Economist's View

Are Recessions in Recession?

The more articles I read like this, the more I start to feel like we are becoming overconfident in our ability to control cyclical swings in the economy.  It's a worry others have as well:

Have Recessions Absolutely, Positively Become Less Painful?, by David Leonhardt, NY Times: The ... United States has endured an almost biblical series of calamities in recent years - wars, hurricanes, financial scandals, soaring oil prices and rising interest rates - but the economy keeps chugging along at an annual growth rate of roughly 3 percent. It has been able to do so with the help of technology that allows businesses to react ever more quickly to changes. But with little notice, those reactions have also created a new feature of the business cycle: the micro-recession. When one of them strikes, activity slows for a few weeks, sometimes in just certain sectors or regions, as companies adjust to a dip in demand. It has happened much more often in the last few years than in earlier expansions, but growth has picked up each time, thanks in part to the adjustments that businesses have made. No company embodies this change, for better and worse, quite like FedEx. When Alan Greenspan, the Federal Reserve chairman, sees Frederick W. Smith, FedEx's chief executive, during halftime of Washington Redskins games, Mr. Greenspan uses the company's vast reach to check in on the economy. "He always asks, 'We still O.K.?' " said Mr. Smith, a part-owner of the team whose stadium suite abuts the one Mr. Greenspan uses. More formally, Federal Reserve staff members rely on FedEx and the nearly six million packages it delivers every day for real-time data that helps set interest rate policy. ... The business cycle has certainly not been eliminated, as some dreamers suggested during the 1990's boom, but recessions really do seem to happen less often. ... Across the economy, quick reactions, like asking workers to put in more hours one week and fewer the next, have helped lead to the business cycle's new hiccups... At FedEx, the first responders to the business cycle are a group of managers who gather for a worldwide conference call every morning at 8:30 Memphis time. Sitting at a faux-wooden conference table in a spare room, beneath a screen that shows every FedEx plane in the air, they review the last 24 hours of activity. ... Changes like this ... have helped foster the recent economic stability. The amount of inventory that companies keep in their warehouses, in case demand suddenly surges or some boxes become stuck in Oakland, has steadily fallen...

This doesn't fully explain the change in the frequency and duration of business cycles, and a business cycle cannot be detected by "first responders" based upon the past 24 hours worth of FedEx data.  There is a step missing here. The article is a story about very short-run variations in output and how companies such as FedEx smooth such fluctuations on a daily or weekly basis, but that does not necessarily change the duration of business cycles.  With apologies for the quality of the artwork, here are two possible paths for output through time, one that wiggles a lot and has lots of  "micro-recessions" and one that doesn't have any due to innovations such as inventory management changes described in the article:

Eliminating high frequency variation in output is certainly desirable and does stabilize the economy in the very short-run, but, though it is certainly possible to construct models with this property, it is not necessarily the case that eliminating "micro-recessions" also eliminates "macro-recessions."  A step connecting the two needs to be provided. For example, better inventory management may smooth very short-run cycles, but be unconnected to business cycle frequency variation in output brought about by wage and price rigidities. 

There does seem to be increased stability in the last twenty years, but I'm not predicting the end of recessions forever and ever just yet.  And with all the evidence that came out during the Social Security debate on the increased economic risk that households have faced over the last thirty years, it is not clear that increased stability at the macroeconomic level translates into an increase in welfare for individual households.

Tax-panel Will Consider Changing Mortgage Interest Deduction

This surprises me.  I didn't think mortgage interest and the capital gains provision on the sale of a home would be on the tax reform table.  But when the deficit problem is this big, and the projected changes in the alternative minimum tax open up an additional $1.2 trillion dollar budget gap, a $61.5 billion dollar deduction is a tempting source of revenue:

Tax Panel to Consider Modifying Mortgage-Interest Deduction, by David Streitfeld, LA Times: ...[D]ebate is starting among policymakers about reining in one of the most sacred cows of American public policy: the mortgage-interest deduction and other generous tax benefits granted to homeowners. A presidential commission on tax reform will take up the subject for the first time Tuesday. "Everything's on the table," said Charles Rossotti, a panel member... The mortgage-interest deduction saved homeowners $61.5 billion last year. No one expects the commission to recommend its elimination. Instead, the panel probably will consider scaling back the deduction for mortgage interest on second homes or home equity loans, and changing the deduction for property taxes, among other things. The stakes in such a discussion are huge. Changing the tax benefits for homeowners, even if done slowly, could cause short-term convulsions in the market as buyers recalculate what they could afford. ... Any proposed shift will encounter strong and possibly overwhelming resistance. But with a rising budget deficit, the prospects for change are much greater than they've ever been, say those involved in the debate. ... Eight years ago, capital gains taxes were eliminated for sellers who had profits of as much as $250,000 (for individuals) or $500,000 (for couples). ... Some policymakers and analysts are beginning to wonder whether such breaks are providing the wrong incentives, giving hefty deductions to millionaires buying Beverly Hills estates as well as to speculators snapping up Las Vegas ranch houses hoping to turn a quick profit... Bush specifically charged the panel to take account of "the importance of homeownership and charity in American society." That led many to conclude that the homeowner deductions were safe. ... But ... the mood changed over the summer. ... One reason for the shift: the expected demise of the alternative minimum tax. ... At a meeting in July, the nine panel members agreed unanimously to recommend eliminating the alternative minimum tax as an unfair and poorly designed parallel tax system. Because their mandate is to be revenue-neutral, that required them to come up with $1.2 trillion in other receipts over the next decade...

House May Swat Fannie and Freddie

In his testimony before the Senate Banking Committee in July, Alan Greenspan said:

What Greenspan Didn't Know, CNN/Money: The chairman ... spent much of his time expressing concerns about the large portfolios of mortgage securities held by Fannie Mae and Freddie Mac. .... Asked ... why Greenspan only raised those concerns relatively recently ... Greenspan conceded it had taken him some time to understand the company's complicated structures, and the risks to the companies and the nation's financial systems posed by the concentration of mortgages in their holdings. "It's taken me quite a good bit of time to disentangle the complex structure," he said. "I didn't fully understand when I first looked at them. "It's only fairly recently that it finally became clear to me," he added. "It was a revelation in certain respects."

The result of that revelation is a likely vote later this month on a House version of a bill intended to address these problems, though the White House favors the stricter Senate version. The likely House vote comes after a compromise over an affordable housing fund:

Fannie Mae Bill May Get House Vote, by Annys Shin, Washington Post: A House bill that would change how housing finance companies Fannie Mae and Freddie Mac are regulated is probably headed to the House floor this month, now that Republican leaders have brokered a compromise over a controversial affordable housing fund provision... The proposed fund would be financed by the profits of Fannie Mae and Freddie Mac and would distribute grants to support the construction of low-income housing. Conservative House members had objected to it out of concern the money would end up in the hands of liberal advocacy groups. ... Thursday the bill's sponsors agreed with a proposal by House conservatives that would prohibit groups that engage in election activity from participating in the fund. ... The agreement ... should clear the way for final House passage. Some of the changes to the bill "don't do any harm. Some I'd rather not have seen," said Rep. Barney Frank (D-Mass.), the ranking minority member of the House Financial Services Committee and a proponent of the low-income-housing fund. But Frank said he was pleased to see the bill go forward, calling the fund "a fundamental breakthrough in federal housing policy." The provision is part of a larger bill that would create an independent regulator for Fannie Mae and Freddie Mac after multibillion-dollar accounting scandals at both companies. ... The White House has criticized the measure for not doing more to rein in the two companies... The Bush administration prefers a Senate bill that would limit the types of assets the companies can hold. The Senate has not yet voted on the measure.

A Comparison of Productivity Growth Across OECD Countries

From New Economist:

New Economist: Productivity in the OECD: US up, others down: How does recent US productivity growth compare with the rest of the OECD? Pretty darn well, according to a new BIS working paper by Les Skoczylas and Bruno Tissot, Revisiting recent productivity developments across OECD countries. They conclude that the US performance stands out (though the Nordic countries have also seen a pick-up in labour productivity growth). The level of US labour productivity "appears the highest among the major industrial countries", and has been rising the fastest:

The level of US labour productivity appears to be the highest among the major industrial countries and has been rising the fastest in the recent past. There are, however, substantial uncertainties surrounding these international comparisons. But there is little doubt that the US performance has sharply improved in relative terms, as productivity growth has accelerated in the United States but decelerated in most other industrial economies. Indeed, only a few countries (mainly some Nordic countries) have also experienced a structural improvement in their productivity performance over recent years.

That, coupled with migration, means a higher potential growth rate for the United States:

In terms of growth rates, and according to the OECD, potential output might currently be growing by around 3-3¼% per year in the United States, compared to around 2½% in the United Kingdom, 2% in the euro area and 1% in Japan. In terms of changes in growth rates, the United States has seen a clear improvement in its relative position: potential growth is still running at roughly the same pace as in the 1980s, while it has decelerated sharply in the euro area and even more so in Japan.

But what are the reasons behind this higher US productivity growth? The report makes some interesting speculations:

First, the improvement in US productivity does not appear to be the sole result of the reported greater use of IT equipment in the United States compared to other countries since the mid-1990s. The bulk of the US accumulation in IT equipment occurred in the 1990s, ie well after US TFP started to accelerate... Second, there has been an acceleration in trend TFP in the United States since the 1970s, a period over which substantial structural reforms have been implemented... Third, industrial countries have experienced substantial changes in trend productivity growth over the past few decades. If history is any guide, this suggests that the recent divergences could well not be maintained in the future...

Worth reading. The paper also presents some interesting views about the likely impact of structural reform on productivity growth, which I will return to in a subsequent post.

Krugman: A Pig in a Jacket

Paul Krugman takes a look at the administration's sudden support of energy conservation. He starts by recalling Dick Cheney's rejection of energy conservation during the California energy crisis and notes the recent about face by energy secretary Samuel Bodman on this issue:

A Pig in a Jacket, by Paul Krugman, NY Times: ...[T]his week Samuel Bodman, the energy secretary ... declared that "the main thing that U.S. citizens can do is conserve." Is the Bush administration going green? No, not really.

Then why the sudden switch to encourage conservation?

The background to Mr. Bodman's remarks is growing public anger over ... the price of gasoline, but the worst is yet to come: just wait until people see their winter heating bills, especially for natural gas ... the political danger to the administration is obvious: polls suggest that many people blame... administration for failing to control price gouging.

Krugman notes that during the California crisis, hardly anyone would believe prices were manipulated, though later it was confirmed that they were, whereas this time it is widely believed that prices are being manipulated when there is no evidence of that happening:

Now, much of the public believes that corporate evildoers with close ties to the administration are conspiring to drive prices up. But this time they aren't, at least so far.

Paul Krugman defending energy companies? Wow!

Just in case you think I've gone soft on the energy industry, let me say that claims that we're having a crisis because environmentalists wouldn't let oil companies do their job are equally bogus... the current crisis is nobody's fault, except Mother Nature's.

