Economist's View

The Benefits Tax View

Richard Green:

"We are all in it together," and benefits taxes, by Richard Green: Tyler Cowen says that the Republican Party should propose raising taxes on everyone because, "we are all in it together."

To some extent, this is a benefits tax view--a view that we should pay to society our fair share of what we get from society.  But the implication of this is not necessarily that everyone should sacrifice in order to put us all on a sustainable fiscal path.

With Ronald Reagan's election in 1980, the US saw a sea change in tax and regulatory policy.  While the policy was suppose to benefit everyone, it clearly hasn't.  For the bottom quintile of the income distribution, income has risen about 5 percent since 1982 (the first year in which Reagan's policies bit); for the next quintile, it has risen 8 percent; for the next, 11 percent, for the next, 20 percent, and for the highest, 45 percent.  But most of the highest quintile didn't do so well--the top 5 percent has seen average household income rise by 68 percent.

These data are before tax, and come from the US Census, Table H-3.  Before anyone suggests that this means that everyone has benefited, I should point out that average income in the lowest quintile of the income distribution is $11,239, which is right at the Federal Poverty Level for a single person household.  In a benefits tax view of the world, people who haven't sufficient income to live should not be taxed (they are living at subsistence levels as it is, and taxing them makes thing worse).

So let's begin by holding the bottom quintile harmless in doing any kind of deficit reduction.  But what of the remaining quintiles?  If we look at the share of income growth by quintile (excluding the meager income growth of the bottom quintile), we find that 3 percent went to the second quintile from the bottom; 7 percent to the next; 18 percent to the next, and 73 percent to the top quintile.  So little has gone to the second and third quintile from the bottom that one could make a case that they should be left along as well.

The fourth quintile, though, has seen a material improvement in incomes, so it is probably OK to ask this group for something--this includes people who nearly everyone would consider middle class.  Nevertheless, the lion's share of the benefits of the policy changes of the early 1980s has appeared to go to the top quintile, and so the top quntile should pay the most to put us on a sustainable fiscal path.

One last calculation--the top 5 percent got 57 percent of the income growth within its quintile.

It is true that households move in and out of quintiles, but as Dalton Conley shows, not as much as we would like to think,  In any event, we have not been all in it together when it has come to benefitting from the policies of the past 30 years.

Paul Krugman: Brewing Up Confusion

Some well-funded groups are trying to "exploit the fiscal cliff to push a benefit-cutting agenda":

Brewing Up Confusion, by Paul Krugman, Commentary, NY Times: Howard Schultz, the C.E.O. of Starbucks,... posted an open letter urging his employees to promote fiscal bipartisanship by writing “Come together” on coffee cups. ... In the letter, Mr. Schultz warned that elected officials “have been unable to come together and compromise to solve the tremendously important, time-sensitive issue to fix the national debt,” and suggested that readers further inform themselves at the Web site of the organization Fix the Debt. Let’s parse that, shall we?

First of all,... the fiscal cliff ... doesn’t reflect a failure to “fix the debt” by reducing the budget deficit — on the contrary, the danger is that we’ll cut the deficit too fast.

How could someone as well connected as Mr. Schultz get such a basic point wrong? By talking to the wrong people — in particular, the people at Fix the Debt... For example,... Maya MacGuineas, the organization’s public face,... was trying to confuse readers on that point, and she apparently confused Mr. Schultz too. More about Fix the Debt in a moment..., let’s move on to Mr. Schultz’s misdiagnosis of the political problem we face.

Look, it’s true that elected politicians have been unable to “come together and compromise.” But ... implying a symmetry between Republicans and Democrats, isn’t just misleading, it’s actively harmful. The reality is that President Obama has made huge concessions. ... In return, the Republicans have offered essentially nothing. ... Given that reality,... when people like Mr. Schultz respond by blaming both sides equally ... they’re ... rewarding intransigence and extremism...

I’m willing to believe that Mr. Schultz doesn’t know what he’s doing. The same can’t be said, however, about Fix the Debt. You might not know it reading some credulous reporting, but Fix the Debt isn’t some kind of new gathering of concerned citizens..., it’s ... the usual suspects ... backed by an impressive amount of corporate cash.

Like all the Peterson-funded groups, Fix the Debt seems much more concerned with cutting Social Security and Medicare than with fighting deficits in general... What’s happening now is that all the Peterson-funded groups are trying to exploit the fiscal cliff to push a benefit-cutting agenda that has nothing to do with the current crisis, using artfully deceptive language — as in that MacGuineas letter — to hide the bait and switch.

Mr. Schultz apparently fell for the con. But the rest of us shouldn’t.

Fed Watch: Japan Follow-Up

Tim Duy:

Japan Follow-Up, by Tim Duy: Some follow up to last week's piece on Japanese monetary policy:

First, I think there are some obvious implications for US policymakers: The Federal Reserve has all but given fiscal policymakers the green light to accelerate debt issuance to support stimulus efforts. Matthew O'Brien at the Atlantic points out that while the Fed is willing to tolerate inflation slightly as high as 2.5%, the Fed's forecast remains at 2.0% or below through 2015. So the Fed is willing to tolerate higher inflation, but not willing - or able - to generate higher inflation. The ball is thus passed to fiscal policymakers to do the job. Fiscal policymakers, however, have fumbled the ball. Badly. Even while the Treasury can borrow for 10 years at well below 2%, Washington is prepared to drop an austerity bomb on the economy. Austerity looks to be a done deal; it is only the level of austerity that is at issue.

Second, a thread is making the rounds claiming that Japanese Prime Minister Shinzo Abe is all bark, no bite. Joshua Wojnilower argues that Abe is a closet austerian, thus ultimately the actual stimulus enacted will be of the short-term, low-power variety. Noah Smith is less diplomatic, pointing out that Abe's first time at the helm was something of a disaster because Abe fundamentally has a narrow focus:

I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second.

This is why Abe allows himself to be surrounded by corrupt and incompetent people. He is entirely focused on his cultural conservative quest. The other day Abe called Obama "Bush". He just deeply, truly, does not care about stuff that does not involve boosting Japanese nationalism.

Smith has a theory:

So why is Abe making all this noise about revoking central bank independence, setting hard inflation targets, etc.? I have a hypothesis: He is talking down the yen.

There is a long history of Japanese policymakers talking down the Yen; who could ever forget former Finance Minister Eisuke Sakakibara, AKA Mr. Yen? That said, if Abe wants a sustained depreciation, is is going to take something more than just talk. After all, look at what has been accomplished over the past ten years:

If the goal of all the talk was a weak Yen, policymakers have failed miserably. And If Abe can't follow through with a real policy change, talking alone will continue to fail, and the recent decline in the Yen will prove ephemeral.

This leads me to my third thought, that the level of intervention required to change the economic outcome is much, much higher than most anticipate. You can't just dabble in monetization; you need to commit to it. Case in point: Switzerland. Floyd Norris, the author of the original NYT piece that prompted my initial post, seems to argue that raising inflation is not all that hard:

“At this point, moving to a 2 percent target would not be such a giant step,” said Kenneth Rogoff, a Harvard economist who has suggested inflation targeting in the United States as well as in Japan. “They have to pursue it vigorously until we have inflation expectations firmly higher. No one knows how much they would have to do to accomplish that.”

The Bank of Japan has in the past been hesitant to really try to establish that credibility...

To establish the credibility, the central bank would have to show a readiness to create credit at a rapid rate. It would probably also need to take steps to hold down the value of the yen, a move that would no doubt cause concern in the United States.

It is, however, very doable, as Switzerland has shown. When the euro zone debt crisis was at its worst, Switzerland became a safe haven for European investors worried that the euro might blow up. That drove up the value of the Swiss franc versus the euro and damaged Switzerland’s ability to compete. The Swiss government responded by announcing that the euro would not be allowed to fall below 1.2 Swiss francs. If necessary, the government would simply sell francs to meet any demand.

That has been necessary, and the Swiss have accumulated a huge portfolio of foreign currency. So, too, could the Japanese if they chose to announce that the dollar would henceforth be worth at least 100 yen, a level not seen since 2009.

Rogoff is correct; no one really knows what is necessary. I don't think that 100 yen is a meaningful target; aside from a couple of energy-price induced spikes, Japan has not had meaningful inflation since the early 1990's. The Yen has fluctuated between 80 and 160 during that time. Shoot for 160 and it might be interesting. And how does this relate to Switzerland? Although Norris holds it out as an example, look at inflation in that economy:

And nominal GDP:

The Swiss National Bank appears to be struggling to stave off deflation and stabilize the path of nominal GDP. So how exactly is this a lesson in establishing inflation target credibility? Despite all the efforts of the Swiss National Bank, their work still fall short.

Norris is certainly right on the political implications. I think the extent of direct currency depreciation necessary to by itself meet a 2% inflation target in Japan would be unacceptable to Japan's trade partners. Monetary policy to support domestic demand - monetization of deficit spending - would be much more tolerable, perhaps even welcome.

Bottom Line: Economic policy in Japan is never boring.

Links for 12-31-2012

• Fed's Computer Models Pose Problems - WSJ.com
• The Macroeconomics of Middle Earth - Frances Woolley
• Big Depositors Seek a New Safety Net - NYTimes.com
• An All-Star for the Team of Rivals? - Economic Principals
• Another year in thrall to the central bankers - Gavyn Davies
• Back when fifty years was a long time ago - West Coast Stat Views
• "We are all in it together," and benefits taxes - Richard Green
• Is Our Austerians Learning? - Paul Krugman
• The Hostage Drama Begins - Paul Krugman
• Should Japan "reflate"? - Noah Smith

Must Middle Class Taxes Go Up?

Longish travel day today, but hope to have internet access along the way. Anyway, another quick one before heading out:

Greg Mankiw says middle class taxes are going to go up unless we make large cuts to social services:

Too Much Wishful Thinking on Middle-Class Tax Rates

Dean Baker responds:

Greg Mankiw Says We Have to Tax the Middle Class More

The 'Great Scam'

Following up the post below this one, Paul Krugman explains why it's important to realize that deficit reduction is not the true goal of Republicans, it's just a means to bring about tax cuts for the wealthy and pay for them with cuts to social services such as Medicare and Social Security:

...Remember, George W. Bush campaigned on the basis that the surplus of the late Clinton years meant that we needed to cut taxes — and Alan Greenspan provided crucial support, telling Congress that the biggest danger we faced was that we might pay off our debt too fast. Now Greenspan is helping groups like Fix the Debt.

And as Duncan Black points out, the Bush experience tells us something important about fiscal policy: namely, that when Democrats get obsessed with deficit reduction, all they do is provide a pot of money that Republicans will squander on more tax breaks for the wealthy as soon as they get a chance. Suppose Romney had won; do you have even a bit of doubt that all the supposed deficit hawks of the GOP would suddenly have discovered that unfunded tax cuts and military spending are perfectly fine?

The point is that the whole focus of budget discussion is based on a combination of bad economics and bad (and fundamentally dishonest) politics. We’re looking not so much at a Grand Bargain as at a Great Scam.

The Republican's 'Biggest Priority'

Is Obama finally figuring it out?:

“They [Republicans] say that their biggest priority is making sure that we deal with the deficit in a serious way, but the way they’re behaving is that their only priority is making sure that tax breaks for the wealthiest Americans are protected,” he said.

“That seems to be their only overriding, unifying theme.”

Seems to be?

Links for 12-30-2012

• The Year in Review: Fantastical Pseudo Economics - Econbrowser
• On the Economics and Politics of Deficits - Paul Krugman
• Greg Mankiw Says We Have to Tax the Middle Class More - Dean Baker
• Too Much Wishful Thinking on Middle-Class Tax Rates - Greg Mankiw
• Economic Consequences Of Banning Semi-Automatic Weapons - EconoSpeak
• Policy implications of capital-biased technological change? - Tyler Cowen
• Going Over the Cliff Is the Only Way to Save the Government - Jeffrey Sachs
• E. Cary Brown on Recent Fiscal Policy - EconoSpeak
• Fixing the Deficit Is Painless - Business Insider
• Epicurus's philosophy - UnderstandingSociety
• Most Findings Are False - Normal Deviate

Why Next to No Political Reaction to the Second Gilded Age?

Brad Delong:

Why Next to No Political Reaction to the Second Gilded Age?, by Brad DeLong: ...During the Gilded Age of the 1890s and 1900s you had strong political movements saying "something is going remarkably wrong with this, this isn’t the country we thought we were going to live in"...

Brad DeLong: ...As a result in the First Gilded Age you had two political movements. The Democratic, left, farmer, labor, semi-socialist, Populist Movement on the one hand. The mixed bipartisan Democratic and Republican, urban, Progressive Movement on the other. Both of them were desperately eager to change America, to repair the flaws of the Gilded Age, to reduce inequality, to make the economy work for everybody--or at least for every white guy--and even to grant women the vote.

They wanted this so much so that someone like Republican President Theodore Roosevelt--as aggressively a partisan an animal as you would ever see--would place his loyalty to the Republican cause second to his loyalty to his progressive principles for American reform. He was happy denouncing Democrats as communist anarchists, but equally happy denouncing rich republicans as "malefactors of great wealth" who desperately needed to be controlled.

Theodore Roosevelt wove his political career out of being head of the Republican party and head of the Progressive Movement. And at the end non-Progressive Republican President Taft simply offended him one time too many, and Roosevelt decided to blow up the Republican Party and hand the presidency to Woodrow Wilson from 1912-1920.

That was the history of America from 1880-1920 or so. After 1920 you do get a Republican Gilded Age resurgence under Harding, Coolidge, Hoover--very corrupt, especially under Harding. But by the late 1920s Progressivism is rising again--even Hoover is running as a Progressive. Then when the Great Depression comes Franklin Roosevelt comes in and he takes the entire progressive agenda off the shelf and promptly begins to implement it.

We haven’t had anything like that over the past thirty years.

And here I’m simply going to throw up my hands and say that I don't know why.

It’s in a great mystery to me. As an economic historian I like to look at political economic patterns from the past and to say we should learn from these and generalize them and take them as providing some insight into the present and the future. In general, we economic historians are extraordinarily successful. There are lots of lessons to be drawn from the first age of globalization for the second. There are lots of lessons to be drawn from the high school-ization of America for the college-ization of America and for education elsewhere in the world. There are lots and lots of lessons to be drawn from the Great Depression for today.

But the political economy of Gilded Ages? Why the first Gilded age produces a Populist and a Progressive reaction and the second, so far, does not? There I throw up my hands and say that my economic historian training betrays me. I have no clue as to what is going on here.

(This is speculative, but I'll give it a shot) I would certainly start by noting the different levels of initial national wealth -- we started from a much higher base this time -- and the presence of social insurance. If we didn't have food stamps, unemployment compensation, and other private and public social backstops to help people through tough times, and a relatively high level of initial wealth to rely upon, the effects would have been much more severe and the response to the Great Recession might have been more like the response to the Great Depression. But as Brad notes, it wasn't just the reaction to the Great Depression that produced a populist movement, it existed before the Great Depression hit. I think you can see elements of a populist movement in recent decades, but it's nowhere as strong as prior to the Great Depression. Again, I think part of this is different levels of initial wealth and the existence of a large middle class, but maybe there is something else too.

I think it matters a lot whether we think of inequality as arising from a problem in the system as a whole, or as the result of individual failures. When people think it's the system as a whole -- the rich and powerful are scheming to hold everyone else down (e.g. robber barons) -- mass movements are more likely than when it is viewed as simply the failings of individuals. I think many people viewed the last few decades as a time of great opportunity. If you weren't rich, or at least doing very well, it was because you hadn't tried hard enough. Anyone who wanted a decent job could get one if they were willing to put out the requisite effort. The Great Recession changed that somewhat, but even now many people want to blame our problems on the poor decisions of individuals, some even try to cast blame for the recession on the decisions of low income households to try to buy houses, rather than some inherent failure within the capitalist system.

Let me back up. Prior to the Great Depression, there was a battle between those who believed the system was at fault (and hence pushed populist remedies) versus those who thought some people were simply less capable and destined to be poor no matter what we did to help them -- it was the duty of the head of the household to provide for their family, and those who didn't were looked down upon. They must not be trying hard enough, they were lazy, etc. But the Great Depression made it clear that trying hard wasn't always sufficient. People who had been able to support their families their whole lives, and were determined to do so during the depression no matter what it took, couldn't. It wasn't a matter of individual effort, or how hard one tried, these was simply no work to be found for great numbers of "upstanding" citizens.

If the people who were known to be willing to do whatever it took to provide for their families could not, then it must be the system, not the individual that was a fault and this was a key idea that allowed social insurance to be passed after the Great Depression. The money wasn't going to no good, lazy people who didn't deserve it, it was going to people who deserved to be helped when the capitalist system, which was known to cycle ruthlessly through booms and busts, let them down. People needed insurance against events that were out of their individual control.

