Since the WSJ is, essentially, rerunning op-eds:
May as well rerun a few of the responses:
[See also Don’t know much about history. by Paul Krugman.]
Since the WSJ is, essentially, rerunning op-eds:
May as well rerun a few of the responses:
[See also Don’t know much about history. by Paul Krugman.]
Brad DeLong places government policy into "three boxes," fiscal policy, monetary policy, and capital markets policy:
Monetary Policy, Fiscal Policy, Capital Markets Policy, by Brad DeLong: Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:
Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.
I would put it somewhat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.
If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.
You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.
I would add risk management to the definitions (e.g., I have called the central bank the "risk absorber of last resort"). When the Fed (or any other government agency) trades T-Bills for risky private sector assets, it changes the overall level of risk in the private sector since the risk has been absorbed onto the Fed's balance sheet (this is not the only way to reduce risk, e.g. government provided insurance against losses would also have this effect, and most of these actions can also create moral hazard). The risk management function of policy is something Brad has talked about in the past as well, and I'm not sure if he'd identify risk management as a separate category, or whether it fits into the the capital markets policy categories he identifies (it would also operate on the wedge between safe and risky assets by reducing the risk premium, so I'd include it there). Either way, I think it's worth mentioning since these actions can also affect the level of economic activity. When markets are frozen with fear, reducing the chance that hidden losses will be discovered after a transaction is complete can help to restore these markets.
Bankers are, apparently, being rewarded generously for their fine performance in recent years:
In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits.
If people were really compensated according to the value they create, wouldn't bank managers would owe us money?
Andrew Leonard's bad day:
The brighter side of high unemployment, Andrew Leonard: ...BusinessWeek contributor Gene Marks ... gloats about how high unemployment is good for his business. I guess any publicity is good publicity... But he didn't pick a good day. Having already been irritated enough by David Brooks, I can't say I was exactly in the mood for an explanation of why high unemployment is great for small businesses because now there are so many "good, bright, educated people" who are "willing -- no, let's admit -- grateful to work for less money and longer hours."
Even better, the bad economy provides cover for getting rid of that "dead weight" that you were feeling too guilty to throw overboard. ... And the capper:
Because let's face it: The upside to the high unemployment rate is that it has helped us control our payroll costs. No one's asking for raises. No one's demanding more benefits. ...It's now easier and more politically correct to hire part-timers, subcontractors, and other outsourced help to fill the gaps. That's because when people are out of work, they'll do whatever they've got to do to bring in cash.
I understand that Gene Marks is ... a small business owner (he sells customer relationship management tools), who is attempting to speak to other small business owners, all of whom, presumably, are also delighted that the potential hiring pool is so chock full of talent desperate to be exploited right now.
But one wonders who exactly is supposed to purchase all those products and services from the small businesses of the world, if unemployment creeps up to the 10 percent mark or higher? High unemployment means low consumer demand. Which usually means small businesses end up going out of business, or at the very least, laying off more employees, who push the unemployment rate even higher. And so on. Low employment might mean it would be harder to find qualified employees, but it also means more customers with money burning a hole in their pockets. Which scenario, do you think, is better for society in general?
I have no problem with contrarian arguments. But a look back at the oeuvre of Gene Marks suggests that in his efforts to be routinely contrarian, he ends up coming off as, well, how can I be polite? What's the opposite of insightful?
Here's what set him off:
The decline and fall of David Brooks, by Andrew Leonard: America needs "a moral revival," declares David Brooks... We are drowning in a sea of debt, and this is because we have lost our moorings; we have abandoned our tradition of Calvinist restraint, self-denial and frugal responsibility. If we don't start living right, we run the risk of cultural failure, that time-honored historical pattern in which "affluence and luxury lead to decadence, corruption and decline."
My my my. I've seen some high horses in my day, but David Brooks is perched on a saddle so far aloft in the clouds of self-delusion that he can't even see the earth, much less reality. Let's examine his thesis more closely.
Americans ran up a lot of debt in the last few decades. There's no question about that. But one of the most striking developments of the last year has been how Americans have responded to the financial crisis at an individual level. We made a collective decision to start saving and stop spending. Is this because we woke up one morning last fall and suddenly became born-again Calvinists? No, it seems clear that we were responding rationally to economic incentives. The economy crashed, unemployment surged, home prices plummeted, and presto: We all started pinching pennies. Morality, insofar as expressed via our spending habits, is merely a reflection of the economy.
To his credit, Brooks acknowledges this point. But then he immediately dismisses it:
Over the past few months, those debt levels have begun to come down. But that doesn't mean we've re-established standards of personal restraint. We've simply shifted from private debt to public debt.
This, Brooks suggests, proves that "there clearly has been an erosion in the country's financial values." Elsewhere he suggests that our cultural decline began sometime around 1980.
Brooks displays a bizarre historical amnesia throughout his column. For example, he never even mentions the transition from the Roaring Twenties to the Great Depression. Maybe it's because the shift from decadence to thrift at that point was also obviously a response to economic incentives. Even worse, a moral revival didn't restore economic growth after the Crash -- government action and ultimately the fiscal stimulus provided by World War II did the trick.
But a far more pertinent point of reference comes much earlier. Has Brooks somehow forgotten that just nine years ago the U.S. operated under a balanced budget and enjoyed a budget surplus? The explosion of public debt since that point has very little to do with the moral failings of Americans, and everything to do with objective fact. George W. Bush cut taxes, but did not match those cuts with spending cuts. Instead, he ramped up spending dramatically, on two wars, healthcare, and finally, a huge bailout of Wall Street.
Bruce Bartlett has calculated that even without Obama stimulus-related spending increases, the current deficit for fiscal year 2009 would be about $1.3 trillion instead of $1.6 trillion. If you are a believer in Keynesian economics, you can make a pretty good case that Obama's additional spending is designed to get the economy growing again, so as to avoid even worse deficits in the future. Do nothing, and a shrinking economy means lower tax revenues and higher social spending. Morality has very little to do it -- the appropriate, responsible fiscal choice at this point is for government to spend, while the people save.
Obama would be in much better position to do what's appropriate, of course, if he hadn't been saddled with a trillion-dollar deficit when he walked in the door. But the responsibility for that does not belong with some widespread betrayal of America's founding puritan values. It belongs explicitly to the party in control over the last eight years.
Update: Paul Krugman:
Moral decay? Or deregulation?, by Paul Krugman: Andrew Leonard is unhappy with my colleague David Brooks for suggesting that rising debt in America reflects moral decay. Surprisingly, however, Leonard doesn’t make what I thought was the most compelling critique.
David points out, correctly, that something changed around 1980 — that consumers started spending a larger share of national income and that debt began increasing. Although he doesn’t point this out, this was also when the federal government first began running substantial deficits even in good years.
David would have you believe that what happened then was a decline in Calvinist virtue. But, um, didn’t something else happen around 1980? Can’t quite remember .. someone whose name begins with the letter “R”?
Yes, Reagan did it.
The turn to budget deficits was a direct result of the new, Irving-Kristol inspired political strategy of pushing tax cuts without worrying about the “accounting deficiencies of government.”
Meanwhile, the surge in household debt can largely be attributed to financial deregulation.
So what happened? Did we lose our economic morality? No, we were the victims of politics.
Bruce Judson is worried about what the latest reports on economic inequality say about our future:
New Income Inequality Data: Surprising and Frightening, by Bruce Judson: The newest economic inequality numbers ... are frightening. Yesterday, the Associated Press released an article titled, US income gap widens as poor take hit in recession. The opening paragraph of the article, based on recent census data, reads:
The recession has hit middle-income and poor families hardest, widening the economic gap between the richest and poorest Americans as rippling job layoffs ravaged household budgets.
The article ... failed to mention that the Census Bureau considered the differences between 2007 and 2008, with regard to economic inequality, statistically insignificant. But, whether the Census Data shows a meaningful increase, or not is irrelevant. The Census Data reports that, contrary to the almost universal expectations of economists, economic inequality most likely did not decrease in 2008. Experts had anticipated that the declines in income of the rich would lead to a reversal in this groups ever–widening share of our national income. Instead, the Census reported that the 2008 income losses by the top 10% of Americans were offset by larger losses among middle class and poorer Americans. ...
Early next week, my new book It Could Happen Here will be released... The book is an in-depth look , based on a historical analysis, of the implications of our historically high levels of economic inequality for the nation’s ultimate, long-term political stability. As economic inequality grows, nations invariably become increasingly politically unstable: Should we complacently believe that America will be different?
A central conclusion of the book is that once economic inequality reaches a self-reinforcing cycle it is halted only by inevitably controversial, hard-fought, bitterly opposed government action. ... In 1928, economic inequality was near today’s levels. Franklin Roosevelt succeeded in reversing the trend toward the continuing concentration of wealth, but it was a turbulent battle. ...
In FDR’s era and in our own, money brings power: both explicitly and implicitly, in hundreds of different ways, both large and small. Today, the wealthiest Americans, together with a number of financial and corporate interests that act on their behalf, protect their ever-increasing influence through activities that include, among others, lobbying, supplying expertise to the councils of government, casual conversation at dinner parties, the potential for jobs after government service, the power to run media advertisements that influence public opinion. Indeed, MIT economist Simon Johnston, writing in The Atlantic asserted that the U.S. is now run by an oligarchy...
The new inequality data suggests that the potential problems for the nation associated with the concentration of wealth and power are even more severe than previously recognized. Two weeks ago, I wrote that “Once income concentration becomes a reinforcing cycle of the kind we are witnessing, it is never stopped by pure market forces.” This mechanism is now in full swing. ...
The great strength of American democracy has always been its capacity for self-correction. However, Robert Dahl, the eminent political scientist, recognized that political power fueled by wealth may ultimately neutralize this central aspect of our democracy. In his 2006 book, On Political Equality, Dahl wrote:
As numerous studies have shown, inequalities in income and wealth are likely to produce other inequalities..
