not appear in any annual appropriation, and they are not well measured by the government – which is part of what makes them so appealing to the big banks and so damaging to everyone else.

If only Romney had turned popular disdain for subsidies against the global megabanks, he would now be coasting into the White House. Instead, by going after the hard-pressed 47% of America – the very people who have been hurt the most by reckless bank behavior – his prospect of victory in November has been severely damaged.

On the 'Austrian' Hatred of Fractional Reserve Banking

Brad Delong on Ludwig von Mises:

...whenever I see something like:

Ludwig von Mises: Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

I find myself under a mysterious but inexorable and irresistible compulsion to waste what would otherwise be productive work time trying to make some kind of sense of it--to at least understand wherein lies the error, and how somebody trying very hard to understand the economy (never mind that he is a big fan of the political leadership of Benito Mussolini) can go so pathetically wrong.

It is, of course, not the case that every expansion of the circulation is an "artificial" (and unnatural) "stimulation of economic activity" that must "necessarily lead to crisis an depression". So why does Ludwig von Mises think that it must?

Here is my current guess as to where von Mises is coming from:

Let us start out with a world of publicly-known technology and constant returns to scale in everything. People happily make things and trade them. And everything sells at its resource cost.

One of the things people make is little disks of gold, usually decorated with pictures of bearded men on one side and allegorical female figures on the other, with lettering saying things like: "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them. These little gold disks trade--like everything else--at their cost of production: the cost of digging the ore out of the ground, extracting the metal from the ore, and stamping the disk into the right shape.

Then somebody has a bright idea: Because these little metal disks are valuable and easy to carry, they are subject to theft. I will offer to perform a service: I will keep everybody's little metal disks in my stronghouse, and let's write out signed, notarized declarations that people have little metal disks in my stronghouse and they can trade those rather than the disks directly. And--as long as 100% of the circulating medium is backed by gold--everything goes on as before, with everything selling for its cost of production.

Then somebody else has a bright idea: They write out a whole bunch of signed declarations that they have little metal disks in the stronghouse, even though they actually do not have any such. They then buy things with these pieces of the circulating medium that they have written out.

These people, Ludwig von Mises says, are thieves: thieves pure and simple:

They have bought useful things.

They have claimed that they have done so by trading (claims to) valuable little metal disks (in the warehouse) for useful commodities.

But they have lied.

They did not have any valuable little metal disks for trade.

And, Ludwig von Mises would say, these lying thieves come in three forms:

• governments that print dollar bills without having 100% gold bullion backing for them in Fort Knox.
• banks that issue bank notes.
• banks that allow depositors to write checks in amounts that exceed the specie reserves they the banks have in their vaults.

The problem, I think Ludwig von Mises would say, is that the wealth of society is the amount of work has gone into creating the commodities in the economy: the food, the clothing, the houses, the little gold disks. The sum of past work crystalized in commodities is society's wealth. The food is wealth, the housing is wealth, the clothing is wealth, and the little gold disks are wealth. Then add unbacked fiat money and bank credit--either public or private, it doesn't matter--to the mix. The fiat money and the bank credit are counted as wealth, as if they were claims to little gold disks that took sweat and tears to create, but they are not wealth at all. They are fictions: false promises that there is somewhere some valuable gold that you have title to.

And, Ludwig von Mises would say, the larger the unbacked circulating medium the bigger the lie and the theft. It is all guaranteed to end in tears. Whenever society thinks that it is richer than it is, plans will be inconsistent and unattainable. When that unattainability becomes manifest, that will trigger the crash and the depression.

That is, I think, where von Mises is coming from.

And, of course, this is wrong--so so so so so so so so so unbelievably wrong.

It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.

One way into the tangle of understanding why it is wrong is to ask each of us: Why are you happy accepting money in exchange when we sell useful commodities?

Hint: It's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them.

That's not why we accept money.

We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.

The fact is that your wealth is only worth its cost of production if you are liquid--if you can wait to sell until somebody willing to pay full cost of production comes along, which is not every minute. The use-value of money is that it allows you to time your other transactions so that you can realize the full exchange value of what you sell, rather than having to sell it at a discount.

Thus there is no paradox: no sense in which the existence of fiat money creates a situation in which society must necessarily think that it is richer than it is, with claims to total wealth valued at more than the value of total wealth itself. You think--correctly--that your fiat money has value, and that value is just equal to the discount from its cost of production that your other wealth incurs because it is illiquid. But what if the government prints more fiat money than the illiquidity gap in your other wealth? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production.

What von Mises misses completely is that the size of this illiquidity gap can and does change suddenly and drastically--and it is the business of the central bank and of the government to alter the quantity of money to keep such changes from disrupting the real economy. ...