Krugman notes that until recently, energy companies weren't interested in building refineries because there was no expected profit in doing so, not because of environmental regulations. With respect to the current crisis, when the supply of a product like energy falls, we need to find a way to reduce demand from its previous levels. Krugman calls this "demand destruction" and notes it is needed to bring demand in line with the reduced supply. But how is this accomplished?

In the absence of an effective conservation policy, prices will do all the persuading: the cost of fuel will rise until people drive less and turn down their thermostats. The problem, of course, is that high prices will impose serious hardship on many families.

And that hardship could mean political trouble, hence the sudden shift to push conservation. But, says Krugman,

[A]s you might expect, the administration's conservation push lacks conviction.... the administration's attempt to promote "Energy Hog," a cartoon pig in a leather jacket, as a conservation mascot verges on the pathetic. So it's going to be a long, cold winter...

The short-run is looking chilly and expensive. What about the longer run?

The long-term case for energy conservation doesn't have much to do with the current shortages. Instead, it's about national security, broadly defined - reduced dependence on Middle East oil supplies, reduced emission of greenhouse gases.

National security? Those are magic words. Will that get the job done?

No such luck: when it comes to substantive actions, as opposed to public relations, it's still the same old, same old. Mr. Bush has ... said nothing about raising mileage requirements and efficiency standards for appliances. And as for a higher gasoline tax, which would be politically possible only with broad bipartisan backing - don't be silly. Conservation's day will come. But it hasn't happened yet.

Has the Bull Left China's Shop?

Are commodity prices about to fall due to events in China? Will slowing demand in some sectors of the Chinese economy coupled with the development of its own production facilities cause excess world capacity for important raw materials such as steel?

From accelerator to brake, The Economist: Nowhere has China's growing economic influence been felt more powerfully than in the world's commodity markets. The country's enormous appetite for base metals, minerals and fuels has pushed their prices to new highs and created record profits ... However, ... As the Chinese authorities have attempted to cool overheated parts of their economy, from construction to cars, consumption of some commodities has slowed sharply or even fallen. ... Chinese demand for oil has been just 2% higher so far this year ... demand for cement has been flat; and that for aluminium has declined by 5%. Analysts had been expecting growth ... Slowing demand has hit prices. It is also turning China into a net exporter of some of the materials for which it has until lately been scouring the globe. ... The extent and duration of China's weakening demand for commodities is hotly debated. ... Demand for some commodities looks as strong as ever. One is coal, ... Copper prices keep hitting record highs: China, which consumes a fifth of the world's supply, ... increased its imports by more than 12% in the first eight months of the year. Uranium, for use in nuclear power stations, is also still in demand.

...[There are] doubts a construction upturn could drive the annual growth of import volumes back to 35-40% ... Import growth ... will be constrained by slowing investment in fixed assets for heavy industries and by the excess capacity built up in the past three years. This excess capacity is the main reason to expect more weakness in the mainland's demand for several commodities and hence in world prices. China's huge investment in production facilities for basic metals and materials increasingly will allow the country not only to satisfy its own demands but also to let any overflow wash into world markets.

Steel is the prime example (see chart). The capacity of China's 260-odd steelmakers could ... by the end of 2005 [be] up by 23% year on year ... At a steel conference ..., Nicholas Lardy, of the Institute for International Economics in Washington, DC, pointed to “massive, massive excess capacity” in China at a time when steelmakers elsewhere are curbing production growth. In aluminium, 20% of new smelter capacity in China is lying idle because of a lack of raw materials. Once that comes on ... supply could outstrip demand growth over the next two years—even though demand will be rising at a double-digit pace...

All of this will cause political headaches for the Chinese as well as economic upset for their trading partners. Until now, China's surging exports of manufactured goods have at least partly been balanced by its strong imports of raw materials. If it now starts to export commodities and basic goods as well, trade tensions can only worsen. ... Whether China's government will manage to consolidate the sector to this extent is questionable, given the strength of vested local interests. But that is not the point. ... Both China and the rest of the world will find an end to the long commodities boom hard to handle.

I understand why I should be concerned if central planning or some other inefficiency in China is causing excess capacity and affecting world markets for steel and other commodities. But that is not the argument. I don't understand why I should be concerned with an outward shift in the world supply of commodities resulting in lower prices for key inputs to production. Why is that a problem?

Financial Times: US Set to Reconsider Agricultural Subsidies

Is this the end of farm subsidies?

US set to reconsider agricultural subsidies, Financial Times: The US administration on Thursday said the country needed to “think beyond the boundaries of current farm policy” in a sign that it was prepared to reconsider decades of reliance on direct agricultural subsidies for its farmers. The comments, made by US agriculture secretary Mike Johanns, are the first clear sign that the US is preparing to make a case to lawmakers and the country’s powerful farm lobby that the US may need to remove trade-distorting subsidies that make the US vulnerable to legal challenge in the World Trade Organisation. ... he suggested that the administration would push for ... environmental programmes and income support for smaller farmers. Such a move could help shield farm programmes from legal challenge in the World Trade Organisation... Mr Johanns said: ... “We have a choice. We can sit back and watch as our farm policy is disassembled piece by piece or we can begin a discussion about how to craft farm policy that provides low-risk, meaningful safety net for our farmers and ranchers.”...

Saying you need to think about something is a long way from eliminating farm subsidies. I'm not holding my breath.

Dallas Fed's Fisher Says Inflation a Poisonous Virus

Thanks to William Polley for making me aware of these remarks by Dallas Fed Bank President Richard Fisher in his discussion of the Reuter's report. As usual, Fisher has interesting things to say:

Contemplating the Nature of Money and the Capillaries of Capitalism, Richard Fisher, president, Dallas Fed: ...I want to speak to you today about money and the role of the Federal Reserve ... Money flows are an economy’s lifeblood, and the Federal Reserve’s great responsibility lies in maintaining the cardiovascular system of American capitalism. ...We cannot let ... the inflation virus infect the blood supply and poison the system. Inflation robs us of all that we might otherwise produce with a sound currency. It forces business to think about accounting rather than production. It distorts decisionmaking by investors. It penalizes the elderly and those who live on fixed incomes. It cheats the consumer, especially those in the lower income brackets. It robs savers of the underlying value of their money...

All you need to know about central bankers is that we abhor inflation. I always carry in my pocket a quote from Benjamin Franklin as a reminder of my obligation as an inflation fighter. In 1748, when we were an agrarian society and the crown was the colonies’ currency, Franklin said, “He that kills a breeding sow destroys all her offspring to the thousandth generation. He that murders a crown”—a dollar—“destroys all that it might have produced.” Inflation has been on a slight upward tilt the past couple of years. Readings on core inflation have been within the acceptable range of 1 to 2 percent, but they are edging closer to the upper end of the Fed’s tolerance zone, with little inclination to go in the other direction. As a result, we are in a tightening phase of monetary policy. ... In contemplating monetary policy from this point forward, the brow begins to furrow. Most forecasters expect growth to slow from its previous pace ... due to additional volatility in prices for natural gas, gasoline, certain chemicals and building supplies. To protect their profits, businesses may become more aggressive in pressing for price increases. Will prices increase more broadly, or will the economy slow as profits get further squeezed? Or will both happen simultaneously? The honest answer is: I do not know.

Another reason for anxiety lies in the federal government’s fiscal predicament. ... If the Federal Reserve were to resist the upward pressure on interest rates, it would in effect monetize those increasing fiscal deficits. The Federal Reserve has staunchly resisted monetizing deficits for more than a quarter century, and I feel strongly that it can ill afford to monetize them today. ... If the United States is to remain an economic colossus, its fiscal authorities, like its central bankers, will have to become paragons of prudence and restraint, implementing policies that will put the nation in a position to bolster, not hamper, its competitive edge...

If inflation is looking for a new friend, the Dallas Fed is the wrong place to look (see here too).  I will note, however, that he does acknowledge the possibility of economic weakness in the future if profits are squeezed from higher energy prices.

Bush Beats LBJ on Spending

According to Cato:

Bush Beats LBJ on Spending, What's New, Cato: In the latest Cato Tax and Budget Bulletin, Stephen Slivinski uses revised data released... by the Congressional Budget Office (CBO) to make ... comparisons of the spending habits of each president during the last 40 years. While ... all presidents presided over net increases in spending, George W. Bush is shown to be one of the biggest spenders of them all, even outpacing Lyndon B. Johnson in terms of discretionary spending. An excerpt from the report: 

The increase in discretionary spending - that is, all nonentitlement programs - in Bush's first term was 48.5 percent in nominal terms. That's more than twice as large as the increase in discretionary spending during Clinton's entire two terms (21.6 percent), and just higher than Lyndon Johnson's entire discretionary spending spree (48.3 percent).

These are from the Cato Tax and Budget Bulletin linked above:

I don't think Cato is happy.

Awake at the Wheel, But What Can the IMF Do?

I have posted two "IMF asleep at the wheel" arguments (here then here) endorsing those calling for the IMF to be more active in pressuring China to revalue the yuan.  This Bloomberg commentary by Andy Mukherjee presents a reasonable counterargument to that position:

U.S. Gains Little by Urging IMF to Hound China, by Andy Mukherjee, Bloomberg: Tim Adams, the U.S. Treasury's new under secretary of international affairs, has mounted a scathing attack on the International Monetary Fund. ... ''The perception that the IMF is asleep at the wheel on its most fundamental responsibility -- exchange rate surveillance --is very unhealthy for the institution and the international monetary system,'' Adams said ... Adams must know ... that if the IMF were to ... force China to accept a big revaluation in the yuan, People's Bank of China may reduce its purchases of Treasuries. A sudden jump in interest rates won't be in the interest of the U.S. economy. What the Bush administration would really want to see is a slowly and steadily appreciating yuan...The crucial question is that if a gradual appreciation in the yuan is all that the Treasury wants, then why not leave the job to his boss, Secretary John Snow, and his ''quiet diplomacy?'' The answer probably has something to do with Charles Schumer, the Democratic Senator from New York. Schumer, together with South Carolina Republican Senator Lindsey Graham, is ready to press ahead with a bill seeking punitive tariffs on imports from the world's most-populous nation. That bill, if it goes through, will turn the strained trade relations between the U.S. and China into an ugly spat. So Adams probably attacked the IMF to prove that the Bush administration, contrary to what Schumer says, is not a ''wet noodle'' on China. IMF Managing Director Rodrigo de Rato ... made it plain that he too, like Adams's boss, preferred to engage China in ''quiet diplomacy.'' He has a point. After all, what can the IMF do? Formal special consultations, which Adams referred to, have been used only twice in the history of the IMF ... The IMF has no authority to make China revalue its currency, just as it's powerless to get the Bush administration to run a tighter budget. Besides, why is Adams so keen to rock the boat? As long as the Chinese are buying Treasuries, it will be cheaper to rebuild New Orleans.