The unequal accumulation of political resources points to an ominous possibility: political inequalities may be ratcheted up, so to speak, to a level from which they cannot be ratcheted down. The cumulative advantages in power, influence, and authority of the more privileged strata may become so great that even if less privileged Americans compose a majority of citizens they are simply unable, and perhaps even unwilling, to make the effort it would require to overcome the forces of inequality arrayed against them.
In the chapter following this quote, Dahl notes “that we should not assume this future is inevitable.” He’s right. But he was clearly concerned. ...
Many current Executive Branch initiatives deserve our support and praise: However, nothing proposed to date will effectively halt growing economic inequality, and its corrosive impact on our economy and the long-term future of the nation. ...
My analysis in It Could Happen Here concludes that without a vibrant middle class, the the American democracy as we know it, is not sustainable. Before the Great Recession, the middle class was in far worse shape than was generally acknowledged. In an economy with a record number of job seekers for every available job, the potential for nearly one-half of all home mortgages to be underwater, and increasing foreclosures, the collapse of the middle class will accelerate. With each job loss and each foreclosure, another family becomes a member of the former middle class.
America has never been a society sharply divided between have’s and have not’s. Unfortunately, this new data says to me we continue to head in that direction. Economists assumed that the Great Recession would be a circuit breaker that would halt this advance, at least temporarily. It did not. ...
Could our democracy survive a transformation into a nation composed principally of a privileged upper class and an underclass that struggles from paycheck to paycheck that lacks basic economic security. My analysis of a broad sweep of history, suggests it could not.
We will only stop the growth of economic inequality if the President and the Congress are ready to fight in the style of Franklin Roosevelt. FDR was a divider not a conciliator. Before World War II, he fought an all-out war at home. Today, “There’s class warfare, all right,” as Warren Buffett said, “but it’s my class, the rich class, that’s making war, and we’re winning.”
I fervently hoped that we have not passed the point of no return, described by Professor Dahl. The recent news shows we are one step further on this road. If we continue down it, our nation may be on the path to becoming a House divided against itself, which ultimately cannot stand.
Are you as concerned as he is? I don't know if we are headed down the path of no return or not, but the part that concerns me is that recent changes in inequality do not seem to be driven by market forces that properly evaluate and reward productive activity.
Republicans worry a lot about the effect that small changes in tax rates would have on economic activity (something there's not a lot of evidence to support) because taxes distort the relationship between effort and reward. But if the rewards have become generally separated from productive effort, particularly the large rewards at the very top of the income distribution where the Republicans argue these incentive effects are the strongest, then there are large distortions in the system that have nothing to do with taxes. That is what Republicans ought to be worried about if they are truly concerned with ensuring that the rewards people receive match their productive effort.
Andrew Leigh says this is a "a terrific piece on social mobility":
American dreams, by Peter Browne: When Barack Obama spoke to schoolchildren at Wakefield High School in Virginia last week, he drew on his own experiences to argue that all young Americans, regardless of their family’s wealth and income – even kids who “goofed off” at high school, like he did – have the potential to rise to the top. ...
But how typical is [this]? ... The seductive idea that anyone can move up the income scale might mean that Americans are more tolerant of a degree of inequality that would cause much deeper unease in many other western countries. ...
[R]ecent research drawing on a series of studies from Europe, the United States and Australia ... has concluded ... that among comparable countries, the United States has an unusually rigid social system and limited possibilities for mobility. ...
President Obama is no doubt aware of this research, and has made oblique references to the problems facing low-income families and neighborhoods in speeches and interviews. But the mobility myth is so widely believed and so deep-seated that it’s not surprising he hasn’t tried to confront the problem head on. When the Economic Mobility Project  surveyed 2100 adults and ran ten focus groups earlier this year it found that respondents overwhelmingly believe that personal attributes – “like hard work and drive” – are the prime determinants of how economically successful an individual can be. A smaller majority also disagreed with the statement that “In the United States, a child’s chances of achieving financial success is tied to the income of his or her parent.”
As the studies show, that statement is true for ... a higher proportion of American children than in most comparable countries. Among the twelve countries analyzed by economist Anna Cristina d’Addio in a 2007 OECD report,... the United States was in a group of four – with France, Italy and Britain – where family background plays the greatest role in influencing adult income. Children born into a poor family in any of these countries had a much lower chance of breaking into a higher income group than in any of the other countries in the study. ...
Britain came out worst, with around 50 per cent of a person’s income explained by his or her parents’ income. ... Italy and the United States weren’t far behind, at around 47 per cent. At the other end of the range were Denmark, Norway, Finland and Canada, where parental income explained less than 20 per cent of the child’s eventual earnings. ...[I]t’s those four countries, rather than the United States, that come closest to realizing the American Dream.
Some studies have found that mobility is not only limited in the United States but has worsened in recent decades. ...
Why do some countries fare so badly...? The OECD report offers the most comprehensive list of likely factors, but its conclusions are tentative. ... But looking at the factors that the OECD believes contribute “significantly” to differences in mobility, it isn’t hard to see why the United States performs badly...
First, there’s the problem of entrenched income inequality. “In general,” says d’Addio..., “the countries with the most equal distributions of income at a given point in time exhibit the highest mobility across generations.” Among the twelve countries examined in the report, the United States has the most unequal distribution of income. ...
Equally interesting is the role of immigration in pushing up mobility. Overall, immigrants tend to be more upwardly mobile than the broader population. ... Yet the United States doesn’t seem to have gained the ... benefits from migration... This clearly has something to do with how well migrant students perform at school. ...
The other key factor identified indirectly by the OECD, and more explicitly in a new Economic Mobility Project  report, is a strikingly low level of mobility among black Americans. ... The author of the Project’s report, New York University sociologist Patrick Sharkey, finds that growing up in a high-poverty neighborhood “increases the risk of experiencing downward mobility and explains a sizable portion of the black-white downward mobility gap.”
These neighborhoods usually suffer from other warning signs for low mobility identified in the OECD report, including a high rate of male unemployment at the time of a child’s birth and a high rate of relationship breakdown. ...
For Barack Obama, the ... reform that’s causing him the most difficulty at the moment – healthcare – also has implications for economic mobility. Child birth-weight is a “significant” factor in explaining low mobility, and the child’s mental health and parents’ physical health are “significant and large” factors, according to the OECD. Like any measures designed to break down the rigidity that keeps many Americans poor, improvements in health will take some time to influence overall mobility. But a system of health insurance for all Americans would certainly have an impact in the long term.
Ironically, the remarkable rise of Barack Obama could make it harder for Americans to recognize the shaky foundations of the American Dream. And the fact that so many people continue to believe the myth could make the problem worse. As the American researcher Isabel Sawhill writes, “When those who are relatively poor believe that they or their children will rise in status over time, they are less likely to complain about the status quo and more likely to accept the prevailing system.” ...
Is it true that we tolerate inequality because we believe we are highly mobile, and that merit rather than family background is the most important factor in determining social outcomes? Even if it were true that merit is the most determinant of social mobility, that is not enough. The opportunity must be present before those with merit can take advantage of it, and ensuring that everyone has a chance to succeed is an important step in fixing the mobility problem. Nothing will ever be completely equal, some people will always have more opportunity than others to get ahead, but we could do a whole lot better than we are doing now at creating the opportunity for people to reach their full potential.
I am not generally predisposed to redistributive policies, and the best solution to the mobility problem is to ensure everyone has an equal chance to succeed. But since equal opportunity is a long way from reality, I believe that redistribution that compensates for differences in opportunity is justified.
I am not as negative toward naked short-selling as Matt Taibbi (feel free to convince me I'm wrong), but his insights into the lobbying effort against financial reform are useful, and I share his concerns about the distortions (e.g. regulatory capture) this brings to the reform process:
An Inside Look at How Goldman Sachs Lobbies the Senate, by Matt Taibbi: ...Later on this week I have a story coming out in Rolling Stone that looks at the history of the Bear Stearns and Lehman Brothers collapses. The story ends up being more about naked short-selling and the role it played in those incidents than I had originally planned..., but it turns out that there’s no way to talk about Bear and Lehman without going into the weeds of naked short-selling...
It’s the conspicuousness ... that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture” ... than this issue.
In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.
In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.
It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement...
The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.
In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts... Goldman Sachs in particular has been making its presence felt.
Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.
Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.
Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.
I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” ... was, to quote one person familiar with the situation, “disgraceful” and “hilarious.” ...
David Warsh on Irving Kristol:
The Straw That Stirred the Drink, by David Warsh: Irving Kristol, who died earlier this month at 89, meant many different things to many different people. One way to remember him is as the editor who, with his friend and City College of New York classmate Daniel Bell, founded The Public Interest in 1965, at just the moment the phenomenon known as “the counterculture” was beginning to grip the popular imagination of the West.
The first issue featured Robert Solow on “Technology and Unemployment,” Daniel Patrick Moynihan on “The Professionalization of Reform,” Nathan Glazer on “The Paradoxes of Poverty,” Jacques Barzun on “Art – By Act-of-Congress,” Daniel Greenberg on “The Myth of the Scientific Elite,” Martin Diamond on “Conservatives, Liberals and the Constitution,” and Daniel Bell on “The Study of the Future.”
And for the next fifteen years, while the Americans lost their way in Vietnam, the Soviet economy stagnated, the Chinese people suffered Mao Tse Tung’s Cultural Revolution, The Public Interest was the quarterly that kept its head, serving as a focal point for meliorists of all kinds. Magazines such as People, Money and Rolling Stone built huge audiences in those years; The Public Interest rarely sold more than 12,000 copies. But the people who read it would in due course take over the nation’s politics.
