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January 31, 2008

Economist's View - 7 new articles

How Naïve Are We About Our Economic Future?

Jon Faust says that "I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison..." How well does the Fed forecast economic conditions? It turns out that "naïve" forecasts of GDP do better than a wide range of more complex econometric models:

Whither macroeconomics? The surprising success of naïve GDP forecasts, by Jon Faust, Vox EU: Over the past ten days, the U.S. Federal Reserve has lowered its policy interest rate 125 basis points based largely on its assessment of the need to battle strong recessionary forces. This comes after a December 12 meeting at which the Fed lowered rates a mere 25 basis points, still hoping to "foster maximum sustainable growth and provide some additional insurance against risks."[1] To some, this rapid change in sentiment might seem surprising. In my view, though, these events mainly serve to remind us of how extraordinarily challenging it is to forecast economic activity.

Economic forecasting challenges I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison: weather forecasters have immense advantages over economic forecasters.

When making a forecast, weather forecasters have access to data on the current and recent past conditions. In contrast, when the Fed made the forecast for the January Federal Open Market Committee (FOMC) meeting, the latest available GDP data were for the third quarter of the previous year. On January 30, we will get an advance release of fourth quarter GDP for the U.S., but this initial estimate will be highly speculative. Historically, the root mean square revision of the annualised quarterly growth rate in the advance release is about 1.5 percentage points--easily enough to spell the difference between slow growth and deep recession.[2]

Further, the GDP data will continue to be revised in important ways indefinitely. For example, the 1999 benchmark revision of GDP data raised measured average growth over 1997 and 1998 by more than one-half of a percentage point.[3] A significant piece of the much-discussed productivity boom of the late 1990s was not in the GDP data until the 1999 benchmark. The weather equivalent would be forecasting temperature without knowing the current temperature, having only a fuzzy estimate of temperature in the recent past, and knowing that, years after the fact, a hot spell might be revised into the data.

Given that we cannot even measure GDP without considerable hindsight, we cannot expect forecasts of real economic activity to be very precise. We can and should, however, ask whether Federal Reserve forecasts are as accurate as possible.

How well does the Fed do? Research over the years has generally supported the view that the Fed's Greenbook forecast, prepared for each FOMC meeting, is outstanding.[4] Recently, discovery of a new dataset has made a more stringent evaluation possible. This dataset has a snapshot of (part of) the Fed's dataset as it stood at the time of about 150 Greenbook forecasts since 1979.[5] Using this dataset, Jonathan Wright of the Federal Reserve Board and I assessed how a wide range of models would have performed if they had been used to forecast based on the information actually available to the Fed when it made its forecasts.[6]

Our results again confirm the high quality of the Greenbook forecast, but are sobering in some respects. When we give ten alternative models only those data that were available to the Fed, the Fed's forecast generally outperforms the alternatives by a wide margin. Chris Sims and others had speculated that the Fed's good performance might be due to the immense resources the Fed pours into assessing GDP in the current period and recent past. Since many of the raw inputs used by the Bureau of Economic Analysis (BEA) to construct the GDP data are public, the Fed attempts to assess current GDP by replicating many aspects of the BEA's efforts. It is probably not surprising that conventional models have trouble competing regarding current and past conditions with a thorough attempt to mirror the data construction machinery of the BEA.

A surprisingly simple forecast While the Fed has a clear edge in assessing current conditions, policy decisions can only affect the future. To assess how the Fed does in projecting where real activity will be in the future, Jonathan and I give the alternative models the data available to the Fed and the Fed's estimate of the current state of the economy. Then we compare how well the models forecast when they all know the Fed's assessment of the current and recent past values of variables.

We find the surprising result that no model clearly outperforms the univariate autoregressive model. This is one of the simplest possible models: it basically forecasts in every period that the GDP growth will simply follow its historical average rate back to the mean. This may be sobering for not only the Fed but for the macroeconomics profession as a whole: knowledge of interest rates, labour market conditions, capacity utilisation, inflation, or any of about 50 additional variables does not systematically improve our ability to foretell where real activity is headed.

There are many details and caveats to be considered in fully understanding the meaning of these results. We can, however, give a bit more precise statement. The univariate autoregressive model, which predicts GDP growth based on four lagged values of growth, has smaller prediction errors than Greenbook and essentially every other model at every forecast horizon between one and five quarters into the future.[7] Our measure of the prediction error is an estimate, however, and one should consider whether the differences in estimated forecast precision are statistically significant. This raises complex statistical issues, but our basic conclusion is that no method significantly outperforms the univariate model.

It is important to emphasise that the results for forecasting inflation are dramatically different than those for real activity. For inflation, Greenbook outperforms all other models, often by a wide margin.

Conclusions Returning to the weather analogy, our results would translate something like this. We are forecasting temperature without knowing current temperature and having only a fuzzy estimate of temperature in the recent past. Further, we find that given a good estimate of recent temperatures, we do not know any systematic way to improve our temperature forecast using measures of other variables such as precipitation, barometric pressure, location of the jetstream, etc.

While necessary, forecasting real activity is a nasty endeavour. Our recent research confirms the basic conclusion of earlier work that the Fed's Greenbook forecast is excellent. No model we assess, however, including Greenbook, historically outperforms a naïve forecast based only on the best available estimate of recent GDP itself.

Note: This column draws conclusions from research that was started when I was an employee of the Federal Reserve Board and joint with Jonathan Wright of the Fed. The opinions stated here are my own and need not reflect Jonathan's opinion or those of anyone in the Federal Reserve System.

Footnotes

1 Minutes of the Federal Open Market Committee, Dec. 11, 2007, p.8, 2 For a summary of GDP revisions across the G-7, see Faust, et al., 'News and Noise in G-7 GDP Announcements,' Journal of Money, Credit, and Banking, v.37, n.3, June 2005, 403-417. 3 This is based on the author's calculation using the data discussed below. 4 Two notable sources are Romer, C.D. and D.H. Romer (2000): 'Federal Reserve Information and the Behavior of Interest Rates', American Economic Review, 90, pp.429-457, and Sims, C.A. (2002): 'The Role of Models and Probabilities in the Monetary Policy Process', Brookings Papers on Economic Activity, 2, pp.1-40. 5 This new dataset was created and preserved over the years by Fed Staffer Douglas Battenberg. 6 Jon Faust and Jonathan Wright, 'Comparing Greenbook and Reduced Form Forecasts using a Large Realtime Dataset', NBER Working Paper 13397, Sept. 2007. 7 See Table 5c, panel 2. Size of the errors is measured by root mean square prediction error (RMSPE). The RMSPE for the autoregressive model is lower at every horizon than 9 of the other 10 models. One model beat the simple model at a few horizons using the RMPSE criterion, but the difference was only few hundredths of a percentage point.