I'm trying to remember why I'm upset about low interest rates and low priced goods, particularly since revaluing is unlikely to return manufacturing jobs to the U.S.  It's because when the system is in disequilibrium and unbalanced, and the disequilibrium conditions persist causing the imbalance to grow, the risks of sudden and severe adjustment back to equilibrium also grow.  It's also because disequilibrium can lead to trade wars that do more harm than good.  So far, there isn't much evidence that quiet diplomacy has brought about the necessary onset of the gradual readjustment process.

What Has the Fed Learned Recently?

Philadelphia Fed president Anthony Santomero draws five lessons from the most recent business cycle and in lesson #5 he lets us know that he thinks interest rates need to continue to increase to remove monetary accommodation:

Lessons from Our Recent Business Cycle: A Policymaker's Perspective, by Anthony M. Santomero, President, Federal Reserve Bank of Philadelphia: ...[T]onight, I will ... reflect on the current business cycle and some of the lessons I have learned ... thus far. I will focus on how ... recent events, as well as ongoing trends, have affected both the economy and the conduct of monetary policy in this cycle. ... [B]efore we start, I must remind you that every business cycle is different. Each is the unique product of: (1) a relentlessly evolving economic structure, (2) some surprising new developments, and (3) a sequence of policy actions attempting to stabilize the situation...

[Evolving structure] To discuss the most recent business cycle experience, one must start at the beginning - with the revolution in information and communications technology and its dramatic effect on the economic structure of the U.S. ... a technological revolution of this magnitude does not produce a smooth economic progression. ... Nonetheless, the application of new information technologies has brought real economic benefits to our economy. ... At the same time ... it spawned unrealistic expectations that were manifested in a stock market bubble ... When the bubble burst and the investment boom deflated, aggregate demand decelerated rapidly ... driving the economy into recession. The technology revolution has also been an important contributor to globalization - a second fundamental factor of structural change driving the economy's evolution in this business cycle. ... Like the introduction of new technologies, ... globalization ... benefits are genuine and worthwhile, but they do not come without some costs. The adjustment costs are significant, and in an environment of rapid change, they are ongoing...

[Shocks] There were several new and surprising developments during the most recent business cycle. In 2000, the U.S. stock market declined precipitously and the tech bubble burst. ... This was followed by ... the terrorist attacks of September 11, 2001. ... All things considered, consumer spending came back relatively quickly. But ... businesses confronted these new uncertainties ... and saw new reasons to defer and delay investment spending. The events that followed ... September 11 - the anthrax attacks and then the wars in Afghanistan and Iraq - only served to heighten these uncertainties. Meanwhile, ... accounting scandals and corporate governance issues created new uncertainties, and ... weakened both households' and businesses' willingness to spend. ... Completing the list of shocks is an unprecedented sequence of natural disasters - hurricanes Katrina and Rita. ... Of ... significance for the national economy in this particular case is the impact of the two hurricanes on energy production. ... a classic supply shock ... Given ... tight market conditions, a significant disruption to production was bound to have a sharp impact on prices. ... the baseline projection for oil prices over the next year or so has risen as a result of recent events. This inevitably will mean somewhat less growth and somewhat higher inflation in 2005 and early 2006 than we otherwise would have had.

[Policy] ...[H]ow has the third factor, ... policymakers' actions, affected economic dynamics over the past few years? Here, ... remarkably aggressive policy action was a defining characteristic ... Indeed, monetary and fiscal policy worked together particularly well ... to provide ample and rapid stimulus during the economic downturn. ... The result has been a clear improvement ... over time. Last year, the U.S. economy turned in its best performance since 1999. ... And so, the Fed began to reduce the degree of monetary policy accommodation ... At its September meeting, the FOMC moved its target for the federal funds rate up ... to 3-3/4 percent. In the press release ..., we said the economy appeared poised to continue growing at a good pace before Hurricane Katrina hit. We... expressed our view that ... economic activity at the national level was ... likely to persist. Moreover, the impact of the disruption on the price level warrants careful monitoring. ... I stand by that view...

[Lessons Learned] ...let me now turn to my original purpose ... five distinct lessons that I garnered from the experiences of the recent past.

• Lesson #1: Technological Innovation Can Drive a Cycle ...new technologies and investment in new technologies can be powerful drivers of business cycle dynamics...
• Lesson #2: Globalization is an Important Factor in Economic Dynamics and Inflation ...global dynamics play an important role in the path our domestic economy will follow...
• Lesson #3: Countercyclical Policy Can Be An Effective Demand Force The shape of this business cycle was substantively affected by countercyclical government policies. ... monetary policy is not a panacea; it is a tool that needs to be handled carefully... it remains to be seen whether expansive fiscal policies can be reversed, and the federal budget can be returned to balance ... I see the value of fiscal integrity, and this requires a cyclically balanced federal budget.
• Lesson #4: Monetary Policy Works Best in a Stable Price Environment ...monetary policy works best in ... an environment in which ... expectations about future inflation are well-anchored...
• Lesson #5: Expectations Matter ...Expectations matter and they play an important role in the conduct of national monetary policy. ... As a central banker, I recognize that long-run price stability is always of utmost importance. ... To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one. But ... the precise course we take with monetary policy must be contingent upon the precise course the economy takes...

...[N]o matter how much we learn, ... I do not think we will ever reach a point where we will eliminate the business cycle. But we may be able to move closer to conducting optimal monetary policy in a world where change is relentless and surprising new developments continue to unfold.

Robert Hall on Job Loss and Job Finding

Robert Hall provides new evidence on the behavior of unemployment in recessions:

Job Loss, Job Finding, and Unemployment in the U.S. Economy Over the Past Fifty Years, by Robert E. Hall. NBER WP 11678, October 2005: Abstract New data compel a new view of events in the labor market during a recession. Unemployment rises almost entirely because jobs become harder to find. Recessions involve little increase in the flow of workers out of jobs. Another important finding from new data is that a large fraction of workers departing jobs move to new jobs without intervening unemployment. I develop estimates of separation rates and job-finding rates for the past 50 years, using historical data informed by detailed recent data. The separation rate is nearly constant while the job-finding rate shows high volatility at business-cycle and lower frequencies. I review modern theories of fluctuations in the job-finding rate. The challenge to these theories is to identify mechanisms in the labor market that amplify small changes in driving forces into fluctuations in the job-finding rate of the high magnitude actually observed. In the standard theory developed over the past two decades, the wage moves to offset driving forces and the predicted magnitude of changes in the job-finding rate is tiny. New models overcome this property by invoking a new form of sticky wages or by introducing information and other frictions into the employment relationship. [Free version from author web site.]

How Much Power is Too Much?

Tyler Cowen at Marginal Revolution notes this story about the president potentially pushing to give the military a broader role in domestic affairs.

Marginal Revolution: A Bush plan for avian flu: President Bush said today that he was working to prepare the United States for a possibly deadly outbreak of avian flu. He said he had weighed whether to quarantine parts of the country and also whether to employ the military for the difficult task of enforcing such a quarantine. ... The president had already raised, in the wake of Hurricanes Katrina and Rita, the delicate question of giving the military a larger role in responding to domestic disasters. His comment today appeared to presage a concerted push to change laws that limit military activities in domestic affairs. ... "...Congress needs to take a look at circumstances that may need to vest the capacity of the president to move beyond that debate," Mr. Bush said. One such circumstance, he suggested, would be an avian flu outbreak. He said a president needed every available tool "to be able to deal with something this significant."

The call is to give the president more power so he can mobilize the military quickly in the event of a disaster such as a hurricane or an outbreak of the flu. The inability to respond quickly in response to a large shock is is a problem that the Fed has also faced, and the inability to respond quickly is a problem faced by deliberative bodies in general. When the Federal Reserve system was created in 1914, it was intended to be a system of cooperating banks. Power was shared in various ways and there was an intent to represent the full spectrum of interests in the monetary policy decision making process.

This changed with the Great Depression. It is widely, though not universally, agreed that the failure of the Fed to pump liquidity into the banking system after the crash was a policy mistake. Two reasons are cited for this failure, the inability of democratic institutions to respond quickly, and not having tools such as open market operations available to use in such situations. Democratic bodies are cumbersome decision making entities and change of any type can be difficult. It doesn't take long watching congress to come to that realization. There are many occasions when this is a good thing, we don't want erratic policy shifts and other change on a continuing basis or with each change in party, but when a quick response is required such as pumping liquidity into the banking system after a stock market crash, the deliberative nature of democratic institutions can be a hindrance to an effective policy response. To combat this in the monetary policy arena, power was concentrated into the Central Bank and new powers, such as the ability to conduct open market operations, were granted (the same ideas lie behind the War Powers Act concentrating power in the hands of the president). Today, the Fed functions largely as a single bank in Washington, D.C. with twelve branches.

There is a constant tension between making decisions in a representative, deliberative manner, which works most of the time, and the ability to respond quickly in emergencies which favors abandoning democratic processes and concentrating power in the hands of an individual or a small group of people. There's a reason the power to set off a nuclear attack is concentrated in such a fashion and we are aware of the potential loss of checks and balances when we grant such powers. Though each new risk or shock brings new calls to concentrate power, we should be very careful in taking this step.  With respect to monetary policy, I contend we have gone too far. One person, Alan Greenspan, should not have so much control over the course of monetary policy. However, a new Chair without Greenspan's political prowess may not command as much power so the changing of the guard may partly resolve this issue. And to bring this full circle, I will never favor the further concentration of military powers into the hands of a single individual with the ability to deploy those resources domestically.

Dallas Fed's Fisher: The Fed Should Staunchly Resist Monetizing the Debt

Richard Fisher, president of the Dallas Fed, says "from time immemorial any central banker worth his or her salt has been genetically unable to tolerate inflation." That means, among other things, never, ever voting to monetize the debt:

A Perspective on the Economic Outlook, Richard W. Fisher, President of the Federal Reserve Bank of Dallas: ...I want to talk to you today about the economy and about confronting problems ... that loom on the horizon. ... The United States ... data present a less than clear picture. ... [T]he pace of economic growth had begun to slow slightly prior to Katrina and ... the disruptions from Katrina, and later from Rita, would initially slow growth a bit more. The U.S. economy grew at a 3.3 percent annual rate in the second quarter. Now, most forecasters anticipate growth closer to 3 percent in the fourth quarter. Many of them expect the bounce back from rebuilding the Gulf Coast to begin in early 2006, though the impact will be spread over several years. ... Inflation has been on a slight upward tilt the past couple of years. Now, the inflation rate is near the upper end of the Fed's tolerance zone, and it shows little inclination to go in the other direction. We now face higher energy prices and businesses' desire to pass the increased costs on to their customers. Combine the energy spikes with spending increases by governments at every level in the aftermath of the two hurricanes-John Maynard Keynes seems to be the patron saint of both liberals and conservatives these days-and you have new demand pressures added to the old ones. The FOMC has taken note of the fiscal situation, as shown by this pre-Katrina passage from the released minutes of the Aug. 9 meeting: "Few signs were evident that greater fiscal discipline in the budget process would emerge any time soon."