An extraordinary galaxy wrote for Kristol in those days on nearly every social issue of the day (Bell, a professor of sociology at Harvard, cut back his participation after the two disagreed on the presidential election of 1972): Peter Drucker, Milton Friedman, Seymour Martin Lipset, James Coleman, Robert Nisbet, Henry Fairlie, Aaron Wildavsky, William Bennett, James Tobin, Richard Zeckhauser, Thomas Schelling, Herbert Stein, Gordon Crovitz, Anthony Downs, David Gordon, John Meyer, Jeffrey O’Connell, Paul Starr, Christopher Jencks, Charles Reich, Michael Novak, Charles Lindblom, Josiah Lee Auspitz. They were conservatives and liberals alike, but the quarterly’s content steadily trended over the years towards the stance that in time would become known as “neoconservative.” (A terrific full issue-by-issue archive can be found here.)
Kristol “was able to pick a side without losing his clarity,” wrote David Brooks in his New York Times column last week.
The side he picked in economics was an odd one. A 1975 issue featured a pair of articles: “The Social Pork Barrel” launched the career of a young Michigan Congressman, David Stockman, who would become budget director for Ronald Reagan; and “The Mundell-Laffer Hypothesis – a New View of the World Economy,” by Wall Street Journal editorial writer Jude Wanniski, introduced the world to economists Arthur Laffer and Robert Mundell, and their newly-invented brand of “supply side economics.”
The striking thing about Wanniski’s article was its anti-establishment tone, anti-Chicago as well as anti-Cambridge, Mass. The new hypothesis might be as transformative as the Copernican Revolution, he averred – or at least that of John Maynard Keynes. Mundell and Laffer’s enthusiasms for a gold standard, fixed exchange rates, large tax cuts and tight money were picked up and greatly amplified by the editorial page of The Wall Street Journal. The Republican Party was divided – insouciant economic populists in one wing, sober technocrats in another.
In the neo-conservative firmament, the stars of ordinarily first-magnitude conservatives Milton Friedman and Martin Feldstein dimmed, while Laffer and Wanniski brightened. The success of The Way the World Works, Wanniski’s 1979 book for editor Midge Decter, nearly ripped apart the boutique social science publisher Basic Books, where Kristol worked as an editor as well.
By then The Public Interest was losing its force. As James Q. Wilson wrote the other day in The Wall Street Journal, “It began to speak more in one voice and the number of liberals who wrote for it declined.” Daniel Bell quietly resigned, in 1980. It didn’t matter. The Republicans were in power; and Kristol was ready for a second act. He would become widely known as “the Godfather” of neo-conservatism, dispensing favors and advice as a political activist operating out of the American Enterprise Institute in Washington.
In its obituary last week, The Economist summed up this second act of Kristol’s career: “American conservatism, before he began to shake it up, was dour, backward-looking, anti-intellectual and isolationist, especially when viewed from the east coast. By the time Mr. Kristol … had finished with it, it was modern and outward looking, plumped up with business-funded fellowships and think tanks and taking the lead in all policy debates.”
Success profoundly changed the game. The Cold War ended. The discipline and sense of fair play seemed to go out of civic life. There hasn’t been anything like The Public Interest since. But for fifteen crucial years in the late ’60s and ’70s, Kristol’s editing was the straw that stirred the drink.
Irving Kristol explains where the economics articles he published in The Public Interest came from:
Among the core social scientists around The Public Interest there were no economists.... This explains my own rather cavalier attitude toward the budget deficit and other monetary or fiscal problems. The task, as I saw it, was to create a new majority, which evidently would mean a conservative majority, which came to mean, in turn, a Republican majority - so political effectiveness was the priority, not the accounting deficiencies of government...
Simon Johnson and James Qwak wonder how much political capital the administration is willing to use to meaningfully reform the financial system:
It's Crunch Time: The Fight to Fix the Financial System Comes Down to This, by Simon Johnson and James Kwak, Commentary, Washington Post: The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.
The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.
But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...
We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.
Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...
Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.
The initial bill needs to be as strong as possible, and I agree that the administration needs to do what it can to prevent the bill from being scaled back. However, the initial legislation won't be as strong as I'd like even if the administration does prevail. But I hope we aren't thinking that we'll take one stab at financial reform and then we'll be done with it. Like climate change and health care, it will require a series of bills to achieve effective reform.
Chris Dillow says the British TV show Come Dine with Me "raises important issues about the nature of rationality and preferences":
Come Dine With Me: the economics, by Chris Dillow: It’s insufficiently appreciated that Come Dine with Me raises some profound issues in economics. Here are three:
1. The importance of norms of fairness. The format of CDWM is simple. There are four people. Each hosts a dinner party for the other three. The guests score their host out of 10. The person with the highest score wins £1000.
In this game, the optimum strategy for a guest is to score their hosts zero. This would mean the maximum score one’s rival hosts could make would be 20, which in a normal game would not usually be sufficient to win. So, if your three rivals play normally, scoring them zero greatly increases your chances of winning.
If everyone knows this, we end up in a Nash equilibrium in which everyone scores zero; this is a one-shot game with scores revealed only after all four dinner parties, so tit-fot-tat doesn‘t apply.
But this never happens. Even contestants who claim to want to win score their rivals reasonably. This suggests that norms of fairness overwhelm selfish optimization*.
This raises the question, though: why is CDWM so different from Golden Balls - which is a pure Prisoners‘ Dilemma game - where we often see the selfish defect-defect strategy?
The answer, I suspect, lies in the abundance effect. The difference between CDWM and Golden Balls is that in the latter money is much more salient. And research (pdf) shows that, the more people think about money, the more selfish they behave.
The lesson is that context - not just incentives - matter.
2. The trickiness of inter-personal comparisons of utility. Let’s assume that games are scored purely according to perceptions of fairness. It doesn’t follow that everyone has an equal chance.
Paul Krugman on Crowding In:
I’m at two deficit conferences Wednesday ... on what to do about the deficit,...[and] why we need to run deficits now. I’m trying to organize my thoughts...
Why, exactly, do we think that budget deficits are a bad thing? The textbook answer identifies two reasons — two ways in which budget deficits now make us worse off in the future. They are:
(1) The fiscal burden: deficits now mean higher debt later, which will have to be serviced, and that means higher taxes and/or less spending on other, presumably desirable things.
(2) Crowding out: when it runs deficits, the government competes with the private sector for funds, so deficits crowd out private investment, which reduces potential growth
All this makes sense under normal conditions. But right now we’re not living under normal conditions. We’re in a situation in which the economy is deeply depressed, and monetary policy — the usual line of defense against recession — is hard up against the zero-interest-rate bound. This weakens argument (1) — and it actually reverses argument (2).
On argument (1): it’s still true that an increase in government spending raises future debt. But not one for one: because higher spending raises GDP, it leads to higher revenue, which offsets a significant fraction of the initial outlay. A back-of-the-envelope calculation suggests something like a 40 percent offset is plausible, so fiscal stimulus only costs 60 percent of what it costs.
But the really dramatic difference is for argument (2). Under the kind of conditions we’re now facing, the main determinant of business investment is the state of the economy, as evidenced by the plunge in investment shown in the figure. This, in turn, means that anything that improves the state of the economy, including fiscal stimulus, leads to more investment, and hence raises the economy’s future potential.
That is, under current conditions deficit spending doesn’t lead to crowding out — it leads to crowding in. In fact, you could argue that the worst thing we can do for future generations is NOT to run sufficiently large deficits right now.
Things won’t always work this way. Eventually we’ll emerge from the liquidity trap, and the normal rules of economic prudence will reassert themselves. But we are not there, or anywhere close to there, right now.
Let me also suggest: Crowding-Out and Crowding-In. Here's the bottom line:
...Let us summarize what we have learned ... about the crowding-out controversy.
• The basic argument of the crowding-out hypothesis is sound: Unless the economy produces enough additional saving, more government borrowing will force out some private borrowers, who are discouraged by the higher interest rates. This process will reduce investment spending and cancel out some of the expansionary effects of higher government spending.
• But crowding out is rarely strong enough to cancel out the entire expansionary thrust of government spending. Some net stimulus to the economy remains.
• If deficit spending induces substantial GOP growth, then the crowding-in effect will lead to more saving-perhaps so much more that private industry can borrow more than it did previously, despite the increase in government borrowing.
• The crowding-out effect is likely to dominate in the long run or when the economy is operating near full employment. The crowding-in effect is likely to dominate in the short run, especially when the economy has a great deal of slack.
• Surpluses have just the opposite effects. When slack exists, they are likely to slow growth by reducing aggregate demand. But in the long run, budget surpluses are likely to foster capital formation and speed up growth.
And finally, see also ZIRP Deficits cause Crowding In of Investment, by reducing Deflation.
Robert Reich says of the public option for health care insurance, "yes we can," even if it means overriding the promises of the person identified with the phrase:
The Public Option Lives On, by Robert Reich: Tomorrow (Tuesday) is a critical day in the saga of the public option. Democrats Charles Schumer ... and Jay Rockefeller ... are introducing an amendment to include the public option in the bill to be reported out by the Senate Finance Committee -- the committee anointed by the White House as its favored vehicle for getting health care reform.
Before you read another word, call and email the Senate offices of Democrats Max Baucus (Montana), Tom Carper (Delaware), Robert Menendez (New Jersey), Kent Conrad (North Dakota), and Ben Nelson (Florida) -- telling them you want them to vote in favor of the public option amendment. And get everyone you know in these states to do the same. Hell, you might as well phone and email Republican Olympia Snowe (Maine) and make the same pitch.
Background: Every dollar squeezed out of Big Pharma and Big Insurance is a dollar less that you'll have to pay ... to cover healthcare costs. The two most direct ways to squeeze future profits are allowing Medicare to use its huge bargaining leverage to negotiate lower drug prices, and creating a public insurance option to compete with private insurers...