This time around, it came as a bit of a shock that they system could still let us down. Many people thought we were beyond Great Depressions/Recessions -- hence the claim above that most failings prior to our recent troubles were viewed as individual rather than the fault of the system. But even though people began to realize it wasn't always a matter of individual effort and ability, since we already have many social insurance protections in place the outcry this time isn't to produce a bunch of new social insurance programs to protect the vulnerable as it was after the Great Depression. Instead, it led to a renewed realization of the value of social insurance (at least I hope this is true) and the fight presently is to maintain or expand what we already have versus scaling back our social protections. I think that, without the Great Recession, our social insurance programs would be even more vulnerable than they are presently. Thus, unlike Brad, I think there have been noticeable effects in shoring up "populist" support for these types of programs. But where I agree, and what I see as puzzling, is why the reaction from those who depend upon these programs hasn't been even stronger. Why are these programs vulnerable at all?

'Is Academic Macroeconomics Flourishing?'

Simon Wren-Lewis continues the conversation on the state of academic macroeconomics:

Is academic macroeconomics flourishing?, by Simon Wren-Lewis: How do you judge the health of an academic discipline? Is macroeconomics rotten or flourishing? ...[A]cademic macroeconomics appears all over the place, with strong disputes between alternative schools.

Is this because the evidence in macroeconomics is so unclear that it becomes very difficult to judge different theories? I think the inexact nature of economics is a necessary condition for the lack of an academic consensus in macro, but it is not sufficient. (Mark Thoma has a recent post on this.) Consider monetary policy. I would argue that we have made great progress in both the analysis and practice of monetary policy over the last forty years. One important reason for that progress is the existence of a group that is often neglected - macroeconomists working in central banks.

Unlike their academic counterparts, the primary goal of these economists is not to innovate, but to examine the evidence and see what ideas work. The framework that most of these economists find most helpful is the New NeoClassical Synthesis, or equivalently New Keynesian theory. As a result, it has become the dominant paradigm in analyzing monetary policy.

That does not mean that every macroeconomist looking at monetary policy has to be a New Keynesian, or that central banks ignore other approaches. It is important that this policy consensus should be continually questioned, and part of a healthy academic discipline is that the received wisdom is challenged. However, it has to be acknowledged that policymakers who look at the evidence day in and day out believe that New Keynesian theory is the most useful framework currently around. I have no problem with academics saying ‘I know this is the consensus, but I think it is wrong’. However to say ‘the jury is still out' on whether prices are sticky is wrong. The relevant jury came to a verdict long ago.

It is obvious that when it comes to using fiscal policy in short term macroeconomic stabilization there can be no equivalent claim to progress or consensus. The policy debates we have today do not seem to have advanced much since when Keynes was alive. From one perspective this contrast is deeply puzzling. The science of fiscal policy is not inherently more complicated. ...

What has been missing with fiscal policy has been the equivalent of central bank economists whose job depends on taking an objective view of the evidence and doing the best they can with the ideas that academic macroeconomics provides. This group does not exist because the need to use fiscal policy for short term macroeconomic stabilization is occasional either in terms of time (when the Zero Lower Bound applies) or space (countries within the Eurozone). As a result, when fiscal policy was required to perform a stabilization role, policymakers had to rely on the academic community for advice, and here macroeconomics clearly failed. Pretty well any outside observer would describe its performance as rotten.

The contrast between monetary and fiscal policy tells us that this failure is not an inevitable result of the paucity of evidence in macroeconomics. I think it has a lot more to do with the influence of ideology, and the importance of what I have called the anti-Keynesian school that is a legacy of the New Classical revolution. The reasons why these influences are particularly strong when it comes to fiscal policy are fairly straightforward.

Two issues remain unclear for me. The first is how extensive this ideological bias is. Is the over dominance of the microfoundations approach related to the fact that different takes on the evidence have an unfortunate Keynesian bias? Second, is the degree of ideological bias in macro generic, or is it in part contingent on the particular historical circumstances of the New Classical revolution? These questions are important in thinking how this bias can be overcome.

When people ask if evidence matters in economics, I often point to the debate over the New Classical model's prediction that only unexpected changes in monetary policy matter for economic activity. These models, with their prediction that expected changes in monetary policy are neutral, cleverly allowed New Classical economists to explain the correlations between money, output, and prices in the data without admitting that systematic policy mattered. Thus, these models supported the ideological convictions of many on the right -- government intervention can make things worse, but not better. (Unexpected policy shocks push the economy away from the optimal outcome, so the key was to minimize unexpected policy shocks. This led to things like the push for transparency so that people would anticipate, as much as possible, actual policy moves.)

At first, the evidence seemed to support these models (e.g. Barro's empirical work), but as the evidence accumulated it eventually became clear that this prediction was wrong. Mishkin provided key evidence against these models through his academic work (see, for example, his book A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient-Markets Models), so I am not as convinced as Simon Wren-Lewis that the difference between monetary and fiscal policy is due solely to the existence of technocratic, mostly non-ideological central bank economists letting the evidence take them where it may. That certainly mattered, but is seems there was more to it than this.

The evidence that Mishkin and others provided was a key reason these models were rejected (it was also difficult to simultaneously explain the magnitude and duration of business cycles with unexpected monetary shocks as the sole driving force), but when it comes to fiscal policy, as noted above, evidence has not trumped ideology to the same degree. One of the reasons for this, I think, is that it's difficult to find clear fiscal policy experiments in the data to evaluate. And when we do (e.g. wars), it's difficult to know if the results will hold at other times. But I can't really disagree with the hypothesis that if an institution like the Fed existed for fiscal policy, there would be a much bigger demand for this information, and that demand would have produced a much larger supply of evidence.

But I am not so sure the difference is "central bank economists whose job depends on taking an objective view of the evidence" so much as it is that these institutions produce a demand for this type of research, and academics respond by supplying the information that central banks need. So the question for me is whether it's the lack of ideology of central bank economists (many of whom are academics), or the fact that their existence creates a large demand for this type of information. Maybe it's both.

Links for 12-29-2012

• Policy Implications of Capital-Biased Technology - Paul Krugman
• More on Capital-Biased Technological Change - Beat the Press
• Are robots and aging demographics self-cancelling problems? - Tyler Cowen
• Glaeser... Where have I heard that name before? - West Coast Stat Views
• How Do We Know Nash Equilibrium Has “Arrived”? - Cheap Talk
• Humidity Levels Explain U.S. Flu Winter Peak - Scientific American
• Bernanke's Message to Congress: More Stimulus, Please - Matt O'Brien
• On the State of Macroeconomics - Economic Incubator
• A Double Shot of Misunderstanding - Paul Krugman
• Trust not in Shinzo Abe, ye monetarists! - Noahpinion
• National Econometricians' Day - Dave Giles
• Giving Deadlines - Frances Woolley

Taylor Rules and NGDP Targets: Skeptical Davids

One of the big, current, passionate debates within monetary policy is the relative effectiveness of Taylor Rules versus nominal GDP targeting (e.g. see here). Which of the two does a better job of stabilizing the economy?

If you want to argue against nominal GDP targeting, David Altig of the Atlanta Fed has some ammunition for you. Here's his conclusion:

Nominal GDP Targeting: Still a Skeptic, macroblog: ... To summarize my concerns, the Achilles' heel of nominal GDP targeting is that it provides a poor nominal anchor in an environment in which there is great uncertainty about the path of potential real GDP. As I noted in my earlier post, there is historical justification for that concern.

Basically, anyone puzzling through how demographics are affecting labor force participation rates, how technology is changing the dynamics of job creation, or how policy might be altering labor supply should feel some humility about where potential GDP is headed. For me, a lack of confidence in the path of real GDP takes a lot of luster out of the idea of a nominal GDP target.

Taylor rule skeptics can turn to David Andolfatto of the St. Louis Fed:

On the perils of Taylor rules. macromania: In the Seven Faces of "The Peril" (2010), St. Louis Fed president Jim Bullard speculated on the prospect of the U.S. falling into a Japanese-style deflationary outcome. His analysis was built on an insight of Benhabib, Schmitt-Grohe, and Uribe (2001) in The Perils of Taylor Rules.

These authors (BSU) showed that if monetary policy is conducted according to a Taylor rule, and if there is a zero lower bound (ZLB) on the nominal interest rate, then there are generally two steady-state equilibria. In one equilibrium--the "intended" outcome--the nominal interest rate and inflation rate are on target. In the other equilibrium--the "unintended" outcome--the nominal interest rate and inflation rate are below target--the economy is in a "liquidity trap."

As BSU stress, the multiplicity of outcomes occurs even in economies where prices are perfectly flexible. All that is required are three (non-controversial) ingredients: [1] a Fisher equation; [2] a Taylor rule; and [3] a ZLB.

Back in 2010, I didn't take this argument very seriously. In part it was because the so-called "unintended" outcome was more efficient than than the "intended" outcome (at least, in the version of the model with flexible prices). To put things another way, the Friedman rule turns out to be good policy in a wide class of models. I figured that other factors were probably more important for explaining the events unfolding at that time.

Well, maybe I was a bit too hasty. Let me share with you my tinkering with a simple OLG model... Unfortunately, what follows is a bit on the wonkish side...

[My comments on this topic are highlighted in the first link, i.e. the one to David Altig's post at macroblog.]

'Falling Off the Fiscal Cliff '

Jason Saving, a senior research economist and advisor in the Research Department of the Federal Reserve Bank of Dallas, discusses the economic consequences of going over the fiscal cliff (see also Over the Cliff We Go for Brad DeLong's views on this issue). After detailing the components of the cliff and noting they amount to $560 billion in budget cuts or tax increases for 2013 alone (though they wouldn't all kick in at once), he notes:

Enlarge

... Interestingly, the various components of the fiscal cliff don’t contribute equally to these negative economic impacts. For example, it might appear that letting the 2001/03 tax cuts expire would have a large impact because this component is among the biggest fiscal cliff budget items, as detailed in Chart 2. However, the cuts are estimated to have the fourth-largest impact, behind the sequester, labor-market provisions and AMT patch.

The reason is that, in the short run, different fiscal policies can have a very different “bang for the buck” (often referred to in economic shorthand as a fiscal “multiplier”). When the government reduces its purchases and lays off workers, as would occur under the sequester, there is an immediate and sizable reduction in demand that feeds back into the overall economy — that’s why the impact of the sequester on GDP is so large. Marginal rate cuts have the smallest multiplier because they flow disproportionately to higher-income individuals, who make the “wrong” choice from a short-run point of view and save those funds instead of spending and pumping them back into the broader economy.[3] ...

He concludes with:

In fiscal policy as in monetary policy, it’s necessary to carefully weigh short-term gain against long-term pain, often when no unambiguously optimal options are available. Many have suggested that the best strategy may be visible, loose fiscal policy today, coupled with strongly worded promises to embark upon fiscal consolidation as soon as it becomes reasonable to do so. But what’s reasonable is not always apparent, making such proposals easier said than done.

Perhaps the real question today is whether we have entered an era of permanently greater polarization in Congress and permanently higher fiscal policy uncertainty. If that’s the case, today’s fiscal cliff may be a harbinger of what’s to come.

Paul Krugman: Is Growth Over?

How important is the digital revolution?

Is Growth Over?, by Paul Krugman, Commentary, NY Times: The great bulk of the economic commentary you read in the papers is focused on the short run: the effects of the “fiscal cliff” on U.S. recovery, the stresses on the euro, Japan’s latest attempt to break out of deflation. This focus is understandable... But... What do we know about the prospects for long-run prosperity? The answer is: less than we think.

The long-term projections produced by official agencies, like the Congressional Budget Office, generally make two big assumptions. One is that economic growth over the next few decades will resemble growth over the past few decades. ... On the other side, however, these projections generally assume that income inequality, which soared over the past three decades, will increase only modestly looking forward. ...

Yet this conventional wisdom is very likely to be wrong on one or both dimensions.

Recently, Robert Gordon ... created a stir by arguing that economic growth is likely to slow sharply — indeed, that the age of growth that began in the 18th century may well be drawing to an end. ...

It’s an interesting thesis... And while I don’t think he’s right, the way in which he’s probably wrong has implications equally destructive of conventional wisdom. For the case against Mr. Gordon’s techno-pessimism rests largely on the assertion that the big payoff to information technology, which is just getting started, will come from the rise of smart machines.

If you follow these things, you know that the field of artificial intelligence has for decades been a frustrating underachiever... Lately, however, the barriers seem to have fallen... So machines may soon be ready to perform many tasks that currently require large amounts of human labor. This will mean rapid productivity growth and, therefore, high overall economic growth.

But — and this is the crucial question — who will benefit from that growth? Unfortunately, it’s all too easy to make the case that most Americans will be left behind, because smart machines will end up devaluing the contribution of workers, including highly skilled workers whose skills suddenly become redundant. The point is that there’s good reason to believe that the conventional wisdom embodied in long-run budget projections — projections that shape almost every aspect of current policy discussion — is all wrong.

What, then, are the implications of this alternative vision for policy? Well, I’ll have to address that topic in a future column.

Links for 12-28-2012

• Why Closing Tax Loopholes Isn’t Enough - NYTimes.com
• Sales Ratio: Existing to New Homes - Calculated Risk
• There's Another No Work Option: Laid Off - Eschaton
• Noah Smith vs. Macroeconomics as a Whole - Brad DeLong
• China tightens up censorship of Internet sites - latimes.com
• Future Inequality, According to the CBO - Paul Krugman
• Five myths about charitable giving - The Washington Post
• Metrics for the “Ever Expanding Government” - Econbrowser
• Are voluntary contracts always mutually beneficial? - Noahpinion
• Why Republicans Don't Care What the Nation Thinks - Robert Reich
• Microfoundations You Can Believe In - Coordination Problem
• The SEC at a Turning Point - Simon Johnson
• Falling Off the Fiscal Cliff - Dallas Fed

'Disease Burden Links Ecology to Economic Growth'

Many development economists argue that "the foundation of economic growth is in political and economic institutions." This research argues that "vector-borne and parasitic diseases" are just as important as "crime or government corruption" in explaining the global distribution of income. This is not my area, so I won't comment on the quality of this research, but hoping development economists will chime and explain the degree to which these results should be noted or ignored:

Disease burden links ecology to economic growth, EurekAlert: A new study, published December 27 in the open access journal PLOS Biology, finds that vector-borne and parasitic diseases have substantial effects on economic development across the globe, and are major drivers of differences in income between tropical and temperate countries. The burden of these diseases is, in turn, determined by underlying ecological factors: it is predicted to rise as biodiversity falls. This has significant implications for the economics of health care policy in developing countries, and advances our understanding of how ecological conditions can affect economic growth.

According to conventional economic wisdom, the foundation of economic growth is in political and economic institutions. "This is largely Cold War Economics about how to allocate property rights—with the government or with the private sector," says Dr Matthew Bonds, an economist at Harvard Medical School, and the lead author of the new study. However, Dr Bonds and colleagues were interested instead in biological processes that transcend such institutions, and which might form a more fundamental economic foundation.

The team was intrigued by the fact that tropical countries are generally comprised of poor agrarian populations while countries in temperate regions are wealthier and more industrialized. This distribution of income is inversely related to the burden of disease, which peaks at the equator and falls along a latitudinal gradient. Although it is common to conclude that economics drives the pattern of disease, the authors point out that most of the diseases that afflict the poor spend much of their life-cycle outside the human host. Many cannot even survive outside the tropics. Their distribution is largely determined by ecological factors, such as temperature, rainfall, and soil quality.

Because of the high correlations between poverty and disease, determining the effects of one on the other was the central challenge of their statistical analysis. Most previous attempts to address this topic ignored disease ecology, argue Bonds and colleagues. The team assembled a large data set for all of the world's nations on economics, parasitic and infectious vector-borne diseases, biodiversity (mammals, birds and plants) and other factors. Knowing that diseases are partly determined by ecology, they used a powerful set of statistical methods, new to macroecology, that allowed variables that may have underlying relationships with each other to be teased apart.

The results of the analysis suggest that infectious disease has as powerful an effect on a nation's economic health as governance, say the authors. "The main asset of the poor is their own labor," says Dr Bonds. "Infectious diseases, which are regulated by the environment, systematically steal human resources. Economically speaking, the effect is similar to that of crime or government corruption on undermining economic growth."

This result has important significance for international aid organizations, as it suggests that money spent on combating disease would also stimulate economic growth. ... The research sets the stage for a number of future analyses that need to lay bare the relationship between health care funding and economic development.

Will Macroeconomists Ever Agree?

Kevin Drum wonders if macroeconomists will ever be able to agree:

The part I can't figure out is why there's so much contention even within the field. In physics and climate science, the cranks are almost all nonspecialists with an axe to grind. Actual practitioners agree pretty broadly on at least the basics. But in macroeconomics you don't have that. There are still polar disagreements among top names on some of the most basic questions. Even given the complexity of the field, that's a bit of a mystery. It's understandable that economics is a more politicized field than physics, but in practice it seems to be almost 100 percent politicized, with the battles fought out by streams of Greek letters demonstrating, as Matt says, just about anything. I wonder if this is ever likely to change? Or will changes in the real world always outpace our ability to build consensus on how the economy actually works?