In this environment, the markets, if left to their own devices, would produce higher interest rates to ration money and balance the demand and supply of capital. If the Federal Reserve were to resist the upward pressure on interest rates, it would in effect monetize the burgeoning fiscal deficits. The Federal Reserve has staunchly resisted monetizing deficits for more than a quarter century, and I feel strongly that it can ill afford to monetize them today.

I am glad to see the Fed signaling to fiscal authorities that it will not monetize the debt as it has not, in my opinion (and others) been vocal enough in this area. We have heard from a number of Fed officials this week (here, here, here, and here), and unless there are dramatic changes as new data arrive, interest rates are going up.

[See also:  William Polley who discusses Bush's remarks today about not yet having a list of final candidates for Fed Chair and notes his statement that the Chair should be politically independent, as endorsed here.]

St. Louis Fed President Poole: Increased Transparency Has Stabilized the Economy

William Poole, president of the St. Louis Fed, lists the changes the Fed has taken to increase transparency which he believes based upon empirical work he presents has made Fed policy more predictable.  He believes the increased predictability has, in turn, helped to bring about the increased macroeconomic stability in recent decades:

How Predictable is Fed Policy?, William Poole, President, Federal Reserve Bank of St. Louis Fed: Day in and day out all of us depend on a high degree of predictability of the nation’s monetary arrangements. ... Historically, the least predictable aspect of our monetary system has been monetary policy. ... Unpredictability can have high costs. ... Monetary policy decisions can create surprises that affect outcomes from household decisions as to what jobs to take and where to live. Similarly, business firms find that their decisions as to hiring and investment in physical capital may turn out well or poorly depending on the course of monetary policy and its effects on the economy. ...Since 1989, the FOMC has adopted many practices that improve the transparency of its policy actions. Enhanced transparency is ... essential if markets are to understand Fed policy and therefore be more successful in predicting policy adjustments. ...Here are some milestones of changes in FOMC practices that have enhanced transparency:

• August 1989: Policy changes in the target fed funds rate are limited to multiples of 25 basis points. Prior practice of changing the rate in other steps often created market uncertainty as to exactly what the Federal Reserve’s intention was.
• February 1994: Starting with this FOMC meeting, the Committee released a press statement describing its policy action at the conclusion of any meeting at which the Committee changed the target funds rate. Prior to this practice, the market had to infer from Fed open market operations whether, and how, the Fed’s policy stance had changed. Consequently, the market was often uncertain as to the current setting of Fed policy.
• August 1997: Public acknowledgment that policy is formulated in terms of a target for the federal funds rate. The market had come to believe that the fed funds rate was the policy target but all uncertainty about this issue disappeared after this time.
• August 1997: A quantitative target fed funds rate is included in the Directive to the System Open Market Account Manager at the Trading Desk of the Federal Reserve Bank of New York (the “Desk”). Previously, the Fed often discussed policy in terms of the “degree of pressure on reserve positions” in the money market. A clear focus on a quantitative target ended the ambiguity.
• May 1999: A press statement following the conclusion of every FOMC meeting includes the intended funds rate and the policy “bias.” The bias indicated that the Committee was leaning toward an increase or decrease in the fed funds target but had not yet decided to actually change the target.
• December 1999: In its press statement, the FOMC replaces the policy bias language with “balance of risks” language in an effort to lengthen the horizon of its statement and provide a summary view of its outlook for the economy.
• January 2002: The vote on the Directive and the names of dissenting members, if any, are included in the press statement. Previously, this information was not available to the market until the meeting minutes were released following the subsequent FOMC meeting six to eight weeks later.
• August 2003: The FOMC introduces “forward-looking” language into its post-meeting press statement.¹ This language suggested the probable direction of the target federal funds rate over the next one or more meetings.
• January 2005: Release of minutes of FOMC meeting advanced to three weeks after the meeting (and before the next scheduled FOMC meeting.)

The purpose of these changes, which have gone a long way toward lifting the traditional veil of secrecy over monetary policy, is to increase transparency of policy, improve accountability, and provide better information to market participants about the future direction of policy. ... Accumulating evidence showed that ... market participants have been increasingly accurate in predicting FOMC policy actions as the steps towards more transparency listed above were implemented. The basic theme of this work is that the economy will function more efficiently if the markets and the Fed are interpreting incoming data the same way. ...It is quite clear that the markets understand Fed policy to a much greater extent than before. My own view is that the market’s improved understanding ... has much to do with the economy’s improved stability. Recessions have become milder and core inflation more stable. Maintaining these gains is important to economic welfare. I would not claim that we have enough evidence to say that the gains are permanent, but we do have enough to say that the effort has been very productive.

---

1. “In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Federal Reserve Press Release, August 12, 2003. In the press release of January 28, 2004 the language was modified: “…the Committee believes that it can be patient in removing its policy accommodation.” Subsequently, in the press release of May 4, 2004 a second modification of the language was introduced: “… the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.”

There is quite a bit more in the speech on the empirical evidence for increased accuracy in the prediction of Fed behavior.

Graphs Gathered from Blogs (September 2005)

The collection of graphs is at Optimetrica:

Graphs Gathered from Blogs (September 2005).

There is also a directory of links to graphs from other months.

Governor Kohn as the Next Fed Chair?

The speculation over the next Fed chair is beginning to heat up.  This time the focus is on Federal Reserve Governor Donald Kohn. To me, a factor cited in the article as a weakness, his lack of party affiliation, is a strength:

Kohn, Long Shot for Fed Chief, Helped Shape Greenspan's Views, Bloomberg: ...During his 30 years at the Board of Governors, Kohn ... has attended more policy meetings than any current Fed member. He served as Greenspan's top strategist for 15 years before Bush promoted him to governor in 2002. He embraces much of Greenspan's thinking on financial markets, risk and interest-rate policy. ... [S]ays Robert Parry, former San Francisco Fed Bank president ... ''He was very close to the chairman, and they discussed issues frequently. He and this chairman were really a team.'' Kohn shows up as a long-odds candidate to replace Greenspan in surveys and on betting sites, well behind leader Ben S. Bernanke ... One drawback: Kohn has few visible alliances on Capitol Hill, analysts say. Kohn says he has no party affiliation and declined to be interviewed for this story... ''If you talk to the Fed staff in private and ask them who would Greenspan like to replace him, the answer would be Don Kohn,'' says Roger Kubarych, economic adviser to HVB America Inc. and a former deputy director of research at the New York Fed. ... Under Greenspan, Kohn helped scrap policies that kept financial markets guessing about where the Fed wanted interest rates to go. Following a presentation by Kohn in December 1987, Greenspan urged reluctant policy makers to assign a numerical target to the federal funds rate, the interest charged for overnight loans between banks. Eventually, that figure became the most important signal of Fed policy. ... Because of his close alliance with Greenspan and personal involvement with policy across three decades, Kohn may also be the most resistant to major change, former colleagues say. ... Like Greenspan, Kohn remains a skeptic on the merits of tethering Fed policy to a numerical inflation goal. He favors a discreet approach that allows the Fed to maneuver around its double mandate from Congress: keeping inflation low and keeping employment high.

I think the writer means discretionary policy rather than a "discreet approach." I'm a stronger advocate of inflation targeting than Kohn, but I would not oppose him and a Greenspan clone with his experience would not be likely to upset financial markets.

The Bank of Canada's David Dodge on Solving Global Imbalances

David Dodge, Governor of the Bank of Canada, discusses global imbalances in The Financial Times and how their resolution is a shared worldwide responsibility, but I thought I'd go back to a more extended version of his remarks from a September 9 speech.  Among the issues cited as necessary to avoid a worldwide recession are the need for countries to adopt fiscal, labor market, financial market, and social safety net reform.  Fiscal reform will prepare countries for coming demographic challenges and also allow fiscal policy to be used, if necessary, to combat deficient aggregate demand.  The other reforms are intended to increase worldwide flexibility to respond quickly and efficiently to economic shocks and avoid prolonged recessions.  In addition, the reforms are intended to stimulate aggregate demand by reducing the need for saving.  His point that all countries have a role to play in the rebalancing effort is worth emphasizing since much of the debate on this issue has involved trying to identify a particular country or policy that explains the current situation when a combination of factors is at work:

The Evolution and Resolution of Global Imbalances, Remarks by David Dodge, Governor of the Bank of Canada: ...Today, I will talk about two types of global economic imbalances. The first relates to ... savings and investment ... being distributed across countries in an increasingly uneven way. The second is the possibility that, over the next couple of decades, the global economy might face a protracted period in which desired savings exceed planned investment, partly because of demographic trends. If economic policy-makers do not take appropriate measures quickly enough, there is even a risk—albeit a small one—that the world economy could end up with ... widespread demand deficiency and a persistent deflationary gap. ...Geographical imbalances are not necessarily a bad thing, nor are the large capital flows that they generate. Indeed, ... world financial markets ... allow savers in one country to lend to borrowers in another. Such a process leads to higher global growth ... If markets ... operate without interference, imbalances can resolve themselves in a reasonably smooth manner. But in the absence of appropriately functioning market mechanisms, there is a greater risk that the correction will be abrupt and disorderly. ... a disorderly correction might also lead governments to adopt wrong-headed protectionist measures... [R]egardless of how these imbalances are resolved, it is clear that the resolution will require greater net national savings in the United States. Investment in the U.S. economy will need more financing from domestic sources ... This implies an increase in net U.S. exports and a decrease in net exports elsewhere in the world, as well as an increase in domestic demand in other countries. Exchange rate movements have an important role to play in this regard, ... efforts by some countries to slow or prevent required adjustments by pegging exchange rates are ... counterproductive. ... such policies raise the risk of a much larger and more disorderly correction in the future, as well as an outbreak of protectionism... Within the United States, higher interest rates can be expected to lead to increased savings. Authorities could also encourage greater national savings with a tighter fiscal policy. And they could implement ... reforms to encourage national savings through taxation ... and other measures. But if the United States alone were to act to resolve its imbalance ... it would leave the global economy with much weaker aggregate demand. And so a number of other countries must focus on stimulating domestic demand. ... So, how can we stimulate domestic demand outside the United States? ... Structural reforms to remove market rigidities are important for most of us. Many need to improve or develop their financial system ... For some, the development of social safety nets would be helpful, so citizens don't feel the need to hold excessive precautionary savings. And for a few, more stimulative fiscal policy would be helpful.