Why aren't people getting hot under the collar about climate change?:
Cassandras of Climate, by Paul Krugman, Commentary, NY Times: Every once in a while I feel despair over the fate of the planet. If you’ve been following climate science, you know what I mean: the sense that we’re hurtling toward catastrophe but nobody wants to hear about it or do anything to avert it.
And here’s the thing: I’m not engaging in hyperbole. These days, dire warnings aren’t the delusional raving of cranks. They’re what come out of the most widely respected climate models... The prognosis for the planet has gotten much, much worse in just the last few years.
What’s driving this new pessimism? Partly it’s the fact that some predicted changes, like a decline in Arctic Sea ice, are happening much faster than expected. Partly it’s growing evidence that feedback loops amplifying the effects of man-made greenhouse gas emissions are stronger than previously realized. For example,... global warming will cause the tundra to thaw, releasing carbon dioxide, which will cause even more warming, but new research shows far more carbon dioxide locked in the permafrost than previously thought, which means a much bigger feedback effect.
The result of all this is that climate scientists have, en masse, become Cassandras — gifted with the ability to prophesy future disasters, but cursed with the inability to get anyone to believe them.
And we’re not just talking about disasters in the distant future... The really big rise in global temperature probably won’t take place until the second half of this century, but there will be plenty of damage long before then.
For example, one 2007 paper in the journal Science ... reports “a broad consensus among climate models” that a permanent drought, bringing Dust Bowl-type conditions, “will become the new climatology of the American Southwest within a time frame of years to decades.” ...
In a rational world, then, the looming climate disaster would be our dominant political and policy concern. But it manifestly isn’t. Why not?
Part of the answer is that it’s hard to keep peoples’ attention focused. Weather fluctuates..., any year with record heat is normally followed by a number of cooler years...
But the larger reason we’re ignoring climate change is that Al Gore was right: This truth is just too inconvenient. Responding to climate change with the vigor that the threat deserves would not, contrary to legend, be devastating for the economy as a whole. But it would shuffle the economic deck, hurting some powerful vested interests even as it created new economic opportunities. And the industries of the past have armies of lobbyists in place...; the industries of the future don’t.
Nor is it just a matter of vested interests. It’s also a matter of vested ideas. For three decades the dominant political ideology in America has extolled private enterprise and denigrated government, but climate change ... can only be addressed through government action. And rather than concede the limits of their philosophy, many on the right have chosen to deny that the problem exists.
So here we are, with the greatest challenge facing mankind on the back burner, at best, as a policy issue. I’m not, by the way, saying that the Obama administration was wrong to push health care first. It was necessary to show voters a tangible achievement before next November. But climate change legislation had better be next.
And as I pointed out in my last column, we can afford to do this..., economic modelers have been reaching consensus ... that the costs of emission control are lower than many feared.
So the time for action is now. O.K., strictly speaking it’s long past. But better late than never.
James Surowiecki interviews Joseph Stiglitz about "the mishandling of the financial crisis, the relationship between government and markets, and the future of capitalism around the world."
Robert Shiller defends financial innovation:
In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...
But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.
The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.
Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.
Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children’s education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...
Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.
Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... “continuous workout mortgages”...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...
Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.
Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.
Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...
Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.
Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.
As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.
Washington Post Puffs Gold Buggery, by Barkley Rosser: The business section of today's Washington Post contains one of the most ridiculous news stories I have seen yet. I would not mind if this were a column, but "What's Making Gold a Hot Commodity" by Frank Ahrens is supposedly a news story, and as such it should not contain whoppingly erroneous statements without some correction. So, Ahrens himself says the following: "In the long term, with each new dollar introduced into the system, each dollar you hold becomes worth less. That's more than just inflation, which we think of as simply rising prices. That's debasement of not only our currency, but the globe's reserve currency." It may well be that nonsensical thinking such as has this pushed the price of gold back over $1,000 per ounce again, but why should a business section reporter repeat it without the slightest doubt. It is not even good monetarism, as monetarists only view money supply expansions beyond growth of real output and not offset by velocity changes as inflationary.
A bit later, Ahrens uncritically quotes Peter Boockvar, an equities trader at Miller Tabak: "It amazes me that any self-respecting central banker is not alarmed that gold is over $1,000 an ounce and the dollar is trading at all-time record lows." All-time record lows? Only against gold. Currently the dollar is about 1.46 against the euro, while it hit 1.5990 in July 2008. It is around 92 against the yen, but in 1995 got as low as 79.95. It is a bit over 1.5 against the pound, but was at 1.98 last year (and further back in history was over 4.0). Utter drivel.
I do recognize that later in the article Ahrens brings up some factors that might caution people a bit against buying gold too frenziedly, such as how much of it is held by central banks, and how little demand for it is due to industrial use (only about 10%). But he never mentions that it has already been above $1,000 twice before, only to fall back, and in the late 1970s was much higher in real terms, at well over $800, only to fall very far below that and stay well below that for decades. The warnings could have been a bit clearer, along with avoiding mindlessly repeating totally ridiculous non-facts spouted by wacko gold bugs.
Stephen Ziliak emails:
Only moralists and economists know that Adam Smith's Theory of Moral Sentiments (1759) turned 250 years old this year.
However worthy an Adam Smith party, I thought you'd like to know about another party and sentiment, "Arthur's Day" - the Guinness Brewery's 250th birthday party - to be celebrated Thursday, September 24th, all over the world:
My article, "Great Lease, Arthur Guinness - Lovely Day for a Gosset!" (prepared for a special "Beeronomics" issue of the Journal of Wine Economics), shows how clever counting at Guinness did not stop two and a half centuries ago when Arthur signed a 9,000 year lease for the brewery, house, and land at St. James's Gate in exchange for 45 pounds a year (nominal, not inflation adjusted)!
"The great innovation in statistics in the era after Galton and Pearson was made in the private sector of the economy, between 1904 and 1937, at Guinness's Laboratory, to the end of improving, however gradually, production of a consistent beer at efficient economies of scale" (Ziliak 2009, p. 4).
Here's the article "Great Lease, Arthur Guinness—Lovely Day for a Gosset!":
Abstract: Small sample theory—the great innovation in statistical method in the period after Galton and Pearson—was ironically discovered by a brewer during routine work performed at a large brewery, Arthur Guinness, Son & Company, Ltd. For four decades William S. Gosset applied small sample experiments to the palpable end of improving, however gradually, the production and control of a consistent unpasteurized beer when packaged and sold at efficient economies of scale. Introducing, "Guinnessometrics." Annual output of stout at Guinness’s Brewery may have topped 100 million gallons but Gosset’s scientific knowledge was built one barleycorn at a time; in fact, the inventor of small sample theory worked closely with botanists and breeders. In the process, the brewer, William Sealy Gosset (1876-1937) aka "Student," an Oxford-trained chemist—though self-trained in statistics—solved a problem in the classical theory of errors which had eluded statisticians from Laplace to Pearson. In addition, though few have noticed, Gosset’s exacting theory of errors, both random and real, marked a significant advance over ambiguous reports of plant life and fermentation asserted by chemists from Priestley and Lavoisier down to Pasteur and Johannsen, working at the Carlsberg Laboratory. Central to the Guinness brewer’s success was his persistent economic interpretation of uncertainty, what Ziliak and McCloskey (2008) call the "size matters/how much" question of any series of experiments. An enlightened change in Guinness human resources policy gave an incentive structure that also seems to have nudged "Student," who rose in position to Head Brewer, to find a profit when the opportunity knocked. Beginning in 1893, Guinness vested "scientific brewers" such as Gosset with managerial authority. In fact Gosset was at times involved with price negotiations over hundreds of tons of barley and hops—perhaps hours or minutes before he ran (that is, calculated) a regression on related material. In brewing circles William Gosset is remembered less nowadays than he might be. He did not give two cents for arbitrary rules about statistical significance—at the 5% level or any level arbitrarily assumed. How the odds should be set depends on the importance of the issues at stake and the cost of getting new material, he said from 1904. Yet even in brewing journals, both academic and trade, and for the past 85 years, statistical significance at the 5% level continues to draw its arbitrary line segregating a meaningful from a non-meaningful result, a better barley from a worse.
Bruce Bartlett and Barry Ritholtz on Ron Paul's call for the Fed to be audited:
Auditing the Fed, by Bruce Bartlett: Ron Paul finally got his wish yesterday and the House Financial Services Committee held a hearing on his legislation to audit the Federal Reserve. There were only two witnesses: the Fed's general counsel and Tom Woods, a historian from the Ludwig von Mises Institute. The testimony is available here.
I urge those curious about this issue to read both statements. I think it is abundantly clear that this is a crackpot idea. The Fed is already thoroughly audited in every area except two: monetary policy and dealings with foreign central banks. The only purpose of having additional audits of the Fed is to undermine its independence precisely with regard to these two areas. If Woods presents the best argument for doing so, the argument is very shallow indeed.
Whatever one thinks of the Fed's policies in recent years--and there certainly are grounds for criticism--there is no reason whatsoever to believe that undermining its independence and putting the Congress in control of monetary policy--Ron Paul's goal--would improve matters at all. Indeed, there is every reason to believe that full congressional control of monetary policy would be a disaster. Instead of getting Switzerland-like stability, as Paul foolishly imagines, the more likely result would be Zimbabwe-like hyperinflation.