I took a shot at answering this in April 2011:

... Why can’t economists tell us what happens when government spending goes up or down, taxes change, or the Fed changes monetary policy? The stumbling block is that economics is fundamentally a non-experimental science, particularly in the realm of macroeconomics. Unlike disciplines such as physics, we can't go into the laboratory and rerun the economy again and again under different conditions to measure, say, the average effect of monetary and fiscal policy. We only have one realization of the macroeconomy to use to answer important policy questions, and that limits the precision of the answers we can give. In addition, because the data are historical rather than experimental, we cannot look at the relationships among a set of variables in isolation while holding all the other variables constant as you might do in a lab and this also reduces the precision of our estimates.

Because we only have a single realization of history rather than laboratory data to investigate economic issues, macroeconomic theorists have full knowledge of past data as they build their models. It would be a waste of time to build a model that doesn't fit this one realization of the macroeconomy, and fit it well, and that is precisely what has been done. Unfortunately, there are two models that fit the data, and the two models have vastly different implications for monetary and fiscal policy. ... [This leads to passionate debates about which model is best.]

But even if we had perfect models and perfect data, there would still be uncertainties and disagreements over the proper course of policy. Economists are hindered by the fact that people and institutions change over time in a way that the laws of physics do not. Thus, even if we had the ability to do controlled and careful experiments, there is no guarantee that what we learn would remain valid in the future.

Suppose that we somehow overcome every one of these problems. Even then, disagreements about economic policy would persist in the political arena. Even with full knowledge about how, say, a change in government spending financed by a tax increase will affect the economy now and in the future, ideological differences across individuals will lead to different views on the net social value of these policies. Those on the left tend to value the benefits higher, and place less weight on the costs than those on the right and this leads to fundamental, insoluble differences over the course of economic policy. ...

Progress in economics may someday narrow the partisan divide over economic policy, but even perfect knowledge about the economy won’t eliminate the ideological differences that are the source of so much passion in our political discourse.

A follow-up post in February empahsizes the point that it is not at all clear that the strong divides in economics can be settled with data, but it's not completely hopeless:

...the ability to choose one model over the other is not quite as hopeless as I’ve implied. New data and recent events like the Great Recession push these models into unchartered territory and provide a way to assess which model provides better predictions. However, because of our reliance on historical data this is a slow process – we have to wait for data to accumulate – and there’s no guarantee that once we are finally able to pit one model against the other we will be able to crown a winner. Both models could fail...

I think the Great recession has, for example, provided evidence that the NK model provides a better explanation of events than its competitors, but it is far from a satisfactory construction and it would be hard to call its forecasting and explanatory abilities a success.

Here's another post from the past (Sept. 2009) on this topic:

... There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available (as to how far this kind of "eclecticism" will get you in academia, I'll just note that this is exactly the advice Mishkin gives in his textbook on monetary theory and policy).

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by price rigidities of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the thorough analysis that is needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities in a  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could, and the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes if didn't, but that was no reason to ignore the answers when it did.

Part of the disagreement is over the ability of this approach -- using an older model guided by newer insights (e.g. that expectations of future output matter for the "IS curve") -- to deliver reliable answers and policy prescriptions.

More on this from another past post (March 2009):

Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.

The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice? Hopefully, it is the ability to answer questions that are the least important, so the modeling choices that are made reveal what the modelers though was most and least important.

The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment ,or when we found ourselves in mild, "normal" recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, where prices depart from fundamentals, or when markets are incomplete. When this crisis hit, I looked into our tool bag of models and policy recommendations and came up empty for the most part. It was disappointing. There was really no choice but to go back to older Keynesian style models for insight.

The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades,; did not even envision that this could happen, let alone build it into their models. Markets work, they don't break down, so why waste time thinking about those possibilities.

So it's not the math, the modeling choices that were made and the inevitable sacrifices to reality that entails reflected the importance those making the choices gave to various questions. We weren't forced to this end by the mathematics, we asked the wrong questions and built the wrong models.

New Keynesians have been trying to answer: Can we, using equilibrium models with rational agents and complete markets, add frictions to the model - e.g. sluggish wage and price adjustment - you'll see this called "Calvo pricing" - in a way that allows us to approximate the actual movements in key macroeconomic variables of the last 40 or 50 years.

Real Business Cycle theorists also use equilibrium models with rational agents and complete markets, and they look at whether supply-side shocks such as shocks to productivity or labor supply can, by themselves, explain movements in the economy. They largely reject demand-side explanations for movements in macro variables.

The fight - and main question in academics - has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it's been a fairly brutal fight at times - you've seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.

What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important (some don't even believe that policy can help the economy, so why put effort into studying it?).

I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.

Here's yet another past post (August 2009) on the general topic of the usefulness of macroeconomic models, though I'm not quite as bullish on the ability of existing models to provide guidance as I was when I wrote this. The point is that although many people use forecasting ability as a metric to measure the usefulness of models (because where the economy is headed is the most improtant question to them), that's not the only use of these models:

Are Macroeconomic Models Useful?: There has been no shortage of effort devoted to predicting earthquakes, yet we still can't see them coming far enough in advance to move people to safety. When a big earthquake hits, it is a surprise. We may be able to look at the data after the fact and see that certain stresses were building, so it looks like we should have known an earthquake was going to occur at any moment, but these sorts of retrospective analyses have not allowed us to predict the next one. The exact timing and location is always a surprise.

Does that mean that science has failed? Should we criticize the models as useless?

No. There are two uses of models. One is to understand how the world works, another is to make predictions about the future. We may never be able to predict earthquakes far enough in advance and with enough specificity to allow us time to move to safety before they occur, but that doesn't prevent us from understanding the science underlying earthquakes. Perhaps as our understanding increases prediction will be possible, and for that reason scientists shouldn't give up trying to improve their models, but for now we simply cannot predict the arrival of earthquakes.

However, even though earthquakes cannot be predicted, at least not yet, it would be wrong to conclude that science has nothing to offer. First, understanding how earthquakes occur can help us design buildings and make other changes to limit the damage even if we don't know exactly when an earthquake will occur. Second, if an earthquake happens and, despite our best efforts to insulate against it there are still substantial consequences, science can help us to offset and limit the damage. To name just one example, the science surrounding disease transmission helps use to avoid contaminated water supplies after a disaster, something that often compounds tragedy when this science is not available. But there are lots of other things we can do as well, including using the models to determine where help is most needed.

So even if we cannot predict earthquakes, and we can't, the models are still useful for understanding how earthquakes happen. This understanding is valuable because it helps us to prepare for disasters in advance, and to determine policies that will minimize their impact after they happen.

All of this can be applied to macroeconomics. Whether or not we should have predicted the financial earthquake is a question that has been debated extensively, so I am going to set that aside. One side says financial market price changes, like earthquakes, are inherently unpredictable -- we will never predict them no matter how good our models get (the efficient markets types). The other side says the stresses that were building were obvious. Like the stresses that build when tectonic plates moving in opposite directions rub against each other, it was only a question of when, not if. (But even when increasing stress between two plates is observable, scientists cannot tell you for sure if a series of small earthquakes will relieve the stress and do little harm, or if there will be one big adjustment that relieves the stress all at once. With respect to the financial crisis, economists expected lots of little, small harm causing adjustments, instead we got the "big one," and the "buildings and other structures" we thought could withstand the shock all came crumbling down. ...

Whether the financial crisis should have been predicted or not, the fact that it wasn't predicted does not mean that macroeconomic models are useless any more than the failure to predict earthquakes implies that earthquake science is useless. As with earthquakes, even when prediction is not possible (or missed), the models can still help us to understand how these shocks occur. That understanding is useful for getting ready for the next shock, or even preventing it, and for minimizing the consequences of shocks that do occur. 

But we have done much better at dealing with the consequences of unexpected shocks ex-post than we have at getting ready for these a priori. Our equivalent of getting buildings ready for an earthquake before it happens is to use changes in institutions and regulations to insulate the financial sector and the larger economy from the negative consequences of financial and other shocks. Here I think economists made mistakes - our "buildings" were not strong enough to withstand the earthquake that hit. We could argue that the shock was so big that no amount of reasonable advance preparation would have stopped the "building" from collapsing, but I think it's more the case that enough time has passed since the last big financial earthquake that we forgot what we needed to do. We allowed new buildings to be constructed without the proper safeguards.

However, that doesn't mean the models themselves were useless. The models were there and could have provided guidance, but the implied "building codes" were ignored. Greenspan and others assumed no private builder would ever construct a building that couldn't withstand an earthquake, the market would force them to take this into consideration. But they were wrong about that, and even Greenspan now admits that government building codes are necessary. It wasn't the models, it was how they were used (or rather not used) that prevented us from putting safeguards into place. ...

I'd argue that our most successful use of models has been in cleaning up after shocks rather than predicting, preventing, or insulating against them through pre-crisis preparation. When despite our best effort to prevent it or to minimize its impact a priori, we get a recession anyway, we can use our models as a guide to monetary, fiscal, and other policies that help to reduce the consequences of the shock (this is the equivalent of, after a disaster hits, making sure that the water is safe to drink, people have food to eat, there is a plan for rebuilding quickly and efficiently, etc.). As noted above, we haven't done a very good job at predicting big crises, and we could have done a much better job at implementing regulatory and institutional changes that prevent or limit the impact of shocks. But we do a pretty good job of stepping in with policy actions that minimize the impact of shocks after they occur. This recession was bad, but it wasn't another Great Depression like it might have been without policy intervention.

Whether or not we will ever be able to predict recessions reliably, it's important to recognize that our models still provide considerable guidance for actions we can take before and after large shocks that minimize their impact and maybe even prevent them altogether (though we will have to do a better job of listening to what the models have to say). Prediction is important, but it's not the only use of models.

Links for 12-27-2012

• Tax fairness and the wealthy - Washington Post
• Capital-biased Technological Progress: An Example - Paul Krugman
• Looks as Though the Austerity Bomb Is Going to Go Off... - Brad DeLong
• Secretary Geithner Sends Debt Limit Letter to Congress - Treasury Notes
• Cacique Democracy - Acemoglu and Robinson
• Is Growth Over? - Paul Krugman
• Rise of the cyborgs - Noahpinion
• The Chained CPI - Jared Bernstein
• Behavioral science - UnderstandingSociety
• How Your Mind Organizes Reality - Scientific American

'A Conservative Case for the Welfare State'

Bruce Bartlett argues conservatives should support the welfare state:

A Conservative Case for the Welfare State, by Bruce Bartlett, Commentary, NY Times: At the root of much of the dispute between Democrats and Republicans over the so-called fiscal cliff is a deep disagreement over the welfare state. Republicans continue to fight a long-running war against Social Security, Medicare, Medicaid and many other social-welfare programs that most Americans support overwhelmingly and oppose cutting. ...

This is foolish and reactionary. Moreover, there are sound reasons why a conservative would support a welfare state. Historically, it has been conservatives like the 19th century chancellor of Germany, Otto von Bismarck, who established the welfare state in Europe. They did so because masses of poor people create social instability and become breeding grounds for radical movements.

In postwar Europe, conservative parties were the principal supporters of welfare-state policies in order to counter efforts by socialists and communists to abolish capitalism altogether. The welfare state was devised to shave off the rough edges of capitalism and make it sustainable. Indeed, the conservative icon Winston Churchill was among the founders of the British welfare state.

American conservatives, being far more libertarian than their continental counterparts, reject the welfare state for both moral and efficiency reasons. It creates unhappiness, they believe, and inevitably becomes bloated, undermining incentives and economic growth.

One problem with this conservative view is its lack of an empirical foundation. Research by Peter H. Lindert of the University of California, Davis, shows clearly that the welfare state is not incompatible with growth while providing a superior quality of life to many of those left to sink or swim in America. ...

There are many ... ways ... in which what the conservatives call bloated European welfare states are actually very efficient. ...

American conservatives routinely assert that the people of Europe live in virtual destitution because of their swollen welfare states. But according to a commonly accepted index of life satisfaction, many heavily taxed European countries rank well above the United States...

If conservatives want to support the welfare state out of the desire to defend capitalism from "socialists and communists" -- to defend it against the instability that high degrees of inequality cause -- no problem, though it's interesting that they would acknowledge that the system itself can lead to societal inequities that are so dangerous the government needs to intervene to fix them. I prefer the efficiency argument (which is not to say that the other argument has no merit, it does). When there are substantial market failures -- the type that exist in retirement and health markets for example -- the government can make these markets work better through rules, mandates, and other regulatory interventions, or it can provide the services itself. Whether a heavily regulated private market will work better than the government providing services itself in the presence of substantial market failures is something that can be debated, and in general the lines aren't always clear. But for health and retirement markets it does appear that direct government provision works better than heavily regulated markets (i.e. "privatization"). In any case, the broader point is that the government provision of social insurance either directly or indirectly can be justified on an efficiency argument, i.e. as a means of overcoming market failures that prevent the private sector from providing these important goods and services in sufficient quantities at the lowest possible price.

Fed Watch: Missing The Big Japan Story

Tim Duy:

Missing The Big Japan Story, by Tim Duy: The potential exists for groundbreaking changes in Japanese economic policy - and I sense that Western journalists, caught up in the current celebration of central bankers, are missing the bigger story. In my opinion, a higher inflation target by the Bank of Japan is not particularly interesting. After all, the Bank of Japan can't hit the current "goal" of 1 percent inflation. I don't have much faith that renaming the "goal" a "target" and increasing it to 2 percent will be like waving a magic wand. But something much more significant is afoot - the possibility of explicit cooperation, albeit perhaps forced cooperation, between fiscal and monetary authorities. The loss of the Bank of Japan's independence to force the direct monetization of deficit spending is the real story.

Floyd Norris at the New York Times begins a recent article on Japanese monetary policy with a quote from then-Federal Reserve Governor Ben Bernanke:

...under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Norris continues:

Now we may find out if Mr. Bernanke was right. Japan appears to be ready to do whatever it takes to end its long run of falling prices. The Bank of Japan took limited action on Thursday, and more is expected in the new year.

Norris then proceeds with a generic review of Bernanke's point that monetary policymakers are not without tools even at the zero bound. Norris includes mention of Bernanke's "helicopter drop" reference, but fails to put it in proper context. The proper context is in terms of the cooperation between fiscal and monetary policy. This is my central complaint; that reporters have a tendency to not carefully read this speech.

Notice that Bernanke does not say a "determined monetary authority." He says a determined "government." Bernanke clarifies this earlier in the speech:

Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The problem, in my opinion, is that reporters tend to report this speech without explicitly (or even implicitly) defining the importance of fiscal policy. And we know that Bernanke himself does not believe that monetary policy can stabilize the economy in any and all times. From the most recent post-FOMC press conference:

For example, I hope it won’t happen but if the fiscal cliff occurs, as I’ve said many times, I don’t think the Federal Reserve has the tools to offset that event and, in that case, we obviously have to temper our expectations about what we can accomplish.

What does this have to do with Japan? Norris acknowledges the political pressure change on the Bank of Japan:

This week the Liberal Democratic Party, which had ruled Japan for nearly its entire postwar history until it was swept from power three years ago, won a landslide victory. Shinzo Abe, the prime minister from 2006 to 2007, will get another chance.

Mr. Abe devoted a decent part of his campaign to criticism of the Bank of Japan, the country’s central bank. He wants the bank to pursue inflation, and to effectively print money until it gets it. At one point during the campaign he spoke of a 3 percent inflation target, although he seems to have cut that back to 2 percent.

Fine, political pressure is interesting, but the inflation target is just one part of the plan, and I would argue not the most important part. From another New York Times reporter, Hiroko Tabuchi:

In his campaign speeches, he [Abe] called on the bank to set an inflation target of 2 to 3 percent and to buy more bonds to finance government stimulus efforts, another facet of his growth strategy. He warned that he would push to amend laws regarding the central bank to allow the government a bigger say in setting monetary policy. [emphasis added]

The implications are clear. From the Financial Times:

Mr Shirakawa, the BoJ governor, has warned that “monetising” government debt could undermine confidence in Japan’s fiscal discipline, resulting in higher interest rates that would make it much harder to finance the deficit.

What would Bernanke say about the impact of joint monetary and fiscal policy? From his 2002 speech:

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices...A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

...Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets.

US monetary policy would have been much more effective if complemented by fiscal policy. Same goes for Europe. Abe appears to be poised to try something along that route:

In an appearance on Fuji TV on Sunday, Mr Abe, who this week is set to become Japan’s seventh prime minister in just more than six years, said a new approach was essential to defeating the deflation dogging the economy.

“It has to be different from the traditional methods – the traditional methods have not been able to defeat deflation for more than a decade. That’s no good,” he said.