Ricardo Hausmann: Stop Behaving as Whiner of First Resort

If Ricardo Hausmann was chair of the Fed, or in charge of fiscal policy, things would be different. He says consumption has been above its natural, sustainable rate and needs to adjust downward. Thus, monetary and fiscal policies designed to increase consumption and avoid a slowdown only delay the inevitable adjustment of consumption back to its natural rate:

Stop behaving as whiner of first resort, by Ricardo Hausmann, Commentary, Financial Times: The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US to deal with the so-called subprime crisis. Interest rates should be slashed quickly and $150bn put into taxpayers' pockets...

The goal seems to be to avoid a 2008 recession at all costs. As Larry Summers ... put it, failure to act would make Main Street pay for the sins of Wall Street.

It is easy to lose sight of the overall picture. Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. ... Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions.

The adjustment of private consumption to sustainable levels is necessary, but is likely to have a negative influence in the short run on the growth of aggregate demand... It is hard for this adjustment to take place without bringing down the rate of growth of gross domestic product, possibly to negative numbers. ...

Returning to a sustainable path is good for the US and the world economy over any horizon that assigns some value to what happens after 2008. Sustainable growth is not the consequence of an unsustainable consumption boom but of the progress and diffusion of science, technology and innovation – which show no sign of slowing down.

An efficient adjustment to the US over-consumption imbalance (and Chinese under-consumption) in a way that does not hurt longer-term growth should be based on compensating for the decline of US consumption with an increase in domestic investment and in consumption abroad. It should not be based on giving the US consumer more rope with which to hang himself.

Hence, macroeconomic policy should not be based on a panicky attempt to avoid a 2008 recession at all costs but on a forward-looking strategy that achieves the needed reduction in consumption at the lowest cost in terms of the stable growth. This is not achieved by giving US households a $1,000 cheque by April, a trick that no macro­economic textbook would argue is particularly effective. If there is fiscal room – a big if, given the weak structural position of the US government and its likely cyclical worsening – it would be better spent in accelerating investments in plant and equipment via accelerated depreciation schemes, to improve the capacity of the economy to keep on growing after the crisis.

The logic behind monetary easing is also suspect. ... It is understandable that politicians facing a November election and bankers with a lot of their money at stake should feel that this is the worst crisis ever and have an obvious interest in exaggerating the consequences for Main Street.

They all assume that if banks lose capital, they will stop lending. This is what happens in developing countries because of incomplete financial markets, but is not what one would expect in the world's most sophisticated capital market. In fact, bank capital has already been lost and the solution is not to put more air into the bubble but to put more capital into banks. This is already happening: Citibank, UBS, Merrill Lynch and Morgan Stanley have raised more than $100bn from foreign investors and sovereign wealth funds. Authorities might use their moral suasion to accelerate this process.

The US should face its need for adjustment with courage and reason, not fear. It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession. Many poorer countries with weaker markets and institutions have survived and benefited from an adjustment that involves a year of negative growth. Faster bank recapitalisation, fiscal investment stimulus and international co-ordination should be first on the policy agenda.

Even with effective monetary and fiscal stimulus, all adjustment costs can't be avoided - some people will incur losses no matter what monetary and fiscal authorities do. Some already have and adjustments are underway. The question, as noted above, is how to get to the long-run sustainable path for consumption and investment at the smallest possible cost.

This comes partly from using a different analytical framework, one oriented in the New Keynesian rather than in the Real Business Cycle tradition, but for me minimizing adjustment costs means avoiding the chance of sharp, abrupt, severe, self-reinforcing downturns where consumption initially falls way below its long-run sustainable path only to crawl back up to the long-run equilibrium later. Thus, I prefer supporting aggregate demand in the short-run so that it falls slowly to the long-run equilibrium rather than doing little or nothing and taking a chance that it falls precipitously, even if this means it will take longer for the adjustment process to be completed.

The Fed Cuts the Target Rate by Half a Percent

Here's the press release:

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

So the vote wasn't unanimous (9-1 as there are two open seats), Richard Fisher from the Dallas Fed dissented, and nine of the twelve district banks asked for a change in the discount rate consistent with the 50 bps rate cut. The other three banks, Dallas, Minneapolis, and Richmond, either did not agree with a 50 bps rate cut prior to the meeting, and/or they wanted to alter the spread between the discount rate and the federal funds rate.

While noting inflation concerns, the Committee also appears to be ready to cut rates further should incoming data suggest further cuts are necessary. Hopefully, though, we can now all catch our breaths for a little while and get a better assessment of exactly where we are.

Update: Fed cuts rates by 50 basis points (Financial Times), Fed Cuts Rates by Half Point (WSJ), Fed Lowers Rate Half Percentage Point to 3%, Says `Downside Risks' Remain (Bloomberg), Fed Cuts Rate for Second Time in 8 Days (NY Times).

Update: The Lone Dissenter: Dallas's Fisher (WSJ Economics Blog),50 Bps and a Song... (Barry Ritholtz), Fed Cuts Fed Funds Rate 50bps (Calculated Risk), Another 50 basis points (William Polley), 50bp, Right on Schedule (Felix Salmon), Half Point Cut (Jeffrey Cane), Fed rate cut (Jim Hamilton)

"Expansionary Aggregate Demand Policies are Likely to Bring about a Period of Stagflation"

Guillermo Calvo responds to Larry Summers call to to move beyond monetary and fiscal stimulus and begin repairing the underlying problems in the financial system. While he agrees that the financial system needs to be strengthened, he does not have much faith in monetary and fiscal policy and believes their use will result in stagflation:

Guillermo Calvo, Economic Forum: I agree that we need "consistent, determined approaches" which will probably take us far beyond conventional monetary and fiscal policy. The main problem, however, is that we don't seem to have a consistent macro view that is widely agreed upon and is itself consistent with the stylized facts of the current crisis. Thus, for example, policy has strongly relied on lowering the reference interest rate, a policy that is typically justified in models that abstract from credit market difficulties. The same applies to fiscal expansion. This lack of intellectual consistency is bound to create further confusion. Thus, I would encourage Larry and the other high-profile commentators to give a simple but clear view of their underlying assumptions.