In the end, I agree with Barry Ritholz that whatever the Fed's failings, those of Congress are vastly worse. As he put it in explaining why he didn't testify yesterday:
I was invited to testify this week to the House Financial Services Committee about reform and regulation.I politely demurred.While I have been critical of the Federal Reserve (especially the Greenspan years), my beef with them has been their judgment and decision-making process. Congress, on the other hand, is a whole different matter. Its not their judgment, but rather, the fact they are owned not by the American people, but by lobbyists, and corporate interests. They have become structurally deformed.How weird is it for me, who spent so many pages blaming the Fed for a lot of the recent crisis, to find myself in a position of defending them from outside political pressure? The choice we face is the recent Fed regime of secrecy, nonfeasance, irresponsibility, and easy money — versus something possibly likely to be a whole lot worse. ...If the Fed has been a major source of problems, Congress is much worse. They were the great enablers of the crisis, readily corruptible, bought and paid for by the banking industry. I find Congress to be the worse of two evils — lacking in objectivity, incapable of producing legitimate regulatory review. ...
As I've made clear in the past, I also think that auditing the Fed, or reducing its independence in other ways, is a bad idea. The strange marriage of the populists and libertarians on this issue has given it more momentum that I expected, but hopefully not enough to carry the day.
Ezra Klein interviews Barney Frank about financial reform:
Barney Frank Talks Back, Washington Post: ...What's the most important part of financial regulation?
Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. ...
Do you worry that the banks that are "too big to fail" have gotten even bigger?
Banks do fail. Wachovia failed. The problem is not banks but non-banks. The answer is: We will be restricting their activities. They will not be as big, as they will need much more capital. And if they do get big, they will not be so leveraged. It's not the size of the institution that's the issue, it's the amount of leverage.
Sen. Dick Durbin recently said that the big banks "frankly own the place" after they killed "cramdown" bankruptcy legislation in the Senate. Won't banks brush off financial regulation reform?
No. The big banks have been somewhat discredited. That's why the credit card bill went in pretty easily over their objections. I believe reining in derivatives and reducing leverage at high levels will be somewhat easy to do.
What killed the primary-residence bankruptcy bill [cramdown] was not the big banks but the community banks and credit unions. They do have a lot of clout. And they have a legitimate grievance: They have not been behind the abuses. If we only had community banks and credit unions, we wouldn't be in this problem. And it's important to note that they're not just powerful because they have money, but because they're in everybody's district, and they're responsible and thoughtful citizens.
So you think the big banks really have lost their power on the Hill?
Look at the credit card bill. Small banks don't do credit cards. ...
Should the administration have started on financial regulation sooner?
No! They were busy. I understand the media always wants to have bad things to say. But they were working on undoing where we were. They were working to put liquidity back. The problem was that 2008 took longer to end than we thought it would. It didn't really end till April of 2009. The early months of the Obama administration were spent trying to dig out of the hole. Let me ask you a question. What harm came from waiting?
The argument is that you won't get as much regulation because the banks are stronger now.
That's nonsense. ...
Is executive compensation a big part of the problem?
Absolutely. The problem is not just the amount. Shareholders will deal with that. It's the incentive. People had incentives to take risks because they got paid off if the risk paid off and paid no penalty if the risk blew up. They were taking risks free of the consequences of failure. Heads they won, tails they broke even. ...
You became a YouTube celebrity a few weeks ago for snapping at a town hall protester who held up a picture of Barack Obama with a Hitler moustache. You said that arguing with her would be like debating a dining room table. Why don't more of your colleagues yell back?
So the question is, you're asking me, who yelled back, why other people don't yell back? ... I don't know. Ask them.I hope he's right, but I expect the fight will be tougher than implied above. Just about everybody has a credit card, and lowering fees on the cards, etc., is an easy sell to legislators looking to gain or maintain votes. Other proposals may not enjoy the same broad based support and appeal, especially after lobbyists and others spin the legislation as opposed to the best interests of the very people the legislation is trying to protect.
Bruce Bartlett reiterates his disappointment with Republican attitudes toward taxes and the deficit:
Fiscal Responsibility Requires Higher Taxes, by Bruce Bartlett, Commentary, Forbes: Throughout most of our nation's history,... everyone who thought of themselves as a conservative believed absolutely in the necessity of balancing the budget... Today, the notion seems quaint. Republicans pay lip service to balancing the budget, but only when Democrats are in office. ... [T]he now-universal view among conservatives [is] that ... taxes must never be raised to reduce deficits. That's a cure worse than the disease...
This reversal of the historical conservative position has had enormous implications for our national finances. ... The reason why conservatives supported a balanced budget in the first place wasn't so much about the economics as a belief that it was a constraint on spending and the growth of government. That deficits were inflationary, raised interest rates and led to crowding out in financial markets, which reduced economic growth, was really a secondary consideration.
A key reason why a balanced budget requirement constrained spending is that deficits led to higher taxes. Since people don't like paying taxes, they put a brake on spending that couldn't be financed out of current revenues. In the event that there was some new program that was widely deemed to be desirable,... it was commonly understood that new taxes dedicated just to these programs were an essential requirement for enactment.
Programs that couldn't be financed weren't seriously considered until the Bush 43 administration. Contrary to the experience of Social Security and Medicare, he offered no dedicated financing for the Medicare drug benefit. It simply added to the budget deficit and will add as much to it over the next decade as the February stimulus package that every Republican voted against.
And, of course, no effort was made to pay for tax cuts or pork barrel projects. In fact, Republicans jettisoned PAYGO (pay as you go) budget rules in 2002. ... When pressed about their abandonment of support for the balanced budget, Republicans say that supporting higher taxes to reduce deficits only made them tax collectors for the welfare state. ...
In the 1970s, conservatives talked themselves into believing that cutting taxes was a better way of restraining government's growth than supporting a balanced budget. Just take away Congress's credit card, Ronald Reagan used to say, and it will be forced to cut spending.
This reversal of the long-held conservative position proved to be extremely popular, politically, and had a lot to do with the Republican takeover of Congress in 1994. It is now Republican dogma that taxes must never be increased no matter how big the deficit. The last Republican to do that, Bush 41, got thrown out of the White House..., Republicans believe. ...
During Bill Clinton's administration, Democratic economists got religion on deficits. They believe that his 1993 tax increase sparked an economic boom. They also saw that ... the federal budget [go] from deficit to surplus... Clinton's big mistake was in not locking up the surpluses in some way. One idea would have been to use the surpluses to create private Social Security accounts that Republicans wouldn't have dared to touch any more than they would dare to cut Social Security benefits.
Instead, the surpluses were completely dissipated on temporary tax cuts and spending programs that bought reelection for Republicans in 2002 and 2004, but made no lasting contribution to the economy's growth. Even as the surpluses turned into deficits, Republicans' position didn't change--they were still for big tax cuts...
Indeed, back in February when Congress was debating the stimulus package and the Treasury was facing a deficit of $1.2 trillion this year, the Republican position was that tax cuts--and only tax cuts--would stave off a deep recession. How that would have helped when incomes were falling to such an extent that tax revenues were virtually collapsing on their own was never explained. Tax cuts were a mantra to be repeated endlessly whether they had any rational connection to the economy's problems or not.
Everyone knows that fiscal discipline must be restored eventually, or we will face truly horrifying consequences... Everyone also knows that this will involve a combination of higher revenues and lower spending. The idea that we can restore fiscal health only with spending cuts is childish, as I tried to explain last week.
What we face is a game of chicken. Republicans think if they wait until the last possible second to support the smallest possible tax increase necessary to make a budget deal work, they can get the largest possible spending cuts. The problem is that there is not one iota of historical evidence that this strategy will work. The budget deals of the 1980s and 1990s were all roughly 50-50: half tax increases, half spending cuts.
At some point, taxes have to be back on the table as the price that must be paid for profligate spending. Only then will the American people realize that they can't have their cake and eat it too, as Republicans have preached for the last decade. Only when the American people go back to believing that spending must be paid for will they stop demanding something for nothing and put the country back on the path to fiscal sanity.
At CBS Money Watch, some reactions to recent data releases:
And an update:
The Waxman-Markey cap-and-trade climate bill won't destroy economic growth:
It’s Easy Being Green, by Paul Krugman:, Commentary, NY Times: So, have you enjoyed the debate over health care reform? Have you been impressed by the civility of the discussion and the intellectual honesty of reform opponents? If so, you’ll love the next big debate: the fight over climate change.
The House has already passed a fairly strong cap-and-trade climate bill, the Waxman-Markey act, which if it becomes law would eventually lead to sharp reductions in greenhouse gas emissions. But on climate change, as on health care, the sticking point will be the Senate. And the usual suspects are doing their best to prevent action.
Some of them still claim that there’s no such thing as global warming, or at least that the evidence isn’t yet conclusive. But that argument is wearing thin — as thin as the Arctic pack ice... So the main argument against climate action probably won’t be the claim that global warming is a myth. It will, instead, be the argument that doing anything to limit global warming would destroy the economy. ...
It’s important, then, to understand that claims of immense economic damage from climate legislation are as bogus, in their own way, as climate-change denial. Saving the planet won’t come free (although the early stages of conservation actually might). But it won’t cost all that much either.
How do we know this? First, the evidence suggests that we’re wasting a lot of energy right now...— a phenomenon known ... as the “energy-efficiency gap.” The existence of this gap suggests that policies promoting energy conservation could, up to a point, actually make consumers richer.
Second, the best available economic analyses suggest that even deep cuts in greenhouse gas emissions would impose only modest costs on the average family. Earlier this month, the Congressional Budget Office released an analysis of the effects of Waxman-Markey, concluding that in 2020 the bill would cost the average family only $160 a year, or ... roughly the cost of a postage stamp a day.
By 2050, when the emissions limit would be much tighter, the burden would rise... But the budget office also predicts ... that G.D.P. per person will rise by about 80 percent. The cost of climate protection would barely make a dent in that growth. And all of this, of course, ignores the benefits of limiting global warming.
So where do the apocalyptic warnings about the cost of climate-change policy come from?
Are the opponents of cap-and-trade relying on different studies that reach fundamentally different conclusions? No, not really. ... Instead, the campaign against saving the planet rests mainly on lies.