And Abe is determined to make it happen - even if it requires stripping the central bank of its independence:

...Mr Abe has already made clear that Mr Shirakawa will be replaced when his current term as governor ends in April and that his successor will be a candidate more willing to push aggressive easing. “We want to have someone who supports our thinking,” he said on Sunday.

Or he will push for legal changes such that the Bank of Japan to once again falls under control of the fiscal authorities.

Japan might very well be heading toward the end-game of permanent zero interest rate policy: Explicit monetizing of deficit spending. That is the real story here - it goes far beyond just inflation targeting.

Bottom Line: Inflation targeting is not the whole story in Japanese monetary policy. It is a facet of a much greater story. A story of a modern central bank stripped of its independence. Of a modern central bank forced to explicitly monetize deficit spending. Ultimately, it is the story of the end game of the permanent zero interest rate policy.

Links for 12-26-2012

• A Conservative Case for the Welfare State - Bruce Bartlett
• Private Investment and the Business Cycle - Calculated Risk
• Central Banks Can Phase in Nominal GDP Targets - Jeff Frankel
• Using Fannie and Freddie for Stealth Stimulus - naked capitalism
• The Republican Strategy of Fanaticism - Robert Reich
• A Christmas Tale - Matt Bors
• The State We’re In - Uneasy Money

Merry Christmas to All

Links for 12-25-2012

• Monetary Policy and Interest Rate Uncertainty- FRBSF Economic Letter
• The Fed and Interest Rates - Paul Krugman
• The 'National Review's Post-Election Cruise -- New York Magazine
• A Research Agenda for Climate Change Adaptation - Urbanization Project
• People Hate Losses and That Affects U.S. Budget Talks - Cass Sunstein
• 7-Eleven Stores Focus on Healthier Food Options - NYTimes.com
• Plan to Limit Fed’s Mandate Is Folly - Ramesh Ponnuru
• Six decades of economics publishing - Chris Blattman
• On DeLong V Krugman - Angry Bear
• Austerity for Posterity - Nancy Folbre

Twas the Night Before Christmas

Twas The Night Before Christmas:

was the night before Christmas, when all through the house
Not a creature was stirring, not even a mouse;
The stockings were hung by the chimney with care
In hopes that St. Nicholas soon would be there;

he children were nestled all snug in their beds,
While visions of sugar-plums danced in their heads;
And mamma in her kerchief, and I in my cap,
Had just settled our brains for a long winter's nap,

hen out on the lawn there arose such a clatter,
I sprang from the bed to see what was the matter.
Away to the window I flew like a flash,
Tore open the shutters and threw up the sash.

he moon on the breast of the new-fallen snow
Gave the lustre of mid-day to objects below,
When, what to my wondering eyes should appear,
But a miniature sleigh, and eight tiny reindeer,

 

ith a little old driver, so lively and quick,
I knew in a moment it must be St. Nick.
More rapid than eagles his coursers they came,
And he whistled, and shouted, and called them by name:

ow, Dasher! now, Dancer! now, Prancer and Vixen!
On, Comet! on, Cupid! on, Donder and Blitzen!
To the top of the porch! to the top of the wall!
Now dash away! dash away! dash away all!"

 

 

 

s dry leaves that before the wild hurricane fly,
When they meet with an obstacle, mount to the sky;
So up to the house-top the coursers they flew,
With the sleigh full of Toys, and St. Nicholas too.

 

nd then, in a twinkling, I heard on the roof
The prancing and pawing of each little hoof.
As I drew in my head, and was turning around,
Down the chimney St. Nicholas came with a bound.

e was dressed all in fur, from his head to his foot,
And his clothes were all tarnished with ashes and soot;
A bundle of Toys he had flung on his back,
And he looked like a peddler just opening his pack.

is eyes—how they twinkled! his dimples how merry!
His cheeks were like roses, his nose like a cherry!
His droll little mouth was drawn up like a bow,
And the beard of his chin was as white as the snow;

he stump of a pipe he held tight in his teeth,
And the smoke it encircled his head like a wreath;
He had a broad face and a little round belly,
That shook when he laughed, like a bowlful of jelly.

e was chubby and plump, a right jolly old elf,
And I laughed when I saw him, in spite of myself;
A wink of his eye and a twist of his head,
Soon gave me to know I had nothing to dread;

e spoke not a word, but went straight to his work,
And filled all the stockings; then turned with a jerk,
And laying his finger aside of his nose,
And giving a nod, up the chimney he rose;

e sprang to his sleigh, to his team gave a whistle,
And away they all flew like the down of a thistle.
But I heard him exclaim, ere he drove out of sight,
"Happy Christmas to all, and to all a good-night."

Unpuzzling the Puuzzled

Greg Mankiw says he is puzzled:

A Krugman Puzzler

Brad DeLong does the unpuzzling that, as he notes, shouldn't be needed:

In Which Greg Mankiw Pretends to Be Puzzled...

PGL explains what Mankiw should be puzzled about:

Paul Krugman Puzzles Greg Mankiw

Adam Ozimek continues the discussion:

Krugman vs Mankiw on Interest Rates

Paul Krugman with more on the topic:

Bond Vigilantes and the Power of Three

Nothing to add, that pretty much covers it, but I do wonder: When Greg Mankiw asks, relative to 2003, "are circumstances different now?" just how much eggnog has he had?

Smart Machines, A New Guide to Keynes, and The Inefficient Markets Hypothesis

Haven't read these papers yet, but looks like I should (I added open links when I could find them):

First, Sachs and Kotlikoff (anything to keep these two from writing about the deficit and the accumulated debt is, in my view, a plus):

Smart Machines and Long-Term Misery, by Jeffrey D. Sachs, Laurence J. Kotlikoff, NBER Working Paper No. 18629, Issued in December 2012: Are smarter machines our children’s friends? Or can they bring about a transfer from our relatively unskilled children to ourselves that leaves our children and, indeed, all our descendants – worse off?

This, indeed, is the dire message of the model presented here in which smart machines substitute directly for young unskilled labor, but complement older skilled labor. The depression in the wages of the young then limits their ability to save and invest in their own skill acquisition and physical capital. This, in turn, means the next generation of young, initially unskilled workers, encounter an economy with less human and physical capital, which further drives down their wages. This process stabilizes through time, but potentially entails each newborn generation being worse off than its predecessor.

We illustrate the potential for smart machines to engender long-term misery in a highly stylized two-period model. We also show that appropriate generational policy can be used to transform win-lose into win-win for all generations.

Next, Jordi Gali revisits Keynes:

Notes for a New Guide to Keynes (I): Wages, Aggregate Demand, and Employment, by Jordi Galí, NBER Working Paper No. 18651, Issued in December 2012 [open link]: I revisit the General Theory's discussion of the role of wages in employment determination through the lens of the New Keynesian model. The analysis points to the key role played by the monetary policy rule in shaping the link between wages and employment, and in determining the welfare impact of enhanced wage flexibility. I show that the latter is not always welfare improving.

Finally, Roger Farmer, Carine Nourry, and Alain Venditti on whether "competitive financial markets efficiently allocate risk" (according to this, they don't):

The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World, Roger E.A. Farmer, Carine Nourry, Alain Venditti, NBER Working Paper No. 18647, Issued in December 2012 [open link]: Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.

Real Tree or Artificial Tree?

A bit late for most of you, but in case it comes up over the next few days:

Real Tree or Artificial Tree, by Tim Taylor: My family always had real Christmas trees when I was growing up. I've always had real trees as an adult. Living in my own little bubble, it thus came as a shock to me to learn that, of the households that have Christmas trees, over 80% use an artificial tree, according to Nielsen survey results commissioned by the American Christmas Tree Association  (which largely represents sellers of artificial trees). But in a holiday season where the focus is often on whether we are naughty or nice, what choice of tree has greater environmental impact? ...

Paul Krugman: When Prophecy Fails

When people are "absurdly wrong for years on end," it's time to stop listening to them:

When Prophecy Fails, by Paul Krugman, Commentary, NY Times: Back in the 1950s three social psychologists joined a cult that was predicting the imminent end of the world. Their purpose was to observe the cultists’ response when the world did not, in fact, end on schedule. What they discovered ... is that the irrefutable failure of a prophecy does not cause true believers ... to reconsider. On the contrary, they become even more fervent, and proselytize even harder.

This insight seems highly relevant as 2012 draws to a close. After all, a lot of people came to believe that we were on the brink of catastrophe — and these views were given extraordinary reach by the mass media. As it turned out..., the predicted catastrophe failed to materialize. But we can be sure that the cultists won’t admit to having been wrong. No, the people who told us that a fiscal crisis was imminent will just keep at it, more convinced than ever.

Oh, wait a second — did you think I was talking about the Mayan calendar thing?

Seriously, at every stage of our ongoing economic crisis — and in particular, every time anyone has suggested actually trying to do something about mass unemployment — a chorus of voices has warned that unless we bring down budget deficits now now now, financial markets will turn on America, driving interest rates sky-high. And ... very few of the prophets of fiscal doom have acknowledged the failure of their prophecies to come true so far. ...

I and other economists argued from the beginning that ... budget deficits won’t cause soaring interest rates as long as the economy is depressed —... the biggest risk to the economy is that we might ... slash the deficit too soon. And surely that point of view has been strongly validated by events.

The key thing ... to understand, however, is that the prophets of fiscal disaster ... are at this point effectively members of a doomsday cult. They are emotionally and professionally committed to the belief that fiscal crisis lurks just around the corner, and they will hold to their belief no matter how many corners we turn without encountering that crisis.

So we ... will not persuade these people to reconsider their views in the light of the evidence. All we can do is stop paying attention. It’s going to be difficult, because many members of the deficit cult seem highly respectable. But they’ve been hugely, absurdly wrong for years on end, and it’s time to stop taking them seriously.

Links for 12-24-2012

• Department of "Oh Dear!": Basic Macro Briefing Weblogging - Brad DeLong
• How Party of Budget Restraint Shifted to ‘No New Taxes,’ Ever - NYTimes.com
• Will retiring boomers be a drag on economy? Many say no - McClatchy
• Stabilization Won’t Save Us - Nassim Nicholas Taleb
• Capital and interest in the steady state - Nick Rowe
• Norquist and LaPierre: Emperors Losing Their Clothes? - EconoSpeak

'Paradigms, after Fifty Years'

I get in trouble if I blog too much when family is around for the holidays, so a quick one from David Warsh:

Paradigms, after Fifty Years, Economics Principals: For a book built on a narrative of, among other things, the history of our understanding of electricity, The Structure of Scientific Revolutions, by Thomas Kuhn, has had a remarkable run. It appeared in 1962, and people have been arguing about it ever since. ... For Structure is the book that made the word paradigm, meaning a way of seeing, part of the everyday discourse of nearly everyone who deals with ideas for a living. ...

Before Kuhn, the philosophy of science was boring and the history of science a backwater... There was a lot of boilerplate instruction about the steps of the scientific method and the logic of scientific discovery (if you’re not wrong, you might be right) to be found in the first chapters of textbooks, but, as Kuhn wrote at the beginning of Structure, this was no better than an image of national culture drawn from a tourist brochure.

After Kuhn, the focus shifted to the social organization of science: to the textbooks themselves, graduate education, the communities (“invisible colleges”) in which science was done, and the various nexuses in which results were put to work, from scientific journals and legal briefs to corporate laboratories and entrepreneurial start-ups. ...

How does a science get started? According to Kuhn, the story goes something like this: in the beginning someone contributes a powerful example of how to think about a set of scientific problems: Aristotle’s Physica, Ptolemy’s Almagest, Newton’s Principia, Franklin’s Electricity, Lavoisier’s Chemistry, Lyell’s Geology. The achievements appear, not out of the blue, but they are transformative. A community forms around them because they offer not a finished theory but rather a thinking cap, a pre-analytic way of seeing things and asking questions about them.

This way-of-seeing aspect that each possessed Kuhn designated a paradigm. The word itself is ancient Greek; he borrowed it from language studies, where it described the all-but-unconscious pattern by which one learns to conjugate a verb or decline a noun when learning to speak a language. A successful paradigm is enabling. It both poses plenty of unanswered questions and suggests means by which they might be conclusively answered. ...

This is the route to what Kuhn called “normal science.” By that he meant successful science, rather like filling in the outlines of a hastily drawn map once a new continent has been discovered. In this metaphor, normal scientists come in all sorts of guises: trailblazers, pioneers, settlers, sodbusters, ranchers, developers. Kuhn, unfortunately, chose two other metaphors to describe the conduct of this phase, and those labels have sometimes caused proud scientists to rebel at his description. Successful normal scientists were “puzzle-solvers,” he said, working away at adducing facts, producing theories and making sure the one dovetailed with the other. Or they were, in essence, engaged in “mopping up” after a big paradigmatic invasion. ...

Kuhn was a great student of the Copernican revolution, which meant he thoroughly understood the Ptolemaic system that it overthrew – crystalline spheres arrayed around an earth at the center of the universe. Ptolemy, and the astronomers who worked in his tradition for nearly fifteen hundred years, were excellent normal scientists. They had built a system that cohered; when observation of the heavens produced a troubling fact (anomalies, Kuhn dubbed such facts), they added a sphere or two.

But the troubling facts multiplied. Eventually a scientific crisis was at hand – anomalies with which existing normal science simply could not cope under any circumstances. At that point, a “revolutionary,” usually a young scientist, capable, but with little commitment to the old tradition – in this case, Copernicus – would produce a new paradigm, radically reordering the old facts, ignoring some and adducing new ones. The new paradigm would be resisted for a time, science being an inherently conservative enterprise, but gradually would gain adherents among the young. In time, the new order would be widely accepted. ...

In Structure, Kuhn went on to make the point that scientific revolutions didn’t have to be huge events with sweeping cultural ramification, such as the Copernican, Newtonian or chemical revolutions. The professional groups affected by them could be far smaller. ...

An especially fascinating aspect of the story has to do with the reception of Structure. A tendency to mildly disparage it has emerged. Hacking, in his introduction, assures us that science has moved on. The Cold War is over; physics is no longer “where the action is.” Today, he says, “biotechnology rules.” Thus Structure, he writes, “may be – I do not say it is –more relevant to a past epoch in the history of science than it is to the sciences as they are practiced today.”

David Kaiser, a physicist who is a professor in the history of science at the Massachusetts Institute of Technology (where Kuhn spent his last seventeen years), put the case clearly on the eve of a fiftieth-anniversary symposium: “Kuhn had an ambition with the book, which was common at the time: he really thought there was a structure, a hidden key that makes science tick. I think many of my colleagues today in the history and sociology of science would find that ambition wrong-headed. There is not a single magical key that will unlock the way science gets done.”

There is another possibility, of course – that, for one reason or another, it is the historians and philosophers of science, taken as a group, that have got it wrong. They are, after all, “normal” scientists. For as Daryn Leboux, of Queens University, and Jay Foster, of Memorial University of Newfoundland, said in their Science magazine review of the fiftieth anniversary edition, Structure was a revolution of its own, and revolutions are complicated things. They can spark backlash as well as assimilation. It is possible, even likely, that The Structure of Scientific Revolutions is one of those books, like The Origin of Species, that take more than a generation, even two or three, to find its level – a real anomaly in the age of blink. I eagerly look forward to the seventy-fifth anniversary edition.

'In the Fiscal Debate, a Little Symbolism Can Go a Long Way'

Tyler Cowen on the negotiations over the fiscal thingie:

In the Fiscal Debate, a Little Symbolism Can Go a Long Way, by Tyler Cowen, Commentary, NY Times: ...We must decide whether to pursue a relatively loose and stimulative policy, and to trust in our later discipline, or to slam on the brakes now.

Yet there may be a way to square this circle. When it comes to income tax rates, we could raise them for virtually everyone, to send a clear message that the current fiscal situation is unsustainable. ...

To see how this could work, consider this script: Let’s say the Republicans decide to largely give in to what the President Obama is proposing. There is, however, a catch: the president has to agree to raise marginal tax rates on all income classes, not just on the rich. The tax increase would be one-quarter of a percentage point, or some other arbitrary small amount, with larger increases possible for higher incomes, as has been discussed. The deal also stipulates that both the president and Congress must publicly acknowledge that current plans for government spending can’t be financed unless taxes on most or all income groups climb further yet, and by some hefty amount.

Given the slow economy, it is undesirable to reverse all or even most of the Bush tax cuts. A small but publicly trumpeted clawback of some of the cuts would send the right message to voters, while minimizing the macroeconomic fallout. The nice thing about symbols — single shots across the bow — is that they often can suffice. ...

Of course, the notion of tolerating — and especially endorsing — any tax increase is anathema to many of President Obama’s opponents. But keep in mind that possible alternatives, like another debt-ceiling debacle or an agreement that panders to our fiscal illusions, would probably be worse for both the economy and the longer-term reputation of the Republican Party.