To be consistent with my preaching, let me say that I am of the view that the current subprime crisis is starting to look more and more like those in emerging markets. The big but somewhat superficial difference, however, is that initially the problem did not entail a whole country but a sector (and, incidentally, since a sector does not print its own money, its situation is similar to that in emerging markets which suffer from Liability Dollarization, or Original Sin). Since the subprime sector hit the global financial market, it had the potential to damage other sectors through contagion, much like it happened in emerging markets after the Russian August 1998 crisis. Thus, we are witnessing the effects of a "supply" shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve "stocks," while transitory fiscal policy involves "flows." Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry's thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.

"Why Don't Chimpanzees Like to Barter Commodities?"

Chimpanzees are reluctant to trade "a very good commodity (apple slices)" for "an even more preferred commodity (grapes)." This research attempts to explain why and in the process learn something about how barter might have arisen among humans:

Why don't chimpanzees like to barter commodities?, EurekAlert: For thousands of years, human beings have relied on commodity barter as an essential aspect of their lives. It is the behavior that allows specialized professions, as one individual gives up some of what he has reaped to exchange with another for something different. In this way, both individuals end up better off. Despite the importance of this behavior, little is known about how barter evolved and developed.

This study (published in PLoS ONE on January 30) is the first to examine the circumstances under which chimpanzees, our closest relatives, will exchange one inherently valuable commodity (an apple slice) for another (a grape), which is what early humans must have somehow learned to do. Economists believe that commodity barter is one of the most basic precursors to economic specialization, which we observe in humans but not in other primate species. First of all, the researchers found that chimpanzees often did not spontaneously barter food items, but needed to be trained to engage in commodity barter. Moreover, even after the chimpanzees had been trained to do barters with reliable human trading partners, they were reluctant to engage in extreme deals in which a very good commodity (apple slices) had to be sacrificed in order to get an even more preferred commodity (grapes).

Prior animal behavior studies have largely examined chimpanzees' willingness to trade tokens for valuable commodities. Tokens do not exist in nature, and lack inherent value, so a chimpanzee's willingness to trade a token for a valuable commodity, such as a grape, may say little about chimpanzee behavior outside the laboratory.

In a series of experiments, chimpanzees at two different facilities were given items of food and then offered the chance to exchange them for other food items. A collaboration of researchers ... found that the chimpanzees, once they were trained, were willing to barter food with humans, but if they could gain something significantly better – say, giving up carrots for much preferred grapes. Otherwise, they preferred to keep what they had.

The observed chimpanzee behavior could be reasonable because chimpanzees lack social systems to enforce deals and, as a society, punish an individual that cheats its trading partner by running off with both commodities. Also because of their lack of property ownership norms, chimpanzees in nature do not store property and thus would have little opportunity to trade commodities. Nevertheless, as prior research has demonstrated, they do possess highly active service economies. In their natural environment, only current possessions are "owned," and the threat of losing what one has is very high, so chimpanzees frequently possess nothing to trade.

"This reluctance to trade appears to be deeply ingrained in the chimpanzee psyche," said one of the lead authors, Sarah Brosnan ... at Georgia State University. "They're perfectly capable of barter, but they don't do so in a way which will maximize their outcomes."

The other lead author, Professor Mark F. Grady, Director of UCLA's Center for Law and Economics, commented: "I believe that chimpanzees are reluctant to barter commodities mainly because they lack effective ownership norms. These norms are especially costly to enforce, and for this species the game has evidently not been worth the candle. Fortunately, services can be protected without ownership norms, so chimpanzees can and do trade services with each other. As chimpanzee societies demonstrate, however, a service economy does not lead to the same degree of economic specialization that we observe among humans."

The research could additionally shed light on the instances in which humans also don't maximize their gains, Brosnan said.

links for 2008-01-30

Eric Rauchway: The Party of Stinkin'

What's behind the Republican's "inability to govern"? Do Democrats overreach?:

The Party of Stinkin', by Eric Rauchway, TNR: If the mixed results in the early Republican primaries--a Huckabee here, a McCain or Romney there--portends a split between the GOP's religious, fiscally conservative, and security-state wings, it won't be the first time a national American political coalition has failed. But it will be the third time in a hundred years an apparently strong Republican majority cracked up due to the party's inability to govern. By contrast, Democratic coalitions have failed mostly because the party has overreached after governing successes.

In the midst of an economic depression, the Republican Party assembled a presidential majority in 1896 for William McKinley and his conservative platform. McKinley won despite the revolt of many traditionally Republican western states, whose citizens believed the party's elite had grown too cozy with industrial and financial leaders, while leaving the stricken farmers of the heartland in the cold. ...

With McKinley, the Republican Party shifted away from its post-Civil War habit of bludgeoning the South, and McKinley ran as a candidate of sectional reconciliation. He wooed the South with symbolic gestures, like declaring that their soldiers had demonstrated "American valor" in battle... He wooed the West with promises of renewed prosperity under his tariff and monetary policies. And Roosevelt's subsequent presidency--he took 56% percent of the popular vote in 1904--appeared to show that the Republicans could campaign and govern as a truly national party.

But the seeming solidity of this coalition concealed real divisions, owing largely to the Republicans' unwillingness to give Westerners what they demanded. Out there in the new states, voters began agitating for and adopting democratic measures--women's suffrage; initiative, referendum, and recall; and ways to popularly elect Senators and presidential candidates. Mere national prosperity, unevenly spread as it was and almost never trickling down to farmers, wasn't going to satisfy them. They actually wanted to take part in the country's government and change it for themselves.

Roosevelt made the right noises in response to this stirring insurgency... But, since he was a Republican beholden to eastern industry, he could do little more than talk... As another student of Rooseveltiana more acutely mentioned, he was "the greatest concocter of 'weasel' paragraphs on record."

Roosevelt's successor, William Howard Taft, couldn't weasel charmingly enough for an electorate increasingly dissatisfied with Republican complacency. In 1910, the Democrats took the Congress.