Thus, last week Glenn Beck — who seems to be challenging Rush Limbaugh for the role of de facto leader of the G.O.P. — informed his audience of a “buried” Obama administration study showing that Waxman-Markey would actually cost the average family $1,787 per year. Needless to say, no such study exists.
But we shouldn’t be too hard on Mr. Beck. Similar — and similarly false — claims about the cost of Waxman-Markey have been circulated by many supposed experts.
A year ago I would have been shocked by this behavior. But as we’ve already seen in the health care debate, the polarization of our political discourse has forced self-proclaimed “centrists” to choose sides — and many of them have apparently decided that partisan opposition to President Obama trumps any concerns about intellectual honesty.
So here’s the bottom line: The claim that climate legislation will kill the economy deserves the same disdain as the claim that global warming is a hoax. The truth about the economics of climate change is that it’s relatively easy being green.
[See also Can Countries Cut Carbon Emissions Without Hurting Economic Growth? by Robert Stavins.]
Rushing to the Exits?, by Tim Duy: A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.
The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:
Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.
Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.
But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”
In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”
The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.
The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of truth behind a rumor that was circulating earlier this month. From Across the Curve:
I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.
Given the FOMC's own forecast, any consideration of tightening seems silly:
While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011. Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:
On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases. Indeed, unit labor costs are giving you the exact opposite story:
And employment compensation for the private sector is likewise trending down:
Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through. That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:
Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world’s largest energy-consuming nation.
Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That’s more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.
“The market has a glut of crude oil and refined products right now,” Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. “If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices.”
And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do? The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth. From Goldman Sachs (no link):
In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.
The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.
So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:
Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.
“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”
So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:
The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.
The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.
Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.
At CBS Money Watch:
Jeffrey Sachs says our public management systems need an overhaul:
The Failing U.S. Government--The Crisis of Public Management, by Jeffrey D. Sachs, Scientific American: The crisis of American governance goes much deeper than political divisions and ideology. The U.S. is in a crisis of policy implementation. Not only are Americans deeply divided on what to do about health care, budget deficits, financial markets, climate change and more, but government is also failing to execute settled policies effectively. Management systems linking government, business and civil society need urgent repair.
The recent systems failures are legion and notorious. The 9/11 attacks might well have been prevented if the FBI and the intelligence agencies had cooperated more effectively... Hurricane Katrina caused mass devastation and loss of life because recommendations to bolster the levees ... and other protective measures were neglected for decades despite urgent expert warnings, and because the federal emergency relief effort failed... The U.S. occupation of Iraq was marked by massive ... corruption, incompetence, and implementation failures by U.S. agencies.
On the economic front, the current financial crisis is a remarkable systems failure. Government regulatory agencies completely dropped the ball... The list, alas, goes on and on. Military procurement systems are ... broken... Public construction systems are failing... Roads, bridges, rail, water and sewerage systems and many dams are in dangerous disrepair...
We need a better scientific understanding of these pervasive systems failures. It is wrong to think that they illustrate the inevitable failure of government. Other governments around the world more successfully manage infrastructure investments, health systems and environmental resources, apparently with greater flexibility, less corruption, lower costs and better outcomes. America should be learning from their experiences.
Several factors are at play. A key one has been the flawed privatization of public-sector regulatory functions. ... A second has been the collapse of planning functions within the federal government. ...
A third, and paradoxical, factor is the chronic underfunding of government itself. ... The public is wary of putting more funds into government having witnessed one public sector failure after another. Yet without investing more resources in skilled public managers in health care, energy systems, and national security, we are probably doomed to remain stuck in the hands of vested interests and lobbies.
Fourth, today’s challenges cut across technical specialties, government departments and public and private sectors. ... Yet our government agencies are not designed to take a holistic approach.
In short, we have arrived at a point where the challenges of sustainable development —including public health, infrastructure, energy and national security—require changes not only to policy but also to basic public management systems. In many crucial areas, tinkering will no longer suffice: we need an overhaul to regain government control over regulatory processes, reduce lobbying, restore public planning and ensure the adequate financing of skilled public managers, and align public management systems with holistic strategies.
As evidenced by the response to the recent crisis, I'd add a fifth item to the list, opposition to the construction of the kinds of technocratic institutions that are needed to manage public systems:
Conservative Interventionism: The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930’s Reconstruction Finance Corporation and the 1990’s RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial ... economy ... without an overwhelming degree of corruption and rent seeking. The discretionary power of executives, in past crises, was curbed by new interventionist institutions constructed on the fly by legislative action.
That is how America’s founders ... envisioned that things would work. They were suspicious of executive power, and thought that the president should have rather less discretionary power than the various King Georges of the time. ...So I wonder: why didn’t the US Congress follow the RFC/RTC model when authorizing George W. Bush’s and Barack Obama’s industrial and financial policies? Why haven’t the technocratic institutions that we do have ... been given a broader role in this crisis?
Dark Age in Macroeconomics? A History of Taught approach, by Nick Rowe: (Or maybe the title should be: "Notes from the Phelps/Lucas Administration"; or "Notes to supplement our fading memories of the late 1970's".)
Is this a Dark Age in macroeconomics? In other words, have we collectively forgotten some (important) stuff that we used to understand?
I want to approach this question by looking at what was taught in the past to economics graduate students, so we can compare what is left out now to what was left out then.
I have a sample of one: my own lecture notes from grad school. I began my MA at UWO in 1977, and continued into the PhD. I took everything in macro/money that was offered. At the time, UWO was arguably the top Canadian department in macro/money (OK, Western grads would argue for; Queens grads would argue against), and would hold up well against anywhere in the world.
Macro 1 (David Laidler). Required course. Review and critique of ISLM (lags, stocks flows and the government budget constraint, are the IS and AD curves really demand curves? [no], the missing AS curve). Crowding out debate. Non-Walrasian macro (Barro and Grossman). Say's Law. Phillips Curve (up to Phelps and Friedman). Consumption function (Friedman/Modigliani). Demand for money. Investment demand.
Macro 2 (Michael Parkin). Required for those continuing to the PhD. (I can't resist quoting from the first page of my notes here: "Economics [is] Understand + Explain Phenomena using Rational models. How could Rational Behaviour [lead to] Disaster? Market Failure."). Review and critique of Neoclassical model of labour market. Lucas and Rapping (from the Phelps volume), and why their model was logically incoherent (Michael Parkin was right on this point). Mortensen's (also from Phelps volume) search theory of unemployment. Theories of implicit wage contracts (sticky wages). Theories of price adjustment (proto New-Keynesian). ISLM plus Phillips Curve (distinction between proto New-Keynesian and New Classical interpretations of Phillips Curve). Adaptive vs. Rational expectations. Policy Irrelevance Proposition ("[deviations of output from y* are] just noise, but obviously false").
Money 1 (Don Patinkin/Peter Howitt). Optional. Hume. Fisher. Lavington. Wicksell. Keynes' Tract, Treatise, and General Theory. Patinkin's Money interest and Prices. Are money and bonds net wealth? Commodity money. Solow/Swan growth model. Money and growth. Optimal quantity of money. Transactions costs. Baumol/Tobin and Miller/Orr models of demand for money.
Money 2 (Joel Fried). Optional. Microfoundations of money, Menger, Ostroy, Jones. Money in general equilibrium theory. Clower constraints. Transactions costs. Financial markets. Tobin. CAPM. Efficient Markets. Modigliani/Miller theorem. Term structure of interest rates. Tobin portfolio choice. Friedman and Monetarism. International finance. Dornbusch overshooting. Exogenous vs endogenous money. Canadian monetary policy.
Advanced Macro (Peter Howitt). Optional. (Lovely quote from the first page: "We are Aristotelian monks, trying to solve anomolies to stop future generations wasting their time doing the same thing.". Non-Walrasian disequilibrium theory (Clower, Leijonhufvud, Barro/Grossman, Malinvaud, Benassy, etc.). Stability. Catastrophe theory(!). Price adjustment under oligopoly. Optimal control theory. Inventories. Phelps/Winter price setting with transient monopoly power (from the Phelps volume, proto New-Keynesian).
(I learned some more money/macro in David Laidler's History of Thought class. But I was the only graduate student in that class, so I'm not going to count it. My colleague Calum Carmichael, who took the same course as an undergraduate, estimates that about one quarter of the Honours economics students took that class.)
I make the follow observations:
1. The Phelps volume was clearly very influential in the late 1970's. This supports Paul Krugman's memory, and my own.
2. The beginnings of the split between New Classical and New Keynesian approaches was already apparent in the late 1970's. I saw several references to the distinction between Fisher and Phelps on the interpretation of the Phillips Curve. (Fisherian market-clearing with misperceptions vs Phelpsian disequilibrium price adjustment). This too supports Paul Krugman's memory.
3. We received a very broad education in short run macroeconomics and monetary theory. Probably much broader than today's students. That tends to support the Dark Age hypothesis.
4. But there is one glaring omission from our education: we did lots of short run business cycle theory but almost no long run growth theory. We briefly covered the Solow growth model, but only as a prelude to money and growth. There was no interest in growth theory per se! If growth theory is important, and it is, that directly contradicts the Dark Age hypothesis. We barely touched on half of macro! The late 1970's were the Dark Age, for growth theory.
Why did we ignore growth theory?
Growth theory wasn't on the agenda. It wasn't that growth was unimportant; just that there seemed to be nothing important to say about it. All the exciting policy debates were about inflation and unemployment, not long run growth. All the exciting theoretical developments were about inflation and unemployment, not long run growth. "Endogenous" growth theories (a stupid misnomer, because growth is endogenous in Solow too, just with an extremely simple functional relationship to the exogenous variables, namely g=n) came later.
Fiscal policy has been off the agenda for much the same reasons, until recently.
(5. We spent surprisingly little time on open economy macroeconomics as well, for a Canadian school.)