In our country, the typical approach to fiscal deadlines is to kick the can down the road. But that assumes we are kicking a can, not a grenade. It’s time for at least one party — and why not the electoral loser? — to do something just a little shocking. It can give in on much of the negotiations, but insist that both sides start stressing the fiscal truth.

Maybe I'm just having one of those days and can't see the obvious, a house full of family will do that, but I'm a bit confused about the spending side of this proposal. Does Tyler mean that the spending cuts Obama has proposed will remain, but the tax increase will be moderated for now and replaced by a commitment to increase them further at some future date? If so (and I may have this wrong), why is the only worry that "Given the slow economy, it is undesirable to reverse all or even most of the Bush tax cut"? Why isn't it undesirable to cut spending as well? When all is said and done, spending cuts plus tax increases, how would the burden be distributed? Is the current situation -- the baseline from where we start the changes -- fully optimal, or do we also need to correct distortions, inequities in the past distribution of income, etc.? If there are corrections that are needed, and I believe there are, then the share equally notion has much less force.

It's true that “we are all in this together” under Tyler's proposal, but it is not at all clear that the shares are equitable. In any case, it probably doesn't much matter since the chances of Republicans agreeing to vote for a tax increase, no matter how small, is extremely low.

Links for 12-23-2012

• Guess Who Still Believes in Invisible Vigilantes - Paul Krugman
• Back When I Feared the Bond-Market Vigilantes - Brad DeLong
• In Fiscal Debate, a Little Symbolism May Go a Long Way - Tyler Cowen
• Ideas and Political Entrepreneurs: Airline Deregulation - Ed Lopez
• We’ve Been Falling Off That Fiscal Cliff - EconoSpeak
• Bedford Falls or Pottersville? - Robert Reich
• Greenblatt on civilization - UnderstandingSociety
• Maya and the Vigilantes - Paul Krugman

Bush's 1995 Letter of Resignation from the NRA

Via a Greg Anrig retweet of a tweet from Catherine Crier:

U.S. Letter of Resignation Sent By Bush to Rifle Association. NY Times (1995): Following is the letter of resignation sent last week by former President George Bush to the National Rifle Association: May 3, 1995

Dear Mr. Washington,

I was outraged when, even in the wake of the Oklahoma City tragedy, Mr. Wayne LaPierre, executive vice president of N.R.A., defended his attack on federal agents as "jack-booted thugs." To attack Secret Service agents or A.T.F. people or any government law enforcement people as "wearing Nazi bucket helmets and black storm trooper uniforms" wanting to "attack law abiding citizens" is a vicious slander on good people. ...

Both John Magaw and Judge Freeh were in office when I was President. They both now serve in the current administration. They both have badges. Neither of them would ever give the government's "go ahead to harass, intimidate, even murder law abiding citizens." (Your words)

I am a gun owner and an avid hunter. Over the years I have agreed with most of N.R.A.'s objectives, particularly your educational and training efforts, and your fundamental stance in favor of owning guns.

However, your broadside against Federal agents deeply offends my own sense of decency and honor; and it offends my concept of service to country. It indirectly slanders a wide array of government law enforcement officials, who are out there, day and night, laying their lives on the line for all of us.

You have not repudiated Mr. LaPierre's unwarranted attack. Therefore, I resign as a Life Member of N.R.A., said resignation to be effective upon your receipt of this letter. Please remove my name from your membership list. Sincerely, [ signed ] George Bush

'The New Mandate on Defense'

Barney Frank argues that, when it comes to defense spending, we should "spend less, and liberals should not flinch from that position." The essential point, I think, is that "the major trade-off in putting together a total deficit reduction package is between the military and health care," and, though he does note this in a couple of places, I wish that point had been stressed more in the article (the essay is much, much longer):

The New Mandate on Defense, by Barney Frank, Democracy: There were so many encouraging signs for liberals in the election results this year that one of the most significant has been overlooked. For the first time in my memory, a Democratic candidate for President argued for less military spending against a Republican candidate who called for great increases—and the Democrat won. ...

Because so much of that spending stems from overreach advocated by those who believe that America should be the enforcer of order everywhere in the world—and because we subsidize our wealthy European and Asian allies by providing a defense for them...—there has been increasing conservative support for reining in the military budget. Ron Paul, who goes far beyond most liberals in his eagerness to impose severe military cuts, was a popular figure with a significant base of GOP support not despite taking this position but in part because of it.

Earlier this year, for the first time that I can recall, a majority of the House of Representatives voted to reduce the military appropriation recommended by the House Appropriations Committee. The cut was only $1.1 billion—less than it should have been—but it ... passed... with the support of ... a significant minority of Republicans...

A realistic reassessment of our true national security needs would mean a military budget significantly lower... That is, by next year, we no longer should be forced to spend additional funds—close to $200 billion a year at their peak—in Afghanistan and Iraq. Additionally, we can reduce the base budget by approximately $1 trillion over a ten-year period ... while maintaining more than enough military strength...

Even with the revenue increase we can achieve by raising taxes on the wealthy, serious deficit reduction must come in part from reducing military spending beyond what the President proposes, unless we make very deep cuts in the nonmilitary parts of the budget. ... Given the numbers involved, the major trade-off in putting together a total deficit reduction package is between the military and health care...

To be clear, this is not an argument against America continuing to be the strongest nation in the world. ... That said, being the strongest nation in the world can be achieved much less expensively than at current levels. Obama ... underestimates the extent to which the public is willing to support even further reductions, and I believe that he may appear to be overly influenced by being told that as President, he has the duty to continue to lead the indispensable nation.

The United States was indispensable in 1945 and for many years thereafter... But things have changed. We can no longer afford ... extending a military umbrella over many allies on whom it is not raining—and who can well afford their own protective gear if it does. ...

This all means that a major political task going forward for liberals is pushing for further reductions in military spending, an objective that we now know is not only socially and economically necessary but also politically achievable.

Important social services versus tax cuts for the rich and military spending. Those with unmet needs and little social/economic power versus the wealthy and the military. I suppose in some sense, given who's in this battle, it's remarkable there's been any headway at all. But there needs to be more progress on protecting the vulnerable.

Links for 12-22-2012

• In defence of GDP as a measure of wellbeing - vox
• Medicare Spending Isn't Out of Control - Uwe E. Reinhardt
• Try, Try Again - macroblog
• Enough! - Andrew Sullivan
• Nine great statistics papers - Normal Deviate
• Kenen on the euro - Barry Eichengreen
• PCE Inflation Update - Dallas Fed
• Mortgage Brokers and the Three Axes - askblog
• Moseley and Krugman - Nick Rowe
• Do Consumers Benefit from Energy Regulations? - Michael Roberts
• Access to Assault Weapons Amplifies Pre-existing Risks - Monkey Cage
• The Path of Economic Recovery from Superstorm Sandy - Liberty Street

'A Pitfall with DSGE-Based, Estimated, Government Spending Multipliers'

This paper, which I obviously think is worth noting, is forthcoming in AEJ Macroeconomics:

A Pitfall with DSGE-Based, Estimated, Government Spending Multipliers, by Patrick Fève,  Julien Matheron, Jean-Guillaume Sahuc, December 5, 2012: 1 Introduction Standard practice in estimation of dynamic stochastic general equilibrium (DSGE) models, e.g. the well-known work by Smets and Wouters (2007), is to assume that government consumption expenditures are described by an exogenous stochastic process and are separable in the households’ period utility function. This standard practice has been adopted in the most recent analyses of fiscal policy (e.g. Christiano, Eichenbaum and Rebelo, 2011, Coenen et al., 2012, Cogan et al., 2010, Drautzburg and Uhlig, 2011, Eggertsson, 2011, Erceg and Lindé, 2010, Fernández-Villaverde, 2010, Uhlig, 2010).

In this paper, we argue that both short-run and long-run government spending multipliers (GSM) obtained in this literature may be downward biased. This is so because the standard approach does not typically allow for the possibility that private consumption and government spending are Edgeworth complements in the utility function[1] and that government spending has an endogenous countercyclical component (automatic stabilizer)... Since, as we show, the GSM increases with the degree of Edgeworth complementarity,... the standard empirical approach may ... result in a downward-biased estimate of the GSM.

In our benchmark empirical specification with Edgeworth complementarity and a countercyclical component of policy, the estimated long-run multiplier amounts to 1.31. Using the same model..., when both Edgeworth complementarity and the countercyclical component of policy are omitted,... the estimated multiplier is approximately equal to 0.5. Such a difference is clearly not neutral if the model is used to assess recovery plans of the same size as those recently enacted in the US. To illustrate this more concretely, we feed the American Recovery and Reinvestment Act (ARRA) fiscal stimulus package into our model. We obtain that omitting the endogenous policy rule at the estimation stage would lead an analyst to underestimate the short-run GSM by slightly more than 0.25 points. Clearly, these are not negligible figures. ...
_____

1 We say that private consumption and government spending are Edgeworth complements/substitutes when an increase in government spending raises/diminishes the marginal utility of private consumption. Such a specification has now become standard, following the seminal work by Aschauer (1985), Bailey (1971), Barro (1981), Braun (1994), Christiano and Eichenbaum (1992), Finn (1998), McGrattan (1994).

Let me also add these qualifications from the conclusion:

In our framework, we have deliberately abstracted from relevant details... However, the recent literature insists on other modeling issues that might potentially affect our results. We mention two of them. First, as put forth by Leeper, Plante and Traum (2010), a more general specification of government spending rule, lump-sum transfers, and distortionary taxation is needed to properly fit US data. This richer specification includes in addition to the automatic stabilizer component, a response to government debt and co-movement between tax rates. An important quantitative issue may be to assess which type of stabilization (automatic stabilization and/or debt stabilization) interacts with the estimated degree of Edgeworth complementarity. Second, Fiorito and Kollintzas (2004) have suggested that the degree of complementarity/substitutability between government and private consumptions is not homogeneous over types of public expenditures. This suggests to disaggregate government spending and inspect how feedback rules affect the estimated degree of Edgeworth complementarity in this more general setup. These issues will constitute the object of future researches.

Employment Trends before and after Past Disasters

More here.

Paul Krugman: Playing Taxes Hold ’Em

I think Justin Wolfer's claim that there are now three parties, the Democrats, the Republicans, and the Tea Party, at odds in the House is correct. That appears to be working in the president's favor, at least for the moment:

Playing Taxes Hold ’Em, by Paul Krugman, Commentary, NY Times: A few years back, there was a boom in poker television — shows in which you got to watch the betting and bluffing of expert card players. Since then, however, viewers seem to have lost interest. But I have a suggestion: Instead of featuring poker experts, why not have a show featuring poker incompetents — people who fold when they have a strong hand or don’t know how to quit while they’re ahead?

On second thought, that show already exists. It’s called budget negotiations, and it’s now in its second episode.

The first episode ran in 2011, as President Obama made his first attempt to cut a long-run fiscal deal — a so-called Grand Bargain... Mr. Obama was holding a fairly weak hand... The deal, if implemented, would have been a huge victory for Republicans... But ... Mr. Boehner and members of his party couldn’t bring themselves to accept even a modest rise in taxes. And their intransigence saved Mr. Obama from himself.

Now the game is on again — but with Mr. Obama holding a far stronger hand. ...

Yet earlier this week progressives suddenly had the sinking feeling that it was 2011 all over again, as the Obama administration made a budget offer that .. involved giving way on issues where it had promised to hold the line... Are we about to see another round of the president negotiating with himself, snatching policy and political defeat from the jaws of victory?

Well, probably not. Once again, the Republican crazies ... have saved the day. ... Mr. Boehner had evident problems getting his caucus to support Plan B, and he took the plan off the table Thursday night; it would have modestly raised taxes on the really wealthy, the top 0.1 percent, and even that was too much for many Republicans. ...

As in 2011, then, the Republican crazies are doing Mr. Obama a favor, heading off any temptation he may have felt to give away the store in pursuit of bipartisan dreams.

And there’s a broader lesson... This is no time for a Grand Bargain, because the Republican Party, as now constituted, is just not an entity with which the president can make a serious deal. If we’re going to get a grip on our nation’s problems ... the power of the G.O.P.’s extremists, and their willingness to hold the economy hostage if they don’t get their way, needs to be broken. And somehow I don’t think that’s going to happen in the next few days.

What Do Economists Know (about Guns)?

Stephen Williamson:

Guns, by Stephen Williamson: Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? ...

What's the problem here? ... The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. ...
There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax..., the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

The U.S. Labor Market: Status Quo or a New Normal?

The introduction to this NBER Digest research summary says it well, "[There is no] compelling evidence that there have been changes in the structure of the labor market that are capable of explaining the [recent] pattern of persistently high unemployment rates." I've noted this research before, but it's worth emphasizing again, particularly since one of the authors, Ed Lazear, was the Chairman of the President’s Council of Economic Advisers during the Bush Administration:

The U.S. Labor Market: Status Quo or a New Normal?, by Laurent Belsie, NBER Digest: The recession of 2007 to 2009 caused such high and persistent unemployment that it led many to conclude that the labor market had undergone structural changes, making it difficult or impossible to return to pre-recession employment levels. But in The United States Labor Market: Status Quo or A New Normal? (NBER Working Paper No. 18386), Edward Lazear and James Spletzer suggest that cyclical, not structural forces, are behind the surge in unemployment from 4.4 percent in the spring of 2007 to 10 percent in the fall of 2009, and the slow decline since then.

"[T]he current recession does not appear fundamentally different from prior ones, except that it is worse," they conclude. They fail to find "any compelling evidence that there have been changes in the structure of the labor market that are capable of explaining the pattern of persistently high unemployment rates." Instead, they note that "the evidence points to primarily cyclic factors."

The authors note that there are a number of ongoing, long-term industrial and demographic shifts in the labor market, but that none of these factors can explain the recent rise in unemployment. For example, the relative decline in U.S. manufacturing jobs has been under way for a half century, and the rise in female employment dates back to the second half of the twentieth century. The U.S. labor force is also aging, but again this is a long-term trend.

The authors' evidence suggests that long-term trends played a limited role in the recent recession and other past recessions. For example, in each of the business cycles between December 1979 and March 2012, the rise or fall in unemployment can be explained by changes in gender-specific unemployment rates, not by shifts in the gender composition of the workforce. Similarly, the aging of the workforce does not correlate very strongly with shifts in the unemployment rate during business cycle sub-periods. Since November 1982 the changing age composition of the workforce has lowered the unemployment rate by eight-tenths of a percentage point. This trend is reinforced by changes such as the rising education of the workforce and the shift toward service jobs, which have worked to lower unemployment over the last four decades.

The authors suggest that the rapid rise in unemployment during the 2007-9 recession can be explained almost entirely by the rise in unemployment within industries. Some industries such as construction, manufacturing, and retail trade saw unemployment soar. But these were the same industries that saw large decreases in unemployment during the recovery. The construction sector, for example, accounted for 19.4 percent of the increase in the national unemployment rate during the recession; this sector also accounted for 21.5 percent of the decline in the unemployment rate during the recovery.

The same phenomenon has occurred with mismatch -- the difference between vacancies and the number of unemployed in an industry, occupation, or location. Industrial mismatch rose during the 2007-9 recession, and then declined just as quickly. Occupational mismatch -- always higher than industrial mismatch and less sensitive to the business cycle -- rose during the recent recession but has since fallen below its pre-recession level. "There is no evidence that the recession resulted in a long-lasting skills gap that would require retraining experienced workers to work in different industries," the authors conclude. "Turning unemployed manufacturing and construction workers into nurses and teachers would not provide those workers with immediate jobs; there is already a surplus of unemployed even in the low unemployment industries."

There are at least two areas where this recession appears different than previous ones. First, the long-term unemployed make up a larger share of total unemployment than in past downturns, even those with comparably high unemployment rates. Second, there are more vacancies per unemployed person than even a couple of years ago. This shift of the Beveridge curve -- which measures the relationship between job openings and the unemployment rate -- may suggest that some permanent structural change is under way and is keeping the unemployed from filling the jobs that are available. The authors conclude that the reason for such a shift, if it has indeed occurred, won't be known until unemployment returns to normal levels.

On the Beveridge curve, see here.

Links for 12-21-2012

• Managing Complements - Digitopoly
• Existing Home Sales - Calculated Risk
• The hawkish nature of the Evans Rule - MacroMania
• The Economy in 2012, in 34 Charts - Matthew O'Brien
• In Japan, a Test of Inflation Targets - NYTimes.com
• How Democrats Became Liberal Republicans - Bruce Bartlett
• On Not Seeing the Forest for the Equations - Paul Krugman
• The Confused and the Confusing - Stephen Williamson
• NY Fed: Progress in Improving Tri-Party Repo Sector - WSJ
• Does monopoly power cause inflation? - Nick Rowe
• The End of Mystique - Twenty-Cent Paradigms
• The Neomonetarist Perspective - Miles Kimball
• Last-Ditch Attempt to Derail Volcker Rule - Simon Johnson
• How Will We Pay For Superstorm Sandy? - Liberty Street
• Confusion in the Anti-Keynesian Ranks - Econbrowser

Interview with James Galbraith (Part 2)

Here's the second part of the interview with Jamie Galbraith conducted by Roger Strassburg for www.nachdenkseiten.de (Part 1, Speech):

Interview of James Galbraith (Part 2): RS: In the U.S., ever since the firing of the air traffic control folks, unions have really gone down in the U.S. Do you see any possibility that that could ever change?