...[T]he second type of imbalance ... will be posed by evolving economic and demographic realities. ... Let me ... expand on this risk by highlighting two trends that will be important over the next decade or two. First, ... Asia's share of the world economy will continue to grow. ... Asian nations have traditionally had a higher rate of savings ... so, all other things being equal, we can expect that global desired savings will rise. But all other things are not equal. The second trend that we can expect is higher desired savings in most OECD economies as the baby-boom generation prepares for retirement. Taken together, these two trends can certainly be expected to lead to a higher level of global desired savings. So it is critical for policy-makers to act now, so there can be an increase in demand and investment to compensate... To deal with this expected slower growth in domestic demand, ... what can policy-makers do to support  ... private consumption, government spending, and investment? In terms of investment, ...  First, one might look to governments to provide an expansionary fiscal policy. ... Certainly, the economies of emerging Asia have the scope to support demand with fiscal policy. But in North America, Europe, and Japan the scope for fiscal policy ... appears to be very limited ... But if there is one thing that all governments can do to stimulate demand, it is to have appropriate structural policies ... We all need to take steps to improve the flexibility of our labour markets ... We also need to recognize that well-functioning credit markets are extremely important ... The improvement of labour and financial market policies is particularly important in Europe. In emerging Asia, improving income-security policies is essential ...In closing, ... I'm not saying that a disorderly correction to global imbalances is certain to happen. Nor am I saying that the global economy is inevitably headed for a deflationary shortfall in demand. What I am saying is that, as prudent policy-makers, we must not rely on good fortune to help us muddle through...

Rip van IMF?

Continuing with the question of whether the IMF has been asleep at the wheel, whether it is finally waking up, and where adjustments must be made to rebalance the world economy, here's Brad Setser:

Has the IMF been asleep at the wheel, and ignored surveillance of exchange rates?, Brad Setser: Tim Adams - the new US Treasury Under Secretary - thinks so:

IMF Article IV requires that the IMF exercise "firm surveillance" over the exchange rate policies of members. ... We understand that tough exchange rate surveillance is politically difficult for the IMF. It is also true that a country has the right to determine its own exchange rate regime. Nevertheless, the perception that the IMF is asleep at the wheel on its most fundamental responsibility—exchange rate surveillance—is very unhealthy for the institution and the international monetary system. (emphasis added)

I am not exactly a fan of the Bush Administration's economic policy, but on this, I agree with Tim Adams and the Treasury. The IMF did not call out countries with overvalued exchange rates in the 1990s ... And it has refused to call out countries that are engaging in massive, sustained intervention to maintain undervalued exchange rates now. The IMF remains far more willing to criticize countries with inappropriate fiscal policies (the US) than to criticize countries that are intervening heavily to maintain inappropriate exchange rates (China, Malaysia, many oil exporters who peg to the dollar). ... The IMF's Articles call on every country to "avoid manipulating exchange rates or the international monetary system to prevent effective balance of payments adjustment or to gain unfair competitive advantage over member countries." It is pretty clear at least to me that China's de facto peg is an impediment to effective balance of payments adjustment. ... But you might ask, doesn't every country have the right, according to the IMF charter, to select its own exchange rate regime. Certainly. But that does not give it the right to hold to whatever exchange rate it likes without being subject to international criticism. I'll turn the microphone over to Morris Goldstein.

IMF members are free to pick fixed rates, floating rates or practically any currency regime in between. ... But what is not permitted under IMF rules is to engage in a particular kind of intervention - namely large scale, protracted, one-way intervention. .... China ... cannot legitimately maintain that it alone gets to decide as a sovereign matter what the exchange rate between the RMB and the dollar should be ... regardless of economic signals about whether that rate is or is not an equilibrium rate...

Much of the recent strain associated with globalization can be linked to China's steadfast defense of its dollar peg, and its current policy of spending $300 billion, a bit over 15% of its GDP, to resist RMB appreciation. That has consequences. Among other things, ... It almost certainly reduces overall employment in the manufacturing sector. ...It helps keep US interest rates low, and that supports employment in the housing sector. China may not impact on overall employment in the US, but it certainly has an impact on the composition of employment. If the Fund does not take multilateral exchange rate surveillance seriously, the US will no doubt eventually opt for what might termed unilateral exchange rate surveillance - and I don't think that is a good thing. De Rato and the Fund claim that US concerns about exchange rate manipulation reflect domestic political pressure. No doubt true. But that does not mean the basic argument made by the US lacks merit. ... Of course the US is taking a risk by pushing on the Fund to push on China too. There is a small chance China might actually listen to the US, and agree to make real changes to its exchange rate regime ... if the US government continues to run large deficits and US households continue not to save, it is not clear that the US really wants global adjustment ... On one hand, the US wants China and others to let their exchange rates appreciate, which means that they will intervene less and thus have fewer dollars to invest in US treasuries. On the other hand, the US government intends to borrow a ton of money ($100 b, $200 b) to rebuild New Orleans and the Gulf Coast, pushing the US deficit up. If China and others followed the US government's advice, the world's central banks [would be] ... buying fewer bonds, just when the US needs to sell more bonds to borrow the funds needed to rebuild...

The Best News Money Can Buy

Having used the term "Faux News" a few times myself, I couldn't resist posting this:

Faux News Is Bad News, Editorial, NY Times: Federal auditors have blistered the Bush administration for secretly concocting favorable news reports about itself by hiring actors to pose as journalists and slipping $240,000 in taxpayer funds to a sell-out conservative polemicist. ... the administration plainly violated the law against spreading "covert propaganda" at public expense, according to the report of the Government Accountability Office. ... The scheme was so seamy that auditors were unable to document whether Mr. Williams actually delivered all the articles and talk-show hype that his company claimed in quietly billing the government for $186,000 worth of yessiree-Bob "news."...

 

Fed Watch: How Does the Fed See the Economy Evolving?

Tim Duy has his latest Fed Watch:

I was struck by the title of David Altig’s piece The Savings Rate Increases – And That Ain’t Good, as well as similar thoughts by Kash at Angry Bear. What strikes me is that I often see hand-wringing about the possibility of a rise in the savings rate and the economic imbalances manifested in the current account deficit. In my mind, these are two sides of the same coin – it is most likely that the latter will improve in tandem with an increase in household saving, and that means a fall in consumption growth. Fundamentally, the current account represents an excess of broadly defined consumption over productive capacity, and reducing economic imbalances implies bringing the former in line with the latter. Of course, the speed of the adjustment process matters, as explained by James Hamilton here. But it is the process nonetheless.

Is this the perspective of Fed policy makers? I have suggested so in the past, and I believe this is the story Greenspan is currently spinning. Some relevant excerpts from his speech earlier this week:

If indeed this is the case, the implied increase over the past decade in consumption expenditures financed by home equity extraction, rather than by income and other assets, would account for much of the decline in the personal saving rate since 1995….

…Nonetheless, it is difficult to dismiss the conclusion that a significant amount of consumption is driven by capital gains on some combination of both stocks and residences, with the latter being financed predominantly by home equity extraction.

If so, leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth. The personal saving rate, accordingly, would rise.

Carrying the hypothesis further, imports of consumer goods would surely decline as would those imported intermediate products that support them. And one would assume that the U.S. trade and current account deficits would shrink as well, all else being equal.

How significant and disruptive such adjustments turn out to be is an open question. Nonetheless, as I have pointed out in previous commentary, their economic effect will, to a large extent, depend on the flexibility inherent in our economy. In a highly flexible economy, such as the United States, shocks should be largely absorbed by changes in prices, interest rates, and exchange rates, rather than by wrenching declines in output and employment, a more likely outcome in a less flexible economy.

In this speech, Greenspan is detailing his view on the importance of home equity extraction in fueling consumption growth and pushing the savings rate into negative territory. But read carefully into what Greenspan is suggesting. This is not the traditional view that households have fundamentally changed their saving behavior as a result of increased wealth. Instead it is the more subtle point that:

Because the personal saving rate is measured relative to personal disposable income, any purchases financed with the proceeds of capital gains will increase personal consumption expenditures but not income, and therefore the measured saving rate will decline.

So here is my interpretation of Greenspan’s view: Suppose my (hypothetical) household saves 10% of its income annually. Now suppose that I sell my house and extract $10,000 in equity as cash to spend on a new sailboat. From my perspective, I still save 10% of my income, but the Bureau of Economic Analysis doesn’t agree. They count only my spending on the sailboat, but don’t recognize the equity cash as income.

Should the housing market change in such away that reduces equity cash outs, then consumption will fall and savings will rise. Savings doesn’t rise, however, because I made a conscious decision to save more as my marginal propensity to save out of current income is the same. Instead it rises because my non-income resources have been constrained.

Why is such a subtle distinction important? Because it implies that Greenspan believes that the savings rate can rise in the absence of significant drop in household wealth from sliding home values. Traditionally, the story is that the savings rate will rise in response to the wealth effect when the property bubble (assuming it exists) pops. Greenspan is outlining another – and more benign – path. All you need is the housing market to change in such a way that refinancings and cash outs slow, not the bottom falling out. Moreover, even if prices slide a bit, it won’t be a big blow to wealth anyway:

In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices. In addition, the LTVs for recent homebuyers appear to be lower in those states that have experienced the most explosive run-up in house prices and that, conceivably, could be at risk for the largest price reversal. That said, the situation clearly will require our ongoing scrutiny in the period ahead, lest more adverse trends emerge.

Also note that under the Greenspan scenario, the current account deficit will improve – again, two sides of the same coin.

I believe this all ties into how the Fed (or at least a Greenspan-helmed Fed) believes the economy will evolve as the next year passes. To recap the story so far, the Fed has shown concern that economic slack has evaporated, and, with rising energy prices in the background, inflationary pressures are building. To stem these pressures, they have tightened policy to reduce growth. They are not targeting the housing market directly, but recognize that since housing has been a driving force in the expansion, it will likely be the recipient of the brunt of their policy efforts.

A cooling of the housing market, however, is not undesirable, and a major decline in values is unlikely. After all, haven’t their critics complained that excessively loose monetary policy caused a bubble to begin with? And, under the Greenspan scenario, a housing slowdown is necessary to trigger a needed rebalancing of economic activity. Moreover, with excess slack drying up, some sector needs to pull back, especially with any sense of fiscal discipline long gone.

Won’t a worried consumer upset this whole plan? I doubt the Fed is all that focused on the consumer confidence numbers. First, they will discount numbers that appear hurricane induced. The same holds for personal consumption spending. Indeed, most of the decrease in August spending was a fall in auto sales. This is just another chapter in the continuing story of Detroit’s woes, fundamentally a structural problem and outside the Fed’s purview. Detroit’s profits rely on cars that guzzle gas. Rising gas prices have soured consumers on those cars. The Fed can cut rates to zero, but it won’t make more gas – it will only raise the price of gas further.

Second, and more importantly, I doubt Greenspan & Co. believe that consumption fluctuations fundamentally drive business cycles. Instead, Fed policymakers will have their eyes glued on the investment numbers. And last week’s durable goods report for August likely eased any fears in that direction. I also suggest paying attention to a little reported figure in the durable goods report, unfilled orders for nondefence, nonair capital goods:

With unfilled orders continuing to pile up, I can’t see the Fed panicking about investment yet. The series last rolled over in September 2000 (the Fed had paused in May, and did not ease until January 2001). And don’t forget today’s ISM numbers, which revealed a surge in manufacturing activity in September – perhaps a precursor to another strong durable goods report.