OK. Let's compare notes!
This is very similar to my own experience, we also did very little growth theory (nothing beyond Solow-Swan, also as a prelude to looking at whether money was "superneutral"), and I didn't take any international at all - it wasn't part of the macro sequence (the international economy was not considered very important for understanding business cycle fluctuations). The emphasis was on short-run stabilization policy, monetary policy in particular. However, my experience was a bit different in that by the time I got to graduate school in the early 1980s, the split between saltwater and freshwater economists was well underway.
Paul Krugman says:
But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?
The answer was that they split. One faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever.” That faction became New Keynesian, saltwater economics.
The other faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can’t.” That faction became real business cycle, freshwater economics.
Here's what I said about this just under two and a half years ago (edited slightly). As you can see, even though this was written well before Krugman's statement, it basically agrees with his assertion that everyone knew the New Classical model was in trouble by 1980 or 1981 (the Mishkin paper noted below was published, I believe, in 1982, but given the long publication lags the results were well known long before then). It also agrees with his comments that one faction, the New Keynesians, built upon the old Keynesian structure by giving it rational agents and microfoundations who operated in an environment beset with rigidities of one type or another (these rigidities prevent agents from fully neutralizing nominal shocks such as changes in the money supply), and the other faction reemerged as the real business cycle school:
I entered graduate school in 1980. Though it started with a pretty traditional IS-LM framework with some AD-AS thrown in, most of our time was spent learning the New Classical model. Much of the research effort at that time, at least the effort I was made aware of, was to try and punch holes in the result that comes out of the New Classical framework that only unanticipated money can affect real variables like output and employment.
This assault came on both theoretical and empirical fronts. Mishkin, for example, had published an empirical paper in the early 1980s that challenged work by Barro and others from the later 1970s supporting the New Classical model and its implication that only surprise money matters. On the theoretical front, the old Keynesian model -- which had been criticized for, among other things, lacking microeconomic foundations and lacking rational expectations -- was being reconstructed into the New Keynesian model. This model would eventually overcome theoretical objections that plagued the older Keynesian model, and it would also do a better job than the New Classical model of explaining the magnitude and persistence of business cycles and other features of the macroeconomic data. We learned some about Real Business Cycle models - but for the most part that work went on elsewhere and would surface later with more force as an alternative to the New Keynesian framework. But we were certainly made aware of the real business cycle model, e.g. arguments about reverse causality to explain statistical money income correlations. I'd say the same about growth theory - we did the Solow-Swan basics, but very little beyond that. Stabilization policy was the main issue we worried about at the time.
Does money matter? I thought so, that's what my dissertation was all about, it gave theoretical and empirical reasons to doubt the New Classical result that expected money does not affect output, but the issue of whether money matters was not settled until later. We now accept, for the most part, that the Fed can affect real interest rates and also affect the real economy, but at that time there was a very strong split within the profession on this issue. It wasn't until later that a general belief that anticipated monetary policy was a potentially useful stabilization tool surfaced in the profession. It's sometimes surprising to me today how complete the conversion on that issue has been, though it's certainly not 100%.
So, it wasn't generally agreed that money mattered, i.e. that money was a useful policy tool for stabilizing the real economy. But the Keynesian economics I learned at the time, which was in the implicit and explicit labor contracting framework for the most part, did say that money mattered. In fact, since the point was to challenge the New Classical result that money did not matter, the focus was mostly on monetary policy. As for fiscal policy, the Keynesian model we talked about - beyond the simple IS-LM version we learned at first - paid very little attention to fiscal policy, though papers such as Barro's "Are Bonds Net Wealth" were part of the conversation. Thus, when I went to graduate school - and this was partly due to who was teaching the courses - the primary focus was on whether and how changes in monetary policy affected the real economy.
In any case, even though it was a few years later than Nick's experience, we also spent considerable time on the ideas that Krugman notes have since been lost as we entered our recent "Dark Ages."
I'm sorry, I really am. Here's the economics of apologies:
Saying sorry really does cost nothing, EurekAlert: Economists have finally proved what most of us have suspected for a long time – when it comes to apologizing, talk is cheap.
According to new research, firms that simply say sorry to disgruntled customers fare better than those that offer financial compensation. The ploy works even though the recipient of the apology seldom gets it from the person who made it necessary in the first place.
The ... Nottingham School of Economics' Centre for Decision Research and Experimental Economics ... set out to show whether customers who have been let down continue to do business after being offered an apology. They found people are more than twice as likely to forgive a company that says sorry than one that instead offers them cash. ...
Roman Frydman and Michael Goldberg argue that the behavioral assumptions used to motivate agents in economic models need to change:
An economics of magical thinking, by Roman Frydman and Michael D. Goldberg, Commentary, Economist's Forum: Confidence seems to be returning to markets almost everywhere, but the debates about what caused the worst crisis since the Great Depression show no sign of letting up. Instead, the spotlight has shifted from bankers, financial engineers and regulators to economists and their theories. This is not a moment too soon. These theories continue to shape the debate about fiscal stimulus, financial reform, and, more broadly, the future of capitalism, which means that they remain a danger to all concerned.
Unfortunately, the assumptions that underpin these theories are largely inscrutable to those without a Ph.D. in economics. Indeed, the debate is full of terms that mean one thing to the uninitiated and quite another to economists.
[Money Watch link] After its rate setting meeting today, the Fed announced that it "will maintain the target range for the federal funds rate at 0 to 1/4 percent," and that it "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Very few analysts thought the Fed should raise the rate, calls for higher rates came from a few inflation hawks but that's about it, and nobody I know of expected the Fed to change its interest rate policy. So no surprises here.
Of more interest are the Fed's characterization of economic conditions, its plans for the special facilities and other non-standard monetary policy options it has put in place to deal with the crisis, and its exit strategy.
At CBS Money Watch:
I argue that most people do not feel like their interests are represented when policy decisions are made about regulation, bailouts, and other matters, including decisions by the Federal Reserve on setting the target interest rate, and that needs to change.
There's not a populist bone in Robert Reich's body. Not a one:
Why the Dow is Hitting 10,000 Even When Consumers Can't Buy And Business Cries "Socialism", by Robert Reich: So how can the Dow Jones Industrial Average be flirting with 10,000 when consumers, who make up 70 percent of the economy, have had to cut way back on buying because they have no money? Jobs continue to disappear. One out of six Americans is either unemployed or underemployed. Homes can no longer function as piggy banks because they’re worth almost a third less than they were two years ago. And for the first time in more than a decade, Americans are now having to pay down their debts and start to save.
Even more curious, how can the Dow be so far up when every business and Wall Street executive I come across tells me government is crushing the economy with its huge deficits, and its supposed “takeover” of health care, autos, housing, energy, and finance? Their anguished cries of “socialism” are almost drowning out all their cheering over the surging Dow.
The explanation is simple. The great consumer retreat from the market is being offset by government’s advance into the market. Consumer debt is way down from its peak in 2006; government debt is way up. Consumer spending is down, government spending is up. Why have new housing starts begun? Because the Fed is buying up Fannie and Freddie’s paper, and government-owned Fannie and Freddie are now just about the only mortgage games remaining in play.
Why are health care stocks booming? Because the government is about to expand coverage to tens of millions more Americans, and the White House has assured Big Pharma and health insurers that their profits will soar. Why are auto sales up? Because the cash-for-clunkers program has been subsidizing new car sales. Why is the financial sector surging? Because the Fed is keeping interest rates near zero, and ... the government is still guaranteeing any bank too big to fail will be bailed out. Why are federal contractors doing so well? Because the stimulus has kicked in.
In other words, the Dow is up despite the biggest consumer retreat from the market since the Great Depression because of the very thing so many executives are complaining about, which is government’s expansion. And regardless of what you call it – Keynesianism, socialism, or just pragmatism – it’s doing wonders for business, especially big business and Wall Street. Consumer spending is falling back to 60 to 65 percent of the economy, as government spending expands to fill the gap.
The problem is, our newly expanded government isn't doing much for average working Americans who continue to lose their jobs and whose belts continue to tighten, and who are getting almost nothing out of the rising Dow because they own few if any shares of stock. Despite ... all their cries of "socialism" -- big business and Wall Street are more politically potent than ever.
It would have been better if the effort to revive the economy had a stronger trickle up component, i.e. give the tax cuts or transfers to the people who need it rather than those who don't, they will spend the extra money, it will trickle up as profits to the owners of businesses as the money is spent and re-spent through the multiplier process, and the owners will use the profits to hire more workers and to make productive investments (and even if the money doesn't trickle up as expected, at least you've helped people in need, when tax cuts for the wealthy don't trickle down, the consolation prize isn't as attractive).
Two from the Antonio Fatás and Ilian Mihov Global Economy blog. First, Antonio Fatás notes cross-country differences in how productivity has evolved during the crisis, and he speculates that the difference may be due to differences in how much effort was devoted to reducing the impact of the recession on employment:
Output, employment and productivity during the crisis, by Antonio Fatás: While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.
In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.
Below is data on labor productivity measured as GDP per hour worked in four countries... In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.
Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.
Next, Ilian Mihov argues that consumer indebtedness might not be as bad as you've been led to believe:
Household debt, consumption and wealth, by Ilian Mihov: It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. ...
Indeed,... debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy.
1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.
Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true).
But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP). ...
2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line! ...
There are ways in which this “neutrality of debt” may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.
In general, many other “imperfections” in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.One quick comment. This is hinted at in the second to last paragraph, but to make it more explicit, the distribution of assets and liabilities can matter, and given the rise in inequality over much of this time period (it coincides with the rise in the green and red lines beginning in the 1970s evident in the diagram above) along with the stagnant wages of the working class, there may well have been important distributional effects.