Roosevelt tried to push his party back in his direction, and when that failed, he led a third-party movement in 1912 that put Woodrow Wilson into the White House, along with a Democratic House and Senate. [...continue reading...]

Update: Underbelly Buce comments.

January 30, 2008

Economist's View - 4 new articles

"Why Don't Chimpanzees Like to Barter Commodities?"

Chimpanzees are reluctant to trade "a very good commodity (apple slices)" for "an even more preferred commodity (grapes)." This research attempts to explain why and in the process learn something about how barter might have arisen among humans:

Why don't chimpanzees like to barter commodities?, EurekAlert: For thousands of years, human beings have relied on commodity barter as an essential aspect of their lives. It is the behavior that allows specialized professions, as one individual gives up some of what he has reaped to exchange with another for something different. In this way, both individuals end up better off. Despite the importance of this behavior, little is known about how barter evolved and developed.

This study (published in PLoS ONE on January 30) is the first to examine the circumstances under which chimpanzees, our closest relatives, will exchange one inherently valuable commodity (an apple slice) for another (a grape), which is what early humans must have somehow learned to do. Economists believe that commodity barter is one of the most basic precursors to economic specialization, which we observe in humans but not in other primate species. First of all, the researchers found that chimpanzees often did not spontaneously barter food items, but needed to be trained to engage in commodity barter. Moreover, even after the chimpanzees had been trained to do barters with reliable human trading partners, they were reluctant to engage in extreme deals in which a very good commodity (apple slices) had to be sacrificed in order to get an even more preferred commodity (grapes).

Prior animal behavior studies have largely examined chimpanzees' willingness to trade tokens for valuable commodities. Tokens do not exist in nature, and lack inherent value, so a chimpanzee's willingness to trade a token for a valuable commodity, such as a grape, may say little about chimpanzee behavior outside the laboratory.

In a series of experiments, chimpanzees at two different facilities were given items of food and then offered the chance to exchange them for other food items. A collaboration of researchers ... found that the chimpanzees, once they were trained, were willing to barter food with humans, but if they could gain something significantly better – say, giving up carrots for much preferred grapes. Otherwise, they preferred to keep what they had.

The observed chimpanzee behavior could be reasonable because chimpanzees lack social systems to enforce deals and, as a society, punish an individual that cheats its trading partner by running off with both commodities. Also because of their lack of property ownership norms, chimpanzees in nature do not store property and thus would have little opportunity to trade commodities. Nevertheless, as prior research has demonstrated, they do possess highly active service economies. In their natural environment, only current possessions are "owned," and the threat of losing what one has is very high, so chimpanzees frequently possess nothing to trade.

"This reluctance to trade appears to be deeply ingrained in the chimpanzee psyche," said one of the lead authors, Sarah Brosnan ... at Georgia State University. "They're perfectly capable of barter, but they don't do so in a way which will maximize their outcomes."

The other lead author, Professor Mark F. Grady, Director of UCLA's Center for Law and Economics, commented: "I believe that chimpanzees are reluctant to barter commodities mainly because they lack effective ownership norms. These norms are especially costly to enforce, and for this species the game has evidently not been worth the candle. Fortunately, services can be protected without ownership norms, so chimpanzees can and do trade services with each other. As chimpanzee societies demonstrate, however, a service economy does not lead to the same degree of economic specialization that we observe among humans."

The research could additionally shed light on the instances in which humans also don't maximize their gains, Brosnan said.

"The Three Trillion Dollar War"

Good question:

Keynesian trillions, Editorial, LA Times: President Bush['s]... final State of the Union speech made clear that he intends ... to ... spend whatever it takes to secure Iraq and Afghanistan -- and his legacy.

Threetrillion_2 While the president's speechwriters were tweaking his address Monday, the White House announced that Bush would ask for $70 billion more for the two wars this year. A Pentagon spokesman said combat operations were costing $12 billion a month, with $9.2 billion spent in Iraq. That's just for combat operations. Including replacing equipment that's being used up and providing medical care and disability benefits for the wounded, Iraq has already cost well over $1 trillion. Back in early 2006, when war spending was running about $5 billion a month, economists Joseph Stiglitz and Linda Bilmes were sharply criticized for a study that predicted the Iraq war would cost up to $2 trillion. Their sequel, to be released next month, is titled "The Three Trillion Dollar War."

The interesting question is why the U.S. economy, beneficiary since 9/11 of the largest military spending binge in history, now requires $150 billion more in the form of a short-term stimulus package. Why hasn't the $1 trillion in defense spending, in addition to the 2001 and 2003 tax cuts, been sufficient to keep the economic boom going? ... Does that mean the fundamentals of our economy are weaker than we thought, and a deeper slump might have occurred without all that spending? ...

The economist John Maynard Keynes taught us in the 1930s that money spent on guns -- or butter, or even digging ditches and filling them up again -- had the same stimulative effects on a slumping economy. We've developed a more nuanced view of government spending since then, but it's still worth asking: What would Keynes say about a $3-trillion war?

Update: Paul Krugman:

An Iraq recession?, Paul Krugman Blog: One thing I get asked fairly often is whether the Iraq war is responsible for our economic difficulties. The answer (with slight qualifications) is no.

Just to be clear: I yield to nobody in my outrage over the way we were lied into a disastrous, unnecessary war. But economics isn't a morality play, in which evil deeds are always punished and good deeds rewarded.

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we're spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

There is one caveat: high oil prices are a drag on the economy, and the war has some — but probably not too much — responsibility for pricey oil. Mainly high-priced oil is the result of rising demand from China and other emerging economies, colliding with sluggish supply as the world gradually runs out of the stuff. But Iraq would be exporting more oil now if we hadn't invaded — a million barrels a day? — and that would have kept prices down somewhat.

Overall, though, the story of America's economic difficulties is about the bursting housing bubble, not the war.

The Myth of the Rational Politician?

Robert Reich is not a big fan of using accelerated depreciation as a means of stimulating a lagging economy. Who wants to invest in more plants and equipment when the economic slowdown means you aren't even using all the plants and equipment you have now? Suppose that, due to an economic downturn, a trucking company that usually runs 100 trucks now has 15 sitting in the yard idle with the drivers at home waiting for the phone to ring. Will a cut in interest rates or a change in the depreciation rate allowed on taxes cause the firm to run out and buy more trucks? I can imagine reasons why you might want to jump on a great deal in such a situation and store up for the future, but generally you'd expect the response to be fairly small:

The Real Recession Problem: Consumers Are at the End of Their Ropes, by Robert Reich: Perhaps the silliest part of an already silly stimulus bill is a provision giving corporations big tax deductions this year on the costs of new machinery, instead of spreading those deductions over several years, as is normally the case. The idea is to get businesses to invest in more machinery, which will stimulate the economy.