But won’t higher interest rates sap firm’s ability to invest? This is the not problem, according to Greenspan:

Softness in intended investment, however, is also part of the story. In the United States, for example, capital expenditures have been restrained for some time relative to the very substantial level of corporate cash flow. That development likely reflects the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade.

Plenty of cash to finance investment, just not enough commitment from firms. The upshot it that the economy evolves in such a way that consumption slows, savings rises, and, as long as investment spending continues to grow, we avoid a recession.

I understand that this appears to be a very benign story, but note that it is being spun by the man who is trying to trigger the whole series of events. If Greenspan didn’t believe he was putting the economy on a course to glide into sustainable growth (over time), he would signal a halt in rate hikes. No such hope there.

Overall, I think it very possible that this path will result in slower growth, especially in consumption spending, than people believe Greenspan or his colleagues are comfortable with. This game is complicated by the increase in energy costs, which policymakers clearly view as an inflation threat and are willing to sacrifice growth to ensure it remains a threat, not a reality. But while this makes the game more risky, it is the game nonetheless.

[All Fed Watch Posts]

UPDATE (by Mark Thoma): Bloomberg's John M. Berry says rates are headed up.

Tax Reform and Better Porridge

Here are brief summaries of three commentaries from Bloomberg, two on taxes, and one on Greenspan, along with links to the longer versions and a comment or two along the way.  First, Gene Sperling on the estate tax:

Massive Estate Tax Cut Unseemly in Any Season, by Gene Sperling, Bloomberg: The award for candor in the post- Hurricane Katrina era has to go to Senate Finance Chairman Chuck Grassley, who observed that ''it's a little unseemly to be talking about doing away with or enhancing the estate tax at a time when people are suffering.'' ... The advocates trot out ... mom-and-pop stores and family farms that must be broken up and sold off to pay estate taxes. Never mind that they have never been able to cite even a handful of such cases. The Congressional Budget Office found that with a $7 million per-couple exemption, only 65 family farms would pay the estate tax ... Those in favor of retaining the tax ... started calling for dropping the top rate to 15 percent from 45 percent ... While these new proposals are designed to look less costly and less slanted in favor of the richest families, they're neither. ... The so-called Kyl compromise would benefit less than 10,000 wealthy families a year. But the cost would be high, at $595 billion over the next decade ... With terrorism threats still looming, deficits escalating, wages stagnating and poverty rising, ... lowering the estate tax for America's most fortunate families is more than a little unseemly in any season.

Next, Kevin Hassett expresses confidence Bush will deliver on tax reform

Why Bush Will Deliver on His Vow to Reform Taxes, by Kevin Hassett, Bloomberg: ...Tax reform can happen next year for three reasons. First, while Republicans ... still possess enough power to pursue ambitious legislation if the spirit moves them. ... Second, the Democrats should be highly motivated to pursue tax reform next year. ...  because of a silly thing called the Alternative Minimum Tax ... The third and best reason [is] that tax reform ... is widely acknowledged to be a good idea. The academic community had a civil war over Social Security, but almost everyone ... will recognize a good plan for change once it emerges. ... Even the bitterest partisan would have to concede that the stars are aligned for tax reform. When the commission report finally appears, that will become apparent to everyone.

Just one note.  The academic community will also recognize a bad plan if that is what emerges.  Caroline Baum is next.  She discusses Greenspan's "return" to his Randian roots as he attempts to influence his legacy and is less than impressed with his effort:

Greenspan, Term Ending, Returns to Randian Roots, by Caroline Baum, Bloomberg: ...Alan Greenspan ... surely wants to have some say in how he'll be remembered. Perhaps that's why ... he returned to his philosophical roots in a speech last week... Greenspan provided a brief history of the changing attitudes toward the government's role in the economy ... and the ultimate triumph of free markets ... Greenspan was present at the creation of Ayn Rand's masterpiece as part of the free-market philosopher's inner circle in the 1950s. ... The last third of Greenspan's speech last week ... left Ms. Rand to fend for herself ... While Greenspan's topic last week was ostensibly how greater flexibility has enabled the U.S. economy to handle shocks, the speech was really ''an attempt to rewrite history and can only be titled, 'Damn, I'm Good,''' ... Rand believed that individuals, including investors, act in their own self-interest. Greenspan is certainly acting in his. On that score, at least, his mentor would be proud.

Some say Greenspan exercised too much discretion, others too little, that he may have stayed the course too long, or that he should stay the current course of low interest rates longer.  I have been critical of his politics and his failure to loudly connect the budget deficit to its implications for monetary policy, and of course there is the continuing debate over his connection to and responsibility for the stock market and housing bubbles.  The porridge is too hot, the porridge is too cold, and as the cook prepares to retire everyone has suggestions for the next cook on how to make the porridge better.  Hardly anyone says the porridge was just right, though some did in the past, and that's understandable as everyone vies to change the recipe more to their liking. But whatever his shortcomings, we could have done a lot worse.  When the new cook arrives, we might love the new and improved porridge.  But then again, the day could come when we miss that old porridge even if we were never quite sure how it was made.

Krugman: Miserable by Design

Paul Krugman looks at federal aid to victims of Hurricane Katrina and addresses failure in health care and housing arising from the dual problems of incompetence and politics:

Miserable by Design, by Paul Krugman, NY Times: ...Start with health care, where conservative senators, generally believed to  be acting on behalf of the White House, have blocked bipartisan legislation that would provide all low-income victims of Katrina with health coverage  under Medicaid...

According to Krugman, the worry over extending Medicaid benefits to all poor victims of the Hurricane is political. If Medicaid is expanded it will create a precedent that will open the doors for future claims of similar need, something the White House does not want to occur, and it may also lead to discussions of national health care which the administration wants to avoid:

In a letter urging Senate leaders to reject the bill, Mike Leavitt, the  secretary of Health and Human Services, warned that it would create "a new  Medicaid entitlement."

People with medical needs will need to be treated somewhere and the effect of this policy is to shift the costs to the states:

...surveys show that many destitute survivors of Katrina are being denied Medicaid, and some are going without medicines they need. Local hospitals and doctors will often treat Katrina victims even if they can't pay. But this means that communities that have welcomed Katrina refugees will, in effect, be financially punished for their generosity...

Krugman next discusses housing. After noting that both conservatives and liberals are in wide agreement that housing vouchers are superior to housing projects (here's my support), he notes:

...But the administration has chosen, instead, to focus its efforts on the creation of public housing in the form of trailer parks, which ... will almost surely be more expensive than a voucher program and may create long-term refugee ghettoes. Even Newt Gingrich calls this "extraordinarily bad policy" that "violates every conservative principle."

So why is the administration abandoning long-held conservative principles? Why trailer parks? Why is medical care for victims of Hurricane Katrina being delayed or denied, something even many in the GOP such as senator Grassley do not favor (see GOP resists Grassley's more caring plan for aid from The Des Moines Register). How can we understand the administration's post-Katrina policy? Krugman explains:

...President Bush['s] ... mission ... is to dismantle or at least shrink the federal social safety net ... Mr. Bush can't avoid helping Katrina's victims, but he doesn't want to legitimize institutions that help the needy ... As a result, his administration refuses to use those institutions, even when they are the best way to provide victims with aid. More generally, the administration is trying to treat Katrina's victims as harshly as the political realities allow, so as not to create a precedent for other aid efforts. As the misery of the hurricane's survivors goes on, remember this: to a large extent, they are miserable by design.

UPDATE: Health Care for Katrina Victims, Editorial, NY Times: The White House has now spent nearly three weeks blocking a bipartisan effort to pay for medical care for the impoverished victims of Hurricane Katrina. On Sept. 16, Senators Charles Grassley and Max Baucus, the Republican and Democratic leaders of the Senate Finance Committee, introduced a bill that would extend Medicaid health coverage for five months to low-income childless adults from Katrina-struck areas. In addition, the bill would expand the pool of traditional Medicaid recipients to include pregnant women, children and the disabled ... The bill would also commit the federal government to paying 100 percent of victims' Medicaid bills rather than requiring the states to pay a share. Full federal payment is vital... without assurance of 100 percent coverage by the federal government, states that treat evacuees could be penalized by getting stuck with all or part of the bill. ... The administration also does not want the federal government to pick up the states' share for Medicaid costs incurred in Louisiana, Mississippi or Alabama in the post-Katrina period. Those three states would also have to pick up other states' costs to treat evacuees ... The Grassley-Baucus bill set the stage for efficiently providing much-needed medical care to Katrina's victims. But a few senators, widely seen to be carrying the administration's water, have thus far blocked a vote. The Senate majority leader, Bill Frist, could clear the way for a vote by the full Senate this week. What is he waiting for?

I've Got Robospurs that Jingle, Jangle, Jingle...

Combine a critical shortage of jockeys, national heritage, some imagination, and lots of money,  and the result is remote controlled robojocks:

Ride 'em, Robot, WSJ: ...The camel-racing world in Qatar ... was on the brink of turmoil. Although a minimum age of 15 years for jockeys was set in 1980 across the Gulf, antislavery groups estimate that thousands of underage jockeys are still used in the region. ... Two years ago the U.S. State Department and human-rights groups began sharply criticizing the use of children as jockeys, and last year the United Nations urged prosecution of adults involved in it. Qatar, along with the United Arab Emirates, raised the minimum age to 18, and expressed a new determination to enforce it. But that's left camel racing in a quandary. To get the most out of their camels, camel racers say, jockeys should weigh less than 60 pounds. That rules out even teenage boys... Known as the "sport of sheiks," camel racing is a multimillion-dollar industry in the Gulf. Camels are valued for the role they played in the deserts of the Gulf -- transporting Bedouins and their belongings in the days before the region found statehood and wealth -- and racing them is considered part of the national heritage... With heritage, big business and the country's reputation at stake, Qatar's prime minister, Sheik Abdullah bin Khalifa Al-Thani, assured his population ... that some way would be found to save this "indispensable sport." Soon he called Sheik Abdullah bin Saud Al-Thani, chairman of the Qatar Industrial Development Bank and a prominent member of the clan that rules the country, floating the idea of developing a robot jockey. Mr. Al-Thani, ... organized a Robotic Jockey Committee ... After speaking with breeders, trainers, racers and psychologists, the committee summarized the relationship between the camel and jockey ... Camels' eyes, for example, roll back far enough to see directly behind them. This meant any robotic jockey would have to bear some resemblance to a human. Camels also have exceptional hearing and might be spooked by mechanical sounds ... The committee concluded that what was needed was a remotely controlled robot with a human form and voice. ... Back in Switzerland, it took months at the drawing board to adjust balance and shock-absorption and to protect against heat. ... The final product is a 59-pound, human-shaped droid. Mechanical arms and legs help it lean, balance and pull at the reins. The robots are fixed to the special camel saddle, equipped with straps, hooks and clips to keep them in place. They receive orders from trainers riding along behind via a remote-control system attached to the back of the camel. Equipped with a global positioning system, cameras and microphones, the devices allow trainers to track the animal's heart rate ... the sounds they make and even their facial expression. And the trainer can use a microphone to deliver such exhortations as the typical "haey hej'in!" The camel trainer uses a joystick on a laptop-size control box to give commands... The robot can also operate a whip, and a button on the joystick sends a signal to pull the reins sharply for an emergency stop. After initial skepticism, some camel owners are warming to the robojocks. "They listened to us and kept coming back to show us what they were making and to ask our input," says trainer Omar Al-Bakher. "And it's good what they've made." The government is providing camel owners complimentary two-day training courses in robot jockeying, for which demand is increasing. Over 50 Qatari camel trainers, out of perhaps 100 in all, have received diplomas. Qatar will sell the saddles at subsidized prices, and rent out the robots by the race. The robots will make their debut when the six-month camel-racing season begins later this month.