Bruce Judson says effective financial reform is essential to restoring trust in government:
Restoring Trust in Our Economic System and the Institutions of Our Democracy, by Bruce Judson: The Financial Crisis Inquiry Commission (FCIC), which started work last week, will have a significant impact on the health of our democracy. When the FCIC completes its efforts, we will either be stronger or weaker as a nation. There is no middle ground. ...
The work of the Commission is important for two reasons. First, by openly educating the public about the causes of the financial crisis it will pave the way for reform. Existing interests will inevitably resist change. Reform becomes far easier when its advocates can point to a roadmap of specific problems that must be addressed. ...
Second, America is becoming an angry nation, with diminished faith in its institutions. There is a growing sense among all but the wealthiest Americans that “the game is rigged” against them. The public perception of the work of the FCIC will inevitably affect, for better or worse, our basic level of trust in the nation’s democratic system.
I have another post at CBS Money Watch:
This reiterates that we need to have plans ready to dissolve systemically important financial firms. What I didn't say is that we should also do our best to prevent firms from becoming a danger to the system due to their size of connectedness.
David Levine "aggressively argues":
our models don't just fail to predict the timing of financial crises - they say that we cannot.
The San Francisco Fed's Bharat Trehan says:
simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances. ... [W]e have taken two simple indicators off the shelf and shown that both would have signaled impending trouble prior to the current crisis. That makes it harder to argue that financial crises are, by their nature, unpredictable. And it shows that such simple indicators can be useful ... as signals of rising levels of risk in the economy.
We ought to be able to say, at the very least, something like:
If you keep eating that junky credit instead of a healthier financial diet, your monetary circulatory system is likely to have severe problems at some point in the future.
Many people had a sense things were out of balance and that at some point it would cause us problems, but the indicators most people looked at pointed to a diagnosis involving exchange rate movements and an international unwinding. The discussion centered on issues such as whether we would have a hard or a soft landing as this process unfolded, there was little discussion of the type of crisis that actually occurred.
So we need two things. First, we need indicators such as those identified in the SF Fed article that can tell us when danger is building in the financial sector.
But that is not enough. Though many people had a sense from the indicators they looked at that things were out of balance, the indicators pointed to international financial issues rather than the true problem, and hence most of the analysis and policy discussions were devoted to guarding against problems related to international financial flows.
Thus, the second thing we have a need for is a set of indicators that do a better job of telling us where the problems are likely to occur. That is where we made the biggest mistake, misdiagnosing the type of crisis that was coming. Having indicators that can do a better job of identifying the type of financial crisis we are facing will allow us to design and implement effective policy responses rather than wasting time analyzing and planning for the wrong type of crisis.
On the G20 Agenda, by Tim Duy: Simon Johnson at the Baseline Scenario has a nice piece bemoaning the US pursuit of a rebalancing agenda at the upcoming G20 meeting. I largely agree with Johnson's tone. Something that sounds nice, but that to which no parties, particularly China and the US, can make a credible commitment. It is, however, keeping some poor staffer at the US Treasury busy 24-7. Johnson's third point, however, misses some important points:
Where is the evidence that this kind of “imbalance” had even a tangential effect on the build up of vulnerabilities that led to the global financial crisis of 2008-09? I understand the theoretical argument that current account imbalances could play a role in a US-based/dollar crisis, but remember: interest rates were low 2002-2006 because of Alan Greenspan (who controlled short-term dollar interest rates); the international capital flows that sought out crazy investments came from Western Europe, which was not a significant net exporter of capital (i.e., a balanced current account is consistent with destabilizing gross flows of capital); and the crisis, when it came, was associated with appreciation – not depreciation – of the dollar.
I believe Johnson underestimates just how close we came to a destabilizing collapse of the Dollar in 2008. That avoidance of that near collapse was well documented by Brad Setser in his legendary "quiet bailout" series:
...The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.So far that hasn’t been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.
Later analysis can be found here. Had it not been for the supporting role that China and other central banks played in financing the US current account deficit, we would have seen a full blown currency crisis, well before the financial crisis of September 2008.
As an aside, the intervention to support the Dollar was also the key event that allowed the US recession to evolve in the pattern envisions by domestic-focused economists, as opposed to those seeped in the traditions of international finance. Brad Delong has a fantastic piece on this issue, including the key assumption failed the internationalists:
Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future…...The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.
I have no doubt that the willingness of central banks to flood the global economy with month in an effort to hold currency pegs contributed greatly to the great commodity price bubble that ultimately sent US real consumption into a tail spin well before the events in the fall of 2008.
As to the G20 proposal itself - easier said than done. Back on the real side of the economy, I believe the US economy is very structurally misaligned, to a disturbing degree. We simply do not make many of the products we want to buy, and have the capacity to make many products - like expensive housing - that no one wants to buy. Moreover, these structural misalignments have been building for at least 15 years, at least partly the consequence of the US strong Dollar policy that gave license for wholesale currency manipulation to support mercantilistic policy objectives. Reversing 15 years of policy in which deep structural shifts occurred will not happen overnight.
Nor do I think the Chinese are interested in making that transition happen. Thomas Freidman has a point here:
China now understands that. It no longer believes it can pollute its way to prosperity because it would choke to death. That is the most important shift in the world in the last 18 months. China has decided that clean-tech is going to be the next great global industry and is now creating a massive domestic market for solar and wind, which will give it a great export platform….So, if you like importing oil from Saudi Arabia, you’re going to love importing solar panels from China.
This restructuring, not so much the financial restructuring, is what I suspect the Administration really wants to address.
Good luck with that.
Larry Summers, blogging from the White House, says the administration's policies will create jobs and help to ensure that "the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy":
A Vision for Innovation, Growth, and Quality Jobs, by Lawrence H. Summers: President Obama laid out his vision for innovation, growth, and quality jobs earlier today at Hudson Valley Community College. The President's plan is grounded not only in the American tradition of entrepreneurship, but also in the traditions of robust economic thought.
During the past two years, the ideas propounded by John Maynard Keynes have assumed greater importance than most people would have thought in the previous generation. As Keynes famously observed, during those rare times of deep financial and economic crisis, when the "invisible hand" Adam Smith talked about has temporarily ceased to function, there is a more urgent need for government to play an active role in restoring markets to their healthy function.
The wisdom of Keynesian policies has been confirmed by the performance of the economy over the past year. After the collapse of Lehman Brothers last September, government policy moved in a strongly activist direction.
As a result of those policies, our outlook today has shifted from rescue to recovery, from worrying about the very real prospect of depression to thinking about what kind of an expansion we want to have.
An important aspect of any economic expansion is the role innovation plays as an engine of economic growth. In this regard, the most important economist of the twenty-first century might actually turn out to be not Smith or Keynes, but Joseph Schumpeter.
Robert Shiller says economists and their models need to take bubbles seriously (compare Dani Rodrik's "Blame Economists, not Economics"):
Economists need to study bubbles, reinvent models, by Robert Shiller, Commentary, Project Syndicate: The widespread failure of economists to forecast the financial crisis ... has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come. ...
[T]he current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. ... You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable ... that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.
Here's something I wrote for CBS Money Watch:
I expect many of you will disagree.
Lee Arnold says via email "this is interesting." It's an analysis of when and if economic growth should be maximized when technological progress involves risks as well as benefits:
The Costs of Economic Growth, by Charles I. Jones, Stanford GSB and NBER, August 18, 2009: 1. Introduction In October 1962, the Cuban missile crisis brought the world to the brink of a nuclear holocaust. President John F. Kennedy put the chance of nuclear war at “somewhere between one out of three and even.” The historian Arthur Schlesinger, Jr., at the time an adviser of the President, later called this “the most dangerous moment in human history.”1 What if a substantial fraction of the world’s population had been killed in a nuclear holocaust in the 1960s? In some sense, the overall cost of the technological innovations of the preceding 30 years would then seem to have outweighed the benefits.
While nuclear devastation represents a vivid example of the potential costs of technological change, it is by no means unique. The benefits from the internal combustion engine must be weighed against the costs associated with pollution and global warming. Biomedical advances have improved health substantially but made possible weaponized anthrax and lab-enhanced viruses. The potential benefits of nanotechnology stand beside the threat that a self-replicating machine could someday spin out of control. Experimental physics has brought us x-ray lithography techniques and superconductor technologies but also the remote possibility of devastating accidents as we smash particles together at ever higher energies. These and other technological dangers are detailed in a small but growing literature on so-called “existential risks”; Posner (2004) is likely the most familiar of these references, but see also Bostrom (2002), Joy (2000), Overbye (2008), and Rees (2003).
Technologies need not pose risks to the existence of humanity in order to have costs worth considering. New technologies come with risks as well as benefits. A new pesticide may turn out to be harmful to children. New drugs may have unforeseen side effects. Marie Curie’s discovery of the new element radium led to many uses of the glow-in-the-dark material, including a medicinal additive to drinks and baths for supposed health benefits, wristwatches with luminous dials, and as makeup — at least until the dire health consequences of radioactivity were better understood. Other examples of new products that were initially thought to be safe or even healthy include thalidomide, lead paint, asbestos, and cigarettes.
The benefits of economic growth are truly amazing and have made enormous contributions to welfare. However, this does not mean there are not also costs. How does this recognition affect the theory of economic growth?
This paper explores what might be called a “Russian roulette” theory of economic growth. Suppose the overwhelming majority of new ideas are beneficial and lead to growth in consumption. However, there is a tiny chance that a new idea will be particularly dangerous and cause massive loss of life. Do discovery and economic growth continue forever in such a framework, or should society eventually decide that consumption is high enough and stop playing the game of Russian roulette? The answer turns out to depend on preferences. For a large class of conventional specifications, including log utility, safety eventually trumps economic growth. The optimal rate of growth may be substantially lower than what is feasible, in some cases falling all the way to zero.