But accelerated depreciation, as it's called, doesn't work. Almost the same tax break was enacted in 2002 and studies show just about no increase in business investment as a result. Why? Because companies won't invest in more machines when demand is dropping for the stuff the machines make. And right now, demand is dropping for just about everything.

This tax break exemplifies the illogic of what's called supply-side economics. If you reduce the cost of investing, so the thinking goes, you'll get more investment. What's left out is the demand side of the equation. Without consumers who want to buy a product, there's no point in making it, regardless of how many tax breaks go into it.

Which gets us to the real problem. Most consumers are at the end of their ropes and can't buy more. Real incomes are no higher than they were in 2000... And home values are dropping... Supply-siders who want to cut taxes on corporations and the rich just don't get it. Neither does most of official Washington. ...

The "political tax" on the stimulus bill, i.e. the things in the bill that make it less than fully effective but are necessary to ensure its passage, appears to be high due to the need to produce legislation quickly. I hope the less than optimal bill that has been produced does not come from politicians holding the stimulus package hostage and knowingly reducing its impact in order to pursue ideological goals. It could be that, but if it's not, then what is it?

Maybe it's "the myth of the rational politician", i.e. politicians who are so uninformed about economics that they truly believe the policies they are insisting be part of the stimulus package will help put people back to work. I know I care about this more than most, but that's why it's necessary to talk about things other than haircuts and laughs, why it's necessary to listen when a politician keeps insisting that tax cuts can pay for themselves, or spouts other such nonsense along the campaign trail or after they are in office.

There are times when it actually matters if politicians understand the basics of economics, and now could well be one of them. Yet most of what passes for information on this topic amounts to reporters asking questions, then nodding their heads at whatever answer the candidate gives - whether it makes sense or not - before moving on to the next question on the list. Sometimes I wonder if the reporters are even listening to the answer, and if they are, if they know enough themselves to follow up effectively.

We can reduce the "political tax" on fiscal policy, but it will require, for one, that the media let the public know when political games or ignorance of basic economics is causing the government to under perform and produce legislation that is less than fully effective. We've had enough government under performance in recent years, failures to serve people in need, but it hasn't always been like that, and it doesn't have to continue.

links for 2008-01-29

January 29, 2008

Economist's View - 5 new articles

"A Helpful Suggestion for the Fed"

Willem Buiter:

A helpful suggestion for the Fed, by Willem Buiter: It is now clear beyond a reasonable doubt that the Fed wants to prevent sudden sharp drops in the stock market. ... I propose that the Fed put its money where its heart is by engaging in outright open market purchases of US stocks and shares.

By intervening through the purchase of the most broadly-based value-weighted index of US stocks, e.g. the Wilshire 5000 Total Market Index, any unlevelling of the playing field between listed stocks can be avoided. I would prefer the Fed to acquire only non-voting shares, or to put any shares it acquires in a blind trust... On January 25 the Wilshire 5000 index stood at 13,423.62. The 52-week peak was on October 7, 2007 at 15,806.69. Let's split the difference and request the Fed to put a floor below the Wilshire 5000 at, say, 14,500.00. ...

What I propose is effectively the same as the Fed attaching a free put option to every equity share in a US-registered and-listed enterprise. It would put paid forever to all those jokes about the Greenspan put and the Bernanke put.

Let's do it!

Barry Ritholtz also has a letter to Ben. My view hasn't changed and is similar to Mark Gertler's. Update: Another view:

Ben Bernanke under fire, Times Online: ...Robert Shiller ... told The Times yesterday that Paul Volcker, the Fed's chairman during the Carter and Reagan administrations, would have made a better job of spotting the consequences of the housing recession and credit turmoil on the American economy than Mr Bernanke. ...

Paul Krugman: Lessons of 1992

There are lessons to be learned from Bill Clinton's 1992 presidential campaign and what happened after he was elected:

Lessons of 1992, by Paul Krugman, Commentary, NY Times: It's starting to feel a bit like 1992 again. A Bush is in the White House, the economy is a mess, and there's a candidate who, in the view of a number of observers, is running on a message of hope, of moving past partisan differences, that resembles Bill Clinton's campaign 16 years ago.

Now, I'm not sure that's a fair characterization of the 1992 Clinton campaign... Still, to the extent that Barack Obama 2008 does sound like Bill Clinton 1992, here's my question: Has everyone forgotten what happened after the 1992 election?

Let's review the sad tale...

Whatever hopes people ... had that Mr. Clinton would usher in a new era of national unity were quickly dashed. Within just a few months the country was wracked by the bitter partisanship Mr. Obama has decried...

No accusation was considered too outlandish: a group supported by Jerry Falwell put out a film suggesting that the Clintons had arranged for the murder of an associate, and The Wall Street Journal's editorial page repeatedly hinted that Bill Clinton might have been in cahoots with a drug smuggler.

So what good did Mr. Clinton's message of inclusiveness do him?

Meanwhile,... Mr. Clinton ... did avoid some conflict by being strategically vague about policy. In particular, he promised health care reform, but left the business of producing an actual plan until after the election.

This turned out to be a disaster... Mr. Clinton didn't deliver legislation to Congress until Nov. 20, 1993 — by which time the momentum from his electoral victory had evaporated, and opponents had had plenty of time to organize against him.

The failure of health care reform, in turn, doomed the Clinton presidency to second-rank status. The government was well run (something we've learned to appreciate...), but — as Mr. Obama correctly says — there was no change in the country's fundamental trajectory.

So what are the lessons for today's Democrats? First, those who don't want to nominate Hillary Clinton because they don't want to return to the nastiness of the 1990s ... are deluding themselves. Any Democrat who makes it to the White House can expect the same treatment: an unending procession of wild charges and fake scandals, dutifully given credence by major media organizations...

The point is that while there are valid reasons one might support Mr. Obama over Mrs. Clinton, the desire to avoid unpleasantness isn't one of them.