JG: Well, a couple of things about that. I think that the role of the firing of the Professional Air Traffic Controllers is exaggerated in this story. PATCO was one of two unions that actually endorsed Reagan in the 1980 election, the other one being the Teamsters. PATCO then turned around and challenged him in a way that was very ill-advised, and suffered, of course, catastrophic consequences.

But that wasn't the reason why the rest of the labor union went into decline at that time. And the fact that Reagan appointed anti-labor people to the National Labor Relations Board also wasn't decisive. What was decisive was the recession, the huge hit to industrial jobs in the Midwest in '81, '82. You had a massive collapse of heavy industry in the U.S., bankruptcies all over the spectrum. I can remember the names of a lot of firms that aren't with us anymore as a result of that period. And that's when the American equivalent of IG-Metall suffered its severe reverses. Since that time, there is at least one part of the union sector which has grown quite rapidly and that's the Service Employees International Union, the public employees union. You can see the politics of this in the West, where in 2010, if it had not been for the unions in the West, the debacle in the midterm elections would have been complete, and the Democrats would have lost the Senate as well as the House. They were the firewall, and that's what brought Jerry Brown back to the governership in California. And the consequence of that is Proposition 30 this year, which basically ends the era of no tax increases in California.

RS: That kills Prop 13.

JG: Prop 13. And you have a Democratic super-majority in the legislature, and California is a place of enormous political significance. So I'm not prepared to say the tide is turned, but the tide that was running against unions in the United States at least ran up against that strong position, which held. What's happening now is – I could end up next week disillusioned – one of the most quietly hopeful moments I have experienced in American politics in a long time.

Three things of significance.

First of all, the banks went for Romney after having been exceptionally generously treated by the President, by the Treasury Department. They turned around, and the bastards went for Romney. It showed what kind of character they actually have. It's not true of every single banker, but it was the sector as a whole.

And guess what? They lost. They lost, and if the President has any moxie, and I think he does, I don't think he will forget that. So that's point number one. And certainly any normal human being, and I think the President is a normal human being, will hold that card in reserve.

Point number two is that the Senate was supposed to go Republican...

RS: I would have surprised if that had happened, but yeah...

JG: But anyway, the Democrats were supposed to lose ground, and they didn't, they gained ground. They gained ground, and the situation is such that – yes, they have exposure in two years – but their position at the moment is one where you have a sense of the high tide of the Republican party's past.

Why? Because as it becomes more and more extreme it becomes more and more regional, and as it becomes more and more regional it becomes more and more extreme. It's hard to reverse that dynamic, and they don't have a good way of doing it.

Number three: To get reelected as President of the United States, your place in history is basically secure, unless you, well, misbehave with an intern or get caught with burglars in the White House. Those kinds of things can unseat you. Or arms for hostages, etc. etc.: Iran-Contra.

Presidents can discredit themselves in their second term, but none of those are likely to happen to Barack Obama. So we're looking at a president who's got four years – and certainly two – where everybody understands he's got a lot of authority, much more authority than your standard lame duck.

And he has actually used that authority already with sending Tim Geithner to the Republicans with his bid on the fiscal cliff. What was the significance of that? The significance of sending Geithner was saying, “look, this is the deal we're offering, and there isn't a back-channel that's going to give you a better one”. If he'd sent Jack Lew, if he'd sent Gene Sperling, people on the other end would say, “you're not the real emissary, I've got to see what Tim Geithner has to say”. Well, he sent Tim Geithner. He didn't give them another channel. I think this was a significant fact.

So the Republicans as far as I can tell are reacting with shock and bluster, indicating they understand they've seen they don't command the same fear that they did before.

You have two possibilities: One is that this is not that serious, that it's all posturing and the the President will fold and I will say, “fooled me once, fooled me twice”. It's possible. And the other possibility is that we'll go past January 1st, and the President will come back with his strengthened hand in the Senate, and it will be the Republicans who will have to basically decide if they want to take the blame for the tax increases and the spending cuts and everything else that's going to happen. And, you know, I can't look into the Republican mind, certainly people I talk to say, “they've caved, actually when you look at it, Republicans have caved every time and they'll cave again”.

RS: When have they actually caved in the past?

JG: Oh, on quite a few things. At the end the bluster didn't hold up the debt ceiling, for example. They got it through.

So there's a test of wills going on at the moment, and there's at least the possibility that the President was right in saying that during his first term his way to political success was basically “rope-a-dope” strategy, was to take everything that was coming at him and to continue to offer conciliation and compromise. And if that's the case, of course, which I hope, it was a purely tactical, successful tactical decision, then the situation now is very different. No longer does it prevail.

And the other possibility is that the President was actually doing what he wanted to do in the first term, and he'll figure out a way to do it again in the second term. And that would be, of course, a great shame.

But still, three reasons why things might still be a little better in the U.S. Now.

RS: But Obama is not really that liberal.

JG: No, but it doesn't matter. The underlying preferences of the President are really a secondary consideration. I mean, a very nice example is Lyndon Johnson. Johnson had a lifelong visceral commitment to civil rights and to the New Deal. But during his entire political rise, he voted against civil rights bills. He didn't bring one to the floor when he was majority leader.

He wasn't going to commit political suicide. He had right-wing supporters in Texas who thought he was a good old white boy just like them. And they were astonished. He was Richard Russell's “golden boy”. Russell made Johnson, and when Johnson had the power he turned around and he told Russell, “I'm going to defeat you on this”, and he did. He didn't ask for Russell's support, he just said, “I'm going to defeat you”, and he did. So, the politics of the matter govern.

And what happened in this case, I mean, I'm not saying this is a universal rule, but what happened in the case, was that you had the financial sector on one side saying, “you've got to cut Social Security and Medicare and Medicaid”. And guess what?

Well, so far, the President has said Social Security is not on the table. Senator Reid has said Social Security is not on the table, we're not going to do that. And on Medicare – Medicaid so far as I know hasn't been discussed much, either, but there may be something – what the President has said, is, well we'll get you some savings, here's the number, 400 billion, and my proposal is that it's too complicated, we'll work it out next year. Right? And when the President was asked, are you prepared to cut beneficiaries, he said, “oh, no. We're going to, you know, cut the cost of some procedures, cut the cost of some pharmaceuticals and so on”. And there are lots of things you can do.

There's no question you have to work on the cost of health procedures, but so long as you're not cutting the services that people actually get, Medicare is there. And if that's the Democratic position, then Social Security and Medicare and Medicaid will continue to serve their function no matter what. And the Republican position is increase the eligibility age for Medicare, which is privatization, or change the cost of living formula for Social Security, which is a cut. I can fight that battle til the cows come home, and I'm not worried for a minute which way the public's going to come down. I would love to have that on every billboard in the country in two years.

RS: To do that it would require legislation, that's where the Democrats are in a little bit better position there.

JG: If the Democrats cave and give the Republicans what they want, then the battle's lost. If the Democrats say, we are not going to cave on these issues, you're right – the Republicans can't do this by fiat, they have to have legislation. And they can't get legislation past Harry Reid. If they can't get it past Harry Reid, they're not going to get it.

RS: You've said not to worry about the fiscal cliff.

JG: Of course the cliff is an artificial deadline. It was self-imposed.

The point there is that while if everything were stretched out for a year and the taxes went up and spending went down by three or four percent of GDP, that would probably have an effect. It would be hard to maintain private spending in the face of a higher withholding and so on. But six weeks wouldn't matter. First of all, withholding rates wouldn't even be adjusted, so people's incomes would be the same. And they're not going to change their spending habits because they know that Congress is going to come in and fix it. Even if they're uncertain about it, they're not going to preemptively adjust their spending very much. And anyway, this is January. This is not the time when people are engaged in discretionary Christmas shopping.

So it's not as though you have to make a decision by January 1st – you don't.

The second piece of that particular bit of blackmail was that it was thought that this would be the last hurrah of a Democratic Senate, and maybe the last hurrah of President Obama, and that these guys with their backs to the wall would cut a deal that would be bad, but better than would happen in the next Congress.

Well, didn't happen, so the whole incentive to be panicked because of what the next Congress might do has gone. It's just gone.

RS: The next Congress could go the other way.

JG: The next Congress will certainly be better. than this one. The House is still Republican, but I actually think that Speaker Boehner's position is a little stronger because of the thrashing administered to the Tea Party. But how stable it is is anybody's guess at this point.

RS: Speaking of the Tea Party, how do you think they're going to end up? Are they quietly going to go away, or they going to continue?

JG: I think it's finished. Of course the people are there, but of course one of the key movers, Dick Armey, just quit Freedom Works. We don't know what that's about, but it suggests organizational disarray.

RS: Yeah, it's like a personality problem.

JG: Whatever the reason, sinking ship and certain small rodents jump to mind.

But in any event, the thing about the Tea Party was that it was ginned up to be a backlash to Obama and to provide a kind of quasi populist cover media talking point for the 2010 election. By 2012, first of all, it had been disciplined internally. The Tea Party types all voted for the debt ceiling, most of them voted for the debt ceiling increase because they were told they had to. So it was clear that they weren't really an independent force. They were on a leash, and when the leash chain was jerked, they had to cooperate.

And secondly, their existence, the people they had dredged up from God-knows-where to run for Senate

In Missouri and in Indiana, these were remarkable specimens, I mean really scraping off of the murky end of the pool.

RS: Michele Bachmann made it back into the House, I'm beginning to worry about Minnesota here...

JG: Well, I don't want to speak anything unnecessarily favorable about her, but in comparison to a guy like Akin, she's at least a tested political figure...

RS: Yeah, that's very faint praise.

JG: Hey, were you expecting more than that?

With Akin these guys had offered up a poster child for discouraging sane voters from empowering these people.

RS: Well, it's actually a good sign, because, I mean, Republicans get a lot of votes. It's not like people in general have figured out that these guys are nuts.

JG: Right, but you know, most people vote on the basis of long-standing party loyalty. Most of the time, there's a margin in there. I don't think the independents are a very large force...

RS: …a lot of people say they are...

JG: Yeah, but what you observe is that the electoral divides are really close one year after the next, and they didn't change all that much. So what's happened in '08 was the needle shifted just enough so that Indiana and North Carolina went for Obama. And in 2012 it shifted just enough back so that those two states stayed with Romney.

RS: That's not terribly surprising, though.

JG: Every other state that Obama won in 2008 he won in 2012. Decisive electoral college. And then you ask, are there any states where the Republicans are moving toward a majority? I think the one place that I would say is a possibility is Iowa.

RS: I worry about Minnesota. It's not as strongly Democratic as it was when I was there.

JG: Yep, that's certainly true, but Minnesota was not in play this year. Pennsylvania was not in play...

RS: No, but some people tried to make it seem like it.

JG: Yeah, there was a little bluffing and so on. But I would say that the you need to ask, are there any states headed in the other direction? North Carolina.

RS: That was a surprise, although I guess that the fact that there's a lot of business down there, a lot of people have moved in from out of state.

JG: Correct, and the next one is going to be Arizona.

RS: That I'll believe when I see it.

JG: Well, there are two things happening in Arizona, and they are a very rapid rise in the Hispanic population, and secondly, influx from California. Arizona was in some polls barely Democratic, barely Republican this year.

Romney won it. One of the things that held up Arizona in the Republican column, in a way, was, of course, McCain. Anyway, there you are, you've got a country where, you know, how many national elections' popular votes have the Republicans won? The answer is, one since 1988, and that was 2004. And in 2004 they scraped through in the electoral college on one state, which was also true in 2000. So it's a party which is actually in many ways barely competitive at the national level.

If the Democrats are smart and continue to nominate strong, appealing, candidates – I'm not saying liberals, I'm not saying conservatives, but people who capture the essence of the Democratic message and manage to convey it.

RS: That's pretty much in the center at this point, isn't it?

JG: Whatever it is.

The Obama quality here is – which I think Romney also had, by the way – is that I'm not ashamed to have the guy as President. There's not something deeply embarrassing about him, you know, crime, sex, senility, whatever things repel you, none of those traits. This is a guy who gets up in the morning and does his job, and everybody can see that. So the Democrats continue to nominate people who are good at what they do. I have the feeling that things are moving their way.

RS: Well, this is the first time in a long time that we've had no scandals whatsoever from the White House...

JG: Just a second on that. I'm not conscious of there having been, I may be misremembering, a White House scandal in the George W. Bush administration. Nothing particularly on the personal side.

RS: Not at all there. It was more about financial dealings, I mean, Bush's involvement with Enron...

JG: Yeah, back history, Bush's back financial history certainly had some issues. But I was thinking that the major White House scandal of that period was probably the Valery Plame matter, and so you really have a problem of Cheney and Scooter Libby and whatever involvement Karl Rove had. But personal scandals were not Bush's problem.

RS: But who do you think really is a potential star of the Democratic party?

JG: I think the interesting question is what will be the public reaction to Hillary Clinton in four years?

RS: Is she going to run?

JG: I would assume. And I think that when you're dealing with someone who's been on the scene for as long as she has, it's risky, I don't think it's a sure thing.

RS: I don't think she polarizes as much when she ran as I expected she would.

JG: Good reputation as Secretary of State. Unquestionably this is a significant figure, but I think that there will be a tough challenge from somebody. Who it would be, I don't know yet.

RS: I don't see anybody yet.

JG: There's Andrew Cuomo, you know, there are people out there. Unfortunately, it in general would be better if it's not a dynastic figure.

RS: Who do you think the Republicans are likely to dig up? They've got a lot of nut cases that didn't get through this time.

JG: They have a lot of people that didn't run last time. They have quite an amazingly open field, and unfortunately, well, fortunately, what happens there is that somebody who is not well known makes a big impression and turns out to be non-viable. That was the Sarah Palin problem, and, well, just go through the whole list of the front-runner du jour, the Rick Perry problem. I think the Republicans have been in a state of complete disarray.

RS: Do you think that there's any chance whatsoever of getting stimulus in this term?

JG: Of Obama getting it? Well, it was in the ask for the fiscal cliff, along with an extension of the payroll holiday, which surprised me, plus unemployment insurance.

I guess the short answer is, not very likely, because the President committed himself to very strict spending limits. What do I think might happen here? The first thing that has to happen is an ongoing reassessment of what the underlying economic conditions actually are. And people need to be disabused even further of the notion that we're on the cusp of some kind of recovery, that this is being taken care of by itself. To me that's the project of the next coupled of years. I don't expect much to develop, I don't expect there to be a great disaster, although if the fiscal cliff stalemate occurs you could have...

RS: It's a little bit like what Gingrich did in '94, isn't it?

JG: Yeah, but that was just a few-day wonder, when the effect of closing federal offices was so dramatic that Republicans gave up on that. Anyway, I anticipate hammering over the next couple of years the need to change ideas. I don't think that in the bad situation in which there is a stalemate and the economy reacts badly to it, I don't think that's necessarily bad for the President politically. It's very clear who's responsible, and then you look at the last two years of his term. It's not obvious that the next midterm election is going to go against him.

RS: Not at all.

JG: You have the 1998 precedent where the voters just get fed up, and just give the President a couple of productive final years, and then we'll see. So, I've been saying things for a number of days that I feel may be too optimistic. I have a certain optimistic streak in me at the moment that I'm having a hard time repressing because it's so rare.

RS: Don't bother repressing it. If you're too optimistic, that'll happen all by itself.

I'm rather pessimistic at the moment, actually. But that has a lot to do with what I'm seeing in Europe. I don't see any change there.

JG: I don't see anything, either. And I think the European situation remains locked into a dynamic of divergence.

Obama Saved, Boehner Sabotaged by 'Lunatic Wing'

Update to the post earlier today about Obama being "Saved by 'Republican Back-Benchers':

Boehner Sabotaged by Lunatic Wing of Republican Party, by Kevin Drum: Even after larding up his Plan B bill with lots of goodies, John Boehner apparently couldn't get his Republican caucus to support it. So he's now pulled the bill and adjourned the House, promising only to return after Christmas "when needed."

This is truly an epic fail. Boehner couldn't even get a piece of obvious political theater passed. He's completely unable to control the lunatic wing of his own party. It's hard to say what's next.

What's next, it seems, is the blame game over which party caused us to go over the fiscal cliff, but I think it's pretty clear who should be held responsible.