Has the IMF Been Asleep at the Wheel?

Has the IMF been too silent in its duty to exercise “...firm surveillance over the exchange rate policies of its members, and [to] adopt specific principles for the guidance of members with respect to those policies?"  Morris Goldstein and Michael Mussa of the Institute for International Economics argue the IMF needs to play a stronger role as "unbiased, international umpire of exchange rate policies" in order to avoid trade wars and the chaos such wars bring about:

The Fund appears to be sleeping at the wheel, Comment by Morris Goldstein and Michael Mussa, Financial Times: Frustrated with the lack of meaningful exchange rate adjustment by China and some other Asian economies, the US Treasury has called on the International Monetary Fund to be more ambitious in its surveillance of exchange rates and warned that the “perception that the IMF is asleep at the wheel on its most fundamental responsibility – exchange rate surveillance – is very unhealthy both for the institution and the international monetary system”. We agree ... But continued acrimony between the IMF and its largest shareholder would not be helpful – especially when the world economy faces critical challenges in reversing large and rapidly rising payments imbalances. ... the Fund has repeatedly emphasised that the massive US external deficit and the corresponding surplus of the rest of the world must start declining. The IMF has rightly focused on many of the policy adjustments important for reducing payments imbalances ... This includes pressing the US for a more responsible fiscal policy.

But ...[while] the Fund has ... endorsed general calls for China and other Asian economies to adopt “more flexible” exchange rate regimes ...[it] has failed to emphasise the need for significant exchange rate appreciation to help reduce global imbalances. ... Massive, sustained, one-way intervention in the foreign exchange market ... has kept the renminbi from appreciating meaningfully against the dollar in nominal terms and has induced moderate depreciation in China’s real effective exchange rate. Many other Asian economies have also limited the appreciation of their currencies. In contrast, the market-determined exchange rates of European countries and of Australia, Canada and New Zealand have appreciated very substantially against the dollar since early 2002. ... Moreover, large-scale, prolonged, one-way intervention by several Asian countries to resist meaningful appreciation is clearly contrary to the IMF’s stated principles for the guidance of members’ exchange rate policies. Yet, the IMF has held no special consultations with Asian countries on their exchange rate policies. Nor has it provided explicit and public advice on the extent of necessary policy adjustments. ... Against this background, it is simply not credible for Rodrigo de Rato, the Fund’s managing director, to claim the IMF has been “well ahead of the curve” in its exchange rate advice to China, that there is “no evidence” that China has been running foul of IMF exchange rate guidelines, ... The key issue is that present exchange rate levels in Asia are not consistent with the need to reduce global payments imbalances in a way that minimises risks of financial disruption and supports sustainable global growth. The IMF has a clear responsibility to address this. More sound bites on the need for “greater flexibility” in currency regimes will not suffice...

If the IMF fails in these duties, others will take up the task. This is apparent in the widespread Congressional support for the Schumer-Graham bill that would impose high US tariffs on Chinese imports to offset the estimated undervaluation of the renminbi. Down this route lies a potential trade war and international chaos. The only viable alternative is to insist that the IMF does its assigned job as the vigorous, competent, unbiased, international umpire of exchange rate policies.

I am in general agreement so long as this is not used to justify past, present, or future U.S. fiscal deficits.

Sales Pitch or Just Another Speech?

Why is Marty Feldstein selling a Social Security reform plan?  Why now? It's a fairly detailed plan that involves a 1.5% opt-in carve-out from payroll taxes that comes with a government match, though the details of how the match and the transition would be funded are left vague. The plan itself, which Feldstein admits may not be the best plan (then why the detail?), is not of as much interest as the question of why he is selling a plan now. Is he seeking administration favor as they think about a new Fed chair? Is this the start of new reform push for the future?  Is that why he expresses confidence a plan will pass before Bush leaves office? Or is it just a dusty old speech he pulled out because it fit well with the theme of the Trinity University Policymaker Breakfast he had been invited to?  Don't you think he could have found another speech to give?:

A font of wisdom on Social Security, David Hendricks, San Antonio Express-News: President Bush ought to hire Harvard University economics professor Martin Feldstein as the White House spokesman for the administration's Social Security reform plan. With clarity and grace, Feldstein can ... articulate an understandable argument for adding personal investment accounts to Social Security's existing annuity program. ... And he did it in a way that puts to shame the muddled presentations that Bush Cabinet secretaries have delivered... Feldstein also offers something neither the Bush administration nor Congress has yet — a detailed plan for personal accounts. ... Feldstein's plan starts with the 10.6 percent payroll tax that funds Social Security's main retirement benefits. The total tax is 12.4 percent, divided equally between employees and employers, but the difference is set aside for the Social Security Administration's disability and survivor benefits programs. Feldstein's plan would carve out 1.5 percentage points from that 10.6 percent payroll tax. If a worker opted in, the government would match that amount as an incentive to start the private investment account. Workers could invest in a handful of investment funds — all broadly invested in stocks and bonds ... that over the past 50 years have averaged an annual yield of 7 percent. That return is not guaranteed, Feldstein stressed. But even if only half of that materialized, retirees still would receive 95 percent of the benefits promised under current formulas. The plan sounds plausible, but it would have to withstand a great deal of national scrutiny and analysis. Where the money would come from for the government match is one question. Feldstein said it may not be the best plan, but at least it helps the public better understand what Bush is urging, in principle. Until Bush provides this kind of detail, it's doubtful workers will rally behind his general proposal. ... Bush, it turns out, may need Feldstein for a bigger role than Social Security reform spokesman. Feldstein is a former chairman of the Council of Economic Advisers under President Reagan, and he's ... being mentioned as a potential replacement for Federal Reserve Chairman Alan Greenspan ... Feldstein said ... that he would serve if appointed by Bush.

Sadly, 'It is Not Even Wrong'

What do weblogs devoted to string theory blog about?

Not Even Wrong: Pauli and Not Even Wrong: When I first started thinking about using “Not Even Wrong” as the title of a book, I did some research to try and find out where the supposed Pauli quote came from. No one seemed to have any information about this, other than the attribution to Pauli, and various different stories existed about the context in which he had used the phrase. I started to worry that these stories, like many of the best ones about Pauli, might be apocryphal, so I contacted a few physicists who had some connection to Pauli to ask them about this. Prof. Karl von Meyenn, the editor of Pauli’s correspondence, wrote back to tell me that the phrase doesn’t occur in his correspondence. He pointed me to a biographical notice about Pauli written soon after his death by Rudolf Peierls as the best source for the story of Pauli using the phrase. Peierls writes

No account of Pauli and his attitude to people would be complete without mention of his critical remarks, for which he was known and sometimes feared throughout the world of physics … No doubt many of the stories of this kind circulated about him are apocryphal, but the examples below come from reliable sources or from conversations at which the writer was present … Quite recently, a friend showed him the paper of a young physicist which he suspected was not of great value but on which he wanted Pauli’s views. Pauli remarked sadly 'It is not even wrong.'

The Peierls article is in

Biographical Memoirs of Fellows of the Royal Society, Vol. 5 (Feb. 1960), 174-192.

It is on-line via JSTOR. Just recently, Oliver Burkeman wrote a short piece for The Guardian about the Pauli phrase and its recent uses. I talked to him on the phone about this...

If you are disappointed not to find string theory, the site has plenty of posts like Is N=8 Supergravity Finite?. Be sure to go through the presentation pages...

Inflation Models and Their Shortcomings

Federal Reserve Governor Donald Kohn discusses inflation modeling to open this conference on The Quantitative Evidence on Price Determination.  He begins by noting some important lessons learned by policymakers over the last 20 years such as the temporary tradeoff between inflation and unemployment and how that relates to the importance of stable inflationary expectations.  He also cites the Taylor rule and more significantly the Taylor principle as an important lesson as well.  The Taylor principle is discussed here, including some of the empirical evidence underlying the debate, but let me elaborate a bit.  The Taylor rule, in its simplest form which will suffice for this discussion, is

ff = a + b(y-y*) + c(π-π*)

where ff indicates the federal funds rate, y* and π* are the target values of output and inflation, y and π are the actual values, and a, b, and c are policy parameters chosen by the Fed. The Taylor principle says that c should be greater than one, i.e. a 1% increase in inflation should be met with an aggressive larger than 1% increase in the federal funds rate (more generally the Taylor rule is forward looking so that it is expected inflation rather than actual inflation relative to target that matters, though this is not a settled area and just one of many considerations, some of which are noted below).

While policy has appeared to work fairly well, Kohn notes there is plenty left to learn.  In particular, he would like to see a more formal role for input cost determination in the models (energy costs in particular) so that the Fed can better understand why the relationship between input costs and inflation has seemingly changed over the last twenty years.  Is it policy?  Is it information technology or some other structural change?  It is clear he is not confident the Fed knows how to respond optimally to energy price shocks.  The other issues he cites as needing further research are expectation formation and credibility.  Are expectations rational?   Is learning important when policy changes?  How does credibility interact with other elements in the models?  Another issue, a key one since wages play a key role in most New Keynesian models, is wage setting behavior.  Again, his remarks indicate the Fed is not satisfied with its understanding of the wage-setting process and in turn its understanding of why wages appear less responsive to changes in productivity than in the past.  Last, he notes a variety of data issues which hinder our ability to investigate these issues.