Second, the policy proposals candidates run on matter. I have colleagues who tell me that Mr. Obama's rejection of health insurance mandates —...an essential element of any workable plan...— doesn't really matter, because by the time health care reform gets through Congress it will be very different from the president's initial proposal anyway. But this misses the lesson of the Clinton failure: if the next president doesn't arrive with a plan that is broadly workable..., by the time the thing gets fixed the window of opportunity may well have passed.

My sense is that the fight for the Democratic nomination has gotten terribly off track. The blame is widely shared. Yes, Bill Clinton has been somewhat boorish (though I can't make sense of the claims that he's somehow breaking unwritten rules, which seem to have been newly created for the occasion). But many Obama supporters also seem far too ready to demonize their opponents.

What the Democrats should do is get back to talking about issues ... and about who is best prepared to push their agenda forward. Otherwise, even if a Democrat wins the general election, it will be 1992 all over again. And that would be a bad thing.

The New Laffer Curve Logic and the Lack of Evidence for It

After being shown again and again that tax cuts don't increase revenues, those who make the Laffer curve argument stopped making the claim generally and shifted the argument to say that while it may not be true across the board, there is evidence that it is true for the very top rates. Now, as Lane Kenworthy discusses below, the argument has shifted again. But even after all of this reformulation of the argument to try and make it work somehow, somewhere, the evidence is still pretty shaky:

The New Laffer Curve Logic, by Lane Kenworthy: "When you cut the highest tax rates on the highest-income earners, government gets more money from them."

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled "The Tax Threat to Prosperity" (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original "Laffer curve" argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The "supply-side" problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the amount of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here. This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via "tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures." When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households' incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let's consider them in turn.

1. Tax reform in 1981 reduced the top marginal rate from 70% to 50% beginning in 1982. Few exemptions and loopholes were closed. The fact that the effective income tax rate on the top 1% of households fell only slightly in the ensuing years appears to support Laffer's argument.

But there are two important qualifications. First, the drop in the top marginal rate is misleading. As Eugene Steurle points out in his book, Contemporary U.S. Tax Policy, "Even before 1981, high-income individuals often avoided a top tax rate of 70 percent through a special provision of the tax code that limited the tax rate on earnings, or income from labor, to a maximum of 50 percent." Furthermore, in 1982, 1983, and 1984 additional tax reforms were enacted that reduced loopholes and enhanced tax compliance and collection via expanded reporting requirements and heightened penalties.

2. Tax reform in 1986 reduced the top marginal rate from 50% to 39% in 1987 and 28% beginning in 1988. The effective rate on the top 1% actually increased slightly in the following years. This, however, is fully explained by the fact that the 1986 reform dramatically reduced loopholes and exemptions. This wasn't a case of high-income households deciding to hide less of their income because the top marginal tax rate had been lowered. They had no choice.

3. Tax reform in 1993 raised the top marginal rate from 31% to 40%. The effective rate on the top 1% increased from 21% in 1992 to 24% in the latter part of the decade. Did the hike in the marginal rate of 9 percentage points encourage tax avoidance? Possibly, but if tax avoidance increased, it was more likely due to the massive rise in incomes among the top 1% that occurred in the second half of the 1990s. The next chart shows this. Average pretax income in this group nearly doubled between 1993 and 2000, soaring from $750,000 to $1,450,000.

4. Tax reform in the early 2000s reduced the top marginal rate by four percentage points, from 39% in 2002 to 35% in 2003. In this case the effective rate on the top 1% of households fell by exactly the same amount, from 24% in 2002 to 20% in 2003.

None of this is to suggest that tax avoidance doesn't occur or isn't worth worrying about. Far from it. But the notion that lowering the top marginal tax rate dramatically reduces such avoidance appears to be wishful thinking.

Update: See also Do capital gains tax cuts increase revenues?, by Justin Fox.

Fed Watch: Sometimes It Is the Path, Not the Destination

Tim Duy tries to figure out what the Fed and the economy will do next. All I can say is good luck:

Sometimes It Is the Path, Not the Destination, by Tim Duy: I spent much time this weekend – as is often the case – considering the path of economic activity over the next year, as well as the Fed's role in defining that path. The Fed has come under widespread criticism for a seemingly awkward communication strategy that culminated with last week's surprise rate cut. I think the last rate cut had the unfortunate appearance of a panicked effort to prop up equity markets. That said, I think the criticism is likely too severe – it is easier to be bitter with the Fed than to admit you just weren't reading the situation correctly.

Of course, it is likely the Fed was not reading the situation correctly as well. But what part of the forecast was in error? We have heard repeatedly of Fed expectations that the economic downturn would be largely limited to the first half of 2008, followed by a gradual reacceleration to trend growth, albeit the anemic trend of roughly 2.5%. We do not yet know that this forecast is fundamentally in error. Indeed, I have argued in the past that it is consistent with the story told by a one-year ahead forecast derived from the yield curve, specifically the 10-2 spread:

Duy1

Looking at the more recent history more closely:

Duy2

The depth of the inversion of the yield curve in November 2006 signaled a 50% percent chance of recession in November 2007 – remarkably accurate, in retrospect. But this is where the path vs. the destination becomes important. In December of 2006, I told a business group that the then current recession hysteria would be short lived, but would return at the end of 2007. I, however, didn't fully know the path to that point – I said it would likely reflect the washing out of the housing market. For that particular group, I don't think the path was particularly important. For financial markets, both the destination and the path are important. The permabears, who were aggressively predicting a recession in early 2007, largely had the path right (financial market meltdown stemming from a faltering housing market), but were a year ahead on the timing.

The steepening of the yield curve signaled by the middle of 2007 that the risks of recession would be dropping dramatically by the middle of 2008. Interestingly, this fit nicely with the Fed's forecast of late last year. The Fed could see the destination – the other side of the downturn, and this was able to make statements such as that of the October 30/31 meeting:

Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

The problem, however, is again the issue of the path to the destination. We can assume that Fed forecasts were largely based on a "constant policy" assumption. They saw the destination, but misjudged the path – the steepening in the yield curve was signaling that the Fed had a significant role in leading the economy to that destination. And that role was aggressive rate cutting (not academic tinkering with the discount rate), rather than holding policy constant. The Fed was trying to focus market participants on the medium term outlook, market participants were telling the Fed they need to do something more to ensure that outcome. Needless to say, confusion reigned.