Sachs: How the Right Is Wrong About Happiness

I guess Jeff Sachs hasn't gone completely off the rails:

How the Right Is Wrong About Happiness, by Jeff Sachs, Commentary, Huffington Post: Today's op-ed page of the Wall Street Journal sheds more light on how conservative elites thoroughly misunderstand and misrepresent the role of government in a decent society. Arthur C. Brooks, president of the American Enterprise Institute, a conservative think tank, makes an empirical claim that government social spending lowers happiness of the recipients by making them "dependent on unearned resources." ...

The claim is false because the countries that have the highest spending on social programs are far and away the happiest. ... They end up with economic prosperity that is broadly shared, very low poverty, low unemployment, social fairness, lower health care costs than in the United States, longer vacation times, guaranteed maternity and paternity leave, better pre-school and many more benefits that make people happy, and help them to raise happier and healthier children. ...

Brooks reports that going on the welfare rolls is correlated with feeling "inconsolably sad over the past month." Well, duh. Perhaps, Mr. Brooks, their life has taken a hard turn. If the sadness were merely the result of inscribing in a welfare program, they wouldn't do it. ...

Second, Brooks terms social programs as unearned income. That's a pretty grotesque generalization... Social security recipients have ... been making payroll contributions; the same with Medicare recipients. Unemployed workers collecting UI ... have been making contributions into the unemployment insurance system... To deem these programs to be "unearned income" is nasty, false, and demeaning.

If we were to do a serious look at whose income is unearned, we would surely start at the top, not at the bottom. CEO salaries, Wall Street bonuses, lobbyists perks... On this I'm with Brooks. Let's take this unearned income away from the super-rich through proper taxation and regulation, and to follow Brooks' logic, help make the rich happier as we close the budget deficit as well.

Saved by 'Republican Back-Benchers'

Republican extremists once again save Obama from himself:

The Eighteenth Brumaire of Barack Obama, by Paul Krugman: These days, political events occur, as it were, twice — the first time as near-tragedy, the second time as farce. [For those puzzled, the reference is here.]

In 2011, President Obama very nearly did immense damage to both the social safety net and the future of his party by offering a disastrous budget deal — a deal that would have raised the Medicare age, cut deeply into other programs, all in return for not much revenue and no rise at all in tax rates. Fortunately, he was saved from himself by what Gail Collins calls the rabid ferrets — the Republican back-benchers who wouldn’t accept any rise in taxes on the rich whatsoever, and effectively scuttled the deal.

This time around, Obama holds a much stronger position, yet for a couple of days there he seemed once again to be negotiating with himself. The offer he made earlier this week wasn’t nearly as bad as in 2011, and some reasonable progressives believe that the benefits — extended unemployment benefits, infrastructure, and extension of some other tax breaks that benefit the poor and middle class — are worth giving up a full return to pre-Bush taxes on the wealthy and the cuts in Social Security that would result from changing the price index. But it was an offer, not a deal — and there was good reason to fear that Obama, having arguably already given away too much, was getting ready to give away substantially more.

Rabid ferrets to the rescue! ...

Some alleged experts still think we’ll have a deal before we go over the cliff. Maybe they know their business, but I don’t see it. And the capitulation we all feared seems a lot less likely than it did two days ago. Thanks, ferrets!

After all the effort to protect social insurance programs during the Bush administration, it's disappointing to see Obama trying so hard to give it away. I thought the programs would be safe once they were in the hands of Democrats, but that hasn't worked out as well as I thought it would.

'Missing the Point in the Economists' Debate'

More on the macro wars. This is from Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State, by Roman Frydman & Michael D. Goldberg:

... To be sure, the upswing in house prices in many markets around the country in the 2000s did reach levels that history and the subsequent long downswings tell us were excessive. But, as we show in Part II, such excessive fluctuations should not be interpreted to mean that asset-price swings are unrelated to fundamental factors. In fact, even if an individual is interested only in short-term returns—a feature of much trading in many markets—the use of data on fundamental factors to forecast these returns is extremely valuable. And the evidence that news concerning a wide array of fundamentals plays a key role in driving asset-price swings is overwhelming.[16]

Missing the Point in the Economists’ Debate

Economists concluded that fundamentals do not matter for asset-price movements because they could not find one overarching relationship that could account for long swings in asset prices. The constraint that economists should consider only fully predetermined accounts of outcomes has led many to presume that some or all participants are irrational, in the sense that they ignore fundamentals altogether. Their decisions are thought to be driven purely by psychological considerations.

The belief in the scientific stature of fully predetermined models, and in the adequacy of the Rational Expectations Hypothesis to portray how rational individuals think about the future, extends well beyond asset markets. Some economists go as far as to argue that the logical consistency that obtains when this hypothesis is imposed in fully predetermined models is a precondition of the ability of economic analysis to portray rationality and truth.

For example, in a well-known article published in The New York Times Magazine in September 2009, Paul Krugman (2009, p. 36) argued that Chicago-school free-market theorists “mistook beauty . . . for truth.” One of the leading Chicago economists, John Cochrane (2009, p. 4), responded that “logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth.’” Of course, what Cochrane meant by plausible foundations were fully predetermined Rational Expectations models. But, given the fundamental flaws of fully predetermined models, focusing on their logical consistency or inconsistency, let alone that of the Rational Expectations Hypothesis itself, can hardly be considered relevant to a discussion of the basic preconditions for truth in economic analysis, whatever “truth” might mean.

There is an irony in the debate between Krugman and Cochrane. Although the New Keynesian and behavioral models, which Krugman favors,[11] differ in terms of their specific assumptions, they are every bit as mechanical as those of the Chicago orthodoxy. Moreover, these approaches presume that the Rational Expectations Hypothesis provides the standard by which to define rationality and irrationality.[18]

Behavioral economics provides a case in point. After uncovering massive evidence that the contemporary economics’ standard of rationality fails to capture adequately how individuals actually make decisions, the only sensible conclusion to draw was that this standard was utterly wrong. Instead, behavioral economists, applying a variant of Brecht’s dictum, concluded that individuals are irrational.[19]

To justify that conclusion, behavioral economists and nonacademic commentators argued that the standard of rationality based on the Rational Expectations Hypothesis works—but only for truly intelligent investors. Most individuals lack the abilities needed to understand the future and correctly compute the consequences of their decisions.[20]

In fact, the Rational Expectations Hypothesis requires no assumptions about the intelligence of market participants whatsoever (for further discussion, see Chapters 3 and 4). Rather than imputing superhuman cognitive and computational abilities to individuals, the hypothesis presumes just the opposite: market participants forgo using whatever cognitive abilities they do have. The Rational Expectations Hypothesis supposes that individuals do not engage actively and creatively in revising the way they think about the future. Instead, they are presumed to adhere steadfastly to a single mechanical forecasting strategy at all times and in all circumstances. Thus, contrary to widespread belief, in the context of real-world markets, the Rational Expectations Hypothesis has no connection to how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. When new relationships begin driving asset prices, they supposedly look the other way, and thus either abjure profit-seeking behavior altogether or forgo profit opportunities that are in plain sight.

The Distorted Language of Economic Discourse

It is often remarked that the problem with economics is its reliance on mathematical apparatus. But our criticism is not focused on economists’ use of mathematics. Instead, we criticize contemporary portrayal of the market economy as a mechanical system. Its scientific pretense and the claim that its conclusions follow as a matter of straightforward logic have made informed public discussion of various policy options almost impossible.

Doubters have often been made to seem as unreasonable as those who deny the theory of evolution or that the earth is round. Indeed, public debate is further distorted by the fact that economists formalize notions like “rationality” or “rational markets” in ways that have little or no connection to how non-economists understand these terms. When economists invoke rationality to present or legitimize their public-policy recommendations, non-economists interpret such statements as implying reasonable behavior by real people. In fact, as we discuss extensively in this book, economists’ formalization of rationality portrays obviously irrational behavior in the context of real-world markets.

Such inversions of meaning have had a profound impact on the development of economics itself. For example, having embraced the fully predetermined notion of rationality, behavioral economists proceeded to search for reasons, mostly in psychological research and brain studies, to explain why individual behavior is so grossly inconsistent with that notion—a notion that had no connection with reasonable real-world behavior in the first place.

Moreover, as we shall see, the idea that economists can provide an overarching account of markets, which has given rise to fully predetermined rationality, misses what markets really do. ...

Footnotes

16 See Chapters 7-9 for an extensive discussion of the role of fundamentals in driving price swings in asset markets and their interactions with psychological factors.

17 For example, in discussing the importance of the connection between the financial system and the wider economy for understanding the crisis and thinking about reform, Krugman endorses the approach taken by Bernanke and Gertler. (For an overview of these models, see Bernanke et al., 1999.) However, as pioneering as these models are in incorporating the financial sector into macroeconomics, they are fully predetermined and based on the Rational Expectations Hypothesis. As such, they suffer from the same fundamental flaws that plague other contemporary models. When used to analyze policy options, these models presume not only that the effects of contemplated policies can be fully pre-specified by a policymaker, but also that nothing else genuinely new will ever happen. Supposedly, market participants respond to policy changes according to the REH-based forecasting rules. See footnote 3 in the Introduction and Chapter 2 for further discussion.

18 The convergence in contemporary macroeconomics has become so striking that by now the leading advocates of both the “freshwater” New Classical approach and the “saltwater” New Keynesian approach, regardless of their other differences, extol the virtues of using the Rational Expectations Hypothesis in constructing contemporary models. See Prescott (2006) and Blanchard (2009). It is also widely believed that reliance on the Rational Expectations Hypothesis makes New Keynesian models particularly useful for policy analysis by central banks. See footnote 7 in this chapter and Sims (2010). For further discussion, see Frydman and Goldberg (2008).

19 Following the East German government’s brutal repression of a worker uprising in 1953, Bertolt Brecht famously remarked, “Wouldn’t it be easier to dissolve the people and elect another in their place?”

20 Even Simon (1971), a forceful early critic of economists’ notion of rationality, regarded it as an appropriate standard of decision-making, though he believed that it was unattainable for most people for various cognitive and other reasons. To underscore this view, he coined the term “bounded rationality” to refer to departures from the supposedly normative benchmark.

The introduction to this book might also be of interest:

Rethinking Expectations: The Way Forward for Macroeconomics, Edited by Roman Frydman & Edmund S. Phelps [with entries by Philippe Aghion, Sheila Dow, George W. Evans, Roger E. A. Farmer, Roman Frydman, Michael D. Goldberg, Roger Guesnerie, Seppo Honkapohja, Katarina Juselius, Enisse Kharroubi, Blake LeBaron, Edmund S. Phelps, John B. Taylor, Michael Woodford, and Gylfi Zoega ].

The introduction is here: Which Way Forward for Macroeconomics and Policy Analysis?.

Links for 12-20-2012

• That Old Sick Feeling - Paul Krugman
• How durable is the emerging NGDP consensus? - The Economist
• The CRA Did Not Cause the Housing Bubble - Credit Slips
• Statement on Erik Loomis - Crooked Timber
• Comments on Housing Starts - Calculated Risk
• Not Science, Not Speculation - Overcoming Bias
• Gretchen Morgenson should not trust Edward Pinto - Richard Green
• Noah Smith Gets One Wrong: State-of-Macroeconomics - Brad DeLong
• Money and bond bubbles: a parable - Nick Rowe

Labor Saving Innovation

When I was a little kid, I used to go and stay with my grandparents for a week or two each summer. I thought it was fun, and I liked going there, but I realized later it was mainly to give my parents a break. So I guess we were all better off. Except maybe my grandparents by the end of the second week.

For awhile, my grandfather was the watermaster for an area north of Yuba City, CA (around Tudor if you know the area, the water came from the Feather river near Star Bend if I remember correctly, and it was used to irrigate crops and orchards). When I visited, I'd sometimes go to work with him and one part of the job was him riding around in his pickup and checking the height of water in concrete pipes spread throughout the area he managed (they were taller than he was, and a couple of feet in diameter -- some were rectangular and much larger). He would then adjust the water if it was too low or too high (probably automated today, don't know, he did it, in part, by adjusting the intake from the river). This required him to take a ladder from his pickup, lean it up against the pipe, look inside and and visually check the water height, and then pack up again.

Like any worker, he preferred the job to be easier rather than harder, so he designed and installed a float system in each pipe that would allow him to check the water height as he drove by. No more getting out of the truck. It was simply really, just a float in the pipe attached to a lever on a pivot with an indicator attached to the other end, but it was a huge timesaver (there's a really bad depiction of it next to this paragraph). There were also markers on the outside corresponding to water heights (in feet) on the inside.

After he did this, he was able to spend more time at other things (one of which I think was a nap each day after lunch), and also take on new things that weren't possible before.

Not sure what started me thinking about this, but it makes me wonder how much innovation on the production floor comes from workers trying to make things easier for themselves. I think it was a government job -- not completely sure -- doesn't matter though, the incentive to reduce irksome labor is there profit motive or not. But even for firms where the profit motive is present -- firms where we think of managers imposing profit-maximizing changes -- how much profit enhancing innovation is actually due to workers just trying to make their day a little easier?

Interview of James Galbraith

Yesterday, I meant to post the first part of an interview with Jamie Galbraith did with Roger Strassburg for NachDenkSeiten (followed by the second part today). But I made a mistake and posted the (entire) speech instead (oops). So let me try to rectify the error, in part, by posting the intended interview [I'll post part 2 tomorrow, but it's here if you can't wait]:

Interview of James Galbraith: NachDenkSeiten: What's your impression so far of the conference, the situation with the IG-Metall?

Galbraith: I was here to give one of the keynote speeches, and my exposure to the rest of the meetings has really been to listen to several of the other opening lectures and to participate in a very interesting seminar on the future of growth following my speech.

As it turned out, my speech paralleled, I think in a quite useful way, the executive board's statement of the IG-Metall at the end of October on solidarity in Europe - something actually that I only saw after I had substantially drafted the speech I was going to give. There was a convergence of views, I think, that the principles outlined by the union are basically exactly right. You have to have the significant move toward European solidarity or the European project is going to be finished. The significance of it is that a change of view has to come, if it is to have any impact on the European situation, it has to emerge in Germany. I mean, and you can say that it's extremely difficult for that to happen...

NachDenkSeiten: It's a long ways away from that.

Galbraith: They're a long ways away from that, but that's where it has to come from, because, well, the rest of Europe and the countries affected can protest, and they can even resist. But the change in climate and the change in perspective cannot come from the weak countries, and unfortunately there's no sign that it's going to come from France, either.

NachDenkSeiten: I'm disappointed there. Is Hollande caving in?

Galbraith: That's hard for me to judge from a distance, but one interpretation is that he's essentially the captive of the Treasury, of the high French bureaucracy in these matters, and one can see how that happens. It happened also in the United States with President Obama. It's extremely hard for a president to break out of the mind meld of the top echelons of the government, no matter what his individual preferences may be. It doesn't matter, even if the president has well-developed contrary ideas. The classical case in U.S. history is Kennedy and Vietnam. Government is set on a certain path, it takes an enormous effort for the president to move it.

NachDenkSeiten: So you're talking about the career bureaucrats as opposed to appointed people?

Galbraith: In the French case it would be the permanent bureaucrats, yes. In Kennedy's case it was people he brought in with him, but nevertheless reflecting the establishment views.

NachDenkSeiten: That seems to be the case with Obama, too, isn't it?

Galbraith: Yes, it was people he chose, but they were people he chose from within the existing hierarchies.

NachDenkSeiten: With respect to solidarity in Germany, so far, anytime there's a protest in the south, it just gets people riled up here – sort of a long the lines of “hey, we're giving you guys money, and now you're protesting against us, with Nazi signs and this sort of thing”.

Galbraith: Right. People in Germany are not, I think, fully aware of what's happening on their southern border.

NachDenkSeiten: Well, the German press hasn't really helped that much. Politicians haven't really helped that much. They've been pretty much pushing the idea, “hey, you know, we did this right, they should follow our example”.

Galbraith: Right. And of course the reality is that what has been presented to the German public as a rescue of Greece or Spain is in fact a rescue of the banks that have lent to Greece and Spain. Add the other countries in as you wish, but it's essentially the same story everywhere. And that rescuing process can go along as Signor Draghi wishes to support it, which he will do because otherwise there's no more euro zone. But it does not amount to actual support for the, well I won't say that it doesn't amount to any support for the underlying economies, but it is designed in such a way that those economies will continue to decline. It's basically a punitive level of support.

NachDenkSeiten: Essentially they have to accept the conditions, which is austerity, austerity, austerity.

Galbraith: That's right. And the problem is that you've stressed the institutions which are the infrastructure of an advanced economy to the point where they're no longer really viable, at least to where they are in certain cases severely impaired.

NachDenkSeiten: Do you think Greece has a chance at all? I mean, right now they've cut 14 percent or so of their deficit.

Galbraith: What I've been saying about the Greek situation is that – and it's not just Greece – that the dynamic has an end state for which there is a model, and that model is Yugoslavia.

NachDenkSeiten: How do you mean, a downward spiral?