Links for 09-20-2012

• Simple Minded Economics in WSJ Op-Ed - tax.com
• Mitt Romney: The Con Artist Conned - Brad DeLong
• Misinformed Monetary Mitt - Paul Krugman
• Can you Spare a Few Trillion? - Antonio Fatas
• Four Histories of the Right's 47 Percent Theory - Next New Deal
• Heed Wyden’s warning - Register Guard
• Thresholds in the economic effects of oil prices - Econbrowser
• Nation of Takers - Paul Krugman
• Masters or Trend-Followers of the Universe? - Baseline Scenario
• Soaring Tuitions: Are Public Funding Cuts to Blame? - Liberty Street
• Three different ways expectations can matter. And the ZLB. - Nick Rowe
• The "Austrian" Hatred of Fractional Reserve Banking, etc. - Brad DeLong

Fed Watch: Fisher Turns to Fear Mongering

Another one from Tim Duy:

Fisher Turns to Fear Mongering, by Tim Duy: Dallas Federal Reserve President Richard Fisher is quick to continue his fear mongering about inflation. Via Bloomberg:

“I do not see an overall argument for letting inflation rise to levels where we might scare the market,” Fisher said on Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays and Vonnie Quinn. “We have seen a sharp rise in inflation expectations. If you let this get out of hand, then I think we will have a market reaction.”

Let's go to the chart:

You really can't say that inflation expectations are surging beyond anything we have seen in the past six years. Moreover, supporting inflation expectations was an expected outcome of Fed easing. And financial markets seem to like it.

Also, it is not clear that TIPS-derived expectations are the best measure (a point I don't make enough). The Cleveland Federal Reserve works on teasing out inflation expectations, and on September 14th reported:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.32 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Yes, near term expectations have gained but from a too-low 1.2% to 1.8%. Moreover, this would be expected not just from anticipation of QE3, but from the rise in gas prices (and note that oil prices are now falling again). By this measure, the more important longer term expectations remain mired well below the Fed's 2% inflation target. Let's at least agree to stop worrying about inflation until we get expectations back up to the Fed's target.

Bottom Line: Fisher stays true to form, clutching to his fears of inflation like a drowning man grabs onto a life preserver. My guess is that he doesn't need to be marginalized by the doves; he does a fine job marginalizing himself.

Fed Watch: Hawks Are Marginalized

Tim Duy:

Hawks Are Marginalized, by Tim Duy: There has been a lot of Fedspeak over the last few days as policymakers expand upon the shift to open-ended QE. See Cardiff Garcia at FT Alphaville for an overview of some of the dovish talk, and see Pedro Da Costa at Reuters for some thoughts on the hawkish talk, described as a "vocal minority." See also Reuters for an interview with St. Louis Federal Reserve President James Bullard, who claims that he would have voted against QE3:

"I would have voted against it based on the timing. I didn't feel like we had a good enough case to make a major move at this juncture," said Bullard, who has been viewed as a centrist on the spectrum of Fed officials, though in recent months he has sounded opinions that have sounded more hawkish as he has expressed doubts about the need for further stimulus.

Bullard does acknowledge his preference for open-ended QE, had he believed it was needed:

Even so, Bullard said some of the contours of the plan, which has no set end date, were in keeping with how he thinks monetary policy should be conducted with interest rates already near zero. Leaving end dates off a bond buying program can make the policy "more effective," he said.

Bullard is also reported to have expressed support for dropping the dual mandate, although I am not seeing a direct quote. Same for concerns about commodity prices:

He also voiced concern that QE3 could spill over into higher commodity prices, as happened with the previous rounds of Fed bond-buying, although he said the soft tone of the world economy would help curb price rises.

The reporter reaches the conclusion:

In discussing his views on more monetary stimulus, Bullard said, "We should take a little bit more (of a) wait-and-see posture." His comments, in an interview with Reuters Insider, highlight potential dissent on the Fed's policy committee next year when he will be a voting member.

Should we be concerned about this warning? I would say no. I think it is easy for Bullard to say that he would have dissented, but a lot harder to actually dissent if he was seated in the meeting. Indeed, he gets the best of both worlds - he gets to display his hawkish credentials by saying he would voted against QE without the pressure of the actual vote. Might he get more vocal next year? Maybe. I suspect his comments will be a function of which way the political winds are blowing. All of his comments to Reuters - anti-QE, concerns about commodity prices, desire to dump the employment mandate - sound like attempts to position himself for a role in a Republican Administration. The more he needs to position himself in that direction, the more hawkish he will appear.

And note that fundamentally, whatever Bullard (or other hawks) say is for the time largely irrelevant. As a group, they were small to begin with, and by now have been intellectually marginalized. Via Cardiff Garcia, Credit Suisse provides a summary chart of policymakers:

The hawks are all bark, no bite. They are more than overwhelmed by dovish-leaning policymakers, even if Bullard joins Kansas City Federal Reserve President Esther George in hawkish dissent. What remains important heading into 2013 (aside from the data, of course), is Federal Reserve Chairman Ben Bernanke. He can pull the moderates where he wants to go. And it obviously is not in a hawkish direction.

Bottom Line: Fed hawks are largely marginalized. Their views have not and will not have a significant impact on policy making. They will only appear to have an impact on policy if the data signals that a policy shift is needed. Given the current set of policymakers on the Fed, the hawks will only have a voice if Bernanke is replaced with one of their own. And that is when it would get interesting, as I am not sure that the moderates would follow a hawkish Chairman.