Is the Fed's forecast still viable? I think so. The yield curve is a good predictor of economic activity – note how the permabears no longer discuss the yield curve; it no longer fits in their paradigm. But I see the path unfolding over the first half of this year. The aggressive rate cutting by the Fed is forcing central banks around the world to continue and even accelerate their purchases of dollar denominated assets, especially those that limit or prevent the appreciation of their currencies. This supports a capital inflow to the US to offset the collapse in the asset backed commercial paper markets and keeping the US financial markets more liquid than they would be otherwise (Brad Setser continues to repeatedly educate us on this topic. See here and here.) The general tendency toward lower rates across the yield curve tends to have a stimulative effect – eventually, mortgage rates drop low enough to help some homeowners. Not all of us are underwater, and could benefit from refinancing.

The US government further supports this process with a temporary stimulus package, issuing debt that foreign central banks are forced to buy, turning the proceeds over to consumers, many of whom are sure to boost spending. Those economies that choose to hold monetary policy constant, such as the European Central Bank, support the US economy by allowing their currencies to appreciate against the dollar, internalizing the US weakness.

All of these stimulating forces are coming to bear over the next six months. But will they be lasting effects? It depends on what you define as "lasting." This story is one in which strong economic growth in the US depends critically on a sustained capital inflow. Capital inflows supported the tech bubble. When that story ended, a few years of subpar growth occurred until capital inflows could find a fresh asset bubble, housing. Where will the next bubble be? Will it even be in the US? Without that consistent, and growing inflow, I suspect the US will suffer a protracted period of subpar activity as the economy is weaned from reliance on foreign production. Or a steady stream of "temporary" stimulus packages forced upon global central banks for financing, until the world is finally saturated in dollar denominated assets. Or a steady stream of monetary easing? Or…? This is something I am still thinking about.

Bottom Line: The amount of stimulus, largely monetary, but also fiscal, coming on line in the next six months suggests that the worst part of the downturn will be relatively short lived, limited to the first half of this year. But the other side of the downturn is likely to be anemic, similar to the wake of the 2001 recession. Lasting growth of the kind we are accustomed to, I fear, depends on capital inflows to support a fresh US asset bubble.

Postscript: Obviously there is a Fed meeting this week. Market participants are expecting 25 or 50bp, most likely the latter. I see that as the most likely result, especially since it is clear that the Fed deems the health of the equity markets as critical (note, this fits into the above story, as a weaker dollar will entice foreign capital into the equity markets - the foreign currency price is lower - as long as equities are not set for a precipitous drop). But, every call is something of a toss-up right now.

Post-postscript: I just realized that if I follow the argument through, my opening statement about the Fed's cut last week merely having the appearance of an effort to prop up equity markets is overly charitable. Perhaps it was simply a straight forward effort to prop up the equity markets to keep foreign players in the game.

Another postscript: It occurs to me that the US is doing the opposite of everything it advised in the Asian Financial Crisis.

Am I currently placing too much weight on the importance of capital inflows? Feel free to comment.

[Tim starts with "I spent much time this weekend ... considering the path of economic activity..." Here's something else Tim did this weekend. This is what happens to Fed watchers when economic conditions get like they are now. Tim is on the left.]

links for 2008-01-28

January 27, 2008

Economist's View - 5 new articles

Lawrence Summers: Beyond Fiscal Stimulus

Larry Summers says now that we have the ball rolling on fiscal policy (if only barely so), and interest rate cuts are in place, the time has come to take the next steps and begin to repair the financial system, to begin containing the damage caused by the housing sector, and to begin work on global coordination of policy. This addresses the first of these steps, repairing the financial system:

Beyond fiscal stimulus, further action is needed, by Lawrence Summers, Commentary, Financial Times: Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession... The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty... It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further...

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macroeconomic stimulus..., there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives...

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan's did in the 1990s. ...

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. ... A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. ...

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. ... It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. ...

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett's recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

Normal economic performance will not return without a return to normality in the credit markets. The fear that pervades the markets will not abate of its own accord, nor is there a silver bullet. But consistent, determined approaches to doing what is needed to resolve each of the problems that arise will, in the end, re-establish confidence.

Martin Feldstein: The Stimulus Package is Not about Long-Term Growth

Martin Feldstein discusses the ability of monetary policy to impact the economy when there are problems in the financial and housing sectors, and the relationship between stimulus to aggregate demand and long-run growth (yesterday's post discussing Andrew Samwick's commentary comes to the same conclusion as Feldstein on whether aggregate demand changes can impact long-run growth):

Seven Questions: Martin Feldstein on the "R" Word, Foreign Policy: Foreign Policy: Everyone is anxiously discussing the possibility that the U.S. economy is in a recession or that it will be soon. You wrote in December that the probability of a recession in 2008 has now reached 50 percent. Where do you stand now?

Martin Feldstein: Well, I think it's higher. ...

FP: And how bad do you think it could get?

MF: It could get worse than the typical recession because the usual channels for turning something like this around through monetary policy are going to be less effective now due to the problems of the credit markets. The housing decline is really very serious this time. You put those two together, and I think we could end up with something that's deeper and longer than has traditionally been true. But it depends on the Fed, the White House, and Congress doing something to either prevent or dampen the magnitude of a downturn...

FP: U.S. President George W. Bush has proposed a roughly $140 billion stimulus package that centers on one-time tax rebates. But George Mason University economist Russell Roberts says the very idea of an economic stimulus package is "like taking a bucket of water from the deep end of a pool and dumping it into the shallow end." As he put it, "If you can make the economy grow, why wait for bad times?" So, is the idea of a stimulus package just political theater, or do you expect it to really help?

MF: I do expect it to help, but let me be clear about why it's not like moving water from one end of the pool to the other, or more accurately, why it is not a way of making the economy grow under all circumstances. If the economy is fully employed and growing at a normal pace, 3.5 percent, with unemployment under 5 percent and no expectation of a downturn, then aggregate demand is not the problem. Then, the only way to get the economy to grow more is to have more investment in capital equipment, people working harder, more innovation, and so on. And you can't do that by simply giving money back to taxpayers to spend more. So, the "spend more" approach to increasing economic activity is not about long-term growth. What it's about is offsetting the risk of an economic downturn. ...