Galbraith: A downward spiral leading to an explosion of violence. And the thing about violence is that it happens quickly, and that it happens along very dirty lines, and it can be provoked. Once you start having the presence of factions that understand the power of violence, it becomes very hard to control. So I think that, as I said this today, this is something that Europeans all remember, that they all observed pretty much directly, pretty close, quite recent, but has been isolated as a historical experience. It's not considered to be European, but it is European.

NachDenkSeiten: It's still isolated and it's still far away. Germans do not see it. They see pictures, but here things are pretty much normal.

Galbraith: That's right. However, one can get to Yugoslavia, or the former Yugoslavia in less than an hour.

NachDenkSeiten: How do see the IG-Metall trying to change its directions now. It initially has pretty much gone along with the reforms that have gone on in the last ten years, the Agenda 2010. Are they turning away from that now, do you think? The SPD isn't yet, but do you think the union is, or didn't you really get into that?

Galbraith: I haven't spoken with the officials about their attitude towards the Hartz reforms and so forth, but I think, well, the title of the conference is “Changing Course”.

NachDenkSeiten: And like I said, they invited you...

Galbraith: Yeah, they invited me. This is the information I have that bears on it, and I'm encouraged, I think having, let's say, a highly-respected German institution taking a different position in these matters would be a significant development.

NachDenkSeiten: I would be, but unions aren't as strong as they used to be.

Galbraith: That's true. Nevertheless.

NachDenkSeiten: Still, Michael Sommer, the head of the DBG, still favors a grand coalition in the next parliamentary session. The idea – what scuttlebutt says essentially is that, the idea is, well, if we cooperate with Merkel, if we're nice to here, that we can influence her.

Galbraith: I think I should stay away from German politics simply on the grounds that I'm not an authority on it, but what Europe needs to begin with is a change of ideas. Without a change of ideas, nothing will happen. That's the starting point. The most effective way to get a change of ideas is to open up the dialog with people who have not previously been heard. And if all you are is an academic voice like me the opportunity to have the dialog opened up, to be part of that, was a development of note. I'm not going to claim too much for it. You never know where things are going to go, but this is how I see how I can be useful.

NachDenkSeiten: What would be your vision of where this could go. What would you recommend to the European Union if you were to try to propose a plan to fix the euro zone at this point, given what's happened so far.

Galbraith: I think that the principles laid out in the IG-Metall document are pretty good to begin with. They're principles of solidarity and justice and generosity. These are exceptionally important, because this is not a question of compassion, this is a question of making things work, and this is the only way you can make things work.

The specifics of this begin with the question of the debt, and recognition that you cannot adjust your way out of a debt that can't be paid. A debt that can't be paid won't be paid. The sooner you relieve the burden of that debt, the better off you are.

Now there are technical ways of doing that which could be done within the European charter.

I think the next step is to recognize that you need to have stabilizing institutions in the euro zone as a whole of the same kind that have existed for a long time within the northern European countries. Not necessarily the whole spectrum of them. This is not about having a federal government in Europe, but there are steps you can take that would help stabilize things. I spoke today about mechanisms that might be effective.

Yesterday, Jill Rubery, who was one of the other keynoters, suggested that a European-wide unemployment insurance scheme would be a good idea. I think this is an excellent idea because it basically says you're going to provide direct support to the people who are the most immediate victims, wherever they may be located, the most immediate victims of the crisis. And since those people are located in the indebted countries to a significant extent, it would help stabilize their economies. That would be a good thing. I've suggested the same principle be applied to pensions, and I would apply it to some of the lowest wage rates in the European Union.

So you can proceed step-by-step, and see that there are ways of doing which are run in parallel with most of the existing institutions to strengthen and stabilize them. If there's a will to proceed, there are ways to proceed.

NachDenkSeiten: Would you replace the national pension?

Galbraith: No, not immediately. I think that anything that can be done by adjustments at the margin should be done that way, because first of all you want to assure people that the institutions that they are familiar with will continue. And secondly, you don't want to have an impossible political battle on your hands every time you try to do something. So I think the way you would do these various things is by appropriate institutional design, not all of which I want to do myself.

NachDenkSeiten: Well, certainly one of the reasons that California isn't Greece is the fact that pensions come from Washington.

Galbraith: Precisely, and therefore California's debt is a small fraction of Greek debt in relation to California's GDP, which of course is a very large fraction of Greek GDP, multiple, shall we say, large multiple.

NachDenkSeiten: That would imply, though, that you'd want to have a European-wide pension system, European-wide unemployment insurance...

Galbraith: But those are things that require really quite a modest staff and a really powerful computer. We set up Social Security continent-wide in the United States in 1935, was done on index cards.

NachDenkSeiten: We didn't replace anything there, though. In this case, there are institutions that are already there.

Galbraith: Right, but we have the capacity to work with the existing institutions now. I agree with you, Social Security was quite simple, but still, it is within the skills of a competent programmer to come up with the right sort of system.

NachDenkSeiten: You mentioned the low wages. Would you try to have a European-wide minimum wage, considering that right now one of the problems is the productivity differences.

Galbraith: You want to have the wages more compressed than the productivity differences. What that does is support purchasing power and improve productivity where it's weak.

You don't what to impose highly disruptive changes. What you want to do is to set a direction that provides for gradual narrowing of differences over time. And the purpose of this is to make it possible for social institutions to function in the poorer countries, and to stabilize people in there homes so that they aren't given the same radical incentive to migrate that they presently have. Basically, you want people who are competent and skilled to be available in their home communities, and not simply sending checks home from a high-income city somewhere halfway across the continent.

NachDenkSeiten: It sounds like Greece is emptying out in that respect, in that the talented people are leaving. A lot of them are coming to Germany, and Germany is just tickled pink about that.

Galbraith: When you have this kind of disruption, this is the first group of people that leave, and the Greeks have diasporas also in Australia, also in the U.S., and of course in...

NachDenkSeiten: Those aren't new, though.

Galbraith: No, they're not new, but it gives a channel for people to leave, and actually a second place that people can go back to, and there's a lot of that. And, of course, also capital flight. It's all a sign of the declining conditions in the edges of the euro zone.

NachDenkSeiten: One of the news items of the past few days is that American companies are leaving southern Europe – without necessarily intending to go back.

Galbraith: Yes. You have a situation where companies are going to leave when they consider the social situation as unstable, when they consider the medical care is not tenable, and their top employees don't want to stay there, when the schools aren't any good or it's too stressful for their kids, all of these things. But it's also just a question of whether there's any hope for a profit in the markets.

NachDenkSeiten: That's Greece...

Galbraith: Yeah.

NachDenkSeiten: That doesn't seem to be understood here, it's still kind of the mercantilist idea, keep your labor costs cheap and export.

Galbraith: Right. Greeks could work for free and I think that BMW would not locate to Thessalonika.

NachDenkSeiten: You said that the debt, as long as the debt is not repayable, that you should essentially write it off and take a much larger haircut at this point.

Galbraith: Yes, of course.

NachDenkSeiten: It's fairly controversial among many economists and politicians. The economist Gustav Horn, for example, says, no, that would disrupt everything, there'd be a domino effect

Galbraith: All debt crises end in a write-down, all of them. I don't know of a single example, except maybe when Mexico got a brief reprieve in 1978 when it discovered oil in the Gulf. But that's the only counterexample I can come up with. They all end that way, because once you've moved into a crisis, you are in a situation which gets worse as time goes on. So it's only a question of now or later.

NachDenkSeiten: How would you go about doing that. One idea would be for the ECB to buy up a lot of the outstanding bonds, and just letting them sit in the books.

Galbraith: So long as they are in existence at unsustainable interest rates, they are what an IMF economist in the 1980's described to me as an unfunded tax liability for the debtor. They just sit there, and they act as a burden on economic activity. You never know at what point you are going to have to actually dip into whatever later growth you might have in order to pay them off. So you have to get rid of them.

NachDenkSeiten: There's considerable confusion here about what happens if the ECB buys up the bonds and the debts don't get paid off. The general myth around here is that the taxpayers would have to jump in and feed the ECB money.

Galbraith: Well the taxpayers don't have the money, the ECB has its own money, so that's not a logical inference.

NachDenkSeiten: It's a very hard myth to kill, though.

Galbraith: When you talk about the ideas that I've just been laying out on unemployment insurance, for example, that question is who's paying for it. What you have to explain is that purchasing power is created by this. What it does is absorb resources, mostly human labor, which is already unemployed, so it's moving things from the non-productive to the productive category, that's how it's being paid for. It's being paid for by work which would otherwise not get done. Then there is a small amount of extra groceries, maybe the people are not as cold as they otherwise would be, small comforts that are achieved by this. But the main benefit is that people who were previously unemployed do something useful, and they do something in the service of other people who now have purchasing power to handle it. That's a very useful thing.

NachDenkSeiten: This has been a hard thing to get across, not only here, but in the U.S., there's a similar problem in the U.S.

Galbraith: Oh, sure. Though I really think that in the U.S. attitudes are more elastic. People understand that you don't want to leave a large part of the population without unemployment insurance for a long period of time. You don't have the same kind of deep resistance to paying those bills because people have paying them for a very long time and everybody sees that the world isn't ending as a result of it.

NachDenkSeiten: That sounds awfully Keynesian for Germany. That's part of the problem. It's very orthodox.

Galbraith: I read some Keynes this morning in my speech. I read from the Economic Consequences of the Peace.

“If the European civil war is to end with France and Italy abusing their momentary victorious power to destroy Germany and Austria-Hungary now prostrate, they invite their own destruction also, being so deeply and inextricably intertwined with their victims by hidden psychic and economic bonds”

And then there's another passage later in the book which goes, “The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings and of depriving a whole nation of happiness should be abhorrent and detestable – abhorrent and detestable! – even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilized life of Europe.

NachDenkSeiten: That was after World War I.

Galbraith: Yes.

NachDenkSeiten: And how right he was!

Galbraith: Yes, it's a stunning passage.

It's one of those books that deserves a careful reading – frequently. I also read something that I like very much, I'll read it for you, too, Lincoln's message to the Congress in December of 1862:

“We can succeed only by concert. The dogmas of the quiet past are inadequate to the stormy present. As our case is new, so we must think anew and act anew. We must dis-enthrall ourselves, and then we shall save our country. Fellow citizens, we cannot escape history. We will be remembered in spite of ourselves. No personal significance or insignificance can spare one or another of us. The trial through which we pass will light us down in honor or dishonor to the latest generation. We say we are for the union. The world will not forget that we say this. We know how to save the union. The world knows that we do know how to save it. We even we hear we hold the power and bear the responsibility. The way is plain, peaceful, generous, just, a way, which if followed, the world will forever applaud.”

This passage in December of 1862 was about emancipation, so it was about giving freedom to the slaves and preserving it for the free. And there is a parallel to the relationship between debtors and creditors.

NachDenkSeiten: Yeah, very much – you're not really free if you're a debtor.

Galbraith: That's correct.

NachDenkSeiten: That is something that's well understood in Germany, which is part of the reason Germans have so much against debt., which is very understandable.

Galbraith: Now the other piece of this is that it's accounting – if you have a surplus, somebody else has a deficit.

NachDenkSeiten: That's not quite been understood yet, I don't think.

Galbraith: Every shopkeeper, of course, knows it.

NachDenkSeiten: Heiner Flassbeck is actually more or less resigned and has said, go southerners, get out of the euro, because it's not going to get any better for you. Others are saying, of course, no we've got to hold it together.

Galbraith: I think that the commitment to save the euro zone has to come from the north. What the southerners should be concentrating on is developing a coherent alternative. If you broke it up and you had six distinct new national currencies, Greece, Italy, Spain, Portugal, Ireland, that's five, and, ok France, maybe. Then first of all you have a lot of potential for speculative instability. And you could have a competitive devaluation situation, and that is not a happy scene.

NachDenkSeiten: I don't see this as being happy, either, because, of course, it's not going to get them out of the debt situation, it'll just make it worse. Debt is denominated in euros.

Galbraith: Yes, they would have to be defaulting on that.

NachDenkSeiten: Which has precedence.

Galbraith: Of course. I think the essence of it is that you devalue and you default. But of course you have a lot of private debts which are denominated in euros, and then there's a whole question of which courts have jurisdiction and how those matters get resolved. It's not cheerful. It's very hard to see how the European Union economy survives a kind of legal donnybrook that a breakup would involve.

NachDenkSeiten: The only thing that could work is the other way around, actually, is if Germany left the euro.

Galbraith: Right. The other possibility is that other model that I mention occasionally, which is the Czechoslovak model, which is to say, a velvet divorce, a negotiated divorce, and into two coherent blocks. And the only way that happens is if France assumes the leadership of the southern block, because it's not a coherent block without France. At least I don't think it is.

NachDenkSeiten: France is in the middle.

Galbraith: France's problem is that it really wants to be with Germany, but it would be better from a French standpoint for it to be the leading country of southern Europe.

NachDenkSeiten: It would probably be better for everyone if nobody was hooked up to Germany, because Germany is going to try to keep the currency strong.

Galbraith: The Dutch and the Austrians are going to try to stay with Germany on that.

NachDenkSeiten: They can afford to. They have similar economies.

Galbraith: Sure. But if I were in a position to try to influence developments in the south of Europe, I would be saying you should be thinking about how to do this, and how to do this in the way which is least likely to cause the entire system to disintegrate on you, recognizing that there's a considerable risk of that.

NachDenkSeiten: Do you think it's possible to design something like that?.

Galbraith: It's not obvious to me, but I don't have the range of knowledge that requires. But I would start assembling working groups to provide some baseline of knowledge about this.

NachDenkSeiten: I'm not sure what Flassbeck has in mind for how to go about doing that, but he's saying that the alternative is worse. And there are people who have let these thoughts run through their heads. Even Paul Krugman has at times said, well, you know, the alternative might actually be worse.

Galbraith: I have a lot of respect for Heiner, but it's not my approach. I would say that the thing you need to do is fact-finding, legal opinions, constitutional opinions. You need to have a much clearer sense of what is involved before making the move. But the fact is that the move to determine what is involved itself a very significant political gesture. And what you do while you are determining what is involved is you remain open to an offer from the other side. That's how you move toward the Czechoslovak solution – or reconciliation. That's how you develop a coherent bargaining position. At the moment the notion that the alternative is that we've got a hand grenade in our hand, and if we don't get something, we're just going to let it go off. Well, the hand grenade, it might kill you and it might not...

Lincoln made a comment in his speech at Cooper Union that the Southern position was the highwayman who holds you up and says, “stand and deliver or else I shoot, and then you will be a murderer”.

Krugman’s Explanation of Stagnant Real Wages

On the run today -- guests arriving soon and I am nor yet ready -- so some quick ones. This one came by email from Fred Moseley, and I haven't had a chance to give it much (i.e. any) thought. Comments?:

Krugman’s explanation of stagnant real wages: In a recent post on his NYT blog (“Technology and Wages”) Paul Krugman argued that the reason for stagnant real wages in the US economy in recent years is that technological change has been “capital-biased”, in the sense of Hick’s “capital using” technological change. Unfortunately, Krugman did not explain clearly what he means by “capital biased technological change” (as several readers complained).

According to Hicks, capital-using technological change (i.e. Krugman’s capital-biased) increases the marginal product of capital faster than the marginal product of labor (i.e. ↑MPK > ↑MPL). Krugman concludes that “we’re seeing new technologies that look, on a cursory overview, as if they’re capital biased.”

My question to Krugman (if I may) is: how do you know that technological change has been “capital biased”? A “cursory overview” of what data? What is the empirical evidence for this conclusion? How are the MPL and MPK estimated, independently of wages and profit? I know of no way to do this, especially for an aggregate production function.

Furthermore, the MPL (or MPK) is a logically incoherent concept, because the MPL (a partial derivative of the production function) requires that labor be increased by one unit and all the other inputs be held constant. But that is not possible in all goods-producing industries – it is not possible to increase labor and output without at the same time increasing raw material inputs (and other intermediate inputs); e.g. it is not possible to produce another shirt without more cloth, and not possible to produce another car without more tires, brakes, etc. If a firm hired labor up to the point where the real wages = MPL, it would lose money, because it would not have taken into account the extra cost of additional raw materials and other intermediate inputs. This non-existence of marginal products is not widely recognized, but it should be.

Another reader made a similar criticism: “The argument depends on the theory that workers are paid their marginal product. Some people hold to this old idea, however it is not supported by the empirical evidence.” Amen.

For further discussion of criticisms of marginal productivity theory (a two part paper), see here and here.

It is time we stop talking about marginal products and look for other better, logically consistent and empirically supported theories of the distribution of income.

I agree with Krugman in a subsequent post where he stated: “If you want to understand what’s happening to income distribution in the 21st century, you need to stop talking so much about skills, and start talking much more about profits and who owns the capital.”.

But marginal productivity theory is not a coherent way to talk about profits.

Fred Moseley
Mount Holyoke College