He concludes by issuing a caution that policymakers not become overconfident in their ability to manage the economy, one that is worth repeating because policymakers have made that mistake in the past, notably with the discovery of the Phillips curve in the early 1960s. The increased macroeconomic stability in recent years known as the Great Moderation may have little to do with policymakers after all, instead it may have arisen from good luck and important structural changes in information and other technology.  Policymakers and researchers must not become complacent in their search to understand of the policy process.  Here are his remarks:

Inflation Modeling: A Policymaker’s Perspective, by Governor Donald L. Kohn At the Quantitative Evidence on Price Determination Conference, September 29, 2005: An occasion like this one is a natural opportunity to reflect on how policymakers' understanding of the inflation process has progressed over time. Clearly we have come a long way since the early 1970s. Most important, we have absorbed the central lesson of Milton Friedman's 1968 address to the American Economic Association--that any tradeoff between inflation and unemployment is only temporary because of the dynamic nature of expectations. We have also taken on board the practical application of this lesson that monetary policy must be vigilant about anchoring inflation expectations. Operationally, maintaining price stability requires abiding by the Taylor principle of raising nominal interest rates more than one for one in response to movements in inflation, especially those movements perceived as persistent. It also requires that policy tighten or ease systematically to bring aggregate demand in line with the economy's productive potential, not only because output stabilization is a policy objective in its own right but also because such actions help to head off undesirable changes in inflation down the road. These basic precepts, embraced by central bankers everywhere, have almost certainly contributed to the improved performance of inflation over the past decade or two, and this better price performance probably has helped to damp business cycles. ... Still, when it comes to inflation modeling and policymaking, as my grade school report cards used to say: There is room for improvement. ... What properties am I looking for in a model of inflation and the economy overall?

Putting the Gini Back in the Bottle

Chinese officials are promising a more equitable distribution of wealth over the next five years:

Chinese Officials Vow to Spread Growth Benefits, by Edward Cody, Washington Post: The ruling Communist Party vowed Friday to spread the benefits of economic growth more fairly among all levels of Chinese society, seeking particularly to close the yawning income gap between farmers and city dwellers. The pledge, issued by the Politburo, the country's top policymaking body, was seen in part as a response to growing unrest, especially in small towns and villages, ... "In the next five years, China should pay more attention to social fairness and democracy and earnestly solve the problems closely related to the people's interests," ... The statement ... reported on a meeting of the 25 Politburo members ... in Beijing under President Hu Jintao, who is general secretary of the Central Committee and thus the senior party leader. ... Hu and his premier, Wen Jiabao, have strongly emphasized the need for more equitable wealth distribution since taking over the Chinese leadership nearly three years ago. Nevertheless, the gap between rich and poor has continued to widen ... The Politburo's call for more determination to attack the problem reflected growing awareness ... that widespread dissatisfaction over the glaring inequalities has become a potentially troublesome political issue. The number of violent incidents across the country has shot up dramatically over the last year ... most stem from economic grievances against local authorities. ... Study Times, the party school's official organ, warned last week that the alliance between party and business, often greased by corruption, itself is a big reason for the income inequality that has farmers so upset. Citing a study published by the Labor and Social Security Ministry, the paper said incomes gaps have reached "the yellow light alarm level" and within five years could reach a "dangerous red light level" that could result in "destabilizing social phenomena" unless something is done to change the trend. Some Chinese academics interpreted that comment as an attempt by concerned government officials to make sure the issue received a prominent place on the Central Committee agenda and in the next Five-Year Plan. Judging from the report published Friday, their tactic was partially successful--the income gap got a prominent spot, but corruption was not mentioned...

---

Note: Gini coefficient definition.

Hooked on Chopsticks

Being good at sports is so easy - just take away the silverware:

Korean golf secret exposed, Asiapundit: Korean female golfers continue to excel in the Lady's Professional Golf Association (LPGA). In fact out of the top 30 female professional golfers, 10 of them are Korean. You may be asking yourself, how is a small country like Korea able to dominate women's professional golfing? What is the secret to their success? Is there some kind of advanced training regimen or some mystic Korean herbal tea that is giving them such an advantage? Well look no further, the Korea Times has leaked the ancient Korean secret to becoming a master golfer; the ability to use chopsticks:

Hankooki.com > The Korea Times > Sports > Dexterity Enables Korean Lady Golfers to Dominate US LPGA: What enables South Korean lady golfers to be so formidable in the U.S. LPGA Tour? It is nothing less than the Koreans’ talent to make things skillfully with their hands, a trait handed down from generation to generation for thousands years. Celadon in Koryo and the Yi dynasty are world famous for blue and white china in quality, and you know that pottery involves the same skills as playing golf. Not to change the subject, South Koreans’ special talent to make things skillfully with their hands is also believed to greatly contribute to their making almost a clean sweep of the World Skills Competition. By the same token, Koreans are good at various sports that are played chiefly with the hands: handball, archery and table tennis, to name a few. Professor Hwang Woo-suk of the Seoul National University who led the first cloning of embryonic human stem cells told in a public lecture that one of his assistants surprised the stem cell big shots of the world with his skills, which were beyond their imagination but actually nothing for Koreans. Professor Hwang, referring to the use of chopsticks, mentioned that the Koreans’ skill with their hands contributed to their success in cloning embryonic human stem cells. An editor golf fan of an English daily newspaper mentioned that one of the root causes for Korean ladies to play such great golf in the U.S. is closely connected to dexterity, which is also critical to preparing delicious Kimchi, a Korean side dish loved by the people around the world.

That is right folks, chopsticks! With the ability to use chopsticks you can become a top professional golfer, make pottery, play handball, become a master archer, and if you still got some time left you can do a little embryonic stem cell cloning on the side. This is not to mention the fact you can be a skilled maker of Kimchi. ... Something else to consider before you start practicing your chopstick skills, don't practice using them like the Chinese or Japanese, follow only the Korean technique for using chopsticks and food preparation:

Japanese, who also use chopsticks like Koreans, once produced a golf great named Ayako Okamoto, who became a member of the LPGA Tour in 1981 and won 17 events between 1982 and 1992. She was recorded as the first woman from outside the U.S. to top the LPGA tour's money list in 1987. ... Despite this, the Japanese do not surpass Koreans in the golf world possibly because they ... use sashimi knife in preparing raw fish, their all-time favorite, instead of directly using hands as Koreans do. Similarly, the Chinese do not distinguish themselves as much as Koreans in the LPGA tour of America because they do not stress the role of hands in making foods. ... Mostly they use fire to create taste instead of using their hands. ... Of course, there are some other factors that make all the great achievements possible including tenacity and indomitability, two characteristics of Koreans, along with quite a lot of synergy among the South Korean golfers. But without the dexterity unique to Koreans their great success would be hard to imagine. 

For those not familiar with the Korean media, these type of articles are very common to reinforce Korean pride and sense of superiority, especially over the Japanese and the Chinese. Everything seems to revolve around Kimchi, chopsticks, and Dokto. My only question is how did Annika Sorenstam become so dominant without Kimchi, chopsticks, and Dokto? If you haven't had enough chopsticks and Kimchi you can read more about it over at Cathartidae.

The Decline in Manufacturing Jobs

The Economist takes a look at trends in manufacturing and service employment. The article argues that the trend towards a more service oriented economy is a good thing and nothing to be concerned about.  Since I didn't agree with that conclusion, I deleted all but the descriptive part of the article.  It's not clear to me that a shift of employment from manufacturing to services makes all workers better off, so I'm not willing to follow The Economist and conclude it is necessarily a good thing:

Industrial Metamorphosis, The Economist: For the first time since the industrial revolution, fewer than 10% of American workers are now employed in manufacturing. And since perhaps half of the workers in a typical manufacturing firm are involved in service-type jobs, such as design, distribution and financial planning, the true share of workers making things you can drop on your toe may be only 5%. ... Our figure of 10% comes from dividing the number of manufacturing jobs—just over 14m, say the latest figures—by an estimated total workforce (including the self-employed, part-timers and the armed forces) of 147m. In 1970, around 25% of American workers were in manufacturing. The share of manufacturing has also been falling in all other developed economies since 1970... (see chart 1).

Indeed, the actual number of manufacturing jobs has fallen by half since 1970. ... Most people today work in services: in America, as many as 80%. But this trend is hardly new. As early as 1900, America and Britain already had more jobs in services than in industry. Even at its peak, early in the 20th century, employment in manufacturing never exceeded one-third of America's workforce. What is new is the recent absolute decline in factory employment. Although manufacturing has long been shrinking as a proportion of America's expanding workforce, the number of industrial jobs stayed more or less the same between 1970 and the late 1990s. Since then, however, manufacturing employment has fallen in every year. Chart 2 shows that since 1996 the number of manufacturing jobs has shrunk by close to one-fifth in America, Britain and Japan. In the euro zone, the average loss has been only 5%. Similarly, manufacturing output has fallen as a proportion of GDP (measured in current prices)...

... Any analysis of labour-market trends soon gets bogged down in a statistical swamp. For instance, a small part of the fall in manufacturing jobs is a statistical illusion caused by manufacturers contracting out services. If a carmaker stops employing its own office cleaners and instead buys cleaning services from a specialist company, then output and employment in the service sector appear to grow overnight, and those in manufacturing to shrink, even though nothing has changed. More generally, the line between manufacturing and services is blurred. McDonald's counts as a service company, but a visit to any of its restaurants puts one in mind of an industrial assembly line, turning out cooked meat products. Similarly, an increasing slice of value-added in manufacturing consists of service activities, such as design, marketing, finance and after-sales support. Last but not least, Britain's number-crunchers stick The Economist, along with the whole publishing and printing industry, in manufacturing, even though almost all our staff are engaged in service-like activities...

Rose-Colored CBO Glasses

The CBO has a fairly rosy forecast of the post hurricane economy:

CBO: Hurricanes' Economic Hit Less Severe, by Andrew Taylor, AP: Cost estimates are incomplete and the data is still coming in, but it seems clear that the economic fallout from the twin hurricanes that hit the Gulf Coast may be less severe than previously feared ... The CBO estimated that the hurricanes' overall impact on the economy would be about one-half of a percentage point for the second half of the year. That compares with a CBO analysis on Sept. 6 that said the impact could be as much as a percentage point. ... When considering private and government support for recovery and rebuilding, the storms will not affect growth in the gross domestic product over the final three months of 2005, Holtz-Eakin said. In fact, economic growth "could even be somewhat higher than was projected before the hurricanes," said Holtz-Eakin, head of the nonpartisan agency that provides economic and budget data to Congress. Most of the economic losses _ as much as 1.5 percentage points _ would come in the July through September period. ... On inflation, the CBO predicted a greater impact than previously seen, almost entirely due to higher energy and gasoline prices. The consumer price index may be almost 1 percentage point higher for the period between the fourth quarter of 2004 and the fourth quarter of this year than previously expected..."But consumer price inflation should revert to pre-Katrina rates in the first half of 2006 ..." CBO said.

Tax Reform Panel Report Delayed

The deadline for the Tax Reform Panel to issue its recommendations has been delayed again:

Bush's Tax-Simplification Plan Pushed Back, AP: A White House commission that's supposed to recommend ways to make income taxes fairer and simpler has been given another extension... When President Bush created the President's Advisory Panel on Federal Tax Reform in January, he told members to report back to him by July 31. In June, that date was pushed back to the end of September. On Friday, the president said the new date is Nov. 1 to finish the report and Nov. 15 to close down their operation.  ... The commission has been examining the possibility of basing taxes on spending rather than income, which could mean a national sales tax or a European-style value-added tax, or recommending some combination of income and consumption taxes.