Repeating from yesterday, which was in large part a follow-up to comments on the Landsburg article about fiscal policy:

I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. ... Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path... Stabilization policy ... changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help.

Restoring Confidence in Financial Markets

Robert Shiller says it's time to to update financial regulation to fit the modern financial world:

To Build Confidence, Try Better Bricks, by Robert Shiller, Economic View Commentary, NY Times: The key to maintaining economic stability is well-placed confidence in the markets. Bubbles, by contrast, result from misplaced confidence.

We are living in a post-bubble world, following the stock market bubble of the 1990s and the real estate bubble of the 2000s. ... We need to restore confidence in the markets' basic ability to function, not in their presumed tendency to make us all rich by always going up...

One main response to the Depression that helped prevent another from occurring was a set of tools that improved confidence by truly improving market security. One of these was the Federal Deposit Insurance Corporation, in 1933, but there were also a large number of others, especially the Securities and Exchange Commission the next year.

These were not obvious innovations and, in fact, were highly controversial at the time. Indeed, it is never obvious how the government should foster well-functioning markets. The fundamental role of governments in promoting markets is clear, but the design of their instruments must make creative use of a great deal of information about financial theory, human psychology and existing institutions and practices. The successful markets we have are a result of considerable inventive effort.

The F.D.I.C. was controversial because it was established amid the ruins of various state-level deposit insurance plans that had just gone bankrupt. Critics at the time also argued that federal deposit insurance would encourage unsound banking. But it turns out that the F.D.I.C. was a very good idea. It restored confidence in the banking system during the Depression, and with hardly any cost.

The S.E.C. was similarly controversial. Critics said it would hamstring or straitjacket the markets. But it is now the model for securities regulation around the world.

We need ... to set up a national study commission and to pay for serious creative research on how to adapt important ideas, like deposit insurance and securities regulation, to a modern financial world. ...

The ... problems ... need urgent attention. The very fact that many people feel they can no longer rely on some of our financial institutions may bring a self-fulfilling prophecy, which could then fundamentally harm economic activity.

The mortgage market is suffering. ... The commercial paper market is suffering, too. ... Other credit markets are also having problems...

Confidence in our brokerage firms is suffering. With every announcement of major losses, some people start to wonder whether they can rely on these companies.

Improvements in the deposit insurance system... [are needed. The] very least we can do is to raise the F.D.I.C.'s limits on insured deposits. The limit of $5,000 in 1934 was 12 years' worth of per capita personal income at the time. The limit was last raised in 1980, to $100,000, which was then 10 years' income. But because of inflation and economic growth, that limit is less than three years' income today. ... We have allowed deposit insurance to go three-quarters of the way to extinction.

The insurance limits of the Securities Investor Protection Corporation, which protects customers when brokerage firms fail, were also last raised in 1980 — to $100,000 in cash accounts and $500,000 in securities — and thus have suffered an equally drastic erosion in real value. Such erosion could suddenly matter if the crisis, or even just the psychology of the crisis, were to worsen.

But far beyond this, at a time when so many problems have arisen outside the limits of existing federal insurance programs, we need to do more than update the programs for inflation. We need to consider the fundamental principles on which they were based, stress-test them for today's environment and consider extending them in creative ways.

Is Unity the Answer?

Ezra Klein on calls for unity:

Unity isn't all it's cracked up to be, by Ezra Klein, Commentary, LA Times: ...I've got unity fatigue. That seems to be one of the chief buzzwords of this election. Unity. Barack Obama invokes it more frequently than John Edwards mentions "mills." My in-box, meanwhile, has only recently recovered from the torrent of messages sent by "Unity '08,"...

What accounts for all this talk of unity and bipartisanship and non-ideological problem solving? ... The short answer is that the candidates have no other choice. Washington these days is rived by partisanship, but that's not necessarily anything new or even particularly worrisome. In Washington, partisanship is like the San Francisco fog; it rolls in, hangs out for a while, and everyone goes about their business. The problem is, in this case, it's created total, impenetrable gridlock.

So, though elections are usually about what is to be done, this campaign has been unusually focused on whether it is in fact possible to get anything done. ...

The problem is that hearing all these presidential hopefuls pledge to end gridlock is a bit like having a friend promise to fix my toilet by checking under the hood of my car. Analytically, it's misguided. Now, ... candidates have to over-promise, so let's grant that they may not believe all their own hype. But at the same time, we shouldn't ignore the essential incoherence at the heart of these arguments:

Gridlock is not something the president of the United States can solve. Political gridlock begins in the U.S. Senate, but we keep trying to end it in the White House. There is no potential executive in either party who would not like to manifest his or her agenda by sheer force of will. But in reality, ... you don't get a doctor's note exempting you from the legislative process just because you ran, or even govern, as an independent. If you don't believe me, ask Arnold Schwarzenegger, the classic post-partisan unifier who couldn't attract a single Republican vote for his centrist health plan when it went before the Assembly.

Gridlock isn't a mystery. ... It's a function of the rules of the Senate, where 40 senators can refuse to end debate on legislation and thus doom its chances of passage. ...

This is the power of the filibuster, and it used to be a rarely invoked power, as the culture of the Senate prized compromise and consensus. In the 1977-78 congressional term, for instance, there were only 13 filibusters. Ten years later, there were 43. Ten years after that, there were 53. The Democrats used the tactic plenty when they were in the opposition a couple of years ago, but now that they're in power, it is the Republicans who are having a filibuster party. If they maintain their current pace, they'll have filibustered a full 134 times this term, more than doubling any other year on record. It's obstructionism on a truly historic scale.

Add to that obstructionist minority a divided government (the White House controlled by one party, Congress by another), the tensions of an ongoing war and a lame-duck president with no chosen successor and thus little concern for his plummeting popularity, and you have a moment that laughs at legislative progress. That's why the presidential campaign has become so focused on "getting things done."

But it's not up to the president. There are a variety of fixes for a filibuster-happy minority. The media, for example, could start accurately reporting the cause of the gridlock, shaming the relevant senators and increasing political pressure to compromise. The voters could eject politicians who refuse to compromise, laying down an electorally enforced preference for a functioning government. The Senate majority could change the rules, essentially eliminating the filibuster. ...

But the president can't do this, not on his or her own. Unity means nothing in the face of obstructionism, and problems can't be solved if legislators refuse to solve them.

links for 2008-01-27